Why a 2023 Recession May Be Mild

When pressed, however—which also happens frequently—I’m in the mild recession camp. The Fed would have to be both incredibly skillful and lucky to avoid any recession at all; everything would have to break its way. But there are several reasons to think that the 2023 recession, if it comes, may be mild. One of those reasons—inflationary expectations—is the subject of this column.

I don’t normally use this space to air academic disputes, which are best kept in academia. But the longstanding academic debate over inflationary expectations has spilled over strongly into the thinking of market participants and policy makers. It is rare nowadays to hear a Federal Reserve official talk about monetary policy for long without bringing up “anchoring” expected inflation. The perceived danger is that expectations will become “unanchored” and soar above the Fed’s 2% target.

One current fashion in academia favors what I call “expectational dominance”—the view that expected inflation is a major determinant, perhaps the major determinant, of actual inflation. In that view, the key to conquering inflation is to bring expected inflation down, or at least to keep it “under control.” Expected inflation is seen as the “dog” rather than the “tail.”

If actual inflation follows expected inflation, you bring the former down by reducing the latter. In fact, many modern academic models don’t even list recent past inflation as a determinant of current inflation—except to the extent that it influences inflationary expectations. Furthermore, the expected rate of inflation that matters in these models is the long-term expected inflation rate. That’s the so-called anchor that central banks fear to lose.

There is an alternative view, however, which reverses the roles of dog and tail. To be sure, it doesn’t claim that expected inflation is irrelevant. Expectations are highly relevant to wage and price setting, not to mention interest rates. But in this alternative view, which I favor, expected inflation is the “tail,” following actual inflation (the “dog”) with a lag.

The debate is hard to resolve because causation clearly runs in both directions. Expected inflation influences actual inflation, and actual inflation influences expected inflation. The issue is quantitative: Which direction of causation is dominant? And the answer matters for how the Federal Reserve should be trying to bring inflation down right now.

If expectations have a life of their own, dragging actual inflation behind them, then monetary policy makers should work on expected inflation directly—as, for example, Chairman

Jerome Powell

did in his hawkish-sounding Jackson Hole speech in August. “Forward guidance,” meaning verbal and written indications of where the Fed is taking interest rates, becomes the key policy tool. To reduce inflation, the Fed must show its teeth and growl.

If, on the other hand, expected inflation mainly trundles passively behind actual inflation, then the Fed will get some “free” disinflation as energy inflation, food inflation and supply-chain problems dissipate. In this view of the world, expectations of inflation won’t remain stubbornly high once actual inflation starts falling. The implication is that the recession won’t have to be as deep.

Let’s compare Mr. Powell’s expectational problem with

Paul Volcker’s

in 1979.

The formidable Mr. Volcker took over the Fed after almost 15 years of mostly rising inflation. Expectations of high inflation—perhaps around 8% to 9%—were firmly ingrained in the beliefs of consumers, wage earners, business executives and bond traders alike. Volcker knew it would take drastic action to break those entrenched expectations, and he had the iron will to do it. The cure was painful, including two back-to-back recessions; but it worked.

The inflation Mr. Powell is dealing with is a youngster. Only about a year and a half ago, the inflation rate was below 2%. Recent inflation has been much higher, of course, and expectations have leapt upward, too. But lasting high inflation isn’t baked into people’s beliefs. They remember low inflation, and they think it will return.

Look at some numbers. The so-called break-even rates of inflation implied by the market for Treasury Inflation Protected Securities are broadly consistent with the Fed’s inflation target. The New York Fed’s survey of consumers finds expected inflation over the next three years to be just under 3%, as does the University of Michigan’s survey.

The implication is that the Fed won’t have to grind the economy into the ground to squeeze expected inflation down to its target. This is not Volcker redux.

Mr. Blinder, a professor of economics and public affairs at Princeton, served as vice chairman of the Federal Reserve, 1994-96.