The economy: Why we should not be surprised by a soft landing

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In sports, no pain means no gain. Until recently, many thought the same maxim applied to economics. No break in inflation could come without sending millions to unemployment lines.

That has been the conventional wisdom among a consensus of economists and forecasters for decades. But it appears that the Federal Reserve Bank officials thought otherwise. They proved themselves right, delivering a steep drop in inflation rates with the lowest unemployment rate in 50 years.

How did the Fed pull off that unexpected wonder? By heeding decades of research — ignored or dismissed by others — that inflation can be broken without triggering an agonizing recession.

Rigorous economic theories, dating back to the late 1960s, implied that the correlation between inflation and unemployment was not the simple relationship suggested by what economists call the Phillips curve: Rising price levels are accompanied by low unemployment. To get prices down, unemployment must go up.

Research by Nobel laureate Robert Lucas showed that the Phillips curve could be upward sloping; that is, high inflation could go hand in hand with high unemployment. And that the curve would be an unreliable forecast for a seesaw between prices and jobs. Indeed, during the stagflation of the 1970s, rising prices and soaring unemployment shared an ominous coexistence.

Another Nobel winner, Tom Sargent, reached similar conclusions. In a compelling history paper, “The Ends of Four Big Inflations,” he found convincing evidence that easing prices are no harbinger of economic decline.

Still more research, at the Federal Reserve Bank of Minneapolis, proposed that the Fed could use the tool of transparency to foster economic stability in the fight against inflation. Tell the public what the central bank is doing — raising short-term interest rates at a moderate pace to reduce inflation to a 2% annual rate — and stick to that target.

That way, the businesses won’t have to make any panicky moves in fear that the Fed will make sudden changes to choke off the economy or ignore inflation to keep bolster payrolls.

This idea was dubbed the “rational expectations” theory. The Fed reveals its inflation target and takes credible steps to achieve it. Stick to the policy and the public will expect favorable results.

However, achieving central bank credibility comes with a price, one that a former chairman of the Federal Reserve, Paul Volcker, was willing to pay. Economist V.V. Chari noted at a recent seminar sponsored by the Heller Hurwicz Economics Institute at the University of Minnesota that the Fed achieved that credibility in the early 1980s when it engineered a significant cut in inflation, which was accompanied by a significant decline in the U.S. economy. A high price to pay indeed, but today the Fed was able to reduce inflation without the steep cost. Credibility is key here to what is called a soft landing — and the Fed’s credibility is in good hands.

Sounds right.

The public’s confidence that the Fed will stick to its low inflation target will lead to more serene choices by businesses and consumers — aiding the Fed to achieve its goals. A virtuous cycle if there ever was one.

Art Rolnick is former director of research for the Federal Reserve Bank of Minneapolis and is an associate economist at the University of Minnesota.