Robert Hall and Michael Woodford receive the 2026 Nobel Prize in Economics for the microeconomic foundations that central banks use today to decide their interest rates. Their models explain why raising rates was the right recipe against post-pandemic inflation.
The 2026 Nobel Prize in Economics has recognised Robert Hall and Michael Woodford, two economists whose models underpin the monetary policy decisions made today by central banks. The academy has awarded their contributions to the microeconomic foundations of macroeconomic stabilisation, as reported by merca2.es.
The analysis by Juan Ramón Rallo points out that these models explain why, during the inflationary outbreak following the pandemic, raising interest rates was the correct recipe, and why they are relevant again now that inflation is returning.
The contribution of Robert Hall, from Stanford University, focused on consumption. In 1978, he published a paper arguing that if families decide how much to spend based on what they expect to earn over their lifetime, current consumption already incorporates all available information about the future. They will only change their spending level if unexpected information arrives: an unanticipated promotion, a layoff, or a sudden inheritance.
If the theory is correct, changes in consumption should be unpredictable. Hall tested this against US data and found that, to a large extent, it held true. Four years later, he estimated that around 80% of families behaved this way, while the rest lived paycheck to paycheck, spending what they earned.
Michael Woodford completed the theoretical framework. In his 2003 book, he presented the new Keynesian three-equation model that is now at the core of the models used by any central bank. The first is demand: families consume according to their expectations of future income and the interest rate. If the central bank lowers rates, saving yields less, and consumption is brought forward.
The second is inflation: companies set prices knowing they cannot change them continuously, so they look to the future rather than the past. What matters are not past costs, but expected ones and foreseeable demand. The third is the central bank's rule: raise rates when inflation rises and lower them when it falls.
The entire framework revolves around a magnitude that no one can observe: natural output, the level that would exist if prices were perfectly flexible. The central bank's task is to bring the gap between actual output and natural output to zero. If actual output is above, the economy is overheating and there is inflation. If it is below, inflation falls.
Rallo explains the application that the academy considers successful. In the face of a negative supply shock, such as rising energy prices or the collapse of supply chains after the pandemic, productive capacity falls. If demand does not decline at the same rate, the economy produces above its natural level. Even with contraction, the economy can be overheated, and inflation appears.
The old Keynesianism would see recession and call for stimulus. Woodford's model says just the opposite: raise rates to prevent inflation from spiralling out of control.
In the face of a negative supply shock, stimulating the economy does not generate sustained recovery: what it generates is inflation.
Juan Ramón Rallo
According to the academy, this explains why inflation in the United States exceeded 5% for more than nine consecutive years in the 70s, peaking at 14.6% in 1980, while in the post-pandemic episode, the peak was 9% in June 2022 and inflation was above 5% for less than two years.
The model, however, does not fit perfectly with what occurred. Rallo recalls that in 2021, central banks diagnosed inflation as transitory. Projections from the European Central Bank placed expected inflation at 1.7% for 2022 and 1.5% for 2023. Christine Lagarde repeatedly stated that it was very unlikely to raise rates that year.
Jerome Powell removed the word transitory before the Senate in November 2021, with inflation already persistent. The Federal Reserve raised rates for the first time in March 2022, with inflation nearing 8%, and the ECB in July, with inflation above 8% and the deposit rate still at -0.5%.
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