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By Paul Krugman
Stop me if you’ve heard this before: In a few days, we’re going to get a couple of important inflation reports, and they might bring some clarity to the debate over whether we can have a soft landing — that is, getting inflation down without a recession.
Of course, if you have been following this discussion, you have indeed heard this before. Clarity in the inflation discussion has been very hard to come by, even if you ignore the people filling my inbox with declarations that the dollar is doomed and that hyperinflation is just around the corner. I’ve compared debates among economists over each new trove of inflation data to ancient Roman priests seeking auguries in the entrails of sacrificed animals, a remark that, oddly, doesn’t seem to have won me many friends among my colleagues.
It’s also disturbing that many economists always seem to come down on the same side of these debates: Optimists are always optimistic, pessimists always pessimistic. I’ve surely been guilty of the same thing.
So I thought I’d devote today’s newsletter to a probably doomed attempt to bring some clarity to this discussion. And to be honest, I’m also trying to preregister my view on how to look at the coming data, especially the Employment Cost Index data that will be released Friday, so that I can’t be accused of picking and choosing which numbers to emphasize after the fact.
One thing all serious participants in these discussions agree on is that you can’t look at just the raw inflation numbers, which bounce around a lot in response to unpredictable, short-term events. Instead, you want some measure of underlying inflation. Remarkably, however, many economists throw the term around without defining what “underlying” means.
What I think we think it means is that there’s a lot of inertia in some, but not all, prices. Many prices are sticky in the sense that companies don’t change their prices every day or even every month; almost nobody changes wages on a frequent basis, for example. Instead, companies change prices or wages at intervals — say, once a year.
How does this create inflation inertia? When relatively high inflation has been going on for a while, companies are likely to raise their prices substantially every time they revise them, even if demand for their products is slack, for two reasons: They’re trying to catch up with rising costs (and competitors’ prices) since their last revision, and they’re trying to get ahead of the inflation they expect to happen until the next time they change their prices.
This is an old idea in economics, going back at least to a 1968 paper by Edmund Phelps. I laid out an informal version in 2008; M.I.T.’s Ivan Werning did a rigorous exposition last year (warning: very technical).
So what I think people mean by “underlying inflation” is this inertial or embedded inflation, which can be hard to get rid of without putting the economy through the wringer, perhaps with a period of high unemployment. Embedded inflation, in turn, should reflect some average of recent increases in inertial prices and expectations of inflation.
But how do we put a number to embedded inflation and track how it’s changing?
This used to be relatively easy. From the 1990s until the eve of the Covid pandemic, inflation expectations seemed fairly stable. Yes, consumers’ predictions of inflation over the next year bounced around a lot, but that was largely a function of gasoline prices and probably had little impact on pricing behavior. And we seemed to have two workable measures of inertial inflation. Core inflation, excluding volatile food and energy prices, looked like a pretty good measure of inertial prices; so did average wages — not because labor costs necessarily drive inflation but because wages tend to be especially sticky and hence a good indicator of sticky prices in general.
Focusing on core inflation really helped policymaking around the time of the 2008 financial crisis, helping the Federal Reserve stay calm when fluctuations in oil and food prices caused large swings in raw inflation numbers.
Unfortunately, these measures haven’t coped well with the weirdness of the economy since Covid-19 struck. There have been wild swings in prices for things other than food and energy, such as used cars. The rise in working from home caused a huge surge in demand for space and hence rents, but market rents can take a year or more to be fully captured by official measures of shelter inflation, which in turn makes up around 40 percent of core inflation, so a lot of reported inflation these days reflects a rent surge that ended many months ago.
As for wage statistics, they’ve been buffeted by changes in the employment mix. Low-wage workers were disproportionately laid off during the worst of the pandemic, so removing them from the mix caused a spurious rise in average wages; the reverse happened as those laid-off workers were rehired, and these compositional effects may still be distorting wage data.
Finally, we know that one-year consumer expectations of inflation are a bad measure, which has led many economists, myself included, to focus on longer-term expectations — say, three or five years — which have been much more stable. But nobody sets prices three years in advance, which raises some questions about what these measures actually reflect.
So in view of all this, where am I looking right now?
On expectations, I’ve been convinced by Joseph Politano’s excellent blog that the best available measure is probably the Atlanta Fed’s index of business inflation expectations, which asks companies how much they expect their costs to rise over the next year (a number they may actually know something about). Here’s what it looks like:
In short: This number is still elevated from prepandemic levels but not by a lot, and it has been coming down.
On prices, I’ve been looking at what’s come to be referred to as supercore inflation, which excludes shelter and used cars as well as food and energy. The Fed has lately been looking at a conceptually related measure: core services, excluding shelter. We’ll get a read on that number Thursday. But with all due respect, that number excludes an awful lot of stuff, and much of what’s left is hard to measure, so it feels a bit like the aforementioned entrails reading to me.
On wages, while there have been a number of attempts to adjust for those compositional effects I discussed earlier, there’s enough dispute among these estimates that I’m still relying mostly on the Bureau of Labor Statistics’ Employment Cost Index, which is supposed to be independent of the mix of employment. Unfortunately, that index is released only every three months. That means Friday’s release will be a big deal.
But beyond the question of what to look at, there’s still an important consideration: What frequency should we be looking at? Everybody worth listening to in this business agrees that changes over the past year lag events by too much, while monthly numbers are too noisy. Many people, including me, have therefore been trying to extract the signal from the noise by looking at three-month rates of change. But lately I’ve been looking at those three-month numbers, and they still look awfully noisy. Here’s supercore inflation, considered from the three- and six-month perspectives:
And here are Employment Cost Index wages and salaries:
In both cases, the three-month changes still have big dips and rises that don’t seem related to anything real happening in the economy. As a result, for the moment, I’m going for six months (look at those steadier lines above) and plan to stick with that on Friday even if the three-month number is closer to what I want to hear.
Overall, the data seems to me to point to gradually falling inflation, even though unemployment hasn’t gone up. I’m hoping that as more data comes in, this view will be increasingly vindicated. But I’m going to try not to let my hopes color my analysis, and that’s why I’ve put my preferred measures on the record today.
Now let’s wait and see.
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Source Images by DNY59 and Iuliia Bondar, via Getty Images
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