Eco Week
Editorial

United States: the cost of disinflation

06/19/2023
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With the return of elevated inflation, the debate on the output cost of bringing down inflation that was very lively in the early 80s has made a comeback. This debate is centered around the sacrifice ratio -the loss in output compared to its trend level for a given decline in inflation- and whether the landing of the economy will be hard or soft. Recently, the semantics have evolved and commentators now speak of the possibility of immaculate disinflation, whereby inflation is brought back to target by the Fed through a restrictive monetary policy but with a very small cost in terms of unemployment. For this to happen, labour tensions should ease and lead to a drop in wage growth. This will take time. In addition, the US economy should do a better job in filling vacancies. Clearly, the jury is still out on what will happen to the unemployment rate in this cycle.

Back in the early 80s, when central banks were trying to get a grip on elevated inflation, academics spent a lot of time discussing the output cost of bringing down inflation. The thinking was that aggressive monetary tightening would cause a drop in economic activity, an increase in the unemployment rate, a decline in wage growth and inflation.

A temporary increase in the unemployment rate above its natural rate and a loss in output compared to its trend level were considered as the price to be paid for lowering inflation to an acceptable level. This price is represented by the sacrifice ratio. In the numerator we find the sum of output losses -the deviations between actual output and its full employment or trend level- and in the denominator the change in trend inflation over a given period, between its peak and its trough.[1]

In 1994, Laurence Ball, a professor of economics at Johns Hopkins University, stated that “disinflations are a major cause of recessions in modern economies - perhaps the dominant cause.[2] This explains why rate hiking cycles give rise to heated discussions between market commentators whether the landing of the economy will be hard or soft. Historically, the latter has been the exception.

Since the Federal Reserve started raising the federal funds rate in this cycle, the debate has been ongoing but recently a new twist has appeared, that of ‘immaculate disinflation’ whereby inflation is brought back to target by the central bank through a restrictive monetary policy but with a very small cost in terms of unemployment.[3]

US: employment rate and federal funds rate

Historically, tightening cycles have seen a significant increase in the rate of unemployment, with the major exception of the 1994 episode during which the unemployment rate continued to decline (chart 1). The latest Summary of Economic Projections shows that the members of the FOMC expect real GDP growth below trend this year and next, but this should only cause a limited increase in the unemployment rate, to 4.5% (from 3.7% in May), which is only slightly higher than its projected level in the longer run (4.0%). This triggered a comment from a journalist during Jerome Powell’s press conference that “it seems like it's getting more immaculate rather than a little messy.[4] It echoes the debate of last year whether a soft landing was a realistic assumption.[5] According to J. Powell, for goods price disinflation we need to see further improvement in supply conditions. This process is underway.