What Did the Last Four Years Teach Us about Managing Inflation?

Q: There’s tremendous attention on inflation these days. But the Federal Reserve and other central banks have been dealing with extraordinary circumstances for more than four years. Would you walk us through the challenges, the responses, and what we have learned, starting with the shutdown from the COVID pandemic?

While “unprecedented” is a term that can be overused, when the pandemic hit in 2020, it was an unprecedented shock. It had been 100 years since we’d had a global pandemic. And, of course, we now have a much bigger, much more complicated, much more integrated global economy, which was abruptly shut down.

It was very hard for policymakers to understand what was happening and to judge what was the right thing to do. Central banks did basically everything in their power to help get their economies going again. They have three monetary policy levers: interest rates, balance sheets, and guidance. They used them all to respond powerfully and quickly.

Q: How were the tools used?

In the U.S. interest rates were cut to zero. There were big rate cuts in many other countries, if there was space to cut.

Central banks also used their balance sheets. They bought a lot of securities to improve the functioning of markets that were really dislocated by the size of the pandemic shock and the uncertainty around it, and subsequently to push down longer-term rates and ease financial conditions.

And, when interest rates were stuck at the lower bound and the Fed was already buying securities and wanted more monetary accommodation to support the economy, policymakers provided guidance. Basically, they said, “We’re not going to raise rates until we reach maximum employment. We’re going to allow the economy to get going, and maybe even get going fairly strongly, before we raise rates.”

That lets businesses say, “OK, we’d better invest so that we can manage demand when it picks up.” That supported immediate spending, which is helpful for the economy when it’s in a hole and stuck at the zero bound.

The Fed also deployed some additional unconventional tools used during the Global Financial Crisis, including central bank lending programs to banks and other financial firms, and it extended them to businesses and others.

At the same time, the government was providing assistance to the unemployed, sending checks to families, and so on. The cumulative effect, not just in the U.S. but around the world, was a faster recovery than people expected. The economy bounced back quickly.

Q: Quickly enough that we got inflation?

A number of factors contributed to inflation but most significant was how the pandemic disrupted supply chains. Here’s one example of how the problems compounded:

Everybody wanted to buy cars to get off mass transportation because of concern about COVID. They had a check from the government that could be used for a down payment. But cars require computer chips, and COVID outbreaks in various countries messed up computer chip manufacturing. Chip manufacturers couldn’t keep up with demand for chips, which meant auto production couldn’t keep up with demand for vehicles.

That scenario of strong demand and weak supply happened in segment after segment of the economy. It created big disruptions.

There were also disruptions in labor markets. You had unemployment in the service sector because people were not going to the gym; they were buying a Peloton. They weren’t going to the movies; they were buying a big-screen TV.

It’s always hard to move labor from one part of the economy to another. That was especially true during the pandemic. But the sectoral reallocation had to happen. You could see in labor market indicators that the labor market wasn’t working well for a while.

The cumulative effect of all of that was inflation starting in 2021.

Q: Many people thought the inflation would be transitory; it would fall as soon as supply chain disruptions resolved. Why didn’t that happen?

Partly, the supply disruptions were simply larger and lasted longer than expected. Partly, Russia went to war in Ukraine and messed up energy markets and commodity markets, broadly boosting inflation further in 2022.

Q: Who made the right call on responding to the inflation?

Many emerging market economies moved quickly. Their central banks didn’t have as much credibility. They hadn’t built it over time, so they felt they needed to respond quickly, and they did.

However, in a lot of advanced economies, including the U.S., the turn was much slower. The Fed was initially thinking, “The supply chain disruptions will pass. We don’t need to respond with strong monetary policy.” And that was a reasonable thing to be thinking at first. And they were confident that they had credibility with the public. They believed that high inflation wouldn’t get built into wage and price setting. That’s important to avoid because then it propagates itself forward and you have persistently high inflation.

In 2022, the main advanced-economy central banks realized that even if the inflation was in some sense the result of temporary factors, it was lasting a long time, and there was a real risk that the high inflation was going to get built into wage and price setting—so they were behind. They raised rates very rapidly. Inflation went to the highest levels we’d seen in 40 years, and interest rates then went up faster than we’d seen in about 40 years, to catch up.

On the whole, the outcomes so far look surprisingly good. Last year, inflation in the United States came down pretty rapidly to around 3%. That’s above the Fed’s preferred level of inflation of around 2%, but it fell a long way back without a big recession.

The economy kind of normalized, the labor market normalized, supply chain disruptions passed. The really strong surge in demand softened in the face of tighter monetary policy and cumulatively that got inflation back to much more reasonable levels.

Q: What happens next?

It depends very much on whether households and businesses are confident inflation is going to come back to 2%. If they are, then they build that into wage contracts, they build that into pricing, and inflation comes gradually back to 2% over the next year or so.

But if this high inflation period was enough to boost the ambient level of inflation to a level like 3%, there may need to be a much slower economy for a while to get inflation back down to 2%.

Late last year, the Fed was reasonably optimistic about the outlook for inflation, and policymakers began talking about when would be the right time to start easing policy. They were hoping for a “soft landing,” where growth would slow to a sustainable pace, and inflation would come down to target. However, the economic data this year have suggested a stronger economy and higher inflation than the Fed anticipated. That has led policymakers to push back on the timing of policy easing—it’s possible the Fed won’t ease policy at all this year, but just wait to give the current tight monetary policy more time to work. All along, the Fed has said that the outlook is very uncertain, and that was right!

Q: How did the response to inflation compare to previous efforts?

In the 1970s, oil and commodity price shocks sent inflation up a lot. The Fed and other central banks didn’t do a good job that time and the inflation became a persistent problem. It took a massive recession in the early ’80s, when the Fed chair was Paul Volcker, to get inflation back down to more reasonable levels. And it didn’t get back to 2% until the ’90s.

Being aware of that history, Fed policymakers knew that if they blew it, it would be very costly. They saw two risks. One, we do too much and cause a recession that’s not really necessary to bring inflation down. Two, we don’t do enough. Inflation stays high and it gets built into wage and price setting. They saw that second risk as much worse because if that happens, you eventually have to have a much bigger recession to get inflation back under control.

Q: Did the delay in the Fed’s response matter?

I don’t think it was a very expensive mistake. If they had raised rates gradually in late ’21, when the situation was less bad, rather than raise them really fast in March, which is what they did, the macroeconomic consequences wouldn’t have been very different.

One lesson they are likely to take away from this period is that they got constrained by their own guidance. By the fall of 2021, it was clear inflation was lasting, so the Fed had a choice. Policymakers could say, “Yes, we said we wouldn’t raise rates until we reached maximum employment, but the situation is different now” and raise rates. Or they could stick with the earlier guidance. They chose to do the latter. They talked about how they were going to have to raise rates soon, but they didn’t do it until March of 2022. That was just late.

So they were constrained by themselves—by the guidance they had provided. That was unfortunate. I think they’ll be careful to not get in that sort of bind again.

Q: Has our understanding of how monetary policy should respond to inflation changed in the last few years?

Going forward, I think central banks will say, “We need to be flexible about responding to inflation. And we want to be more symmetrical than we might have been going into 2020.” That’s one lesson from the events of the last few years. When the economy was really weak after the financial crisis, and inflation stayed low for a number of years, some central banks decided that high inflation wasn’t something to worry about and they needed to be more aggressive about responding to low inflation.

That came about because inflation was 2%, plus or minus, from the mid-’90s until 2020. If the economy got a little bit hot or cold, it didn’t really have an effect on inflation. If there were shocks—something happened in the Middle East and oil prices went up—there was higher inflation for a while, but people just kind of looked through that, and it came back down. What central bankers say is, inflation expectations became really well anchored. If you’re a central bank, that’s terrific. You’ve built a lot of credibility. Everybody believes you.

But then we got the biggest supply shocks we’ve experienced since the 1970s because of the pandemic and the war in Ukraine. Suddenly we had an inflation problem of a sort that we hadn’t had in decades. The Fed understood the lessons from the 1970s; they did respond, maybe with a lag, but they did respond effectively. And I think the awareness of the need to respond to high or low inflation will remain.

Q: What else has changed about our understanding of inflation?

I remember people saying things like, “You need a 7.5% unemployment rate for two years to get inflation back down.” Those assessments were looking back to what happened in the 1970s. The thing is, back then the Fed didn’t have as much credibility. It didn’t keep inflation expectations well anchored. Because of that, inflation got out of hand, and it took a big recession to get it back down again.

This time, even as it was raising rates, the Fed made a fundamental judgment call. Policymakers believed that because this inflation largely had to do with temporary supply disruptions and temporary effects of higher commodity prices—which really did pass—then, as long as the economy doesn’t overheat, the labor market doesn’t get too tight, and inflation expectations remain reasonably anchored around 2%, we don’t need to have a huge recession to bring inflation down. They believed a soft landing was a real possibility.

However, there’s also a possibility that the economy will have to slow more to get inflation all the way back down to 2%. There’s a paper I really like by my old boss, Ben Bernanke, and Olivier Blanchard on what drove the inflation in the U.S. over the last few years. Their bottom line is that the temporary supply disruptions and commodity price shocks pushed inflation up for a time. That transitory inflation went up and came down. But, in addition, the economy did overheat for a while. The labor market was really tight in part because it was so dislocated as a result of the pandemic. Businesses had huge vacancy numbers. They couldn’t hire enough workers. Wages went up a lot.

Bernanke and Blanchard argue that period of a very tight labor market and overheating economy accounted for about 1% of the current inflation. And that 1% may be a more troubling kind of underlying inflation that may be harder to get rid of.

We don’t know if they’re right or not. If they are, the economy may need to slow further for a time, just enough to get a little slack in labor and goods markets and help bring inflation down. The unemployment rate is currently 3.8%, and the Fed estimates the long-run normal level of the unemployment rate to be around 4%. Maybe the unemployment rate will have to rise above 4%—some people might even say to 5%. I don’t think anybody’s saying 7.5% anymore. That analysis just looks wrong now.

Most of the inflation was transitory. It came, it went, but there is this underlying bit of inflation that may be more costly to bring down. And whether or not we get a truly soft landing or not depends on how that plays out. As some have said, the “last mile” of the disinflation may be the hardest.

Q: What’s the difference between 2% inflation and 3%?

There’s a huge debate in the literature about why 2% should be the target, why not 1%, why not 3%, why not 4%? Without getting into the details of that, the Fed’s reasoning is that a 2% inflation rate best balances their dual mandate of achieving maximum employment and stable prices.

Two percent is a bit higher than what you might think of as consistent with price stability, but that little bit more kind of lubricates price setting and wage setting, which helps the Fed to better achieve the maximum employment part of the mandate.

If they just stopped at 3% and declared that the new target, I think inflation expectations would come unanchored. Maybe expectations would eventually end up well anchored at 3%, but it would take a while, and there would be costs. Nobody wants to take that chance.

I think they want to continue to aim for 2% over the next few years. If, later this year, they found themselves with an inflation rate around 3%, an unemployment rate around 4%, and the economy chugging along, I’m not sure that they would want to set out to cause a recession to bring inflation down from 3% to 2%. They might operate with slightly tight monetary policy and figure very gradually over time they’ll move inflation down. But that would be a really hard call for the policymakers, and if they end up in that situation, it’ll be interesting to see what they say.