In this post, Stone Center Senior Scholar Paul Krugman discusses how the U.S. economy achieved disinflation without a recession, and what that means for important policy questions.
By Paul Krugman
Large numbers of Americans have already voted, although many more will wait until election day. Either way, many will vote in the belief that the U.S. economy has performed badly under the Biden-Harris administration, and that Trump would do better.
It’s a painful spectacle, since the economy has in fact done remarkably well — a recent article in The Economist calls it “glorious.” Many economists expected Covid-19 to inflict long-term “scarring” on the economy; instead, as Figure 1 shows, real GDP is now well above pre-pandemic projections:
Figure 1: A glorious economy
And while inflation did shoot up in 2021–22, the latest GDP report confirms that we’ve achieved a soft landing: inflation is now more or less back to the Fed’s 2 percent target, and it got there without the recession many economists — especially but not only Larry Summers — insisted would be necessary. Figure 2 is one picture that I find useful, comparing the annual rate of PCE inflation with prime-age employment since the beginning of 2021:
Figure 2: The eagle has soft landed
Let’s leave aside the question of why Americans are so negative about what has, objectively, been a remarkable success story. What I want to do instead is ask what went right. How did we pull this off?
The thing is, there are really two distinct stories out there, which often get blurred together (as they do, for example, in the latest IMF World Economic Outlook.) They bear a conceptual family resemblance, but they have quite different implications for some important questions. First, could that burst in inflation have been avoided (and, relatedly, was Bidenomics good or bad)? Second, should the Fed get credit for bringing inflation down, or was disinflation simply the economy healing from pandemic disruptions?
The two stories I have in mind are (a) a nonlinear Phillips curve and (b) what’s sometimes called transitory inflation or, because it took years to play out, Long Transitory (a term I think I coined, by analogy with Long Covid.) It might be better, however, to call the second story “sectoral shocks.” I illustrate these stories in Figure 3 and 4, which need some explaining. I personally flirted with story (a) but now mostly believe in story (b).
The nonlinear Phillips curve story is laid out in some detail by Eggertsson and Benigno, in their paper for Jackson Hole. They generally put aggregate output on the horizontal axis; I use employment in Figure 3, but it’s much the same. The basic idea is that there’s a fairly flat relationship between how hot the economy is running and the inflation rate as long as the economy isn’t running too hot. But when you reach the point of labor shortage, the relationship gets much steeper. According to this story, expansionary fiscal policy in the wake of the pandemic pushed us into this steep part of the curve in 2021, leading to much higher inflation than conventional Phillips curves — estimated over a period when the economy generally had some slack — would have predicted, taking us to a point like that labeled “Summer 2022.”
Figure 3: The nonlinear Phillips curve
The story of disinflation is then that of the red arrow: falling aggregate demand, as the fiscal impulse faded and the Fed raised rates, let us slide back down the curve, reducing inflation without a large cost in employment.
The Long Transitory or sectoral shocks story, shown in Figure 4, is my version of the analysis done by, for example, Jared Bernstein, chair of the Council of Economic Advisers. As we all know, the pandemic and its aftermath caused big shifts in the structure of consumer spending, notably a shift away from in-person services toward durable goods but also big changes associated with working from home and so on. In the figure I oversimplify by just making it goods vs. services, although we know it was more complicated than that.
Figure 4: Sectoral shocks
The key thing, however, is that given these sectoral shocks we need to think about sectoral supply relationships, not just an aggregate supply curve. As in Figure 3, Figure 4 shows us arriving temporarily at a point like “Summer 2022” in both panels. However, this wasn’t a point at which the economy as a whole was greatly overheated, only those parts of the economy that had experienced a sharp rise in their share of spending.
Why does this matter? Suppose that we had immediately experienced a large fall in aggregate demand — or, equivalently, never had the rise in demand that followed the American Rescue Plan. Again, I represent this by red arrows. But in this scenario, while falling demand would have reduced inflation without much job loss in the overheated sector, it would have led to considerable job loss elsewhere.
How, then, did we achieve disinflation without a recession? The answer is that the economy adapted, increasing its capacity in the stressed sectors, unkinking supply chains and so on.
These two stories obviously bear considerable resemblance to each other; the sectoral shocks story requires nonlinearity of the employment-inflation relationship, and as I’ll explain shortly the nonlinear Phillips curve story only makes any sense empirically if it includes a large role for pandemic-related disruption. But they have quite different implications for our understanding of the recent history of inflation and the evaluation of past policy.
If you believe the nonlinear Phillips curve story, you should also believe that the United States could have avoided the 2021-2022 burst of inflation at fairly low cost: fiscal stimulus and the Fed’s slow reaction led us to move up the near-vertical portion of the curve, so absent those actions we could have stayed near the kink, achieving similar job growth with much lower inflation.
And according to this story, the disinflation of 2022–2024 was largely a matter of sliding down that near-vertical stretch, thanks to the Fed’s rate hikes.
If you emphasize the role of sectoral shocks, however, you see a temporary burst of inflation as the necessary price of rapid recovery from the Covid recession. Look at the red arrows in Figure 4: The only way to have avoided inflation in the stressed sectors would have been to depress demand in a way that would have led to many fewer jobs elsewhere in the economy. This implies that Big Fiscal in 2021 was in fact appropriate, even though the price was temporary inflation.
And the sectoral-shocks view also casts doubt on the role of the Fed in disinflation. If the main driver of disinflation was adaptation of the economy’s supply side, it’s hard to see how higher interest rates did that.
As I said, I was initially sympathetic to the nonlinear Phillips curve story, but at this point I’m convinced that sectoral shocks fit the facts much better. I’d cite three main pieces of evidence.
First, prime-age unemployment was, if anything, somewhat low when inflation was surging — and high as it was plunging. So this can’t be simply a demand-side story. In fact, while the nonlinear Phillips curve story suggests that disinflation could have occurred without a large price in lost jobs, it’s hard to reconcile with the fact that we seem to have paid no price at all.
Labor markets do, indeed, seem to have been tight for a while and have loosened since, but this was clearly because something — presumably pandemic-related factors — temporarily discombobulated those markets (sorry for the technical language.) Figure 5 shows the widely cited ratio of job openings to the number of unemployed; its rise and fall was clearly a supply-side rather than a demand-side phenomenon, which makes it hard to assign blame for inflationary overheating to excess demand or credit for disinflation to tight money:
Figure 5: Disrupted labor markets
And if we’re invoking pandemic disruption as a central factor in the rise and fall of inflation, it’s really hard to justify applying what amounts to a one-sector approach that doesn’t distinguish between inflationary pressures in different sectors.
Second, there’s direct evidence that sectoral shocks drove inflation’s rise and fall. Figure 6 shows the New York Fed’s index of supply chain pressures. Discount the early months of the pandemic, which everyone remembers for shortage of toilet paper. After that, the index closely tracks inflation:
Figure 6: On the chain gang
Finally, if we look beyond the United States, what we see is very similar inflation dynamics across advanced countries, even though they followed quite different policies — nobody else pursued U.S. style fiscal expansion. In particular, if you use comparable price indexes, cumulative inflation since the eve of the pandemic has been almost eerily similar in the U.S. and the euro area:
Figure 7: We are the world
All of this suggests to me that sectoral shocks, which is more or less a supply-side story, is a better theory for inflation’s round trip than a demand-side story involving a nonlinear Phillips curve.
If you agree, this has two important implications for recent policy history.
First, Bidenomics — fiscal stimulus even though the economy was beginning to recover — was actually the right thing to do. Yes, we had a burst of inflation, but given the sectoral shocks we could only have avoided that burst at the cost of much lower employment; and since inflation didn’t get entrenched in expectations, in the end we handled the pandemic shock very well.
Second, while the Fed presided over rapid disinflation and what looks like a soft landing, it probably doesn’t deserve credit for causing that disinflation, which was instead the result of private sector adaptation to the Covid shock.
Does this mean that the Fed was wrong to raise rates? Not necessarily; unlike some members of Team Transitory, I didn’t attack the Fed for tightening policy, and I don’t believe with the benefit of hindsight that it did great damage.
The thing is, when the Fed began raising rates, we didn’t know either that disinflation would be this painless or that expected inflation would remain low. The sectoral shocks model suggested that this would happen, but nobody could be sure that this model would be vindicated as thoroughly as it has. So it made sense to raise rates as a precautionary measure, just in case ’70s-style stagflation was a real possibility.
And while dire warnings that it would be very hard to control inflation have been proved wrong, dire warnings that Fed tightening would cause a recession have also proved wrong, at least so far. Why, exactly, is an interesting question; has r-star, the neutral interest rate, soared, or is something else going on? At this point, however, it looks as if the Fed may have done the right thing for the wrong reason.
I believe that the Fed should be cutting rates fairly quickly now, in a way for the same reason I was OK with rate hikes earlier: we don’t know whether the economy can sustain high rates without eventually cracking, and as a precaution we should move to avoid that risk.
In the end, though, the story seems to be that through a combination of good judgment and good luck, America handled the economics of the pandemic and its aftermath remarkably well.
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