The 1970s Economic Theory That Needs to Die

If you were trying to engineer a representative of the mainstream economics establishment, you might come up with Austan Goolsbee. He became an economics professor at the University of Chicago at age 26 and went on to chair Barack Obama’s Council of Economic Advisers. He is now the president of the Chicago Federal Reserve. So when Goolsbee says that the conventional wisdom on economic policy is dangerously wrong, it’s worth paying attention.

Last month, Goolsbee gave a speech criticizing what he calls the “traditionalist view” of monetary policy: the belief that the only way to tame inflation is by causing a recession. This view so thoroughly dominates the economics profession that it is often considered something closer to a law of nature. It is why, when inflation began taking off last year, nearly every economist, forecaster, and CEO believed a recession was around the corner. Then the seemingly impossible happened. The inflation rate, which peaked in June 2022, fell to within a point or two of the Fed’s 2 percent goal, and the much-anticipated recession never arrived. The traditionalist view had been wrong. More than that, it may now be a liability. “In today’s environment,” Goolsbee said in the speech, “believing too strongly in the inevitability of a large trade-off between inflation and unemployment comes with the serious risk of a near-term policy error.”

Don’t let the dry econ-speak fool you. For someone in Goolsbee’s position, a sentence like that is the equivalent of standing on the steps of the Federal Reserve with a bullhorn screaming, “Stop before you crash the economy!”

“If you believe that the only way to bring inflation down is to adopt a tighter policy,” Goolsbee told me recently, “then by the time you realized that wasn’t the case, you’d have created a recession that was not necessary.”

Causing a recession in order to tame inflation is painful enough. Causing a recession when inflation is already getting under control would be tragic. The past year has been something of an economic miracle. Against all odds, we didn’t actually need a recession to bring down inflation. But if the Fed is unwilling to accept the good news, then we just may get one anyway.

The traditionalist view emerged from the stagflation crisis of the 1970s. With inflation spiraling out of control, Fed Chair Paul Volcker famously jacked up interest rates to record levels and plunged the U.S. economy into a major recession. Unemployment reached nearly 11 percent in 1982 and stayed high for years. But it worked. Inflation stabilized, and Volcker went down in history as the hero who saved the economy. The economics establishment drew a clear lesson: The cure for inflation is a recession.

This remained the dominant view of monetary policy for the next 40 years, familiar to anyone who has sat through an introductory economics course. So as inflation spiked in 2022, the overwhelming view was that a recession would be the necessary treatment. The Federal Reserve projected hundreds of thousands of job losses by the end of 2023. Former Treasury Secretary Larry Summers predicted that the U.S. would need five years of unemployment above 5 percent to bring inflation under control. A Bloomberg Economics model forecasted a 100 percent chance of a recession by October 2023.

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But then inflation started falling, and falling, and falling. Prices are still not quite where the Fed wants them, but they’re close. Meanwhile, by many measures, the economy is in terrific shape. Unemployment is below 4 percent. Wages are rising faster than prices. Growth has been faster than in most of America’s peer countries. Some economists half-jokingly refer to the situation as “the immaculate disinflation.”

There are two main theories for why the traditionalist view appears to have gotten things so thoroughly wrong. The first could be summarized as “COVID was different.” When the country first reopened after the pandemic, pent-up savings collided with limited supply to push prices temporarily higher. As the economy has returned closer to normal, those prices have come down. At the same time, labor-force participation has reached its highest point in more than two decades, perhaps thanks to the rise of remote and hybrid work. That has allowed the economy to add jobs without increasing labor costs so much that employers would be forced to raise prices.

The second theory has to do with the role of expectations. The scariest thing about inflation is the way it can become self-reinforcing: When future inflation becomes expected, business owners preemptively raise prices and workers demand higher wages. This dynamic led to the infamous “wage-price spiral” of the 1970s. But inflation expectations have remained stable this time around. In other words, one reason the Fed didn’t have to engineer a recession is precisely that Americans already trust it to bring inflation under control.

Whatever the exact explanation, some economists are convinced that the old consensus—you can’t stop inflation without a recession—has turned out to be wrong. The question now is whether the Fed will learn that happy lesson. (As one of 12 members of the Federal Open Market Committee, which convenes regularly to vote on interest rates, Goolsbee has a direct role to play in providing an answer.) At its most recent meeting in September, the Fed signaled that it will likely increase rates again before the end of 2023 and keep them at that level—the highest in 20 years—well into 2024. Higher interest rates make it more expensive for consumers to buy a home or car and for businesses to make investments, which, in turn, is supposed to reduce hiring, blunt wage growth, and depress spending. The entire point is to cool prices by grinding the economy to a halt. So far, the post-pandemic economy has been resilient, but there’s a limit to how long rates can go up—and stay up—before their full pain is felt.

Of course, there are risks in the other direction as well. An external shock—such as spiking oil prices in response to war in the Middle East—could send inflation shooting up again. But some economists find that possibility far less threatening than an overcorrection. Mark Zandi, the chief economist at Moody’s Analytics, told me an overcorrection is “the No. 1 risk I worry about.” Justin Wolfers, an economics professor at the University of Michigan, refers to it as the fear “that keeps me up at night.”

The economy, in other words, appears to be gliding smoothly toward the kind of “soft landing” that until recently seemed unimaginable. But if the Fed continues to raise interest rates, or just keeps them too high for too long, it risks driving the plane off the runway. “Paul Volcker was my mentor,” Goolsbee told me. “But what people have to understand is that this isn’t the 1970s.”

The Fed might not be able to so easily suppress a half century’s worth of inflation-fighting instincts. Although inflation has come down considerably in recent months, it is currently running at about 3 or 4 percent, depending which measure you use, which is still above the Fed’s 2 percent target. Everyone would prefer to avoid a recession, but some officials think that this “last mile” of inflation will never come under control as long as the economy maintains its current strength. As Fed Chair Jerome H. Powell put it in a speech yesterday, “Additional evidence of persistently above-trend growth, or that tightness in the labor market is no longer easing, could put further progress on inflation at risk and could warrant further tightening of monetary policy.”

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To this line of thinking, the traditionalist view has not been disproved; the past year of disinflation was just the easy part. The hard part is taming the labor market, which is still running too hot for comfort. The price of goods has returned to the pre-pandemic trend, but the price of services—which is driven by wages—has remained higher. Inflation hawks point to the September jobs report, which showed about 336,000 jobs added to the economy. Analysts had been expecting half that. And though inflation expectations have remained calm, the traditionalists worry how long that can last if the Fed doesn’t hit its stated target of 2 percent.

Some experts have suggested that the 2 percent number is an arbitrary goal. Goolsbee isn’t one of them. When I asked him whether the Fed would ever consider easing up on its inflation target, he replied, “Over my dead body.” Where he parts ways with some of his colleagues is in his optimism about inflation’s true trajectory. In his view, the current stickiness is a statistical artifact; the data simply haven’t caught up to reality.

Here’s why: The cost of housing is a huge component of overall inflation statistics. But because of the idiosyncratic way in which housing inflation is calculated, the official figures tend to lag current prices by about a year. That means today’s housing numbers are likely still reflecting the market of 2022. Once they’ve adjusted, inflation should get closer to the 2 percent target on its own, even if the labor market stays hot—and on that front, there’s evidence that wage growth is cooling, too, even as the economy adds jobs.

The story of Paul Volcker slaying the inflation dragon is the Federal Reserve’s founding myth. The belief in a mechanical relationship between inflation and unemployment is the closest thing it has to sacred law, and raising interest rates to cool prices is the essence of what it does. Economists like Goolsbee are asking the Fed to put all of that to the side. To suspend disbelief. To abandon its secular creed. To erase Volcker’s legacy from their memories, if just for a moment. If the central bank can achieve what Goolsbee calls the “golden path” between inflation and recession, he believes this moment will be just as defining for the Fed as the 1970s were. Only this time, its legacy will be defined by restraint rather than relentlessness.

“No central bank has ever cut inflation this much without a deep recession,” he told me. “So it’s not just a soft landing. It’s a landing from a higher level than anyone has been able to pull off. And I think we can do it.”