Inflation and the economy are still the biggest issues for many voters the mind Heading into the 2024 election, though, inflation has fallen from its dizzying highs in June 2022, when prices hovered around 9 percent. Last month, it was a much more manageable 3.3 percent.
But it is still not entirely clear what caused the fall in inflation.
In a recent episode inexplicableWe’ve seen why it’s still such a difficult mystery to crack.
While the jury is out on the exact reasons, there are two basic theories that explain why inflation has declined over the past few years.
Theory 1: It was the Fed
In mid-2022, the Federal Reserve raises interest rates and soon thereafter, inflation begins to decline. Case closed, rate hike is what it did. right?
The problem is that the normal way interest rates affect inflation increases unemployment. Interest rates rise, businesses struggle to hire more workers, and unemployment rises. But in 2022, unemployment has barely changed. Something else was going on.
Instead, economists like Adam Posen of the Peterson Institute for International Economics argue that inflation has fallen because of public expectations. As Posen explains, “If people are convinced that the central bank or society will reduce inflation in the future, they don’t react much to movements in inflation today.” People don’t feel the need to ask for raises and businesses stop raising prices. Basically, it’s a self-fulfilling prophecy.
Posen points to the fact that after the pandemic triggered the latest round of deflation, inflation did not completely spiral out of control. Because the Fed built trust with the American public over the years, convincing them that it would act when needed. When the Fed finally raised interest rates in 2022, it largely served as a reminder that it was under control, calming people’s concerns about rising inflation.
“The strongest evidence for this is that we’ve had general shocks across major economies across Europe, Japan, the US, the UK, Canada,” Posen said. “But of those, once central banks raise rates, it all comes back.”
Theory 2: It was the end of the epidemic
Economist Claudia Sahm isn’t sold on the theory that expectations are the main thing driving down inflation in 2022. “A key part of this is having to listen to the person on the other side,” says Sahm. “Regular people aren’t listening to the Fed.”
Instead, Sahm thinks the answer is much more specific: “To me, the most obvious explanation is that we’re curing supply problems caused by the pandemic.”
Sahm said that after the pandemic essentially shut down the economy, it took years for the supply chain to fully come back online. When this happened, there was more production, which meant more things for people to buy with their extra cash, which ultimately brought down inflation.
Why is it so hard to figure out?
As supply chains reopen, the Fed has raised interest rates, making it harder to allocate credit. But there is a more fundamental problem here. “Anything in macroeconomics is very difficult to test empirically,” said Vox senior correspondent Dylan Matthews. “You can’t experiment with the Fed.”
Ultimately, Matthews says inflation — and our economy as a whole — is still so difficult to understand because of the nature of money. “Money seems like this very difficult thing, but money is a psychological concept. Money is the idea that we can put numbers on what we owe each other, even though we realize that these numbers are kind of made up.”
Inflation is, in a sense, a psychological phenomenon. “So understanding inflation, I think, is ultimately about understanding people and how they relate to each other. And that is the ultimate mystery.”
Listen to the full episode and don’t forget to follow along inexplicable on Apple Podcasts, Spotify, Amazon MusicOr wherever you listen to podcasts.
