Fed Confronts a ‘New World’ of Inflation

The Federal Reserve is wondering if long-standing inflation assumptions still hold, as inflation remains stubborn and surprisingly rapid. This is a series of economic soul quests that can have a significant impact on the US economy.

For years, the Fed’s policy makers have had guidance in dealing with inflationary surprises. When setting monetary policy, they largely ignored the disruption in the supply of goods and services, assuming they would work on their own. The Fed guides the economy by adjusting interest rates that affect demand. Therefore, the main focus was to maintain equal consumption and business activities.

But after two years of turmoil in the global economy due to the non-stop supply crisis, from roaring transport to the war in Ukraine, central banks have stopped waiting for normality to return. They have been aggressively raising interest rates to slow down consumer and corporate spending and cool the economy. And they are reassessing how inflation will develop in a world where problems may continue to occur.

If the Fed determines that the shock is unlikely to be mitigated, or that it will take so long that inflation will remain elevated for years, policymakers will try to crush demand and limit supply, resulting in more. There may be a series of aggressive rate hikes. Goods and services. That painful process increases the risk of recession, which will sacrifice work and close the business.

“The disinflationary forces of the last quarter century have been replaced by a completely different set of forces, at least temporarily,” Federal Reserve Chair Jerome H. Powell said in a Senate testimony Wednesday. rice field. “The real question is how long this new set of forces will last. I don’t know. But in the meantime, our job is to have the greatest employment and price stability in this new economy. Is to find. “

When prices began to rise sharply in early 2021, top federal policymakers joined many external economists in predicting that changes would be “temporary.” For most of the 21st century, inflation was sluggish in the United States, influenced by long-term trends such as aging population and globalization. The one-off pandemic shock, especially the shortage of used cars and the problem of sea shipping, seemed to decline over time and allow that trend to recover.

But by the end of last year, the central bank had begun to rethink its first call. Supply chain problems were getting worse, but not good. Instead of falling, price increases accelerated and expanded beyond several pandemic-affected categories. Economists have a monthly habit of predicting inflation to peak just to see inflation continue to accelerate.

Fed policymakers are now analyzing what many have missed and what they are saying about the relentless inflation burst.

“Of course, we’ve been carefully considering why last year’s inflation rate was much higher than expected and why it’s going to last,” Powell said in a press conference last week. “It’s hard to exaggerate the degree of our interest in the question, morning, day, night.”

The Fed continues to react. This winter and spring, the purchase of bonds during the pandemic era slowed and then stopped. We are currently shrinking our wealth holdings and robbing the market and economy of a bit of juice. The central bank has also stepped up its plans to raise interest rates, raising key policy rates by a quarter point in March, 0.5 points in May and three quarters last week, signaling more in the future.

Given that the economy is behaving astoundingly, we make these decisions without much use of established game plans.

“We have spent a lot of time as a committee and have seen a lot of time personally,” said Patrick Harker, president of the Federal Reserve Bank of Philadelphia, in an interview Wednesday. “Nothing fits this situation perfectly.”

The pre-pandemic economic era was stable and predictable. The United States and many advanced economies have spent these decades wrestling with inflation, which appears to be declining like never before. Consumers began to expect prices to be relatively stable, and executives knew they couldn’t charge any more without scaring them.

Shocks to supplies beyond the Fed’s control, such as oil and food shortages, could push prices up for some time, but usually declined rapidly. Currently, the big picture of the “temporary” supply shock is being questioned.

From the blockade of China, which has delayed the production of computer chips and other commodities since the outbreak of the pandemic, to the invasion of Russia’s Ukraine, where access to gas and food is restricted, global commodity supply continues to decline. Has been done.

At the same time, demand is skyrocketing, boosted by the government’s pandemic bailout checks and a strong labor market. Companies can charge more for limited supplies, and consumer prices have risen sharply, rising 8.6% in the year to May.

research According to a survey by the Federal Reserve Bank of San Francisco released this week, demand is driving about one-third of the current inflation surge, while supply-related problems and ambiguous combinations of supply and demand factors are about three. It turns out that it is driving two-thirds.

This means that even if supply in key markets is stagnant, returning demand to more normal levels should alleviate some inflation. The Federal Reserve, for example, makes it clear that oil and gas prices cannot be lowered directly. Because these costs affect global supply more than domestic demand.

“There’s really nothing we can do about oil prices,” Powell told Senator Wednesday. Still, he later added, “There is work to ease demand in order to better balance supply and demand.”

But it also says that if supply shortages, which are causing most of today’s inflation, are not mitigated, the Fed may need to take stricter steps to bring annual price increases back to normal. Means. 2 percent level.

“The events of the past few months have made the path to lower inflation without causing a recession much more difficult given the war, commodity prices, and additional supply chain problems,” Powell said. .. Wednesday.

Asked if inflation control requires a very high unemployment rate, Powell said Thursday that “the answer will depend to a large extent on what happens on the supply side.”

There is an important reason why Fed officials cannot wait indefinitely for supply to recover. If supply shocks and higher prices last long enough, they can convince consumers to expect inflation to endure — acting in a way that makes rapid price increases a more lasting feature of the economy. change. Workers may demand greater wage growth to cover expected rent and grocery price increases.

In addition, the surge in food and energy costs caused by the war in Ukraine can infiltrate other prices, serving restaurant meals, traveling by plane or bus, or occupying hotel rooms. It costs money to warm up.

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

“I think their concerns are: This is not an old energy shock,” Sharif said. “The higher you stay, the more likely you are to bleed to many other things.”

Some supply disruptions may have improved. Chip manufacturing It shows signs of a rise that could put pressure on the automotive and electronic markets. If some retailers like Target have a bloated inventory, prices can drop as companies try to clear the shelves. However, economists warn that it is premature to call the flicker of hope decisive.

“The supply chain is a mole,” Fed President Tom Birkin of Richmond said in a webinar on Tuesday. “People say you solve one problem and then another.”

So far, central banks are quickly trying to raise interest rates to places that are clearly restraining the economy. At that point, the central bank will assess how much more it needs.

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