Three Ways High Inflation Could End: Easily, the Volcker Way, Stagflation

Inflation in 2022 is likely to exceed 5% for the second year in a row, even as economic growth has slowed. The Federal Reserve has tightened monetary policy while emphasizing that reducing inflation is its top priority. But what does the path to achieving this goal look like for the country and the economy?

Drawing on economic history beginning in the 1960s, Federal Reserve Bank of St. Louis economist William R. Emmons described three scenarios for how “unacceptably” high inflation could come down—that is, return to the Fed’s target level of 2%. During a Dialogue with the Fed presentation hosted by the St. Louis Fed on Sept. 26, 2022, he described scenarios that essentially amount to three paths: one that is quick and relatively pain-free, another that is more protracted and painful, and the last which looks something like the meandering, even more difficult route the U.S. traversed through the stagflation of 1967 to 1982.

Emmons explained that the Federal Reserve will provide a key leadership role in guiding the economy’s path, but the public also has an essential role to play.

• The quick and relatively pain-free outcome is possible if all businesses and workers act rapidly to match price- and wage-setting demands economywide to a 2% inflation rate, Emmons said. If they don’t, the fight to restrain inflation could be more protracted and painful.
• The second path would involve the Fed raising interest rates enough to reinforce the integrity of the inflation target, which could create “economic slack”—a contracting economy and rising unemployment, he said.
• The third path—a longer and even more difficult route to 2% inflation characterized by a period of stagflation—could result if neither of the first two materializes.

The Easy Way: Immaculate Disinflation

In the “immaculate disinflation” scenario, inflation falls quickly from a level of around 6% in the year through September 2022, to 2% by 2023 or 2024, and then it stays there, Emmons said. The Fed has been formally committed to targeting 2% inflation since 2012, a level it seeks to achieve on average over time, according to an August 2020 FOMC statement.

This scenario—the most optimistic of those Emmons outlined—would be part of a “soft landing,” where inflation and the steps necessary to reduce it cause minimal damage to the overall economy. There may still be an economic slowdown or recession, but perhaps it’s a mild one.

Inflation expectations

The scenario would depend largely on the Fed’s credibility, according to Emmons.

If the Fed reinforces 2% inflation expectations among households, businesses and policymakers with communication and monetary policy actions, it could essentially short-circuit a potential wage-price spiral, he said. In such a spiral, inflation leads employees to ask for higher wages, which causes businesses to incur higher costs and, as a result, to increase prices—which leads to more inflation.

A Wage-Price Spiral Can Feed Inflation

“The idea is that if central banks are credible and communicating this 2% target, and if people are on board with that, it could stop those sorts of feedback effects or pernicious spirals from getting underway,” Emmons said.

The inflation and labor costs link

Emmons used a graph like the one below to illustrate how inflation and people’s incomes from work are connected.

The graph, recreated in the St. Louis Fed’s ALFRED® online database of vintage versions of U.S. economic data, includes the second quarter of 2017 through the third quarter of 2022 and shows:

• The quarterly percentage change at an annual rate in the Fed’s preferred measure of inflation, the personal consumption expenditures (PCE) chain-type price index. The PCE index accounts for prices that U.S. consumers pay for a wide range of goods and services and for changes in consumer behavior.
• The employment cost index (ECI), also expressed as the quarterly rate of change on an annualized basis. The ECI is a broad measure of the cost of employing someone that includes benefits as well as wages.

As Emmons pointed out, at the time of his presentation, incomes from wages, salaries and benefits had not been keeping up with inflation.

Inflation Has Been Far above the Fed’s Target

NOTE: The shaded area marks the 2020 COVID-19 recession as defined by the National Bureau of Economic Research.

The last time this measure of inflation rose to these levels was at the beginning of 1981, Emmons said. This measure of employment costs last reached these levels in 1989.

On the positive side, economic forecasters generally accept the possibility of an outcome like immaculate disinflation, Emmons said, citing two representative forecasts (one from the Fed) that show inflation coming down nearer to the Fed’s target over the next year with only a moderate increase in unemployment.

Paul Volcker

The Hard Way: Paul Volcker Returns

The late Paul Volcker was chairman of the Federal Reserve from 1979 to 1987. He’s typically associated with a fairly radical but successful switch in monetary policy that helped move the country from double-digit inflation to inflation in the very low single digits, Emmons said. However, there were economic costs.

The following chart, also from the presentation and recreated in the St. Louis Fed’s ALFRED online database, compares inflation and unemployment over most of Volcker’s term as Fed chair. It illustrates the economic cost—again proxied by the unemployment rate—of bringing down inflation this way.

Like with the immaculate disinflation scenario, in the “Paul Volcker returns” scenario, inflation would fall to the Fed’s 2% target and stay there. But it would decline more erratically and unpredictably over a longer time—roughly through 2026.

Emmons characterized the scenario as “having root canal surgery without anesthesia” because it would involve raising interest rates very aggressively and very rapidly to punishing levels. That could lead to a “hard landing,” perhaps marked by one or more recessions and potentially high unemployment.

In this scenario, disinflation occurs due to an extended period of economic slack rather than because of central bank credibility. Emmons described slack as running the economy below its potential for a considerable period, which could mean anything from deep recession to slow, weak economic growth.

Wide belief that the Fed is willing to impose such economic pain to fight inflation would be its key economic mechanism, said Emmons. The idea isn’t to impose economic pain for the sake of it, he added, but rather to change price- and wage-setting expectations and behavior.

The Default Option: Stagflation

“Stagflation” is the combination of a stagnant economy—that is, slow or weak growth in gross domestic product (GDP)—and high inflation. In this scenario, Emmons said, inflation oscillates, maybe hitting the Fed’s target level briefly, but only settling at 2% on a more permanent basis when a long enough streak of good luck—that is, an absence of adverse shocks—occurs. This could take a decade or more. It may be the disinflation scenario the U.S. is left with if conditions for the first two don’t materialize, he added.

The last era of stagflation in the U.S. was from 1967-82. Emmons outlined some economic conditions during that time:

• There were four recessions.
• Average annual inflation was 6.5%.
• The unemployment rate averaged 6%.
• Inflation topped the previous 15-year average in every year.

While economic growth wasn’t weaker than its 15-year average in every year during this period, it was frequently disappointing, Emmons said.

Even after inflation fell following this period of stagflation, unemployment stayed in the 6% range for another five years.

“This is a long, long time of high inflation and high unemployment,” Emmons said. People felt like the economy just couldn’t get ahead of inflation’s relentless pressure, he added.

Unanchored inflation expectations is the key economic mechanism in this third scenario, he said. In this case, the central bank’s credibility and inflation expectations aren’t meaningful influences, because businesses and households don’t believe inflation is really tethered to the Fed’s target.

In response, they act in a way that may be individually rational, but cumulatively helps to ratchet up inflationary pressures, Emmons said. As a result, inflation is pushed up and down by external shocks (like those affecting food or energy prices) and economic booms and busts—until, by chance, there aren’t a lot of shocks.

Emmons acknowledged that no one knows how the current inflation situation will play out, and that his possible scenarios are just three among many.

Volcker’s turn to very high interest rates was a last resort, which Emmons described as tough medicine that only a decade of stagflation made a viable solution. And the economy isn’t currently suffering from a malaise like that of the 1970s, which opened the door to Volcker’s policies of the early 1980s, he said.

Thus, a period of stagflation could be the path we and the economy face not by choice, but by default, he said.

“Summing it up, I think the history, looking back at the 1970s, is very important for giving us a framework for thinking about the scale of the challenge that we could be facing,” Emmons said.