Thread by @ModeledBehavior

Why is there so much disagreement about the inflation outlook? Let me do a little thread here to try to explain why things are so uncertain…

I think that a lot of economists (not all) agree output will be above potential over the next 12-18 months, but we disagree about the implications.

I think a lot of economists (not all) agree that there will be significant labor market slack over the next 12 months, but disagree about the implications.

I think the disagreement is less about the size and sign of the output and demand gaps, and more about what the net effect on inflation will be.

The thing is it’s really not normal for output to be above potential while there is still labor market slack. These things usually go together, Okun’s Law relates the two. So the uncertainty about which prevails when in opposite directions is understandable

There are two things to think about with respect to labor slack and inflation. First, I don’t think you should look at the Great Recession recovery as proving that as long as we have slack we can be confident inflation will be below target.

The reason slack was so consistently a deflationary force in this period was the fed constantly underestimated it. It wasn’t labor slack that kept us from hitting the 2% target, it was rates that were set as if slack was much lower than it was.

Slack will be much less of an inflation headwind this time around because the fed is not going to underestimate it to the same extent as before. So you can’t count on it as being as big of a wet blanket for heating up prices

Second, what is the mechanism through which labor slack leads to weaker price pressures? It’s through wages. So everyone on here claiming that we have entered a new era of bargaining power already and things have really changed are basically saying that mechanism won’t work

If the fed is not underestimating labor slack, and workers are managing to somehow have a lot of bargaining power and wage growth, there’s really no way for labor slack to lean against output > potential to push inflation down.

In other words, those most confident this bargaining power is permanent should also be most concerned inflation is going to be high. But that’s really not the case

What I am less certain about is what happens when short term labor supply shortages push wages up a lot, which is now, but this is then followed by labor slack when supply increases, but also a negative output gap is happening the whole time.

I think the positive price pressures are going to outweigh the negative. Especially given downward nominal wage rigidity that is going to keep these short term wage adjustments from being undone.

But I don’t think you can really have a sustainable wage price spiral in this context. Which combined with expectations being firmly anchored makes me not worry about runaway inflation at all. I think it’s a total non-issue.

What would have been best IMO is spreading the stimulus out slower, which of course is what I’ve been saying for a long time

FYI @Neil_Irwin this is the flip side of your column suggesting bargaining power may be real. If so, it’s very suggestive of more inflation than the fed and white house think is coming