{A} mericans’ real incomes fell by more than 10 percent during the pandemic recovery as prices rose at the fastest pace in 40 years. As of late 2023, real wages remained about 2 percent below the pre-pandemic trend.
The main culprit of inflation was the Federal Reserve’s expansionary monetary policy, but after the Fed jacked up interest rates in 2022, inflation has come down and is near its 2 percent long-run target. Inflation in personal-consumption expenditures (PCE), for example, has averaged just 1.9 percent over the past 8 months, although consumer price index (CPI) inflation remains above 3 percent.
Despite the Fed’s actions, many on the left, including Paul Krugman and Joseph Stiglitz, are trumpeting lower inflation as evidence that inflation was transitory all along. However, no one making these claims predicts that the price level will fall, which is what the term “transitory inflation” would imply.
The Persistence of Team Transitory
Transitory inflation results from disruptions to the production of goods and services, which reduces their supply and pushes up their prices. The Covid-19 pandemic and accompanying lockdowns caused supply problems, which persisted long-term in the form of shipping backlogs, supply-chain bottlenecks, and shortages of lumber and automotive computer chips. If supply shocks alone were to blame, prices should have fallen back to their pre-pandemic growth paths as the disruptions faded and activity resumed. Yet prices remained high.
Importantly, the transitory view implies that inflation will dissipate without the Fed needing to raise interest rates. That’s what Fed officials projected throughout 2021. It eventually became clear that higher interest rates would be necessary to get inflation down. Now, “Team Transitory” is moving the goalposts, claiming lower inflation was not caused by higher interest rates and that its transitory view was right all along.
Transitory Inflation Implies Deflation
Standard monetary theory explains why prices remain elevated. If inflation is caused by overly expansionary monetary policy, then prices will remain above their pre-pandemic trend (unless the money supply shows a significant contraction). This view is consistent with the fact that the rate of inflation has come down but the price level has not.
The transitory view, in contrast, cannot explain a permanently elevated average price level. Krugman and Stiglitz claim that falling inflation implies that inflation was transitory — but that’s not correct. If supply constraints dissipate enough to return the economy to its previous growth path, which they have, then we should also see the price level decline to its previous growth rate. In other words, we should experience a decline in average prices, not just a decline in inflation.
That hasn’t happened. Prices have not gone down. They’re still going up, just at a slower rate.
Do Caveats Apply?
What if supply-chain bottlenecks are still holding the economy back? That would help explain why prices have not fallen. But given that the economy has recovered to its pre-pandemic trend, persistent supply problems cannot be what is keeping prices high.
What if supply shocks have dissipated, but they were offset by larger, persistent increases in aggregate demand? That’s basically the monetary view: The economy experienced supply-chain problems early in the recovery, but as they were resolved, expansionary monetary (and some say fiscal) policy created persistent inflation. That is why the price level has not come down.
The Phillips Curve?
Krugman and Stiglitz said inflation would come down without raising interest rates. Stiglitz summarizes the debate: “Team Transitory. . . argued that the expected benefit of such a rate hike was low, since inflation would come down on its own.” Krugman similarly explains that, as of 2021, Team Transitory (of which he counted himself as a member) argued that “we were mostly seeing temporary disruptions from the Covid-19 pandemic, which would fade away over time.”
Clearly, they were wrong. So how can they argue that inflation was transitory? They do a bait-and-switch by contrasting their view with another view that was also wrong.
Some economists, most notably Larry Summers, argued that reducing inflation would have to come at the cost of higher unemployment. This view was based on the classic Phillips curve, the economic theory which maintains that policymakers face a trade-off between inflation and unemployment.
In 2022, for example, Summers said, “We need five years of unemployment above five percent to contain inflation.” The left has criticized this view, and even the Biden administration expressed its disagreement by asserting, “Despite what many forecasters were predicting a year ago, inflation is down while growth and the job market have remained strong.”
Here’s the problem: The Phillips curve doesn’t exist, at least not as a useful instrument for policy. Many economists once mistook this relationship to be a causal tool they could use to push down unemployment by creating inflation. Milton Friedman showed the folly of this theory half a century ago (and reiterated in his 1976 Nobel Prize lecture), but policymakers like to think they can control the economy and therefore they ignore the valuable lesson.
Who Is Predicting Deflation?
If the transitory view were correct, prices should have, on average, fallen as the economy recovered. That has not happened — yet. But what if supply constraints are only now being fully resolved, or what if perhaps prices were simply sticky and slow to adjust? The question for those espousing the transitory view is how much prices have yet to fall.
The CPI rose by 17.8 percent from the end of 2020 through 2023. Had the Fed hit its inflation target of 2 percent, the price level would have risen by 6.1 percent over that time, indicating the price level is still 11.7 percent above target. How much of that 11.7 percent is transitory?
If inflation was all supply-side, then we should expect prices, on average, to fall back near their previous levels, which would mean roughly 10 percent deflation from the current level. If inflation was half supply-side, we should expect about 5 percent deflation. However, if we do not expect prices to fall from their current levels, then there is no reason to believe inflation was transitory.
The transitory view implies that the price level should fall, but it has not, at least not yet. Will Krugman, Stiglitz, or anyone else from Team Transitory go on record by predicting deflation in the coming years? If not, they should stop claiming inflation was transitory.