Will The U.S. Economy Pull Off a ‘Soft Landing'?
Paul Krugman
Covid-19 initially dealt a heavy blow to the U.S. economic system. Between February and April 2020, the U.S. economy lost 22 million jobs. Many analysts were concerned that the pandemic could leave "lasting scars" in the form reduced employment, decreased output and more.
Currently, total employment as well as the percentage of adults working are in line with the projections made prior to the pandemic.
The same goes for the workforce...
G.D.P.
Most economic indicators are not scarred at all.
Inflation, which was tame for many decades, soared to levels last seen in the 1980s by 2021-22. Although it has dropped from its peak, the inflation rate is still higher than what we have come to expect. Policymakers have made it a priority to bring inflation down.
How hard will the disinflation hit? Will it cause the same pain as the brutal interest rate decisions made by the Fed in the early 80s? Can we have a "soft landing" as many people say?
This article will explain why some economists, based on past experience, believe we won't have the ability to bring inflation down without putting millions of people out of work. Others, however, do not believe this is a reliable guide and argue that a relatively painless deflation is achievable. I will also explain that even if smooth deflation is possible without a major economic recession, there are still major risks of policy overshooting or undershooting, which could lead to an unnecessary recession, or inflation not being controlled any time soon.
I am in the camp of economists who believe that bringing down inflation doesn't need to be expensive, but you shouldn't listen to any economist who is overconfident on this subject. But I am very concerned about sticking to the plan in the face huge uncertainty regarding the current state the economy and possible future shocks such as debt default or Covid dislocations. Are interest rate increases causing a bank crises?
It is not my goal to convince you that I am right, but to provide you with a general sense of what's going on and how the debate has developed.
Let's start by asking what we mean when we talk about a "soft landing".
The gray, the soft and the hard
There is no standard definition for a soft economic landing. Most economists, I believe, would consider it a "soft landing" if inflation is brought down to a reasonable level without an increase in unemployment.
What is an acceptable rate of inflation? What is a significant increase in unemployment?
Consider the 1988 Presidential Election. George H.W. Bush won by a wide margin mainly because voters had an extremely positive view of Reagan's economy. In November 1988, the unemployment rate was nearly two percentage points higher. The inflation rate was also similar to the recent months.
Why can't we declare victory now? In the 1990s, the Federal Reserve, along with its counterparts from other wealthy countries, came to the consensus that 2 percent was the right inflation target, and not the 4 percent in the late Reagan years. This consensus has a weak empirical and analytical basis, but central banks have come to see it as a test for their credibility.
Even 4 percent inflation can be a shock, and a sudden source of anxiety after years when inflation was so low that people did not think about it. Low inflation can be beneficial because it allows people to conserve mental energy by not worrying about future prices.
Previously, policymakers believed that a rate of unemployment below 4 percent would be impossible to achieve without accelerating inflation. They were wrong. In late 2010, unemployment dropped into the threes without increasing inflation.
At this point, policymakers should be able to achieve results which would have been unthinkable for the majority of the last 40 years. For example, 2 percent inflation with unemployment around the mid-3s.
How far must we fall short to declare that the soft landing attempt failed? Larry Summers, an economist at the University of California-Berkeley, stated in June that a 7.5 percent unemployment rate for two years would be required to control inflation. This would certainly be a "hard landing". Jason Furman, Mohamed El-Erian and other economists have said that the inflation rate could remain at or above 4% for a very long time. Furman refers to this as a 'no-landing' scenario.
Less extreme outcomes could fall into a grey area. What if the unemployment rate only rises to 4 and a half percent? What if inflation is around 3 percent but unemployment remains low, as Joseph Gagnon has suggested?
We'll end up fighting over definitions in any of these situations.
Why worry about a 'hard landing'? Two reasons are at play. Inflation may be hard to slow down because of its inertia. The tools that we use to control inflation tend to be blunt and imprecise. This makes it more likely that we will get the result wrong.
Problem of Inertia
People invoke the 1970s whenever inflation is a problem. It is generally believed that a combination of bad fortune (wars and revolutions across the Middle East), and bad policy (printing excessive amounts of money and ignoring inflation warning signs) led to inflation becoming 'entrenched in the economy'. It was very expensive to remove this entrenched inflation.
What is meant by entrenched inflation? Prices of some commodities, such as oil or soybeans, (or international shipping), fluctuate continuously. Most wages and many prices are only revised at regular intervals. For example, an employer may give its employees contracts that determine their salary for the following year. These price revisions also aren't coordinated. Some wages and prices will be reset in any given month. However, most of them will already have been determined.
In times of sustained inflation, this can lead to a situation where many players in the economy are playing a game called leapfrog. They will raise their prices every time they reset them, even when demand for their product is low. This is partly so they can catch up to the price increases of other players since their last price reset, and partly so that they can get ahead of any future price hikes from their competitors and suppliers. Inflation becomes self-sustaining, unless there is a break in the cycle.
In order to break this cycle, you could impose price controls - simply tell businesses to stop raising prices - or, if a society is sufficiently cohesive, get all major players to agree on a standstill. Israel achieved a significant fall in inflation by a relatively low-cost method in 1985. It did this by getting the major unions to sign a pact that enforced wage and price restrictions.
1971, the price controls caused shortages that led to a collapse of the economy.
12.1%
7.2%
Second Freeze
Unemployment
5.9%
Inflation
5.3%
Price and wage freeze
Jan.
1971
Dec.
1974
12.1%
7.2%
Second
Freeze
Unemployment
5.9%
Inflation
5.3%
Price and wage freeze
Jan.
1971
Dec.
1974
Bureau of Labor Statistics
Viktor Orban, yes, the darling American right, tried to suppress the inflation last year with selective price controls. His effort failed and Hungary now has the highest rate of inflation in the European Union.
What happens if policymakers are unable to negotiate or legislate down inflation? It is a tried and true method to weaken an economy by using contractionary measures, such as tax increases, spending cuts, or higher interest rates, to reduce overall spending. Businesses will increase prices and wages slowly if there is less demand for their product. As they watch other businesses do the same, inflation will gradually decrease.
This approach definitely works. In fact, it is how inflation in the 1970s came under control. It can be extremely costly because companies may have to lay off employees due to a weaker economy before the inflation rate is acceptable.
The 1980s are a good example of this. The inflation rate dropped from 10 percent to 4 percent by the time Bush the elder was elected. Along the way, unemployment soared and didn't return to 1979 levels until 1987. This graphic shows the costs.
Inflation peaks
'Excess' unemployment
Inflation
9.3%
5.7%
Unemployment
5.9%
4.3%
Jan.
1979
Dec.
1987
Inflation peaks
'Excess' unemployment
Inflation
9.3%
5.7%
Unemployment
5.9%
4.3%
Jan.
1979
Dec.
1987
Inflation peaks
'Excess' unemployment
Inflation
9.3%
5.7%
Unemployment
5.9%
4.3%
Jan.
1979
Dec.
1987
Bureau of Labor Statistics
The shaded area represents the excess of unemployment over 1979. In jargon, one 'point-year of unemployment' is one percentage-point of excess unemployment over one year. The disinflation in the 1980s was estimated to cost 15 point years. Larry Summers argued last year that this time disinflation might be comparable to the 1980s. His horrifying pronouncements on how much unemployment will be needed are the result.
Two counterarguments exist. The first is that the inflation rate in 2023 will not be as firmly entrenched as it was at the beginning of the 1980s deflation. The expectation was high inflation in the near future. These expectations are reflected in the wage agreements major employers made with unions. On average, the new contracts provided a 9.8 percent increase in wages in the first year of the contract and a 7.9 percent annual wage hike over the course of the contract. These companies would not have done that unless there was a rapid rise in the cost of living as well as the wages paid by their competitors.
Private-sector labor unions are almost nonexistent today. Surveys show that workers and businesses both expect to see their earnings grow by around 3 percent in the coming year.
Another reason to doubt analogies to the 1980s is the possibility that the economy could be cooled without large job losses. Some economists believe that other indicators, such as the number of unfilled jobs and the rate workers quit their jobs are more accurate indicators of an economic overheat than the unemployment rate. Both measures are high, but they have both declined significantly over the last year without an increase in unemployment.
What do the numbers say? The data show that, despite the fact unemployment has not (yet?) The inflation rate is still far below its peak, despite the fact that unemployment hasn't (yet?)
Unemployment is at a peak
Inflation peaks
Nearly 9%
4.9%
Unemployment
3.5%
3.4%
Inflation
2.5%
Unemployment
It seems to be stable
Jan.
2020
April
2023
Unemployment is at a peak
Inflation peaks
Nearly 9%
4.9%
Unemployment
3.5%
Inflation
2.5%
3.4%
Unemployment
It seems to be stable
Jan.
2020
April
2023
Bureau of Labor Statistics
One could argue that, on the other hand - and this is a tricky concept - 'underlying inflation' (which has moved sideways for the last few quarters rather than downward) has actually been going up. While measures of underlying prices are lower than in early 2022 it is not clear if they have decreased since last November.
Why could inflation be so high? Why might inflation still be high?
Even if the inflation rate is going sideways, rather than downward, it's enough to dispel some of the extreme hard-landing stories. Summers's claim, that we need a period of 7.5 percent joblessness, was partly based on the belief that the unemployment rate needed to reach 5 percent to maintain inflation stability, which at this point doesn't seem plausible. We don't yet know how difficult it will be for inflation to reach the last two percentage points. In the coming months, I think we'll have more information. But I have been saying this for months and the inflation figures continue to offer support to both pessimists and optimists.
Let's say, just for argument's sake, that you believe that a large increase in unemployment is not necessary to curb inflation. This is not a guarantee that unemployment will remain high.
The Fool in the Shower
At least in the short-term, policymakers have a great deal of power over the economy. David and Christina Romer conducted a famous study to examine Federal Reserve minutes in order to identify instances where the Fed intentionally tried to slow down the economy or accelerate it. The Fed got what it wanted.
Power is not the same thing as precision. It is easy for the Fed to achieve its short-term rate targets, and thus manage the economy. Imagine that the Fed increases its target interest rate by a percentage point. Other things being equal, this will lead to less job openings and lower inflation, as well as a possible rise in unemployment. How big will the effects be? Nobody knows for sure.
Fed officials, you will be relieved to know, what they say.