How much can we actually control inflation?

Inflation and the economy are still the biggest issues on many voters’ minds heading into the 2024 election, even though inflation has come down from its dizzying height in June 2022, when prices were climbing at almost 9 percent. Last month, it was a much more manageable 3.3 percent.

But it’s still not entirely clear what brought inflation down.

In a recent episode of Unexplainable, we looked at why this is still such a difficult mystery to crack.

While the jury is out on the exact reasons, there are two basic theories that explain why inflation has abated in the last couple of years.

In mid-2022, the Federal Reserve raised interest rates, and soon after that, inflation started falling. Case closed, the rate hike is what did it. Right?

The issue is that the normal way interest rates influence inflation is by raising unemployment. Interest rates go up, businesses struggle to hire more workers, and unemployment goes up. But in 2022, unemployment barely changed. Something else was going on.

Instead, economists like Adam Posen of the Peterson Institute for International Economics argue that inflation came down because of people’s expectations. As Posen explains, “If people are sure that the central bank or society somehow will get inflation down in the future, they don’t tend to react very much to movements in inflation today.” People don’t feel the need to ask for raises, and businesses stop raising prices. Essentially, it’s a self-fulfilling prophecy.

Posen points to the fact that after the pandemic kickstarted the latest round of inflation, inflation didn’t fully spiral out of control. That’s because the Fed had built up trust with the American public over the years, convincing them that it would act when necessary. When the Fed finally raised interest rates in 2022, it essentially functioned as a reminder that it was in control, which calmed people’s anxieties about rising inflation.

“The most powerful evidence for this is that we had the set of common shocks across the major economies, across Europe, Japan, US, UK, Canada,” says Posen. “But in all of them, once the central banks are raising rates, it all just came back down.”

Economist Claudia Sahm isn’t sold on the theory that expectations are the main thing that brought inflation down in 2022. “A key piece of this is the person on the other side has to be listening,” says Sahm. “Regular people are not listening to the Fed.”

Instead, Sahm thinks the answer is a lot more concrete: “To me, the very obvious explanation is we are healing the supply problems that the pandemic caused.”

Sahm says that after the pandemic essentially shut down the economy, it took years for the supply chain to fully come back online. When that happened, there was more production, which meant more stuff for people to buy with their excess cash, which ultimately brought down inflation.

The Fed hiked interest rates around the same time that the supply chain got back up and running, which makes it hard to assign credit. But there’s an even more fundamental issue here. “Anything in macroeconomics is very hard to empirically test,” says Vox senior correspondent Dylan Matthews. “You can’t run experiments with the Fed.”

Ultimately, Matthews says that inflation — and our economy as a whole — is still so hard to understand because of the nature of money. “Money feels like this very hard thing, but money is also a psychological idea. Money is this idea that we can put numbers on what we owe to each other, even as we understand that these numbers are kind of made up.”

Inflation, in a sense, is a psychological phenomenon. “So understanding inflation, I think, is ultimately about understanding people and how they relate to each other. And that’s the ultimate mystery.”

Listen to the full episode and be sure to follow Unexplainable on Apple Podcasts, Spotify, Amazon Music, or wherever you listen to podcasts.