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There are three points I want to make. First, GDP fell more quickly than the typical policy tightening effect. While the level at this moment is close to its average response, the typical pattern has further steep declines coming. Second, employment has been much stronger than expected, so it would need to weaken a lot to follow the typical relationship. Third, inflation fell much sooner than the historical average. And if past correlations were to hold, most of the reduction in inflation from monetary policy actions to date is still to come, and it would be large.

This traditional approach leaves us with a puzzle. Core inflation began moving down in 2023--not mid-2024. And it did so while the job market was still strong--not after it had already weakened substantially. For the traditionalist, the answer is that it must be noise: Just wait; the real economy will get much worse.

It's possible. But another answer is that something very different is going on: Either nonmonetary shocks are heavily influencing the economy or the nature of the monetary policy environment we are working in today is different. I believe both of these factors are at play. If so, we need to be extra careful about indexing policy to this traditional view of what the incoming data on output and the labor market mean for the inflation outlook.

Sources of inflation

Let's start with the sources of inflation. Recall that inflation began to soar in 2021 even as the unemployment rate exceeded 6 percent and GDP was well below previous estimates of potential output. Such elevated slack should have lowered inflation, not raised it. Also, inflation surged all over the world, including in places with different fiscal responses, also suggesting something else was at work.3

In my view, the most important factors were Covid-related. There were well documented negative supply chain shocks and unusual shifts in the composition of demand. Adding to supply side difficulties, Covid reduced labor supply as labor force participation--especially for women and those nearing retirement--dropped and immigration collapsed. 

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