Today, Explained - How Dylan got inflation wrong

Episode Date: April 19, 2022

Last year, Vox correspondent Dylan Matthews didn’t think inflation would be a big deal. He wasn’t the only one to miss the mark. This episode was produced by Will Reid, edited by Matt Collette, engineered by Paul Mounsey, fact-checked by Laura Bullard, and hosted by Noel King. Transcript at vox.com/todayexplained   Support Today, Explained by making a financial contribution to Vox! bit.ly/givepodcasts Learn more about your ad choices. Visit podcastchoices.com/adchoices

It's Today Explained. I'm Noelle King. For months, my colleague Dylan Matthews, a senior correspondent at Vox, was of a particular opinion about inflation. He said, and many economists said, do not worry. My new opinion is that I am somewhat worried about inflation. In my defense, I was not alone in that prediction. And I've done a lot of thinking recently about why I got that wrong and why other people might have gotten it wrong and how we got into the current situation where inflation really is something to worry about. It's 8.5 percent. It's high. It's getting to a level we haven't seen since the 1970s, early 1980s, when inflation became sort of the defining

issue in American politics and really caused a great deal of damage. And so we're very much not out of the danger zone. Coming up, what economists and Dylan got wrong about inflation and how we might get out of the danger zone. delivered across the GTA from Real Canadian Superstore with PC Express. Shop online for super prices and super savings. Try it today and get up to $75 in PC Optimum Points. Visit superstore.ca to get started. Dylan Matthews, senior correspondent at Vox. Last year, to you, it seemed like inflation would be transitory. There would be an end to it.

Yeah. In 2021, there was kind of a sense by me and some other people that inflation was happening in a few goods, but not everything. It seemed like cars were getting a lot more expensive. It seemed like gas and food were getting more expensive. And my general attitude was, you know, this isn't great, but this too shall pass. And it just kept not passing. And worse, kept spreading to areas other than gas and cars and food into places where you wouldn't expect some of the shortages we were seeing to necessarily be driving prices up. To your credit, you weren't the only person who doubted that inflation would get this bad or last for this long, were you? No. So when I was predicting

inflation under 3% for 2022, I based that very explicitly on both the Federal Reserve, who are basing this on literally hundreds of economists who work for the Federal Reserve System trying to predict these things. They were all suggesting that inflation would cool throughout 2022. The survey of professional forecasters, which is a very useful survey of economists who specialize in doing this kind of forecast, had even lower predictions for inflation in 2022. So there was a really persistent error, and it wasn't an error among everyone. Some people who were publicly projecting high inflation and I think deserve a bit of a victory lap include Larry Summers, the widely hated in some quarters, beloved in some quarters, former Treasury Secretary. So it was not an impossible thing to get right, but it was a

very broad-based failure, not just to me, but of a lot of economists and forecasters. There is a kind of scaffolding or framework behind why you and many, many, many other very smart people thought that inflation wasn't going to be a big deal. Tell me about where this kind of framework begins. Sure. So you kind of have to understand the history of how economists have thought about inflation. The most basic framework for understanding it is something called the Phillips curve. If you Google economics papers on the Phillips curve, you will find thousands and thousands. This is a really crucial idea.

It was based on just a chart that this economist named Albin William Phillips published in 1958, suggesting that inflation was connected to the level of unemployment in the economy. When unemployment gets to a very low point, businesses have to raise wages for their workers because there isn't sort of a large pool of unemployed people they can hire without raising wages. This increase in wages passes through to an increase in prices for consumers, and you get sort of broad-based inflation. Correspondingly, if you tolerate higher unemployment, you can get lower inflation. And I think this theory was kind of taken as a philosophy of how to govern the economy in the 1960s. The time has come when we must get to those who are last in line, the hardcore unemployed,

the hardest to reach. Lyndon Johnson wanted a very low unemployment rate, both for good reasons, I think he was genuine about wanting to eradicate poverty in America, and for bad reasons, which is that he wanted to prosecute the war in Vietnam Vietnam and he wanted to spend lots of money and hire lots of people to fund and arm the war effort. And our objective is to place these 500,000 in private industry jobs within the next three years. He very explicitly was willing to tolerate higher inflation in exchange for that lower unemployment. You know, we'll get a little bit of inflation, but it's temporary. We can always sort of readjust this.

We can just pick a point in the tradeoff between unemployment and inflation. There wasn't a kind of aiming for a best of all worlds. There wasn't a sense that you could have stable prices and low unemployment. And somewhat sensibly, they decided they cared more about unemployment and thought they could have modestly higher inflation for a while in exchange for a better labor market.

And they learned the hard way that that wasn't necessarily so and that that trade-off could break down in certain instances. What did inflation in the 1970s look like? So you get a couple waves of inflation in the 70s. The first comes in the early 70s, in the aftermath of a couple of big international crises. The first was that Richard Nixon took the country off the gold standard. We must protect the position of the American dollar as a pillar of monetary stability around the world.

The other thing was that in 1973, a number of Arab nations invaded Israel. The U.S. stood with Israel. In reaction, a lot of Arab oil-producing countries announced an embargo on oil to countries supporting Israel. They will reduce oil production by 5% a month until the Israelis withdraw from occupied territories. If the Arab countries keep that pledge, it would reduce their production by almost 50% in one year. And so oil prices shot up. That led to first oil inflation and then sort of broad-based inflation. That kind of tamped down in the mid-70s, and then it came roaring back at the end of the decade. And this really challenged the Phillips curve perception for a few reasons. One was just, you suddenly had not just high

inflation, but relatively high unemployment. You had a struggling labor market at the same time that you had really nasty inflation. And that shouldn't happen. We were on a point outside the Phillips curve. And it suggested there was something wrong with that theory and that that whole way of looking at the economy might work in some situations, but it can break down in certain contexts. What year were you born? I was born in 1990. Okay, I was born in 81. And so neither one of us remembers this, but like this for our, was a defining thing. You know, 9% inflation, 10% inflation, and then we manage to pull out of the spiral of the 1970s. What happens there?

So, this is a story of a guy named Paul Volcker, who became the Fed chair in 1979. He was a real character. First, Mr. Chairman, I appreciate your comments and those of your colleagues, your personal support and those of others. I also appreciate your concerns, and I think I understand some of your warnings, personal and otherwise. It was like six sevens. We towered over everyone. He loved cigars and would just chomp on cigars during congressional hearings and public appearances. It is often said that he broke the back of inflation. And what he did to do that is that he engineered two incredibly nasty recessions.

Robin, there are those who claim Paul Volcker is the real father of this recession. In October, soon after he became Federal Reserve chairman, the Fed intensified its efforts to stop inflation. His judgment was, inflation won't go down until the entire world is convinced we're serious about stopping it. And we show we're serious about stopping it by dramatically tamping down on what people are spending. And the way we tamp down on what people are spending

is that we raise interest rates. Mr. Volker, welcome. First, are you willing to accept parenthood for this recession? No, I'll claim no paternity. I don't even like the question being asked that way. The interest rate they're raising is the rate that banks pay for sort of basic day-to-day operations. So when you raise that rate, the rate for mortgages goes up. The rate for credit cards goes up.

The rate for auto loans goes up. The rate for business loans to hire people and do stuff goes up. And so when you raise the rate, you throw people out of work, you shrink businesses, you reduce spending on everything from houses to cars to anything that is financed by debt, and you get a really nasty recession. The gross national product, the value of goods and services produced by the economy, fell during the third quarter, ending September 30th by 0.6%. It had fallen in the second quarter by 1.6%.

And so unemployment surged to over 10% in the early 80s as a result of these policies, which are now often called the Volcker Shock. Home builders who did things like drive a tractor onto the lawn of the Fed result of these policies, which are now often called the Volcker shock. Homebuilders who did things like drive a tractor onto the lawn of the Fed and mail two-by-fours to Paul Volcker to try to intimidate him, they lost their jobs and their livelihoods during this. But a lot of economists look at this as a huge success. He really did end inflation at that period. It slowed down dramatically throughout the 1980s. And then for basically all of your and my lifetime until last year, you had extremely modest price increases of maybe 1% to 3% every year.

And it kind of felt like the inflation problem was solved. And it felt like it was solved because this guy was willing to take really drastic unpopular action for the sake of long-term recovery. You know, we have this idea, we have this notion that like the Phillips curve governs all and then it turns out that that is not okay and that we need something different. And then what we start to see essentially is like one economic theory appears to work fine. Okay, this is the one we're going to go with. And then what we start to see essentially is like one economic theory appears to work fine. Okay, this is the one we're going to go with. And then comes another turn in the great cycle. And that is a catastrophe in 2008. That's right. So 2008, the financial crisis hits, but it's possible to have financial crises without as nasty a recession as we had. And I think some of that was that the Federal Reserve was not as aggressive as it could have been. And I think it wasn't as aggressive as it could have been in part because of the experience of the 1970s,

that they were very nervous about bringing back that kind of inflation. And that meant that they weren't willing to always do the things that might have been necessary to satisfy the other side of their mandate to try to get unemployment down and stimulate the economy. And they tried to do some things. They bought up tons of bonds. But throughout the 2010s, sort of the big failure of the Fed in the eyes of a lot of people was that it didn't satisfy its mandate to minimize unemployment. And so it felt a lot like a lost decade. And it felt like a lost decade due to timidity by the Fed. And I think in reaction to that, a new generation of leadership,

in particular, the current Fed chair, Jay Powell, took a very different direction and started focusing like monomaniacally on trying to reduce unemployment and made inflation a very secondary concern to that task. And that new generation, that new generation that said we focus too much on inflation, on the threat of inflation and not enough on keeping people in jobs that would let them eat and pay their mortgages. That new generation was very influential going into 2020 and into the pandemic. Yeah. Yes. And I would also say it was very successful. In 2020,

in the aftermath of the pandemic, unemployment shot up to 14%. That was higher than the 80s. It was higher than the peak of the Great Recession. It was the biggest unemployment we had seen since the Great Depression almost 100 years ago. And Jay Powell just like fixed it. Now it's below 4%. He really dramatically pushed trillions of dollars into the markets. And he was also joined by Congress and Presidents Trump and Biden. Trump spent trillions of dollars on the CARES Act in March 2020, which included stimulus checks, bonus unemployment insurance,

PPP loans to businesses to keep them afloat. Biden passed trillions more in stimulus after he took office. And so that, in conjunction with the trillions that the Fed was injecting into financial markets, was successful at bringing unemployment down very, very, very rapidly. And I want to underline that because we're talking about some of the side effects in terms of inflation. But I think that was a genuine, massive policy success. They really lived up to the unemployment side of their mandate. And I think a lot of people are better off now because of it. And we easily could have had another lost decade where instead of worrying about inflation right now, we'd be saying, you know, unemployment's still at 9%. People are really suffering. Who cares if inflation

is low? All these people are out of work. They erred very strongly on the side of having fewer people out of work, and there were real benefits to that, but we're also learning that there were some costs. Support for Today Explained comes from Aura. Aura believes that sharing pictures is a great way to keep up with family, and Aura says it's never been easier thanks to their digital picture frames. They were named the number one digital photo frame by Wirecutter. Aura frames make it easy to share unlimited photos and videos directly from your phone to the frame. When you give an aura frame as a gift, you can personalize it, you can preload it with a thoughtful message, maybe your favorite photos. Our colleague Andrew tried an aura frame for himself. So setup was super simple. In my case, we were celebrating my grandmother's birthday

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Ontario only. Please play responsibly. If you have any questions or concerns about your gambling or someone close to you, please contact Connex Ontario at 1-866-531-2600 to speak to an advisor free of charge. BetMGM operates pursuant to an operating agreement with iGaming Ontario in econ 101 you might learn that one definition of inflation is too much money chasing too few goods simple right, right? You want to take care not to flood an economy with too much money. But then the U.S. government floods the economy with a lot

of money. About $5 trillion is one estimate that I've heard. About $1.8 trillion in unemployment and stimulus checks and other things to individuals. about $1.7 trillion to businesses, over $700 billion in state and local aid, just a lot, a lot, a lot of money. And that resulted in total spending, not just sort of matching where it was before the pandemic, which I think would have been the goal, but kind of exceeding it. So the floodgates open, $5 trillion comes pouring into the American economy. Inflation does start to go up. Everybody does notice it. But you didn't think it would turn out to be a big deal.

Why? I had a few philosophies on this. One was, you know, it's better to err on the side of too much than too little. And I think that gets at some of what we talked about, about the 2008 crisis, where we did too little and a lot of people suffered. And I think some of it was also a sense that it would settle down. We might have gotten into a situation where there was more money than there was stuff to buy with it. But that would ease. People would go back to work after they got vaccinated. The virus would kind of die down and stop sort of slowing the economy on its own by making people sick and making it harder to do stuff. And after all the money was dispersed by the federal government, people would spend it and then get back to normal and it wouldn't keep going.

A lot of those assumptions turned out to be wrong. People were pretty prudent with the government's money, and so they've been spending it very gradually. And that's definitely what, like, my personal finance teacher in high school would have told me to do. But it has made sort of the resulting inflation a lot more durable than it otherwise would have been. Prices surging more than they have in 30 years, and there doesn't seem to be an end in sight. The price of a pound of bacon rising more than a dollar, a dozen eggs up 21%,

and a sirloin steak up a whopping $2 a pound. A lot of people are wondering, when is this going to end? It's also meant that price increases in some areas aren't offset by decreases in other areas. Normally, when you have a huge increase in gas prices, people spend less money on other stuff because they only have so much cash. And so they have to offset price increases in one area by spending less on other stuff. That typically means that the other stuff sees its prices fall.

And so you don't get overall inflation, you just get a change in relative prices between types of things. You didn't see that this time in part because people had lots of money in their checking and savings accounts because the government had been so generous. And so you just sort of get a broad overall inflation. We needed a strong fiscal response. We just did a lot of it. And a lot of it was not particularly well targeted. I think in retrospect, by far the most wasteful part of the whole package was the hundreds of

billions of dollars sent to state and local governments. There was kind of an assumption the state and local governments were going to see their tax receipts plummet and they would need all this federal help. And they really didn't. The economy recovered fast. They had a big surge in their tax receipts. And then they got this enormous handout from the federal government. And it would be one thing if they spent that sort of prudently improving services and whatnot. They've spent it on tax cuts. And so sometimes when people hear, you know, we spend too much on stimulus,

they hear like, oh, you wanted to take my check away. That's not necessarily what I mean. I mean that like maybe Texas shouldn't have gotten billions of dollars to like cut taxes and that like maybe that was somewhat inflationary. Again, it was an attitude of it's better to err on the side of doing too much than doing too little. And that still might have been the case, but we definitely erred on the side of doing too much than doing too little. And that still might have been the case, but we definitely erred on the side of doing too much. People are seeing that inflation has gone up by 8 plus percent. Is it fair to assume that your average employee going in to negotiate a salary

is going to ask their employer for more money? Or the person who's already employed is going to go to their boss and say, hey, you know, my paycheck is shrinking here. Yeah, so this is a dynamic that's sometimes called a wage price spiral. And the idea being that when inflation is going up, and people are seeing their wages adjusted for inflation go down, they'll demand higher wages, and they'll get them. I'm skeptical of it basically because employers have a lot of power. So one example I often use is hospitals. I grew up in a small town in New Hampshire. There were basically like two hospitals nearby. And if you were a nurse, you kind of had

to work for one of them. And it was pretty easy for them to not poach each other's people in such a way that people could say, you know, if you don't give me a raise, I'm going to go to this other hospital. And a lot of markets are like that. There are only a few employers who could theoretically hire you, and that reduces your bargaining power and reduces your pay. So I think that has meant that workers can't exploit this inflation to get wage increases as much as they might want to or might be fair. Since last February, the average hourly wages have increased by more than 5 percent. Historically, that is a considerable increase. But with the cost of goods at its highest level in 40 years, it's posing a threat to the nation's economic recovery. All right. So we have trillions of dollars floating around the economy from the stimmy.

We also have a tight labor market. What does it take now? What will it take now to bring inflation down? So I think there are a few key policies to pursue here. And one thing that I think some economists on the left have been emphasizing that I agree is very important is just increasing productive capacity for some things where we have shortages, building more semiconductor factories, building more robust supply chains, expanding renewable energy so that gas prices are less important for people. That's all great. That's all part of a long-term approach to inflation management.

In a more short-term thing, you've got to get the virus under control. And that's a tough public health challenge. People seem sick of masks, and we seem to maybe be reaching an upper limit on how much we can vaccinate people, given sort of the number of people who are skeptical of vaccines for very bad reasons. But there are still some people who aren't working because of fear of the virus. And the more you get the virus under control, the more you can get those people working and expand what we're able to do with our economy. But I think the ugly truth is the Fed needs to use and has started using its lever of trying to

tamp down spending to get it to match what the economy is actually capable of doing. Federal Reserve raising interest rates to a new range of 0.25 to 0.5 percent. And that's ugly and it's causing some concentrated pain. But we're at a point where it's clear that we're not going to expand our ability to make stuff for that supply to reach the level of demands we're at now. We're not able to do that in a very short-term way. What we are able to do is constrain demand a little bit to get it to better match up with what the economy is overall able to do. That's a conclusion I reach with some great regret. Interest rate hikes are a little like chemotherapy. They cause a lot of pain in the now, and they're blunt, and they hurt healthy cells.

But they might be better than the alternative and prevent future pain. Dylan Matthews is a senior correspondent at Vox. Today's show was produced by Will Reed, edited by Matthew Collette, engineered by Paul Mounsey, and fact-checked by Laura Bullard. And also Amina El-Sadi, Matthew Collette, myself, and Will Reed, as Laura is sick today. The rest of our team includes Halima Shah, Hadi Muagdi, Miles Bryan, Victoria Chamberlain, and my co-host, Sean Ramos-Firm. Special thanks this week to Sophie Lalonde. Our supervising producer is Amina El-Sadi. Vox's VP of audio is Liz Kelly Nelson. We use music by Breakmaster Cylinder and Noam Hassenfeld.

I'm Noelle King. Today Explained is part of the Vox Media Podcast Network.