In August 1982 I came to Washington to work for a year on the White House Council of Economic Advisers. Yes, it was the Reagan administration and I was already a liberal. But it was a technocratic rather than a political position, and the council’s new chairman, Martin Feldstein — a moderate Republican of a type that has since largely disappeared — wanted some prodigies to process the data. I should focus on international issues; The new housekeeping clerk was a guy named Larry Summers. What just happened to him?
Anyway, Marty and I had a working lunch the night I arrived, and he had a big question to ask: “Is the world economy on the verge of collapse?”
There were two main reasons for his concern. One was that Mexico had just announced that it could no longer pay its debts, marking the beginning of the Latin American debt crisis. The other was that the Federal Reserve’s efforts to fight inflation had sent the US economy into a tailspin, with the nation experiencing its worst recession since the 1930s, unmatched by the 2008 financial crisis.
But as it turned out, the world economy didn’t collapse. The debt crisis ushered in a “lost decade” in Latin America with widespread economic woes, but it did not spread to global contagion. Finally, further north, a Fed reversal led to a quick recovery; In 1984, Ronald Reagan boasted of “Tomorrow in America”.
Nevertheless, the memory of that summer makes me a little nervous in view of the economic optimism that seems to be spreading at the moment, at least in the media. Forecasts of a “soft landing” – inflation falling to acceptable levels without a recession – are growing. And my own prediction is a soft landing indeed: Inflation does appear to be falling, and while we may not avoid a recession entirely, if we do have one, it will likely be mild.
But the experience of the early 1980s still offers two reasons for caution.
First, controlling inflation in the 1980s was extremely painful. Here’s what used to be the Fed’s preferred measure of underlying inflation (I’ll get to recent problems with that measure in a moment) versus the unemployment rate from 1979 to 1985:
Inflation fell, from about 10 percent to about 4 percent. But the process of disinflation brought with it a huge, sustained rise in unemployment. In the business jargon of the time, there was a very high victim rate. In late 1984, when Reagan was talking about how great the economy was, the unemployment rate was more than double what it is today.
Some people talk as if we are going through a similar ordeal all over again. At least until a few months ago, Larry Summers was plotting 1980s-style disinflation scenarios, saying that unemployment would need to rise to nearly 6 percent to bring inflation under control.
I think he’s wrong. Pandemic-induced distortions have made underlying inflation much more difficult to estimate, to the point where we’re not even sure what the term really means, but many of the measures devised to break the fog are showing a slowdown in inflation, although we have yet to see a rise in unemployment. For example, here’s a metric of the New York Fed’s core multivariate trend – believe me, it’s a smart, sensible approach, though not definitive:
If we are to believe this metric, or the apparent downward trend in wage growth, inflation has already moderated significantly – again without a large rise in unemployment. So, like I said, I think Larry is way too pessimistic. But am I sure? Of course not.
The other reason the experience of the 1980s still weighs on me is that by 1982 it was clear that the Fed had tightened more than intended. That is, it was trying to slow down the economy — it had, in fact, intentionally caused a recession — but it wasn’t intended to cause such a severe recession. The truth is that policymakers then, as now, tried to steer the economy with limited, often outdated information and highly inaccurate tools.
In particular, the Fed tries to reduce inflation by slowing the economy, which it in turn does by raising interest rates. But there is fierce debate about how much the economy needs to slow down, how much interest rates need to rise to achieve a given level of deceleration, and how long it will take for rate hikes to take full effect. I sometimes imagine the Fed trying to operate heavy machinery in a dark room – while wearing heavy mittens.
So even if we don’t need a severe recession to get inflation under control, we could still get one if the Fed brakes too hard. There is, of course, the opposite risk: that the Fed does too little and that inflation cannot be brought under control. But I think the inflation news was good enough to justify taking that risk by being cautious about rate hikes, at least for a while.
The bottom line? A soft landing has become much more plausible than it seemed a few months ago. But it’s anything but a done deal.
Fast hits
Explanation of this new measure of inflation.
A look at the inflation situation from White House officials.
The financial markets are very optimistic about inflation.
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