BU Today: Have we nailed the soft landing? If not, what has to happen for you to deem “mission accomplished?”

Adam Guren: I think it is still too soon to tell if the Fed has nailed a soft landing. The [Consumer Price Index] has settled a bit higher than we would ideally like, although that may be due to how housing inflation is measured. The Personal Consumption Expenditures Price Index [an inflation measure] the Fed prefers looks better, but is still not fully back to the 2 percent target.

Overall, I think there is still some concern about inflation arising from some sectors—housing, shipping costs, energy costs—and that the Fed should remain vigilant. But since inflation got out of hand in 2021, the Fed has done an excellent job and should be commended. Their only misstep was that they were slow to react in the fall of 2021 and spring of 2022, but they made up for that with the strength and speed of their response afterwards.

BU Today: Are you surprised by the economy’s resilience in the wake of the Fed’s 11 interest rate hikes between March 2022 and July 2023?

Adam Guren: Most economists are surprised that the Fed was able to bring down inflation without any real output or unemployment cost. Modern theories of the Phillips Curve—the relationship between output and inflation—tell us there should be a trade-off between output and inflation, and that if the Fed attempts to rein in inflation by raising interest rates, it will come at a cost of lower output and higher unemployment. But there are a number of reasons why this inflationary episode is unusual and might have allowed for a reduction in inflation without denting the real economy.

First, the most interest rate–sensitive sectors—in particular housing and autos—have behaved extremely unusually since the pandemic. House prices and rents have risen dramatically despite higher interest rates, because the supply of homes for sale has fallen by more than demand has. High prices, in turn, have meant that the construction sector has remained strong despite high rates. There has also been a wave of home renovations that has kept construction employment strong. And autos had such severe supply chain disruptions in the pandemic that auto sales have remained strong despite higher interest rates. Typically, autos and construction would lead a contraction in economic activity; famously, workers in these sectors mailed [then Fed chair Paul] Volcker car keys of unsold cars, and two-by-fours from unbuilt houses, in protest of his high rates in the 1980s. This has not been the case this time. 

Second, the labor market has been historically strong, in part due to changes in work induced by the pandemic. Third, there is a debate over the role of so-called transitory factors related to the pandemic: things like supply chains, energy prices, etc., and their role in inflation. But to the extent that these transitory factors mattered a lot and have passed, that could bring down inflation without reducing output.
 
And fourth, unlike the 1970s, the Fed never lost credibility in terms of its commitment to fight inflation, and long-term inflation expectations have not risen dramatically. Part of the reason Volcker needed to raise rates so dramatically in the 1980s was to break the back of inflation expectations and show people that there was a new policy regime in place. But despite all these factors that make this economy unusual, most economists did not think we could bring down inflation so much without affecting output. So, yes, this episode has been surprising.

BU Today: What warning signs are you looking for to judge whether the Fed should take its foot off the brakes and lower interest rates? Should it do that at this week’s meeting?

Adam Guren: Real interest rates—the difference between nominal rates and inflation—remain high, because the Fed has held short-term interest rates high while inflation has receded. There is a concern that high, real interest rates have an effect on the economy, with long and variable lags, and that the effect of high interest rates could yet be fully felt. The other obvious warning sign would be a rise in unemployment and fall in GDP. But the recent GDP report was incredibly strong, and while the unemployment rate has risen, it is still at a historically low level. 

As for what the Fed should do, I would expect it to begin to gradually ease by the end of the year. I’m not sure on the exact timing for this policy shift, but I do think the Fed should indicate that it remains ready to tighten rapidly if inflation takes off, or loosen rapidly if a recession occurs.

BU Today: What lessons for the future should policymakers take from the so-far successful attempts to cool inflation while avoiding recession?

Adam Guren: Policymakers and the economics profession are still digesting the lessons from this episode, and I think it will take a while to learn everything and come to a consensus. But the post-pandemic inflation and economy are unusual in so many ways that I am skeptical that this particular episode will cause policymakers or academics to completely revise their views, especially since the existing policy playbook has worked quite well in addressing this episode.