The speech by Jay Powell, chair of the Federal Reserve, at the Jackson Hole Economic Symposium last month was as close to a paean of victory as a sober central banker could utter. “Inflation has declined significantly,” he noted. “The labour market is no longer overheated, and conditions are now less tight than those that prevailed before the pandemic. Supply constraints have normalised.” He added that, “With an appropriate dialling back of policy restraint, there is good reason to think that the economy will get back to 2 per cent inflation while maintaining a strong labour market.” So, happy times!
This is a better outcome than I and many others expected two years ago. Indeed, the success in lowering inflation with only a modest weakening of the real economy is a welcome surprise. Unemployment, Powell pointed out, was 4.3 per cent — “still low by historical standards”. In the eurozone and the UK, the outlook is less rosy. But there, too, the prospects are for lower interest rates and stronger demand. As he noted, one of the reasons for this success has been the stability of long-term inflation expectations. That is what the regime of “flexible average inflation targeting” was supposed to achieve. But it is also worth adding that there was some luck, notably over labour supply.
Despite these outcomes, lessons need to be learned, because some of the stories being told about this episode are not right. Mistakes were made in understanding the economics of Covid. Mistakes have also been made in attributing the surge in prices to unexpected supply shocks alone. Demand also played a role. It is highly likely that big supply shocks will happen again, just as there will be further financial crises. Central banks must learn from these experiences even if they believe that this episode ended not too badly.