The Fed Delivered Disinflation

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In the Wall Street Journal, James Mackintosh argues the Fed doesn’t deserve credit for the recent decline in inflation. Disinflation occurred “mostly because of things the Fed has no control over, as normality returned after the pandemic,” he writes. Instead, supply-side improvements explain easing price pressures. The best that can be said for the Fed, according to Mackintosh, is that it refrained from stoking a dying fire.

Mr. Mackintosh’s arguments fail. On the demand side, he overlooks the crucial driver of inflation, which is nominal spending (current-dollar GDP). On the supply side, he confuses the level of prices with the growth rate of prices. It’s abundantly clear that the Fed has contributed to disinflation, and that supply-side factors are largely secondary.

As with most financial commentators, Mr. Mackintosh focuses on how the Fed’s interest rate policies affect various sectors of the economy. He looks at saving, borrowing, consumption, investment, housing, employment, and output growth and claims there is no evidence for Fed-led disinflation. But, with the exception of the last item (output growth), these are all peripheral. It’s fundamentally mistaken to look for economy-wide phenomena in specific sectors or industries. Inflation affects all markets, so we need a cause that is common to all markets. This isn’t to deny inflation sometimes has effects on relative prices. It is merely to recognize that localized price changes are distinct from widespread inflation. We’re trying to explain broad-based price pressures. Mr. Mackintosh’s proposed mechanisms can’t.

That leaves his final variable, which is output growth. Let’s dig into the data: What’s happened to current-dollar GDP since the Fed started tightening? Nominal output grew at an average annual rate of 11.6 percent over the last three quarters of 2021 and 6.87 percent over 2022. So far in 2023, the average growth rate is 6.0 percent. There’s clearly been a slowdown in aggregate spending. Whether you’re looking at inflation-adjusted interest rates or the broader monetary aggregates, it’s also clear that monetary policy tightened. Your counterfactual scenario — what you think would’ve happened had the Fed not tightened — must be wildly out of sync to reason otherwise.

Neither does Mr. Mackintosh’s supply-side story work. In theory, it’s true faster real output growth can cause disinflation. But that’s not happening now, largely because we don’t have faster real output growth. Starting in Q2, real output growth averaged 5.33 percent in 2021. In 2022, the average was a measly 0.65 percent. Growth for the first two quarters of 2022 was negative! Real output growth was strong in 2023:Q3, but this is an outlier, and it doesn’t change the fact that growth over the last year — the year over which we’ve seen disinflation — has fallen. So much for actual supply-side disinflation.

There’s an even more basic conceptual error here. If higher prices in 2021 and 2022 were largely driven by supply constraints (e.g., pandemic-related bottlenecks) and those supply constraints have eased up over the last year, we should have seen prices fall over the last year rather than merely growing more slowly. There should be not just disinflation, but outright deflation! Of course, this is nowhere near a reality. Although some prices have declined over the last year, most prices are much higher today than they would have been had they grown at an average rate of 2 percent since January 2020.

Like Mr. Mackintosh, “I’m not convinced that a Fed that let inflation get out of control should now get a lot of credit for clearing up its mess.” We oughtn’t pin a medal on an arsonist’s chest for putting out a fire he started. The Fed is largely responsible for the surge in prices that occurred in 2021 and 2022. But it is also largely responsible for the ongoing disinflation. Alternative explanations simply don’t make sense.