Why did inflation fall?

Revisiting the argument about how monetary policy works

With optimism about an economic “soft landing” growing, I think it’s worth revisiting an issue I wrote about way back in December of 2021 — how (if at all) does monetary policy work to fight inflation?

When Noah Smith graded various economic schools of thought, he gave the prize to mainstream macroeconomics. But many prominent mainstream economists disagree with each other on this topic. In particular, most mainstream economic policy practitioners (represented in the discourse by Larry Summers, Jason Furman, and Olivier Blanchard) are proponents of what I called the “hydraulic” view of monetary policy. On this account, the central bank can raise unemployment by restricting credit, and this higher unemployment leads to slower aggregate wage growth and less inflation. But many¹ other mainstream academic macroeconomists put much more emphasis on the role of forward-looking expectations. Mike Konczal calls this the New Keynesian Phillips Curve, in which (emphasis added) “inflation is the result of expected inflation in the future, market imperfections in the form of nominal rigidities in price-setting, and markups over real marginal costs.”

This disagreement plays out in the background of ongoing debates (see me, Milan, then Milan again) about the American Rescue Plan, because a really important question about discretionary fiscal policy is what the downside risk of spending “too much” is. I would say that at the start of the Biden administration, I was excessively sanguine about this. I thought that if we did too much deficit spending, interest rates would go up and curtail our capacity for further deficit spending. So while it’s a bad idea to waste fiscal capacity on low-value undertakings, I didn’t think it was actually harmful.

That was wrong.