CAMBRIDGE – In just one year, inflation in the United States has fallen from a peak of about 9% to just 3%. Standard economic models suggest that such rapid disinflation would be possible only with a large increase in unemployment. But the unemployment rate has remained steady, at around its 50-year low, for the entire period. Do economists need to throw out our models and start over?
While no macroeconomic theory is perfect, and humility is always in order, a closer look at the data suggests this would be an overreaction. For starters, underlying inflation has fallen by only about one percentage point – much less than the six-percentage-point decline in headline inflation. Moreover, this has happened while labor markets – understood broadly – have loosened considerably, although in a relatively benign manner, with job openings falling instead of unemployment rising.
Underlying inflation is the rate of inflation that would prevail if labor-market tightness remained unchanged. The concept is easier to define than to quantify, but a range of indicators can help us to formulate plausible guesses of its level. In June 2022, when the headline inflation rate peaked at 9%, my rough estimate was that the underlying inflation rate was around 4-4.5%, which is to say that absent any weakening in labor markets, the inflation rate could have been expected to decline by about half. While others may have made somewhat different estimates, no credible economist expected inflation to stay at 9% or higher.
Where did this number come from? The most basic adjustment that virtually all economists make to get a more accurate picture of inflation is to strip out the volatile food and energy components, thereby calculating so-called core inflation. The surge in inflation in 2022 was driven largely by the spike in food and energy prices caused by Russia’s full-scale invasion of Ukraine. Given that no one would expect such spikes to recur repeatedly, core inflation is generally a better predictor of future inflation than the headline rate.
Last year, core inflation stood at around 5%. But even that was too high an estimate of underlying inflation, based on the information available at the time. In any given month, many other volatile and transitory factors can affect even core inflation, such as avian flu, used-car shortages, or increases in the price of jet fuel.
One way to cut through the noise is to look at what is happening to wage growth, because, over time, wage growth and inflation are closely linked. In mid-2022, the overall pace of wage growth was consistent with about 4% inflation. The totality of the data is what led me to my 4-4.5% estimate.
What is the underlying inflation rate today? If you looked only at prices, you would think that it is about 3%. The pace of wage growth, however, is more consistent with 3.5-4% inflation. Taking everything together, it seems reasonable to suppose that underlying inflation is in the 3-3.5% range. Note that this is higher than recent headline inflation, which has been temporarily lowered by falling energy prices.
That leveling off and decline in energy prices has been one of the main contributors to the one-percentage-point decline in underlying inflation. Whether weaker labor markets have also played a role is less clear, as the evidence is murkier and harder to quantify, but the answer appears to be yes.
One cannot judge the tightness of labor markets by the unemployment rate alone. The number of job openings matters a lot, too. In the US, the number of job openings peaked at 12 million – or two openings for every unemployed person – in March 2022.
Since then, this figure has fallen, even as the unemployment rate has held steady: today, there are only 1.6 job openings for every unemployed worker. The result of this immaculate loosening of labor markets – which itself was no surprise, given that there was no reason to expect that pandemic labor-market dislocations would last forever – was slower wage and price growth.
The waning of fiscal support and the tightening of monetary policy probably also contributed to the decline in underlying inflation, by constraining aggregate demand. Aggressive monetary tightening over the last year has also kept long-run inflation expectations anchored, helping to lower underlying inflation over time. Other factors may also have contributed to the decline.
However one does the analysis, the result is the same: the decline in inflation over the past year was largely the predictable (and predicted) consequence of the removal of temporary sources of inflationary pressure. A benign loosening of labor markets provided some additional disinflation.
Unfortunately, it is not clear how much further this cost-free disinflation can go. And, in fact, today many of the temporary factors appear to be mitigating inflation rather than fueling it. If inflation does painlessly fall to 2%, we should celebrate – and engage in more serious soul-searching regarding the standard economic models. But if it does not, the US Federal Reserve will need to be prepared to go further to bring inflation down to an acceptable range.
However one does the analysis, the result is the same: the decline in inflation over the past year was largely the predictable (and predicted) consequence of the removal of temporary sources of inflationary pressure. Standard economic models appear to work, after all.
