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Inflation will come down. Err...the cost will be substantially higher unemployment.

That is, unless the economists are FOS, which is generally the case.


Inflation and the Scariest Economics Paper of 2022

To bring price increases down to 2%, we may need to tolerate unemployment of 6.5% for two years.

By Jason Furman. WSJ

Sept. 7, 2022 9:00 pm ET


The scariest economics paper of 2022 argues that labor markets remain extremely tight, underlying inflation is high and possibly rising, and several years of very high unemployment may be necessary to get inflation under control. The paper is a painstaking empirical exploration by Johns Hopkins macroeconomist Larry Ball with co-authors Daniel Leigh and Prachi Mishra of the International Monetary Fund released by the Brookings Papers on Economic Activity. It shows why the Federal Reserve will likely need to maintain its war on inflation, even if unemployment continues to rise.


Economists use labor market slack to help predict inflation. Typically they look at the unemployment rate, but using the ratio of job openings to unemployment to measure labor market slack offers a clearer picture. Analysts who focused solely on the unemployment rate mistakenly believed the labor market still had substantial slack in 2021 and deemed wage and price inflation transitory. The big burst of inflation that followed left them scratching their heads. Messrs. Ball, Leigh and Mishra find that labor-market tightness itself added 3.4 percentage points to underlying inflation in July 2022.


The paper also argues, convincingly in my view, for a different measure of underlying inflation. Fluctuations in energy and food prices are generally due to factors outside the control of macroeconomic policy makers. Geopolitics and weather have elevated the inflation rate in recent years. Plunging gasoline prices are temporarily lowering the inflation rate now. That’s why economists since the 1970s have focused on “core” inflation, which excludes food and energy.


But food and energy aren’t the only things people buy that are subject to supply-side volatility. Prices of new and used cars, for example, have gyrated over the past two years for reasons that are mostly unrelated to the strength of the overall economy. Both regular and core inflation are based on taking averages of price increases and can be distorted by large changes in outlier categories. The median inflation rate calculated by the Federal Reserve Bank of Cleveland drops outliers to remove these distortions.


Median inflation is a statistically better measure of the underlying inflation that policy makers can actually control. This is worrying because while the Fed’s preferred headline inflation fell to zero in July and annual inflation excluding food and energy has stabilized at around a 4% annual rate, median personal-consumption expenditure inflation shows no sign of moderating and has run at a 6.6% annual rate in the last three months.


The scariest part of the new paper, however, is when the authors use their model to forecast the unemployment rate that would be needed to bring inflation down to the Fed’s 2% target. The authors present a range of scenarios, so I ran their model using my own assumptions. I assumed that the labor market will cool on its own as job openings fall two-thirds of the way back to what they were before Covid. I also assumed that inflation expectations will fall back toward where they were before Covid and that the recent good news on gasoline and other volatile prices will keep coming for the rest of 2022.


Under these assumptions, which are more optimistic than the authors’ midpoint scenario, if the unemployment rate follows the Federal Open Market Committee’s median economic projection from June that the unemployment will rise to only 4.1%, then the inflation rate will still be about 4% at the end of 2025. To get the inflation rate to the Fed’s target of 2% by then would require an average unemployment rate of about 6.5% in 2023 and 2024.


There is, of course, tremendous uncertainty with this forecast. If businesses believe that low inflation is coming and act like it, inflation could fall without a large increase in unemployment. On the other hand, if the labor market doesn’t shift back to the way it was working pre-Covid, or if there are more unfavorable supply shocks, the outlook could be more painful.


What should the Fed do? Four things: First, place more emphasis on the ratio of job openings to unemployment and median inflation as it assesses the tightness of labor markets and the underlying rate of inflation. Second, the new paper shows how much easier it will be to tackle inflation if expectations remain under control. The Fed should follow up on Chairman Jerome Powell’s tough talk at Jackson Hole with meaningful action such as a 75-basis-point increase at the next meeting. Third, be prepared to accept the unemployment rate rising above 5% if inflation is still out of control. Finally, stabilizing at a 3% inflation rate is probably healthier for the economy than stabilizing at 2%—so while fighting inflation should be the central bank’s only focus today, at some point the Fed should reassess the meaning of victory in that struggle.


Mr. Furman, a professor of the practice of economic policy at Harvard University, was chairman of the White House Council of Economic Advisers, 2013-17.

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