The inflation mystery

October 23, 2019
Robert Samuelson

By Robert Samuelson


The virtual elimination of inflation is one of the great uncovered stories of our time. If you go back to the 1970s and the early 1980s — a period when, admittedly, many of today’s Americans weren’t alive — surging inflation seemed unsolvable. From 1975 to 1980, the consumer price index (CPI) rose an average 9% a year. There was much pessimism that inflation could ever be controlled. The idea that it would essentially vanish from public debate was unthinkable. Yet, that’s what has happened.

From 2010 to 2018, the CPI has increased only about 2% annually. In turn, the collapse of inflation has transformed political debate. We have gone from worrying about “stagflation” — the coexistence of high inflation and high unemployment — to arguing about economic growth and inequality. On the whole, this is a better place to be.

Recall the “misery index.” It combines the unemployment rate and inflation. In 1980, the index was 19.6% (7.1% unemployment rate and 12.5% inflation). In 2018, it was 5.8% (3.9% unemployment and 1.9% inflation). There won’t be much anti-inflation rhetoric in the 2020 campaign. Indeed, low inflation is one reason the current economic expansion is the longest in U.S. history. Despite the running feud between President Trump and the Federal Reserve, there has been no sharp increase in interest rates to dampen the recovery.

But there is one gaping hole in this otherwise happy story: We don’t know what’s caused inflation to drop so low and to stay there. It’s a “puzzle,” as economist Janet Yellen, former chair of the Fed, recently put it at a Brookings Institution conference on inflation. The explanation matters. If we don’t fully understand low inflation, we may misinterpret its consequences.

The inflation mystery poses a simple question: Why haven’t wage gains increased faster as the economy has approached “full employment,” which is crudely put between 4% and 5%? Expressed technically, the question becomes: Why isn’t the Phillips Curve working? That’s economist A.W. Phillips, who argued in the 1950s that, as unemployment fell, wage gains would rise. Firms would have to pay more to attract workers. Some wage gains would feed into higher prices, aka inflation.

For many years, the logic worked as expected. Consider the 1961-69 expansion. “Unemployment declined from 6.7% in 1961 to 3.6% in 1969,” Yellen reported to the conference. Over the same period, inflation rose from “just under 1% to roughly 5%.” In the 1970s, the experience was similar.

Yellen offered some possible explanations for the collapse of the Phillips Curve.

(1) We are misreading the labor force. Phillips originally compared unemployment rates and wage gains. But the unemployment rate may be sending the wrong signals about labor force “slack” — the number of people willing to take a job — and, thereby, underestimating the ability of firms to hold down wage gains. Slack may include people who leave the work force when the economy is in recession and return when the recovery takes hold.

(2) Monetary policy — the Fed’s influence on interest rates and credit conditions — may have made people more sensitive to rising prices. In the 1980s, the Fed raised interest rates sharply to curb double-digit inflation. Monthly unemployment exceeded 10%. Unemployment soared again in the 2007-09 Great Recession. To protect themselves against a repetition, companies and consumers may limit wage and price increases. Low inflation may be self-fulfilling. If people think inflation will be low, they act to make it low. Yellen noted that “inflation expectations … have been remarkably stable, in the vicinity of 2%.”

(3) Globalization and new digital technologies create downward pressure on prices. The internet makes price comparisons easier than in the past. The ability of companies to shift production to low-cost foreign suppliers creates more slack, enabling firms either to hold down wages and prices at home or threaten to do so.

The conference offered many views. One paper argued that people form their views about inflation based on grocery shopping. Because it’s the most common form of shopping, it casts a large psychological shadow. Another paper minimized globalization’s effect on wages, asserting that domestic economic conditions still exert the most powerful pressures.

The central question is whether a low-inflation and low-unemployment economy is a new norm — something the Fed can protect — or just a fad. If it is a new norm, the consequences could be huge. A low-unemployment economy would almost certainly give the poorest and least skilled workers “a chance to turn around their lives,” as Yellen said. Therein also lies a danger: The possibility is so appealing that it could cause the Fed to gamble on low inflation.


(c) 2017, The Washington Post Writers Group