The Sacrifice Ratio Puzzle – Econlib
The year 2021 saw a rise in inflation, largely attributed to pandemic-related disruptions in the supply chain and the reopening of economies. The situation was further exacerbated by the Russia-Ukraine war that began in February 2022, leading to a commodity super cycle and sending shockwaves of inflation across major economies, including the United States. In June 2022, CPI inflation in the U.S. peaked at 9.1%, as shown in Figure 1.
Figure 1: Core and Headline Inflation
Headline inflation spiked in 2022 but quickly declined, while core inflation decreased at a slower pace. Source: FRED and author’s own calculations.
Initially, it was anticipated that a prolonged period of high unemployment would be necessary to bring inflation back to the Federal Reserve’s 2% target, based on the classic Phillips curve. However, the actual scenario played out differently. Despite expectations, inflation decreased significantly without a substantial increase in unemployment, hovering between 3.6% and 3.9% in 2021 and 2022.
This unexpected outcome raised questions about the accuracy of economists’ predictions regarding the persistence of supply-side shocks and the impact of unemployment on inflation. It was found that the Phillips curve was flatter than anticipated, indicating a lower sensitivity of inflation to changes in unemployment, and that inflation expectations were firmly anchored around the 2% target.
The period of 2025-26 presents a new set of challenges compared to the previous inflationary episode. The implementation of tariffs during this time period has provided insights into how supply-driven inflation operates and how policy measures can address inflation without necessitating high levels of unemployment.
In 2025-26, the average U.S. tariff rates surged from 2.4% to nearly 18%, resulting in a substantial customs duties collection of $195 billion in fiscal year 2025. Surveys indicate that businesses expect tariffs to contribute significantly to their total unit cost growth in this period, with more companies citing geopolitical factors as top concerns in the supply chain.
Despite the tariff pressures, long-term inflation expectations have remained relatively stable. The challenge for policymakers lies in distinguishing between one-time price level effects from tariffs and sustained inflationary pressures that require monetary tightening. The current environment demands a coordinated approach between monetary and trade policies to address the challenges posed by tariff-induced inflation.
The key takeaway for policymakers is to consider supply-side dynamics and the transitory nature of supply shocks in future inflation forecasts. Maintaining expectations anchoring and central bank credibility is crucial in managing inflation, especially in the face of trade policy distortions like tariffs. The coordinated efforts of policymakers and sustained credibility of central banks are essential in navigating the uncertainties of the current economic environment.
In conclusion, the lessons learned from the 2021-2023 inflation episode and the ongoing challenges of 2025-26 underscore the importance of adapting to changing economic dynamics and coordinating policy measures to achieve stable inflation and sustainable economic growth.
