Nobel economist Paul Krugman says doomsday economic predictions were wrong, and the Fed risks a recession if it tries to respond to 'imaginary' stagflation

Paul Krugman
  • Predictions of a steep recession and runaway inflation are wrong, Paul Krugman said in an op-ed.

  • The top economist said inflation is falling more rapidly than the Fed thinks.

  • The Fed, however, still risks causing a recession if it tries to respond to "imaginary" stagflation.

Grim predictions of a steep recession and runaway inflation are wrong, and the Fed risks sparking a recession if it tries to respond to a stagflation scenario where none exists, according to Nobel economist Paul Krugman.

"Until a few months ago many if not most economic prognosticators were far too negative about America's prospects. In particular, we went through what I think of as the summer of stagflation," the top economist said in an op-ed for the New York Times on Monday. He pointed to the grim economic forecasts last summer, when inflation touched a 41-year-high and market commentators began sounding the alarm for a severe recession, a debt crisis, and a stagflation crisis, with economists arguing that inflation could spiral out of control if prices remained high.

But prices have cooled, and when looking at more recent housing and labor market data, inflation could be dropping even more rapidly than Fed officials think, Krugman said. He previously predicted that the "true" rate of inflation was hovering around 4%, instead of the 6.5% recorded in December.

"To be fair, inflation may not yet be fully under control. But it has fallen enough, without any rise in unemployment at all, to make it clear that such predictions were wildly over-pessimistic," he added.

His more optimistic outlook has been echoed by other economists, who say the US could be on track to avoid a recession after all in 2023, despite blaring alarms last year.

Krugman speculated that the overwhelmingly gloomy negative economic forecasts may have been spurred by a "morality play" – that is, economists trying to appeal to the public's good graces by not downplaying the severity of inflation. The Fed faced an enormous amount of criticism for that in 2021, when central bankers brushed off rising prices as "transitory."

In light of what Krugman says is the reality of falling inflation, the Fed's hawkishness could spell trouble for the economy, particularly if the central bank is intent on keeping interest rates high to lower inflation that isn't there.

"Will policymakers, especially at the Fed, who understated inflation risks in 2021 be flexible enough to accept that they overcompensated in 2022? Because if they don't, the policy response to imaginary stagflation may yet produce an unnecessary recession," Krugman  warned.

The Fed funds rate is currently between 4.5%-4.75%, the highest since 2007. Markets are pricing in another 25 basis-point rate hike in March.

Read the original article on Business Insider