How Much Demand Destruction is Needed to Get Inflation Back to 2%?

Apollo Chief Economist

Inflation is 7.7%, and there is an important debate in Fed working papers about how much demand destruction is needed to get inflation down to the FOMC’s 2% target.

Specifically, these Fed studies quantify the size of the sacrifice ratio, defined as the foregone output accruing from a one percentage point decline in inflation, and the two transmission channels investigated are intrinsic adjustment costs and expectational adjustment costs, with expectations playing by far the most important role.

Unfortunately, the sacrifice ratio is not a particularly useful concept when a significant source of the rise in inflation is not demand but supply chain problems driven by covid.

But a critical insight from these papers is that the sacrifice ratio has increased in recent decades, telling the Fed today that even if inflation quickly falls to, say, 4%, because of supply chain problems getting resolved, the demand destruction required to get inflation down to 2% is likely going to be significant, and therefore the ongoing slowdown could be deeper and longer than the market is currently pricing.

Chart showing projections of higher inflation and slower growth for 2023
Source: Bloomberg, Apollo Chief Economist

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