Federal Reserve officials are questioning whether their longstanding assumptions about inflation still hold true, as price increases remain stubborn and surprisingly rapid — a period of economic soul-searching that could have major repercussions on the U.S. economy.
For years, Fed policymakers had a playbook for dealing with inflation surprises: They usually ignored disruptions in the supply of goods and services when setting monetary policy, assuming they could figure it out on their own. The Fed steers the economy by adjusting interest rates, which affect demand, so its primary focus has been to balance consumption and business activity.
But after two years of uninterrupted supply crises rocking the global economy – from shipping chokes to the war in Ukraine – central bankers are no longer waiting for normality to return. They have aggressively raised interest rates to slow consumer and corporate spending and cool the economy. And they are reassessing how inflation might develop in a world where it seems like the problems just keep coming.
If the Fed determines that the shocks are unlikely to abate — or last so long that inflation remains high for years — the result could be an even more aggressive series of rate hikes as policymakers try to balance demand with a more limited supply of goods and services. That painful process would increase the risk of a recession, which would cost jobs and close businesses.
“The disinflationary forces of the past quarter-century have been replaced, at least temporarily, by a whole different set of forces,” Fed chairman Jerome H. Powell said during Senate testimony on Wednesday. “The real question is, how long will this new set of forces be sustained? We can’t know. But in the meantime, our job is to find maximum employment and price stability in this new economy.”
As prices began to rise rapidly in early 2021, the Fed’s top policymakers along with many outside economists predicted the change would be “transient.” Inflation in America had been sluggish for most of the 21st century, weighed down by long-running trends such as population aging and globalization. It seemed that one-off pandemic shocks, especially used car shortages and shipping problems, would fade over time and cause that trend to return.
But late last year, central bankers began to reconsider their initial decision. Supply chain problems got worse, not better. Rather than fading away, price increases had accelerated and expanded beyond a few pandemic-affected categories. Economists have made a monthly habit of predicting inflation has peaked, only to see it accelerate.
Now Fed policymakers are analyzing what so many people have been missing and what it says about the ongoing inflationary spurt.
“Of course we looked very carefully and hard at why inflation rose so much more than expected last year and why it proved so persistent,” said Mr. Powell at a press conference last week. “It’s hard to overestimate the level of interest we have in that question, morning, afternoon, and evening.”
The Fed has responded. It has slowed and halted pandemic-era bond purchases this winter and spring, and it is now scaling down its asset holdings to extract some juice from the markets and the economy. The central bank has also stepped up its plans to hike rates, raising its key policy rate by a quarter of a point in March, a half point in May and three quarters of a point last week, while announcing more to come.
Understanding inflation and how it affects you
It makes those decisions without much of a set game plan, given the surprising ways the economy behaves.
“We’ve spent a lot of time — as a committee, and I’ve spent a lot of time personally — looking at history,” Patrick Harker, president of the Federal Reserve Bank of Philadelphia, said in an interview on Wednesday. “Nothing quite fits this situation.”
The economic era before the pandemic was stable and predictable. America and many developed economies spent those decades struggling with inflation that seemed to be getting lower and lower. Consumers had come to expect prices to remain relatively stable, and executives knew they couldn’t ask for much more without scaring them off.
Supply shocks beyond the Fed’s control, such as oil or food shortages, could push prices up for a while, but they usually dissipated quickly. Now the whole idea of ”temporary” supply shocks is being questioned.
Global supplies of goods have been curtailed by one issue after another since the start of the pandemic, from lockdowns in China that slowed production of computer chips and other goods to the Russian invasion of Ukraine, which has limited gas and food availability.
At the same time, demand was buoyant, boosted by government pandemic controls and a strong labor market. Businesses have been able to charge more for their limited supply and consumer prices have risen sharply, rising 8.6 percent for the year through May.
Research by the Federal Reserve Bank of San Francisco published this week found that demand was responsible for about a third of the current rise in inflation, while issues related to supply or an ambiguous mix of demand and supply factors about two-thirds of the .
That means bringing demand back to more normal levels should help reduce inflation somewhat, even if supply remains limited in key markets. The Fed has been clear that it cannot directly cut oil and gas prices, for example, because those costs depend more on global supply than on domestic demand.
“There’s really nothing we can do about oil prices,” Powell told senators on Wednesday. Still, he later added, “There is a job to moderate demand so that it can better balance supply.”
Frequently asked questions about inflation
What is inflation? Inflation is a loss of purchasing power over time, meaning your dollar won’t go as far tomorrow as it did today. It is usually expressed as the annual price change for everyday goods and services such as food, furniture, clothing, transportation, and toys.
But it also means that if the supply shortfalls that drive so much of inflation today don’t abate, the Fed could need a more punitive response — one that weakens the economy drastically to align demand — to reverse the annual price hikes. more normal to 2 percent levels.
The path to lowering inflation without triggering a recession “has been made considerably more challenging by the events of recent months, thinking of the war and, you know, commodity prices and further supply chain problems,” Mr Powell said. Wednesday.
When asked whether curbing inflation would require very high unemployment, Mr Powell said on Thursday that “the answer will largely depend on what happens on the supply side.”
There’s an important reason Fed officials can’t wait indefinitely for supply to recover. If supply shocks and higher prices last long enough, they could convince consumers to expect inflation to continue — changing behavior such that rapid price increases become a more permanent feature of the economy. Workers could demand greater wage growth to cover projected rent and grocery price increases, prompting employers to charge more as they try to cover rising labor bills.
In addition, the rise in food and energy costs resulting from the war in Ukraine could trickle down to other prices, making it more expensive to provide a restaurant meal, travel by plane or bus, or heat a hotel room.
“Normally there is some kind of light at the end of the tunnel,” said Omair Sharif, founder of the research firm Inflation Insights. Most of the time, he explained, gas and food supplies are disrupted by short-lived events rather than by wars that can last for months or years.
“I think their concern is this is not the energy shock of yesteryear,” said Mr. Sharif. “The higher it stays and the longer it stays high, the more likely it will bleed into a lot of other things.”
Some interruptions in delivery may get better. Chip production is showing signs of acceleration, which could ease pressure on the automotive and electronics markets. Swollen inventories of some goods at retailers like Target are likely to drive prices down as the companies try to clear their shelves. But economists warn it’s too early to call any glimmer of hope definitive.
“The supply chain is Whac-a-Mole,” Tom Barkin, president of the Federal Reserve Bank of Richmond, said during a webinar Tuesday. “People say you solve one problem and then you have another.”
For now, central bankers are trying to quickly raise interest rates to a place that is clearly constraining the economy — at which point they will judge how much more is needed.
“We need to find price stability in this new world,” Mr Powell said last week.