NEW ORLEANS — Federal Reserve officials kicked off 2023 by addressing a thorny question that is poised to bedevil the central bank throughout the year: How should central bankers understand inflation after 18 months of repeatedly misjudging it?
Lisa D. Cook, one of the Fed’s seven Washington-based governors, used a speech at the American Economic Association’s annual gathering in New Orleans to talk about how officials could do a better job of predicting price increases in the future. Her voice was part of a growing chorus at the conference, where economists spent time soul-searching about why they misjudged inflation and how they could do a better job next time.
Fed officials must “continue to advance our understanding of inflation” and “our ability to forecast risks,” Ms. Cook said during her remarks, suggesting that central bankers could update their models to better incorporate unexpected shocks and to better predict moments at which inflation might take off.
Her comments underscored the challenge confronting monetary policymakers this year. Officials have rapidly raised rates to try to cool the economy and bring inflation back under control, and they must now determine not only when to stop those moves but also how long they should hold borrowing costs high enough to substantially restrict economic activity.
Those judgments will be difficult to make. Although inflation is now slowing, it is hard to know how quickly and how fully it will fade. The Fed wants to avoid retreating too soon, but keeping rates too high for too long would come at a cost — harming the economy and labor market more than is necessary. Adding to the challenge: Policymakers are making those decisions at a moment when they still don’t know what the economy will look like after the pandemic and are using data that is being skewed by its lasting effects.
“The pandemic has triggered a lot of changes in terms of how our economy operates,” Raphael Bostic, the president of the Federal Reserve Bank of Atlanta, said during a panel on Friday. “We’re very much in flux, and it’s hard to know for sure how things are going to evolve on a week-to-week or month-to-month basis.”
Understanding inflation is key to the thorny policy questions facing the Fed. But determining what causes and what perpetuates price increases is a complicated economic question, as recent experience has demonstrated.
Fed officials and economists more broadly have had a dismal track record of predicting inflation since the onset of the pandemic. In 2021, as prices first began to take off, officials predicted that they would be “transitory.” When they lasted longer than expected, both policymakers and many forecasters on Wall Street and in academia spent 2022 predicting that they would begin to fade faster than they actually did.
Given those mistakes, policymakers have begun to suggest that the central bank needs to reassess how it looks at inflation.
What is inflation? Inflation is a loss of purchasing power over time, meaning your dollar will not go as far tomorrow as it did today. It is typically expressed as the annual change in prices for everyday goods and services such as food, furniture, apparel, transportation and toys.
“Our models seem ill equipped to handle a fundamentally different source of inflation,” Neel Kashkari, president of the Minneapolis Fed, said in an essay this week.
The Fed has historically seen lasting inflation as a product of two forces: An overly-tight labor market that is pushing up wages, and consumer and business expectations for higher prices, which can turn into a self-fulfilling prophesy by making it easier for firms to charge more.
But today’s inflation has been driven by pandemic-inspired shifts in demand that collided with constrained supply chains and Russia’s war in Ukraine. While shocks like that are typically expected to fade, they have had staying power this time, and were compounded first as rents rose rapidly and more recently as other service prices have taken off.
“We don’t understand inflation,” David Romer, an economist at the University of California, Berkeley, said on the panel with Ms. Cook.
For now, Fed officials are betting that rapid inflation will slow as supply chains untangle and as a housing cost spike that started in 2021 begins to moderate. But officials worry that while inflation was not originally caused by today’s rapid wage growth, it could be propped up by it — and the hot labor market is only now showing signs of slowing down.
“The pandemic has had a much more prolonged effect on labor supply than many expected,” Ms. Cook said on Friday. “Rapid nominal wage growth has accompanied the recent rise in inflation in ways that traditional measures of labor market tightness — such as the unemployment rate gap — might not be capturing.”
Fed officials can take some solace in cooling pay growth, which was evident in jobs data released on Friday. Ms. Cook pointed out in her remarks that “recent data suggest that labor-compensation growth has indeed started to decelerate somewhat over the past year.”
But policymakers have suggested that they are still looking for a more pronounced slowdown in the economy before they will feel confident that the labor market will return to normal and inflation will fade fully.
Understand Inflation and How It Affects You
“The economy is moving in ways that we will start to see that imbalance disappear,” Mr. Bostic, the Atlanta Fed president, said on Friday. But, he said, it will take time.
In a discussion titled “Is High Inflation Here to Stay?,” panelists warned that bringing down price gains could require a much more severe, painful slowdown in the labor market, which continued adding jobs last month.
“I think high inflation is not here to stay, but it’s going to linger unless we see a huge increase in the unemployment rate that comes from broad-based job destruction,” said Aysegul Sahin, a former Fed economist and now a professor at the University of Texas at Austin. “What we are seeing in the labor market, while it is consistent with a soft landing, it could well be the beginning of the storm and it could well be that we are just not seeing that.”
And officials have been underlining that uncertainty abounds — which means that they need to be careful.
Central bankers want to avoid prematurely abandoning their battle against inflation, but they are also slowing the pace of rate increases to give them more time to see how their policies are impacting the economy.
“The experience of the ’70s showed that if you back off on inflation too soon, it comes back stronger,” Tom Barkin, president of the Federal Reserve Bank of Richmond, said on Friday, referencing an episode 50 years ago in which price increases took off and stayed high for years.
“If you think supply chain improvements and our actions to date are enough to bring inflation down quickly, then our more gradual rate path should limit the harm,” Mr. Barkin added.
Ms. Cook underlined that she and her colleagues are also carefully looking for data and models that can improve their understanding of what is actually happening with inflation dynamics and the economy.
“We’re not accepting anything as religion,” Ms. Cook said. “We’re not just listening to the measures and taking them wholesale.”
“We’re not a monolith,” she added.