Powered by 
In this week’s Grumpy Economist Weekly Rant, John Cochrane examines whether inflation can return to lower levels without triggering a recession or higher unemployment. He explains how expectations of future inflation influence current prices and wages, and why the Federal Reserve cannot bring those expectations down through promises or higher interest rates alone.
Drawing on historical examples from Europe, inflation-targeting reforms in the 1990s, and Argentina’s recent experience, Cochrane argues that credible fiscal and economic reforms can reduce inflation without the conventional costs of monetary tightening. He makes the case that lasting disinflation requires addressing the underlying causes of inflation, supported by a credible commitment to price stability.
Transcript
Hi, I’m John Cochrane, senior fellow here at the Hoover Institution, and welcome to my Grumpy Economist Weekly Rant.
Today, I’m going to talk about immaculate disinflation: how you can get lower inflation without recessions and unemployment.
Now, inflation’s stuck above 3%, at 3.7% in the latest CPI. The hard question for the Fed and Congress is how to bring that down. And if inflation grows to 4% or 5%, that question will be even more pressing.
The usual medicine is higher interest rates, but that might cause a recession. Indeed, that’s the point.
Now, even in the conventional Phillips curve doctrine, inflation comes from people’s expectations of future inflation, as well as from employment. If businesses expect higher inflation next year, they raise prices now. If people expect higher inflation next year, they’re willing to pay higher prices now, and they demand higher wages.
That was the idea behind forward guidance back when interest rates were zero, and the Fed wanted more inflation. The Fed promised to tolerate future inflation, and the Fed hoped that expectations would then raise inflation right away.
Well, conversely, if the Fed can get people to believe inflation will be lower next year, then inflation can come down now, immaculately, without unemployment.
But the Fed can’t change expectations just by giving speeches. Speeches by public officials telling us to trust in a bright future are the last thing in short supply today, and inflation isn’t just a self-fulfilling prophecy unhinged from economics.
So how can we lower inflation expectations?
Standard monetary economics prescribes a durable precommitment to actions, not just words. Fed chair Kevin Warsh is doing a good job of persuading Fed watchers that he’s really an inflation hawk. That helps. But is it enough?
Inflation’s still rising, though maybe less than it might have been otherwise. Just what will that hawk do if inflation surges? That’s the question.
If inflation surges to 1979 levels, will the Fed really repeat 1980? Interest rates over 15%, despite a brutal recession. If people really believe that, then inflation won’t surge to 1979 levels in the first place.
But if people doubt that commitment, then hawkish talk won’t do much good. Look up the cute “Whip Inflation Now” buttons from the 1970s, and it could be a lot harder now, when higher interest rates also raise deficits and threaten too-big-to-fail banks, and it’s unlikely the Fed will get congressional and administration support.
The Fed strategy discussions, those are all attempts to create that commitment to hard action in the future, but they tend to be a bit vague, with too many outs.
And even so, will higher rates alone work?
The 1980s featured important fiscal, tax, spending, and economic reforms too, a lot of economic growth. Without those, it’s doubtful that higher interest rates alone would have durably lowered inflation at all.
The best way to lower inflation expectations is to credibly lower the underlying causes of inflation, not just how the Fed will fight it.
There have been many nearly immaculate disinflations in the past. The most classic examples are the ends of hyperinflations following World War I.
When the German, Austrian, and Hungarian governments solved their long-running fiscal problems- the problems that had caused them to print money in the first place- inflation stopped on a dime, with no high interest rates, with looser money, and with no recession.
When countries including New Zealand, Israel, Sweden, and Canada adopted inflation-targeting reforms in the 1990s, their inflation also dropped suddenly and without high interest rates or recessions. But those reforms also included tax reforms, spending reforms, microeconomic liberalizations, and greater growth.
In Argentina, Javier Milei moved budgets from chronic deficits to surpluses. Yes, it can be done. And inflation dropped from 25% per month to 2% per month without a deep recession or without high interest rates.
Conversely, high interest rates without fiscal and economic reforms have failed many times in the past and led to only greater inflation.
A durable end to persistent inflation comes from fiscal and economic reform along with monetary credibility.
Done right, this inflation can be immaculate. Expected inflation collapses, and actual inflation collapses with it, with no recession.
Alas, central banks can’t do that alone.
Well, thanks for watching, and if you enjoyed this Weekly Rant, please click to subscribe.
John H. Cochrane is the Rose-Marie and Jack Anderson Senior Fellow of the Hoover Institution at Stanford University. An economist specializing in financial economics and macroeconomics, he is the author of The Fiscal Theory of the Price Level. He also authors a popular Substack called The Grumpy Economist.