By Paul Krugman
There are many reasons to be horrified about recent events in the Middle East, and the prospect that attacks on shipping might undermine progress against inflation is way, way down the list. Nonetheless, if you are trying to forecast inflation, disruption of a major choke point for global commerce — the Red Sea is how ships get to and from the Suez Canal — isn’t what you want to see. But how big a deal is it?
Well, it’s not trivial. But while supply problems in general were a major factor in the 2021-22 surge in inflation, and the resolution of those issues is the main story behind recent disinflation, it’s important not to get too physical. The pileup of ships waiting outside the ports of Los Angeles in early 2022 was a conspicuous and highly visible cause of inflation, but it was less important than more diffuse, relatively intangible factors including the way the pandemic and its aftermath disrupted labor markets. Since there’s no reason to expect these more diffuse problems to return, the inflation impact of the conflict with the Houthis and its effect on Red Sea shipping will be limited.
But before I get there, a word about where inflation stands now. Since last week’s report on the consumer price index, I’ve had several conversations with friends who believe, probably based on what they’ve heard from talking heads on cable TV, that inflation is stuck at a relatively high level. Indeed, the core CPI, which excludes food and energy, is up 3.9% over the past year.
But anyone citing that number as evidence of stubborn inflation is deeply misinformed. Indeed, if he or she is in the business of giving financial advice, harping on 3.9% amounts to professional malpractice.
To see why, let me give you a few more numbers:
— Core CPI, past 12 months: 3.9%
— Core CPI, past six months (annualized): 3.2%
— Core HICP (harmonized index of consumer prices), past 12 months: 1.9%
— Market expectations for 2024 inflation: 2.2%
So, when people talk about 3.9% inflation over the past year, they’re averaging 4.6% inflation in the first half and 3.2% in the second half — that is, they’re very far behind the curve. Furthermore, a lot of that inflation reflects official estimates of shelter costs, especially an estimate of what homeowners would be paying if they were renters, which lag far behind market rents.
The harmonized index of consumer prices, which doesn’t include this imputed number — and is the way Europe measures inflation — has already declined to the Federal Reserve’s target of 2%, showing that misleading estimates of shelter costs are the source of any perception of stubborn inflation. And markets know that: Recent market behavior implies a belief in what the data really shows us, which is that inflation is already under control.
Which finally brings me back to the original question: Maybe it looks right now as if we’ve won the war on inflation, but will shipping disruptions in the Red Sea bring it back? This goes back to the question of how inflation got so high for a while, and why it came down so easily.
When inflation took off in 2021, it was initially concentrated in sectors facing supply bottlenecks because of delayed effects of the pandemic, and many economists, myself included, thought that inflation would soon subside once those bottlenecks were cleared. Those of us who believed that were dubbed Team Transitory — and we were wrong. Inflation broadened to include most of the economy.
There are various ways to show this broadening. One way is to compare the rate of inflation as measured by the personal consumption expenditure deflator — which the Fed prefers to the CPI — to the “trimmed mean” estimate produced by the Federal Reserve Bank of Dallas, which excludes extreme price movements.
Until around September 2021, despite a sharp rise in total inflation, the trimmed measure hadn’t accelerated by much, suggesting that bottlenecks in a few sectors were the main story. But then the trimmed mean shot up, too; so it wasn’t just bottlenecks after all.
In that case, however, what was driving inflation? Many economists, most famously Larry Summers, insisted that the problem was excessive spending — and that controlling inflation would mean both large reductions in spending and a large rise in unemployment.
Yet that wasn’t what happened. By almost any measure (except that deeply misleading 3.9% people keep throwing around), inflation fell rapidly in 2023, without any surge in unemployment.
How do we make sense of this story? The best going story is that Team Transitory was basically right, but thinking too narrowly. The pandemic did cause large disruptions, which were a large part of the inflation story, but those disruptions extended far behind physical bottlenecks such as clogged ports and took much longer to resolve.
Put it this way: In the face of the pandemic, Americans rearranged their lives, how they worked and how they spent their money; then, as fears of infection declined, we rearranged our lives again, going back to the old habits in some ways but not others. We stopped going out to eat, then started again; we started working from home, and in many cases continued to do so, which meant big changes in the economy’s geography — that is, where stuff happened.
All this created a lot of what you might call churn, as businesses and people switched up their games.
One readily available measure of churn is the rate at which workers voluntarily quit their jobs. Normally, the quits rate is negatively correlated with the unemployment rate: Workers are more willing to quit when they’re confident about finding new jobs. For a while, however, quits bucked that trend and were really high (as were unfilled job vacancies), before coming down as the economy adapted to the postpandemic changes.
This churn meant that there were widespread temporary shortages of workers and the things workers produced, which drove inflation up; inflation then plunged as the economy settled down. Inflation was transitory after all, but “transitory” was bigger and longer than we realized.
Which brings me back to the Red Sea (no, I didn’t forget about it). One way to think about the effects of Houthi attacks on shipping is that they may recreate a situation comparable to the supply bottlenecks of the first half of 2021, although on a more limited scale. But as I’ve just argued, those bottlenecks ended up being only a relatively small part of the overall inflation story. And nothing happening in the Middle East will cause the kind of broader disruption that led inflation to become so high and widespread.
So the economics of the events in the Red Sea, while not great, aren’t a reason to be greatly concerned. Now ask me about what happens if China attacks Taiwan.