Inflation has been a significant challenge for the economy over the past two years, with the headline consumer price index (CPI) reaching a record high of 9% in June 2022—the highest level since 1982.
Consumers have felt the pinch as prices surge across a broad spectrum of goods and services. Financial institutions’ margins are being squeezed, and policymakers are navigating a delicate balance to control inflation.
Initially, neither policymakers nor professional forecasters anticipated the rapid rise of inflation, which began in April 2021. At that time, the economy was grappling with a pandemic-induced recession, and the unemployment rate stood at 6.1%.
To support businesses and households affected by the pandemic, the federal government implemented expansionary fiscal policies. At the same time, the Federal Reserve employed its available tools to stimulate the economy and achieve maximum employment, one of its mandates alongside price stability.
Several factors contributed to the inflationary pressures. These include stronger and faster demand recovery, a shift in consumer demand from services to goods, supply chain disruptions, a tight labor market, and the war in Ukraine. A hindsight analysis of these factors explains the rise in prices.
A recent study by former Fed Chair Ben Bernanke and French economist Olivier Blanchard highlights the role of easy fiscal and monetary policies, the accumulation of excess savings during the pandemic, and the reopening of previously locked-down economies in driving strong demand for goods with limited supply. This primarily accounts for the high prices of commodities, including durable goods such as vehicles, energy, and food that were observed early on.
However, the effects of these price shocks have since diminished.
According to the analysis, inflation explained by the tight labor market conditions will persist unless there’s a better balance in labor demand and supply. This assessment aligns with Federal Reserve Chairman Jerome Powell’s remarks in his speech on inflation and the labor market at the Hutchins Center on Fiscal and Monetary Policy.
“Core services other than housing may be the most important category for understanding the future evolution of core inflation,” he said in the November 2022 speech. “Because wages make up the largest cost in delivering these services, the labor market holds the key to understanding inflation in this category.”
Recent labor market reports from the U.S. Bureau of Labor Statistics (BLS) indicate a slight easing of conditions. The number of job openings per unemployed person decreased from 2 to 1.6 in May. The June payroll employment report showed that the economy added 209,000 jobs with a downward revision of more than 100,000 jobs in the previous two months. This suggests a moderation in hiring demand.
Average hourly earnings also declined over a 12-month period from a peak of 6% in March 2022 to 4.4% in June. This indicates progress toward a balanced labor market that can prevent a wage-price spiral.
‘This progress in controlling inflation represents a significant achievement for the Federal Reserve, which must carefully walk a tightrope to bring inflation down without breaking the economy.’
Dawit Kebede
The headline CPI also decreased over the past 12 months to 3% in June 2023 mainly due to declines in prices for energy, food, and durable goods. However, core inflation, which excludes volatile energy and food prices, remained at 4.8% compared to a year ago. That’s well above the Fed’s target of 2%.
In the most recent CPI report, housing prices, which account for 40% of the weight for core inflation, contributed to more than 70% of the monthly increase. Even so, the lagged nature of housing price indicators means they don’t accurately reflect current market conditions.
Other indicators that track current rent prices all suggest a decline in the CPI housing index in the coming months.
This progress in controlling inflation represents a significant achievement for the Federal Reserve, which must carefully walk a tightrope to bring inflation down without breaking the economy.
The Federal Open Market Committee acknowledged the lag between monetary policy and its effects on economic activity and inflation when it paused rate hikes in June. However, the summary of economic projections released at the time revealed that committee members’ median projections of the fed funds rate anticipate a 50 basis point increase from current levels by year-end.
Considering the encouraging labor market and inflation reports from June, the committee should reassess the need for further rate hikes in their upcoming meeting.
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