The Immaculate Disinflation

We have long maintained that inflation is a complex and mysterious beast.? With so many moving parts, it is nearly impossible to model and predict.

A task made even more difficult these past few years, with new dynamics emerging from the pandemic, extreme monetary and fiscal policies, and conflicts in Ukraine and the Middle East.?

Thanks to these and other factors, CPI soared to 8-9% before dropping down to current levels of around 3.5%.? Unexpectedly, this dramatic decline has occurred without the expected economic weakness or unemployment.

Even with the benefit of hindsight, understanding the spike in inflation and the ‘immaculate disinflation’ is murky.? There are just so many factors at play, leaving the causes open to interpretation, where the data can be made to fit different theories.

One such theory that has resurfaced from the depths of ridicule is that of inflation being transitory.

Some economists, including Nobel laureate Joseph E. Stiglitz, claim that team transitory was right all along.? They argue that the surge in inflation was not driven by excessive aggregate demand, but instead by supply chain disruptions and shifts in consumption patterns.?

Accordingly, this camp attributes the disinflation to improved supply chains and lower energy prices and not restrictive monetary policy.? In fact, they argue that CPI has not come down due to central bank action but despite it.? The argument is that rate hikes have elevated shelter costs, as higher rates restrict construction and thus housing supply and higher mortgage costs force more people into rentals thus pushing up rents.

Following this logic, restrictive rates were and are unnecessary in the battle against inflation. This implies that central banks can start easing without fears of CPI reaccelerating and thus avoid the risks of leaving rates too high for too long.?

The obvious difficulty with this line of thinking is that we will never know what would have happened had the central banks not responded so aggressively.? Those in the ‘permanent’ team argue that without the rate hikes, inflation would be much higher today.?

While this camp acknowledges that some of the inflationary factors were indeed transient, they also point out the more long-lasting elements of labour shortages, wage growth, inflation expectations, and of course, the excess demand resulting from the flood of pandemic stimulus and increase in the money supply.? To get these entrenched factors under control, central banks needed to take aggressive action.

In an attempt to dissect the factors causing the drop in US inflation, Allianz Research attributed an almost equal weighting to improved supply chains and actions taken by the Federal Reserve (Fed).? Where the Fed’s contribution came from both higher rates squeezing demand and their signaling helping to re-anchor inflation expectations.

Based on this analysis and the facts thus far, both sides can cherry-pick evidence and claim theoretical superiority.? But until we have completed the ‘last mile’ in the battle against inflation, it seems premature for either team to be doing victory laps.

For now, we will file this mystery as unsolved and wait to see which theory is more right (or less wrong).? At this stage, the only thing we can be certain of is that the case of ‘immaculate disinflation’ will be the subject of innumerable Ph.D. dissertations and occupy economic theory wonks for years to come.?

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