It’s been two years since inflation started to rise above the Federal Reserve’s target of 2% or so. At first, many economists thought elevated inflation would be “transitory,” or short-lived, since it stemmed at least in part from COVID-related supply-chain snafus that would eventually abate. President Biden was a member of Team Transitory, insisting in July of 2021 that higher prices would be temporary.
The inflation doves are in hasty retreat, given that it went as high as 9% last year. To get inflation down, the Federal Reserve has raised interest rates at one of the fastest paces ever, boosting its short-term lending rate by 4.75 percentage points in a mere 12 months, including the latest quarter-point raise on March 22. Inflation has dropped to 6%, but Fed Chair Jerome Powell has consistently said that’s not nearly good enough.
A new analysis by two prominent economists contains some advice for Powell: Just give it time. Robin Brooks, chief economist at the Institute for International Finance, and Peter Orszag, COE of Financial Advisory at Lazard, argue in the paper that much of the recent spike in prices is due to COVID-triggered supply-chain disruptions, and that normalization simply takes longer than many people expect. They also point to the considerable time lag in monetary tightening as justification for the Fed to take a “wait-and-see approach” by halting rate hikes and assessing the results of their work for several months, or even longer.
If Brooks and Orszag are right, the Fed would have more maneuvering room to address the recent spate of regional bank failures, caused in part by rapidly rising rates and sharp rate differentials among assets banks must hold against deposits. It would also suggest consumers are due for a break as stubborn inflation retreats in coming months, which could also boost President Biden in the reelection bid he seems likely to announce soon.
At least four major factors have conspired to push inflation up since 2021, but economists disagree on which of those forces is most important. Supply-chain problems clearly caused shortages during the COVID pandemic, pushing prices up. Demand for goods soared as people stuck at home stopped traveling and going out, and spent more on stuff. Tight energy supplies, exacerbated by Russia’s invasion of Ukraine last year, contributed to rising prices. And in the United States, generous stimulus programs filled consumers’ pockets with money, goosing spending even more.
Supply chains are now more or less back to normal, with the New York Fed’s supply-chain pressure index back to pre-COVID levels. That suggests tight supply chains are no longer causing inflation. But Brooks and Orszag find otherwise. They note that while input prices that manufacturers pay for raw materials and components are back to normal, output prices—what consumers pay—are still elevated. Manufacturers may be keeping prices as high as they can for as long as the market allows it, to maximize profit. Or they might still be trying to cover elevated costs from backlogs or other COVID-related disruptions.
The paper estimates that the lagged effect of supply-chain disruptions caused 30% to 70% of core inflation—excluding volatile food and energy costs—at the end of 2022. If so, other factors contributing to inflation would be less important than widely believed, especially the huge stimulus bill Biden signed in 2021, which has earned a considerable share of the blame for rising prices.
Supply chains mostly affect goods, rather than services, yet goods account for just 42% of the consumer prices index as the Labor Dept. defines it. Without food and energy, that’s just 21%. So what about services? Shifts in demand may explain services inflation, just as it explained goods inflation early in the pandemic.
The annualized price change for services was 3.2% before the pandemic. That dropped to 1.3% early in 2021, as travel plunged, restaurants closed, and consumers largely stayed home. Then service inflation started to rise in 2022 as Americans got vaccinated and started to go out again. Services inflation in the latest reading, for February, was at a 41-year high of 7.3%. That parallels the spike in goods prices earlier in the pandemic, with about a one-year lag.
Goods inflation, leaving out food and energy, has plunged from 12.4% a year ago to just 1% now. If services inflation follows a similar arc, it could be close to peaking, with the pace of services inflation decelerating throughout 2023. Another reason to think that could happen is the winding down of stimulus programs and the consumer drawdown of savings, leaving less money to splurge with.
As for food and energy, those price trends are improving, as well. Food inflation peaked last August, at an 11.3% inflation rate, and is now down to a 9.5%—still way too high, but moving in the right direction. Energy price trends are more encouraging. Soaring oil prices sent energy inflation to 41% last June. That’s now down to 5%. Energy inflation could soon turn negative since current prices will be compared with the elevated prices of a year ago, in the immediate aftermath of Russia’s Ukraine invasion.
Brooks and Orszag also highlight the lag in monetary tightening, meaning the amount of time it takes for Fed rate hikes to generate the desired economic slowdown that typically brings spending down, and with it, inflation. Various studies peg that lag at two to eight quarters. Using four quarters, or a full year, as a baseline would imply that Fed tightening has barely begun to hit the economy, since it only began in March 2022. If so, the impact of Fed rate hikes will start to come into full force through the rest of 2023.
In addition to inflation, the Fed must now worry about mid-sized banks at risk of failing the way Silicon Valley and Signature collapsed earlier this month. Those banks bore unsustainable losses as depositors withdrew money and they had to cover the withdrawals by selling securities from a few years ago—with low rates well below prevailing ones—at a loss. The Fed’s rapid pace of rate hikes during the last year clearly outran the ability of those bank managers to keep up with the changes.
Pausing rate hikes now might help restore stability to the banking system. Powell and other Fed policymakers worry about taking their eye off inflation, but inflation might turn out to be tamer than they think. If “transitory” means two years rather than one, many would welcome the definitional change.