Post-pandemic surprises in inflation and labor market highlight need to adjust economic models

When the post-pandemic economy headed into uncharted territory, economic models based on historical data struggled to make accurate forecasts, underscoring the need for models and their users to be flexible during abnormal times, according to a new report from the Federal Reserve Bank of Cleveland.

In the report, Cleveland Fed research economists Paolo Gelain and Pierlauro Lopez describe how their own model fell short starting in mid 2022, after the Federal Open Market Committee started raising interest rates to fight inflation. The model predicted that unemployment would rise as inflation and job vacancies fell, but instead unemployment held steady.

To make sense of that period, Gelain and Lopez adjusted their model. Citing prior research on how economies behave in abnormal times, they made wages and prices more flexible in the model and they made it easier for employers in the model to fill jobs quickly.

“These modifications enhance the model’s alignment with observed economic data, and they help us understand how and why the disinflation of 2023 was not accompanied by higher unemployment rates. This analysis underscores the need for models and their users to be flexible to respond to unprecedented economic conditions,” they write.

Read the Economic Commentary: Understanding Post-Pandemic Surprises in Inflation and the Labor Market