Was Team Transitory Right?

The Times piece quotes Joe Stiglitz: “We’re at a place where we in Team Transitory can rightly claim victory,” and Paul Krugman said those “who argued that the inflation surge of 2021-22 was transitory, driven by disruptions caused by the Covid pandemic and Russia’s invasion of Ukraine, appear to have been right.” The Times piece concludes “The next front for the triumphant Team Transitory is to limit the potential damage from central bankers’ misjudgments by pushing them into big interest rate cuts in the coming months. Otherwise, the expected soft landings could still elude them and questions about why they got it so wrong will return with a vengeance.”

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Before we evaluate the team transitory’s track record, keep in mind that they have created a bit of a strawman. Most economists understood that the supply issues were a major cause of surging inflation. Hence, only a few argued that the economy needed a major recession or a big increase in the unemployment rate to get inflation back to target. The debate was actually fairly narrow. It was between a soft-landing group—arguing for below-trend growth and 0.5% or so rise in the unemployment rate—versus a “hard landing” group—arguing for a very mild recession and say a 1.0% rise in the unemployment rate. I switched sides from “hard” to “soft” over the course of last year.

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Beyond this framing question, there are several other problems with this story. Let’s focus on the US.

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First, the overheating in the economy and the persistence of inflation would have been much greater absent Fed action. As the Fed hesitated in 2021 not only was inflation becoming increasingly broad-based, but the labor market was ripping. Job openings were steadily setting new records, and the unemployment rate was dropping by 1 ? tenths per month. We can only imagine what the labor market and inflation would have looked like today had the Fed not belatedly hit the brakes.

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Second, while inflation has come back down, the price level jump has not reversed. If the inflation was purely due to transitory supply shocks, then why haven’t prices dropped back down to their old trend? The answer is that there is also a demand component to the sharp rise in the price level. The San Fran Fed has a nice piece decomposing the two effects https://www.frbsf.org/economic-research/publications/working-papers/2022/18/

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Third, there does appear to be sustained higher service price and wage inflation. This continues even though supply problems are long gone. Indeed, cost pressures continue despite a stronger than expected recovery in the labor force participation rate. Central banks are winning, but haven’t quite won, the war on inflation.

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Finally, does the Fed need to correct its “mistakes?” I don’t think so. Not only has inflation come down faster than expected, but the economy has proven a lot more resilient than expected. If they get a soft landing, then what is the mistake that they need to correct? If they do cut a few times this year, that does not mean they made a “mistake” it means they are doing the usual recalibration of policy.

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At this stage my main criticism of the Fed (and other major banks) is that by waiting so long to start hiking they took an unnecessary risk of a boom-bust economy. Indeed, I started writing about this in the Spring of 2021. Why did they need to wait until they started to breech their targets before hiking? The sudden shift in policy was necessary to make up for lost time, but could have destabilized financial markets and the economy. Indeed, one cost of this 180 degree turn was it helped create another “moral hazard” problem for the banking systems. It first created complacency on duration risk at banks, and then triggered an implicit guarantee on uninsured bank deposits. Hopefully, the Fed will go back to the old regime of gradualism and pre-emption the next time around.