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Remember summer 2021? It had been a year since COVID shut everything down.
But things were starting to open back up. The first vaccines were out. People were booking travel again. I actually went to see F9 in a theater instead of watching another straight-to-Netflix movie. We are headed to outer space. You acting like we on our way to Home Depot. For the first time in forever, it seemed like things might just be okay. This is crazy, bro! But Dylan Matthews was doing some reporting for Vox.
And he heard a lot of worrying. One thing people worry about when sort of economic activity is growing really fast is inflation. Essentially, economists were worried that a huge influx of spending from all those stimulus checks burning holes in people's pockets would
might drive prices up. But I was skeptical in the summer of 2021 that prices would rise significantly in a way that would get out of control. So we talked to a bunch of experts, sat down to write. And the too blunt headline that I agreed to for that was called Don't Worry About Inflation.
A copy editor saw the headline and was like, Dylan, are you sure you want to go with the headline? And I think my attitude was, I could be wrong. I've been wrong before. But I don't know. In journalism, you can try to weasel your way out of predicting anything specific, or you can just do it and then own it if you're wrong. And for better or worse, I have tried to be the latter type of reporter. And this is a case in which I owned it and I was wrong.
As I'm sure you know by now, Dylan was really, really wrong.
Inflation skyrocketed and it hit levels we hadn't seen in decades. Consumer Price Index data shows inflation is up 8.6% over the last year, the highest rate in 40 years. So in 2022, Dylan wrote a follow-up article with a pretty honest headline. How I and U.S. policymakers got inflation wrong. So I caveated it a bit. As I was going down, I hooked myself onto a bunch of other people and dragged them under with me. Okay.
So it wasn't just you, like a lot of people got this wrong. Yes. If I'm being charitable to myself, which my therapist says I should be, I would say that most people were not anticipating the scale of inflation that we got. The Federal Reserve, private banks, the kind of people who predict these things, they weren't forecasting a big surge in inflation. And then just to make things even weirder, a few months after Dylan wrote that mea culpa, inflation started going away.
Something got inflation under control, but economists still can't agree on exactly what it was. Was it something someone did? Or did inflation just subside, almost like a storm passing through? But the fact that we don't know
It's kind of disconcerting, right? I mean, we're just a few months away from the election. And in a lot of polls, the economy, and specifically inflation, has been the number one issue. I hear people agonizing about what the war in Gaza will mean for Biden. Inflation is a way bigger deal for voters. I hear people talking about whether he's doing enough on climate change. Young voters care so much more about inflation than they do about climate change.
I'm Noam Hassenfeld, and this is the second episode of Unexplainable's series on economic mysteries. This week, with inflation still at the top of so many people's minds, how much can we actually control it? Or as one economist I spoke to put it, What the heck just happened? And what could we possibly do to make sure it doesn't happen again? I'm here to talk about the economy. What, like it's hard? You may be wondering, who got all this money? Nobody knows.
The money's not here. Well, your money's in Joe's house and Mrs. Maitland's house and a hundred others. It's just money. It's made up. It doesn't exist. It's not real. It's not alive. If you believe it.
OK, it's not like we don't know anything about inflation. I mean, I kind of knew nothing about inflation coming into this. But over the last few weeks, I've been talking to economists and reporters, and they told me that the best way to start understanding how inflation works is to break the theories down into two basic buckets. Bucket one.
The first bucket says that inflation comes from people having too much money to spend. Maybe they got lots of stimulus checks, maybe the government printed a whole bunch of cash, or maybe there's just a lot of people working and getting paid. All that money leads to more demand for stuff, people buying more stuff, which drives up prices,
Or to put it all simply, too much money, not enough stuff. So you get inflation. You can think of this bucket like a kind of seesaw. On one side, you got inflation. We'll use a synth sound for that. And on the other side, unemployment. That's going to be a piano. So if unemployment goes down, more people are working, more money to spend. Inflation goes up. On the flip side, if unemployment goes up, there's fewer people working, less money to spend.
inflation comes down, which is exactly what a lot of major economists were pushing for when inflation was skyrocketing a couple years ago. Larry Summers said things like this, that you would need to see unemployment rise significantly before you saw inflation come down. There's going to need to be increases in unemployment to contain inflation.
It might seem kind of weird to hear economists pushing for more unemployment. Like they're advocating for a worse economy. But under this theory, it's just a zero-sum game. The only way to get inflation down is to get unemployment up. It's a necessary pain. So then how do you actually drive unemployment up? The idea is that the Fed, the central bank that sets economic policy in the U.S.,
It can raise interest rates, which makes it harder for businesses to take out loans and hire more people, which leads to more unemployment.
But when the Fed did exactly that in 2022, The Federal Reserve raised interest rates today in its effort to stamp down surging inflation. something unexpected happened. Unemployment didn't change at all. More than half a million jobs were added last month alone. But inflation somehow went down. Inflation is coming down hard and it is coming down a lot faster than I think people thought.
The two sides of that inflation-unemployment seesaw, they were both low. The theory turns out to be badly wrong. It turns out that you could have falling inflation without rising unemployment. So how could raising interest rates bring down inflation without driving up unemployment at the same time? This is where we get to the second stranger bucket that I really want to focus on.
Which is how most economists explain the way inflation came down in 2022. It's more complicated than just this simple seesaw of unemployment going up and inflation coming down.
It's how people feel about the economy and what they think is going to happen in the future. If you look at most theories of inflation now, one of the variables that you will see trying to predict inflation is what people expect inflation to be. Expectations. Inflation somehow happens because people expect it to happen. And it goes away because people expect it to go away. And that might seem a little bit circular, but...
But there's something subtle and important happening there. When you expect more inflation, you do things that cause inflation. So as a worker, you might demand a raise because your prices are going to go up. And unless you get a raise, your standard of living is going to go down. So this has a lot of the same mechanics as the first bucket. People buying more stuff still leads to inflation. But it's not as simple as unemployment up, inflation down.
It's more long-term. When businesses expect future prices to go up across the board, they're going to raise their own prices to keep up. And if enough people and businesses are making those kinds of decisions based on their expectations of where the economy is going, it becomes a self-fulfilling prophecy.
This whole idea of expectations came out of what happened in the 70s and 80s, which is the last time inflation was higher than it was a couple years ago. This is a new strain of inflation, and it infects the whole world. At that point, after years of inflation, the Fed eventually decided to follow the seesaw model, jacking up interest rates, triggering unemployment, just like they planned. But inflation still stayed super high.
Economists weren't really sure what to make of it. Why wasn't the seesaw working? We may have to change our minds about it and simply accept high inflation and unemployment as normal in a new world. So they landed on a new idea. People just didn't trust the Fed. If past experience is any guide, the future of our country is in jeopardy.
Inflation had gone on for so long that regular people didn't think the Fed's higher interest rates would actually do anything. People came to believe that the people who were supposed to be the adults in the room, the Fed, they were just letting it happen and they didn't have the stones to get it under control. Basically, the Fed lost credibility. We've tried care and hope and this inflation will not be charmed.
So the Fed needed to get that credibility back, prove to people that these new interest rates had teeth and staying power. "One cure is a Great Depression." So they allowed interest rates to go sky high, just pummeling the U.S. economy. "High interest rates and the restrictive money supply are taking their toll with the consumer." And it worked.
Inflation fell precipitously, the Fed regained credibility, and people began to see it as an agency that took inflation seriously. I think we owe you, Chairman Volcker, a rousing vote of thanks for your great job in bringing inflation down. Essentially, the Fed anchored people's expectations. They convinced people that no matter what, they wouldn't let inflation spiral out of control. And this is exactly how a lot of economists explain what happened to us over the last couple years.
When the Fed raised interest rates in 2022, they basically reminded everyone there was an adult in the room. That no matter what, the Fed, essentially these people behind the curtain of the economy, they'd never let inflation get that bad again. But this whole idea takes us to a pretty strange place. Because in a sense, it's not the exact policy the Fed set. It's that they got people to trust them.
Which is weird. It can sound a bit like voodoo, and it is kind of like voodoo. Okay. But it does make the role of the Fed almost more psychological, that it's not even about the actual policies they're doing so much as, like, can they actually reassure markets that things aren't going to get out of control? When Dylan told me this, I found it kind of hard to believe.
So I called up Adam Posen, who used to be a central banker in New York and in the UK, you know, one of those people behind the curtain of the economy. And he told me he actually had conversations about the psychological aspect of interest rates all the time. When I was on the policy committee of the Bank of England,
I would go off to vote on policy, and my wife would kindly say, "Go make good policy," as I went out the door. And at one point, she said, "Well, this is just all a communications message. So if you communicate to people that you believe something and they believe you, then it happens." So Adam would go to work, trying to get people to feel confident about the economy. Essentially, yeah. That's a lot of what it is. If you convince people that you're willing
to take the steps necessary to bring inflation down, meaning you're willing to raise rates a lot and you're willing, if necessary, to suffer unemployment or slower growth, then people may believe you're willing to do it and you don't actually have to go through the process. According to this theory, the Fed isn't just controlling interest rates. They're shaping people's beliefs about the world, which they do by constantly being at the ready to adjust those interest rates.
But no one really knows just how ready they have to be. We don't know how long it takes people to change their mind about inflation.
How much the path of past inflation affects their thinking about future inflation. We don't know how high interest rates have to go in order to anchor people's expectations. We don't know how long these expectations last. There's a lot of things we don't know. So for central bankers like Adam, the psychological part of this creates a kind of funny tension. You don't want to give people money.
false impressions that you know precisely what's going to happen, but you don't want to communicate to people how uncertain you are. Adam had to deal with this kind of thing during the financial crisis in 2009, when he was pushing for banks in the UK to buy up all these government bonds. It was all speculative. None of us knew exactly what was the right amount, how long it would take.
or even the mechanisms necessarily. But in order for the plan to work, Adam didn't want to be honest about all that uncertainty. We decided that none of us would go out in public and start saying, well, I'm not sure this is going to work. Oh, I'm really uncertain about this part because then it was even less likely to work. So it's showing confidence to instill confidence.
If I'm being honest, this is not exactly what I pictured the Fed doing behind the curtain. I thought the Fed was almost like this kind of supercomputer, figuring out the precise mathematical way to balance the economy just right. But the Fed's most important role might just be when that curtain opens, performing a kind of theater.
It's less about exactly what they do than it is about how they do it, publicly and confidently. Like Adam said, it's showing confidence to instill confidence. Now, to be clear, it's not just theater. The Fed raising interest rates does make it harder for people to make big purchases. It makes it harder for businesses to expand.
But according to Adam, the bigger, more enduring impact of raising interest rates might just be in how it makes people feel about the future. This feeling of trust in the people behind the curtain.
I'm trying to say something nice. Please, you don't need us. No, no, you need to be able to not have to believe it. No, it's... And this is a longstanding complaint of mine. It's like the Fed is treated like the Wizard of Oz behind the curtain. That they're in charge of the economy and they do all these things. It's like, no. Coming up in a minute. The Fed chair is not in charge of the economy. In many ways, he's watching it roll along like the rest of us.
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How much clearer can I say? There's always money. All right. So inflation is kind of a mystery. Even the smartest economists and Vox reporters struggle to get a handle on it sometimes. And it's still not totally clear what drove inflation down in 2022. The most widely accepted theory right now is inflation expectations. And the most widely accepted theory right now is inflation expectations.
The Fed raised interest rates, which on the one hand did make it harder for people to buy big things. But more importantly, the rate hike reminded everyone that the Fed was in control, that people didn't need to worry, that they didn't need to ask for raises, that businesses didn't need to raise prices. No more inflation spiral.
But a few economists like Claudia Assam have started questioning whether the Fed really has this much influence, whether the messages it's sending are even getting through. A key piece of this is the person on the other side has to be listening.
regular people are not listening to the Fed. And if they happen to hear them, you know, in the news, it's not like they're like, oh, wow, I've really got to change my behavior because of something the Fed says they're going to do six months, 12 months from now. It's just not plausible. Claudia is an economic consultant who used to work as a researcher at the Fed.
And she gets kind of frustrated with the emphasis on expectations because she says in order for that to explain inflation, regular people need to be paying attention. And when you look at the data, it doesn't really seem like they are.
Just take what happened after the 2008 financial crisis. The Fed came out and they said, we're going to have a statement and tell everyone that we want a 2% inflation target. And that's going to help people believe we're going to get inflation to 2%. And thus, we will get inflation to 2%. But if you look at the surveys, there was no response. People's expectations barely changed at all. Those measures that we have didn't hardly move.
Claudia obviously knows the Fed affects the economy. It influences markets, it influences mortgage rates, all kinds of things. But she just doesn't think the Fed brought down inflation by influencing regular people's expectations. I have a hard time when I do a reality, a gut check, that the words of the Fed on inflation get all the way down to the people, change the way they think about inflation and thus change their behavior and thus bring down inflation.
This idea of expectations might just give regular people a little too much credit for understanding what's going on with the economy.
In case you think I'm being unfair to regular people, just take a look at this Guardian-Harris poll from last month. Yeah, well, it's really quite an extraordinary poll. We've seen polls before that show Americans having a more negative view on the economy. I've never seen one quite like this. About half of respondents said the U.S. is in a recession, stocks are down, and that unemployment is at a 50-year high. Except...
All of those things are wrong. So why people feel this is really quite a mystery. The economy has pretty much been growing since COVID. Stocks are near an all-time high, and unemployment is close to a 50-year low. A lot of economists credit the Fed for these positive trends. They say the Fed calmed down people's inflation expectations because right after the Fed raised interest rates in 2022, inflation did start coming down.
But Claudia credits something else. It wasn't mainly the Fed pulling the strings. It was something a lot more concrete that happened around the same time.
It was our collective emergence from the pandemic. It gave me the very obvious explanation is we are healing the supply problems that the pandemic caused. The pandemic led to all sorts of real world issues that just took a really long time to fix. And you have a $20 trillion plus economy in the United States and we basically shut it down.
That is kind of like on the computer. You can do a hard stop pretty fast, but you want to turn that back on. It can take a while, particularly if the computer has some problems to start with. And right when that computer started to boot back up, that's when inflation started to come down. Claudia says it wasn't the interest rate hike reminding people that the Fed was in charge, keeping their expectations in check.
It was the supply chain slowly, finally coming back online. There was more production, which meant more stuff for people to buy with all that money. According to Claudia, the solution was in the real world, not the guy behind the curtain. The Fed chair did not unload the docks in L.A. He did not take a second job. He did not...
process immigrant work visas. There were all kinds of things that needed to be done to get the economy out of the COVID disruptions, and those have nothing to do with the Fed. In Claudia's read, the way we recovered from inflation in 2022, it was kind of like how we recover from a storm. It just takes time. We clean up the rubble, we rebuild, and slowly, after a while,
things eventually get back to normal. It's just there is an aspect of this cycle that has been the passage of time. The problem is the passage of time is not the best and least painful way to deal with inflation.
Claudia says there are better things we can do besides waiting or just relying on the Fed. We should not have the attitude of, oh, next time we have inflation, the Fed's got that. We can plan for the future and try to make the impact less severe by building more housing, by focusing on green energy production. We can do something like opening up the strategic petroleum reserves like the U.S. did a couple years ago.
Essentially, Claudia says that when something as big as COVID happens, real-world systems need to be fixed. We can't just rely on the Fed to swoop in and save the day. But Adam still believes in the swoop, in the power of the Fed, that expectations are what brought inflation down. It turns out that expectations do seem to fit the story, and the story makes sense. It holds together, and...
I mean, the most powerful evidence for this is that we had the set of common shocks across Europe, Japan, U.S., U.K. But in all of them, once the central banks started raising rates, it all just came back down. We know it wasn't the seesaw effect that we talked about before. Raising interest rates didn't bring inflation down directly because unemployment stayed low.
Instead, Adam points to expectations. He says the Fed had built up trust with the American public over a long time. Inflation expectations were credibly anchored, and that's what helped keep things under control. And then Adam says that when the Fed raised interest rates in 2022, that's what brought inflation down. It was a reminder that the Fed was in control and always ready to act, that the Fed is here and the Fed is powerful.
So the question is, who's right? I think Claudia's version makes sense. I think Adam's version makes sense. I have truly no idea. Dylan Matthews, the Vox reporter who got this wrong, along with pretty much everyone else, he says figuring this out is not easy. I think there will be economists trying to come up with more and more clever ways to test which of those things are true and in what proportion, like decades and decades from now.
Are you worried at all that it feels like no one really has a handle on this? Like, does it frighten you that no one really seems to have an answer here? Not really. Okay. I will say this. Like, we used to have, like, massive world economy destroying financial panics all the time. No one was in charge. For almost all of those, we didn't have a central bank. Like, let me just pull up a list here.
Yeah, please. So the U.S. had a six-year depression from 1815 to 1821. We had a massive recession from 1836 to 1838 because we paid back the national debt. In 1857, we had a massive recession. The panic of 1873, oh my God, that was a terrible one. Even worse was 1893, 1907, 1920, coming back from World War I. It's pretty reasonable to say that the Fed has helped calm things down over the last hundred years.
But it's a lot harder to prove exactly how. And a pretty big reason why is because it's just really hard to separate correlation from causation. You can't run experiments with the Fed. You can correlate when expectations increase to future inflation increase, but that doesn't mean that the expectations are causing that. It makes me kind of feel like this whole system we've got that I fully take for granted every single day—
It feels like it's kind of just held together by duct tape. Or not duct tape, because I understand how duct tape works. I think one of my all-time favorite Onion headlines was, U.S. economy grinds to halt as nation realizes money just a symbolic, mutually shared illusion. It's funny, but also I think there's something very deeply true about that. Money feels like this very hard thing, but money is also a psychological idea. Money is this idea that we can...
We can put numbers on what we owe to each other, even as we understand that these numbers are kind of made up. And inflation is fundamentally about the value of this shared psychological notion that we bat between each other. And so understanding inflation, I think, is ultimately about understanding people and how they relate to each other. And that's the ultimate mystery.
This was the second episode Unexplainable is doing on economic mysteries. Next week, how understanding our economy might just come down to understanding chaos. I've been educated as a physicist and I was used to motions that were regular. So having the realization that the world could be unpredictable was kind of mind-blowing.
This episode was produced by me, Noam Hassenfeld. We had edits from Marian McKeown, with help from Jorge Just and Meredith Hodnot, who runs our team. Mixing and sound design from Christian Ayala. Music from me, fact checking from Melissa Hirsch, and all kinds of help from Manding Nguyen. Bird Pinkerton watched as more and more platypuses started emerging out of the tree roots. Slowly, one platypus walked over to Bird, paused, and nodded. The platypuses were ready to join the war.
Special thanks to Emily Stewart and Dylan Matthews for their help with this episode. And thanks as always to Brian Resnick for co-founding the show. If you have questions or thoughts about this episode, you can email us at unexplainable at Vox.com. You can also support the show and all of Vox's journalism by joining our membership program today. You can go to Vox.com slash members to sign up. And if you really love supporting us, leave us a nice rating or review wherever you listen. It really helps us out a lot.
Unexplainable is part of the Vox Media Podcast Network, and we'll be back next week.
