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The Fed faces a “new world” of inflation


Federal Reserve officials are questioning whether their long-held inflation assumptions still apply as price increases remain stubbornly and surprisingly fast — an economic soul-searching that could have big implications for the U.S. economy.

For years, Fed policymakers had a playbook for handling inflationary surprises: They generally ignored disruptions in the supply of goods and services when setting monetary policy, assuming they didn’t care. would come out on their own. The Fed guides the economy by adjusting interest rates, which influence demand, so the main goal was to keep consumption and business activity constant.

But after the global economy was rocked for two years by relentless supply crises – from maritime groans to war in Ukraine – central bankers stopped waiting for a return to normalcy. They raised interest rates aggressively to slow consumer and business spending and cool the economy. And they are reassessing how inflation might evolve in a world where it seems like trouble just keeps coming.

If the Fed determines that the shocks are unlikely to subside – or that they will take so long that they will leave inflation high for years – the result could be an even more aggressive series of hikes. rates as policymakers attempt to balance demand with a more limited supply of goods and services. This painful process would increase the risk of a recession that would cost jobs and close businesses.

“The disinflationary forces of the past quarter century have been replaced, at least temporarily, by an entirely different set of forces,” Fed Chairman Jerome H. Powell said in Senate testimony on Wednesday. “The real question is: how long will this new set of forces be sustained? We cannot know. But in the meantime, our job is to find maximum employment and price stability in this new economy.

When prices began to rise rapidly in early 2021, top Fed policymakers joined many outside economists in predicting that the change would be “transient.” Inflation has been slow in America for most of the 21st century, weighed down by long-standing trends like an aging population and globalization. It seemed that one-time pandemic shocks, especially a shortage of used cars and problems with shipping, should fade over time and allow this trend to return.

But late last year central bankers began to rethink their original call. Supply chain issues were getting worse, not better. Instead of fading, price increases accelerated and broadened beyond a few categories affected by the pandemic. Economists have become accustomed to predicting each month that inflation has peaked only to see it continue to accelerate.

Now Fed policymakers are analyzing what so many have missed and what that says about the relentless surge in inflation.

“Of course, we looked very carefully at why inflation rose much more than expected last year and why it turned out to be so persistent,” Powell told a news conference last week. “It’s hard to overstate the interest we take in this issue, morning, noon and night.”

The Fed reacted. It slowed and then stopped its bond purchases in the pandemic era this winter and spring, and it is now reducing its assets to squeeze some juice out of the markets and the economy. The central bank has also stepped up its interest rate hike plans, raising its key policy rate by a quarter of a point in March, half a point in May and three-quarters of a point last week while signaling more rates to come.

He makes these decisions without really having an established game plan, given the surprising behavior of the economy.

“We spent a lot of time — as a committee, and I spent a lot of time personally — watching history,” Federal Reserve Bank of Philadelphia president Patrick Harker said in an interview Wednesday. “Nothing quite matches 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 expected prices to remain relatively stable, and executives knew they couldn’t charge much more without scaring them away.

Supply shocks beyond the Fed’s control, such as oil or food shortages, could drive prices up for a while, but they usually fade quickly. Today, the whole idea of ​​“transient” supply shocks is being questioned.

The global supply of goods has been squeezed by one issue after another since the start of the pandemic, from lockdowns in China that slowed the production of computer chips and other goods to China’s invasion of Ukraine. Russia, which has limited the availability of gas and food.

At the same time, demand has been skyrocketing, boosted by government pandemic relief checks and a strong job market. Businesses were able to charge more for their limited supply, and consumer prices rose sharply, climbing 8.6% on the year to May.

A Federal Reserve Bank of San Francisco study released this week found that demand was driving about a third of the current rise in inflation, while supply-side issues or a combination ambiguity of supply and demand factors accounted for about two-thirds. .

This means that the return of demand to more normal levels should help dampen inflation somewhat, although supply in key markets remains disrupted. The Fed has made it clear that it cannot directly lower oil and gas prices, for example, because those costs depend more on global supply than 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 the demand so that it can be in better balance with the supply”.

But it also means that if the supply shortages driving so much inflation today don’t subside, the Fed may need a more punitive response – one that significantly weakens the economy to bring demand into line – to bring annual price increases back to more normal. 2% levels.

The path to lower inflation without causing a recession “has been made much more difficult by the events of the last few months, thinking about the war and, you know, commodity prices, and other issues with supply chains,” Powell said. Wednesday.

Asked whether containing inflation would require causing very high unemployment, Mr Powell said on Thursday that “the answer is going to depend, to a large extent, on what happens on the supply side”.

There’s an important reason Fed officials can’t wait forever for supply to recover. If supply shocks and rising prices lasted long enough, they could persuade consumers to expect inflation to persist, thereby altering behavior in ways that make rapid price increases a more permanent feature of the economy. Workers could demand greater wage growth to cover projected increases in rent and grocery prices, prompting employers to charge more as they try to cover the rising labor bill .

In addition, the spike in food and energy prices caused by the war in Ukraine could affect other prices, making it more expensive to provide a restaurant meal, travel by plane and bus, or heat a hotel room.

“Typically there is some kind of light at the end of the tunnel,” said Omair Sharif, founder of research firm Inflation Insights. Usually, he explained, gas and food supplies in particular are disrupted by short-lived events rather than wars that could last for months or years.

“I think their concern is this: this is not the energy shock of old,” Mr. Sharif said. “The longer it stays high and the longer it stays high, the more likely it is to bleed into a lot of other things.”

Some supply disruptions could improve. Chip production showed signs of accelerating, which could ease pressure on the automotive and electronics markets. Bloated inventories of some products at retailers like Target are likely to drive prices down as companies try to empty their shelves. But economists warn it is too early to call any glimmer of hope conclusive.

“The supply chain is Whac-a-Mole,” Tom Barkin, president of the Federal Reserve Bank of Richmond, said in a webinar on Tuesday. “People say you solve one problem and you have another.”

For now, central bankers are trying to quickly raise interest rates to a level that clearly constrains the economy – at which point they will assess how much more is needed.

“We have to find price stability in this new world,” Powell said last week.

nytimes

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