In 2022 economist Larry Summers predicted that inflation would only be brought down by an increase in the unemployment rate for a couple of years. Why? If workers expect high price inflation in the near future, they press for wage increases. Wage increases discourage employers from hiring . A low unemployment rate equilibrium requires a balance of financial interests, and common perceptions of economic conditions, between ordinary people and policymakers. Hence, Federal Reserve monetary policy must now tighten to reduce both actual and expected price inflation. In theory, only a period of higher unemployment and low actual price inflation can lower expected inflation rates. Consider DeLong on the matter:
Larry’s fear was that 7% per year inflation would drag the expectations anchor so that inflation expectations would settle at 4% per year—and that it would be the need to get them down to 2% per year that would bring on the recession. ~ B. Delong 12-19-23
According to Delong, Summers was wrong- the Federal Reserve did a masterful job of managing actual and expected price inflation. Hence, Delong expects a soft landing in 2024:
Inflation expectations never got unmoored from their 2% per year anchor—inflation expectations never became adaptive, let alone last-year-plus-one-percentage-point. Moreover, the Fed’s interest-rate increases had less of a depressing effect on the economy than I had feared, and whether by their skill or their luck we appear to have avoided recession and are nearly at the end of the glidepath to a soft macroeconomic landing. ~B. Delong 12-19-23, emphasis added
Short term expected price inflation actually peaked at about 4 to 5 percent, depending upon whether you believe the Federal Reserve or University of Michigan estimates. So it seems that Summers was about just about right regarding price-inflation expectations.
Long and mid term expected inflation didn’t rise as much as short term expectations did, but current wage negotiations depend primarily on short term inflation expectations.
There are clear signs of discontent with economic conditions in the American public. Many Americans are disappointed with the effects that monetary inflation had on real wages. What this means is that we can expect workers to aim too high with wage demands, until the Federal Reserve restores the credibility of its 2% inflation rate target.
The reactions of employers and employees to monetary policy and price inflation are not only determined by inflation expectations. Uncertainty regarding monetary policy doesn’t help, and monetary policy uncertainty has been volatile and is at a high level.
The odds of a soft landing in 2024 are actually low. The risk of a serious recession next year is all too real. In fact, the Federal Reserve has already announced its intention to cut interest rates in 2024 — apparently they think that the economy is on the brink of a recession.
Finally, I will note that it takes time for Federal Reserve monetary policy changes to alter real economic conditions. The money supply is contracting rapidly, and interest rates have risen sharply. The full effects of the Federal Reserve’s recent tightening of monetary policy will be felt in 2024, and I doubt that it will be a soft landing.
