‘Team Permanent’ (Mostly) Won the Inflation Debate

F or almost two years, economists and other observers have been fiercely debating the surge in inflation. By the summer of 2021, economists divided themselves into “Team Transitory,” those who thought inflation would subside relatively quickly, and “Team Permanent,” those who thought it would persist.

Fortunately, the past few months have shown signs that inflation has peaked and started to cool. So much so that earlier this week, Nobel Laureate Paul Krugman — a leading monetary dove who’s been relatively permissive toward inflation and its roots in excessive demand — cited recent data to suggest that Team Transitory has been vindicated:

Inflation is showing signs of normalizing, but Krugman and Team Transitory should not take a bow. To understand why, we need to understand what “transitory” and “permanent” meant at the onset of the debate. Unfortunately, neither term was precisely defined. Did transitory mean inflation for three months, six months, or some other length of time? Using literal definitions, Team Transitory could declare victory so long as inflation returned to normal after any length of time, but that would be ridiculous. Was the painful Great Inflation of 1965–1982 transitory because it eventually ended?

A reasonable definition of the transitory view was that excessively high inflation (i.e., inflation higher than the Fed’s 2 percent average target) would come down within several months. Initially, there were two plausible arguments for this view. First, some of the inflation was due to the disruption of supply chains by Covid measures. Although such negative supply shocks are unpleasant, they should dissipate over time. Second, if inflation became a persistent problem as too much money continued to chase too few goods, the Fed would swiftly tighten its monetary policy to bring inflation down close to target.

By contrast, Team Permanent took a starker view. Proponents, including former Treasury secretary Larry Summers, argued that the Fed’s excessively expansionary monetary policy, combined with the massive March 2021 fiscal stimulus, would lead to high inflation. Team Permanent’s fear is that once inflation has become painfully high, the only way the Fed can bring it down is with a very contractionary policy to slow down the growth of nominal GDP or total dollar spending, which would ultimately rein in prices. Unfortunately, and as we’ve all been thinking about for the past year or so, it is very hard to bring down high inflation without also causing a recession.

For the first few months of the surge, Team Transitory had a strong case. Yes, inflation was high, but both the level of prices and nominal GDP had fallen in 2020 during the pandemic-induced recession. Supply-chain disruptions were a legitimate problem contributing to rising prices. Also in 2020, after years of undershooting its 2 percent inflation target, the Fed announced a new policy framework where its new goal would be to keep inflation close to 2 percent on average over time. This framework is called “flexible average inflation targeting,” or FAIT. If the Fed undershot 2 percent inflation in a given year, it would aim for slightly higher inflation the following year. Thus, inflation slightly above 2 percent would not be troubling. Several months of above-normal inflation could be viewed as prices and nominal GDP “catching up” to their pre-pandemic trends.

By late 2021, however, it was becoming clear that inflation was more than just a blip. Moreover, it was evident that inflation was mostly the result of too much demand rather than just unfortunate supply shocks. Fed chairman Jerome Powell himself acknowledged that the term “transitory” should be retired as inflation kept exceeding Fed forecasts. By the end of that year, both prices and nominal GDP had overshot their pre-pandemic trends, and inflation hit a 40-year record. Then, in early 2022, economists began to question the Fed’s commitment to its new framework and its credibility as Powell explained that the “average” in FAIT has a loose definition where the Fed would make up for previous undershoots of 2 percent inflation but not overshoots.

Despite the high inflation of 2021, the Federal Open Market Committee (FOMC), the Fed’s decision-making body, was reluctant to raise the federal funds rate, its target interest rate, until March 2022 when it finally upped the rate by a small 25 basis points (or one-quarter of a percentage point). That same month, the FOMC also forecast that it would need to raise the rate by only another 75 basis points by the end of the year. This forecast would also prove naïve. Instead, with nominal GDP continuing to run hot and inflation showing no signs of abating, the FOMC raised its target at every subsequent meeting by either 50 or 75 basis points for the remainder of the year. Even now, the FOMC is planning to keep raising its target, albeit at a slower pace this year.

It remains to be seen whether the Fed can pull off a “soft landing” where it reduces inflation without sparking a recession. In fairness to the Fed, the role that supply shocks played cannot be addressed through monetary policy. Nevertheless, it still dropped the ball in 2021 and 2022 by letting demand grow too quickly.

If the Fed successfully engineers a soft landing, it will do so because it rapidly tightened monetary policy last year to rein in excess demand. In that event, the Fed will have averted Team Permanent’s worst fears. However, if the Fed succeeds, it will have done so because it finally took Team Permanent more seriously than Team Transitory.