In June 2022, U.S. inflation rates reached forty-year highs, with the Consumer Price Index rising at an annual 9 percent and Personal Consumption Expenditures Price Index up 7.1 percent. Remarkably, between August 2022 and December 2023, rapid disinflation was achieved without much deterioration in labor market conditions — the unemployment rate remained below 4 percent.
Even more impressively, such positive outcomes were attained amid an unusually rapid cycle of interest rate increases, which saw the target range for the Federal Funds Rate move from near-zero in March 2022 to above 5 percent in July 2023, where it has remained ever since.
These unexpected, albeit welcome, developments have caused puzzlement among both macroeconomists and monetary authorities. Early in the inflation battle, several prominent economists contended that a substantial increase in unemployment rate would be necessary to bring inflation under control.
For instance, Harvard’s Alex Domash and Lawrence Summers noted, “The idea that inflation can fall dramatically without a corresponding rise in labor market slack…runs counter to standard economic theory, and is inconsistent with the historical evidence….The empirical evidence supports the view that taming accelerating inflation requires a substantial increase in economic slack.”
Yet, somehow, the U.S. economy achieved significant disinflation even while maintaining robust job growth and a persistently low unemployment rate. What explains such developments, which appear to run counter to economic theory and past experiences?
Considering the unusual nature of the pandemic shock and the extraordinary scope and scale of the associated policy responses, it was always possible that neither traditional economic patterns nor standard economic theories would offer much guidance to forecasters and monetary policymakers this time around. Such drawbacks, however, have not held economists back from seeking answers to fresh and fascinating puzzles.
Back in 2022, Andrew Figura and Chris Waller offered an intriguing explanation for why a potential soft landing and a relatively painless disinflation was feasible this time around. To grasp the underlying logic of their hypothesis, it is necessary to recall some of the labor market distortions created by the pandemic shock.
Typically, job vacancies rise as unemployment falls and vice versa, in a relationship economists refer to as the Beveridge curve. When the US economy reopened in earnest in 2021, pent-up demand, juiced by a record amount of stimulus, stimulated aggregate demand. Meanwhile, pandemic-related disruptions meant that businesses could not find enough workers. The result was an explosive growth in job vacancy postings.
The unusually large number of vacancies reflected an unprecedented level of labor market tightness, which, given the special circumstances, was unlikely to persist. Figura and Waller noted that the Beveridge curve had become nearly vertical, implying that vacancies rose sharply even as the unemployment rate stabilized near historic lows. They suggested that, as the labor market cooled, firms would reduce their job postings but also minimize layoffs. A decline in vacancy rate, rather an uptick in unemployment rate, would be the primary labor market adjustment mechanism, making a soft landing feasible.
In addition to experiencing a steepening, the Beveridge curve may also have shifted substantially in the aftermath of the pandemic recession. Whereas the downward slope of the Beveridge curve captures typical cyclical forces affecting the demand for labor and the available pool of unemployed workers, actual shifts in the curve are associated with structural changes or shocks.
Gene Kindberg-Hanlon and Michael Girard estimated that “that the labor force was approximately 2 million below trend at the start of 2023 due to COVID-related mortality, lower older-worker participation rates, and lower immigration. The shortage of workers, alongside the large initial layoffs and reallocation effects driven by the pandemic, has also been a large contributor to the observed upward shift in the Beveridge curve.”
Anton Cheremukhin and Paulina Restrepo-Echavarria offer an alternate take on the Beveridge curve’s odd behavior. They argue that a spike in “poaching vacancies,” aimed at encouraging a job-switch by already-employed workers, was largely responsible for the observed surge in job vacancy postings. Their analysis also favors the soft-landing outcome. They observe that if Fed tightening primarily diminishes “poaching vacancies” intending to lure already-employed workers, then it would not result in a jump in the unemployment rate.
So far, developments on the ground have largely favored the explanations discussed above. Sharply lower levels of immigration constrained labor supply in the initial recovery phase and contributed to upward wage pressure (especially in sectors that have historically relied on migrant labor — construction, farming, leisure, and hospitality). Since then, a dramatic surge in immigration has provided a massive boost to the U.S. labor supply and enabled employers to fill open positions without necessarily having to excessively raise wages.
Rapid recovery in the prime-age labor force participation rate also helped ease wage pressures. With the gradual normalization of economic activity and the removal of labor market distortions associated with the pandemic shock, the Beveridge curve is gradually reverting to its pre-pandemic state.
If favorable supply-side developments persist, the Fed may still get its wish for an “immaculate disinflation.” However, the last mile of the inflation battle may prove to be the hardest. Of late, inflation rates appear to be moving sideways. In December 2023, markets were projecting as many as six or seven Fed rate cuts in 2024. Fresh data has caused a dramatic resetting of rate-cut expectations. Reaching that two-percent inflation target may yet entail some economic pain.
Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.