The Fed confronts the “new world” of inflation

Federal Reserve officials are wondering if their long-held assumptions about inflation apply as price increases remain stubborn and remarkably fast – a bout of economic introspection that could have big implications for the US economy.

For years, Fed policymakers had a plan to deal with inflationary surprises: they largely ignored disruptions in the supply of goods and services when setting monetary policy, believing they would work themselves out. The Fed manages the economy by adjusting interest rates that affect demand, so keeping consumption and business activity stable has been a key concern.

But after two years of relentless supply crises rocked the global economy, from delivery disruptions to war in Ukraine, central banks stopped waiting for things to normalize. They are raising interest rates aggressively to slow down consumer and business spending and cool the economy. And they are reconsidering how inflation might play out in a world where it looks like the problems might continue.

If the Fed decides the shocks are unlikely to ease – or it takes so long that inflation remains high for years – the result could be an even more aggressive streak of rate hikes as policymakers try to balance demand with more limited supply. products and service. This painful process will increase the risk of a recession that will lead to job losses and business closures.

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

As prices began to rise rapidly in early 2021, leading Fed policymakers joined many outside economists in predicting the change would be “temporary.” Inflation in America has been slow for most of the 21st century, weighed down by long-term trends such as population aging and globalization. It seemed that one-time pandemic shocks, especially the shortage of used cars and problems with shipping, should eventually disappear and allow this trend to return.

But towards the end of last year, central banks began to rethink their original call. Supply chain problems got worse, not better. Instead of disappearing, price increases have accelerated and gone beyond several categories affected by the pandemic. Economists have a monthly habit of predicting that inflation has peaked only to see it continue to accelerate.

Now Fed policymakers are analyzing what so many people missed and what it says about an inexorable surge in inflation.

“Of course, we have taken a very close and close look at why inflation rose so much more than expected last year and why it turned out to be so resilient,” Mr. Powell said at a press conference last week. “It is difficult to overestimate the extent of our interest in this issue morning, afternoon and night.”

The Fed has responded. This winter and spring, he slowed and then suspended his bond purchases in the pandemic era, and is now cutting his holdings to squeeze some out of the markets and the economy. The central bank also stepped up its plans to raise interest rates, raising its key policy rate by a quarter point in March, half a point in May and three-quarters of a point last week, signaling further increases.

He makes these decisions without a definite game plan, given the amazing behavior of the economy.

“We’ve spent a lot of time – as a committee, and myself – looking into history,” Patrick Harker, president of the Federal Reserve Bank of Philadelphia, said in an interview Wednesday. “Nothing fits this situation.”

The economic era before the pandemic was stable and predictable. America and many advanced economies have spent these decades fighting inflation that seemed to be falling even lower. Consumers were used to expecting prices to remain relatively stable, and executives knew they couldn’t charge much more without scaring them off.

Supply shocks out of the Fed’s control, such as oil or food shortages, could push prices up for a while, but they usually faded quickly. Now the whole idea of ​​”temporary” supply shocks is being questioned.

Global supplies of goods have been shrinking one problem after another since the start of the pandemic, from lockdowns in China that slowed the production of computer chips and other goods, to Russia’s invasion of Ukraine that limited the availability of gas and food.

At the same time, demand was strong, supported by government pandemic checks and a strong labor market. Businesses were able to charge higher fees for their limited supplies, and consumer prices rose sharply, up 8.6 percent in the year to May.

Research work Data from the Federal Reserve Bank of San Francisco this week showed that demand caused about one-third of the current inflation spike, while problems related to supply or some ambiguous combination of supply and demand factors caused about two-thirds.

This means that a return of demand to more normal levels should help bring inflation down somewhat, even if supply in key markets remains volatile. The Fed has made it clear that it cannot cut oil and gas prices directly, for example, because these costs are more related to global supply than to domestic demand.

“There’s really nothing we can do about oil prices,” Mr. Powell told senators on Wednesday. However, he later added, “there is work to contain demand so that it can better balance with supply.”

But it also means that unless the supply shortages that are driving so much inflation today don’t ease, the Fed may need a more stringent response – one that will sharply weaken the economy to bring demand back in line – to bring annual price increases back to higher levels. normal level. 2 percent levels.

The path to lower inflation without triggering a recession “has become significantly more difficult because of the events of the past few months, including the war and, as you know, commodity prices, and further supply chain problems,” Mr. Powell said. . Wednesday.

Asked whether curbing inflation would require causing very high unemployment, Mr. Powell said on Thursday that “the answer will largely depend on what happens on the supply side.”

There is an important reason why Fed officials cannot wait indefinitely for supply to be restored. If supply shocks and higher prices last long enough, they could persuade consumers to expect inflation to continue, changing behavior so that rapid price increases become a more permanent feature of the economy. Workers may demand more wage increases to cover expected increases in rents and food prices, prompting employers to charge more as they try to cover rising labor bills.

In addition, the spike in food and energy prices caused by the war in Ukraine could seep into other prices, making restaurant meals, plane and bus trips, or heating a hotel room more expensive.

“There is usually some sort 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 interrupted by short-term events, not by wars that can drag on for months or years.

“I think what worries them is that this is not an energy shock of the past,” Mr. Sharif said. “The higher it stays and the longer it stays high, the more likely it is to grow into a lot of other things.”

Some supply disruptions can be corrected. Chip production showed some signs of a buildup, which could relieve pressure on the auto and electronics markets. Increased stocks of some items at retailers like Target are likely to push prices down as companies try to clear their shelves. But economists warn it’s too early for any glimmers of hope.

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

For now, central banks are trying to quickly raise interest rates to levels that are clearly holding back the economy – at which point they will assess how much more is needed.

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

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