Fed’s higher interest rates do not get all the credit for lower inflation

15/06/2024

Since beginning its war against inflation two years ago, the Federal Reserve has hiked interest rates 11 times, raising borrowing costs at the fastest pace in 40 years.

But an economy warped by the pandemic has not responded in the usual ways. Employers kept hiring at a robust pace, confounding predictions that the jobless rate would soar. Consumers did not step up their savings to capitalize on higher rates, and sales of big-ticket items like automobiles stayed strong.

Yet inflation fell anyway, as snarled supply chains healed and more workers joined the labor force, developments that the Fed did not control. Consumer prices are now rising at an annual rate of 3.3 percent, down from a mid-2022 peak of more than 9 percent.

The central bank’s campaign against the runaway prices that pose perhaps the greatest threat to President Biden’s reelection has effectively been a two-front war — and Fed Chair Jerome H. Powell commands only half the battlefield.

Supply chains recovering from disruptions caused by covid and the war in Ukraine have done more to lower inflation than higher interest rates have. Now the relative impact of supply side gains and interest rates will shape the Fed’s decision on when, and by how much, to lower borrowing costs.

“Far and away, the major thing was resolving the supply chain. I don’t think you can really dispute that,” said economist Dean Baker of the Center for Economic and Policy Research.

The central bank’s interest rate hikes helped cool parts of the $28 trillion U.S. economy. Sales of single-family homes fell by a third in five months as the Fed’s initial move sent 30-year mortgage rates shooting up from below 4 percent to more than 6 percent.

But through March, improved supply chain performance, by itself or in connection with the greater availability of dockworkers and truck drivers, accounted for 86 percent of the reduction in inflation since 2022, according to calculations by the White House Council of Economic Advisers.

“I think the supply side is incredibly important,” said Lael Brainard, director of the National Economic Council.

A February study by three Federal Reserve economists agreed, identifying “a significant role for supply factors in the run-up and retreat of goods prices.”

The Fed signaled last week that it is likely to reduce rates once this year, with investors expecting it to move at its September meeting. The latest economic data has been encouraging, after an unexpected resurgence of inflation earlier this year.

On Friday, the government said import prices fell 0.4 percent in May, helped by lower fuel costs. That report came one day after the Labor Department reported that wholesale prices dropped by 0.2 percent and are up only 2.2 percent over the past year.

The supply side of the economy has driven the improvement. The labor market in recent months has cooled off, taking some pressure off wages. More than 3 million workers have entered the labor force since March 2022, driven in part by immigration.

Supply chains are operating smoothly, according to a gauge maintained by the Federal Reserve Bank of New York. Improved readings on that index lead falling prices by about six months. In April, durable goods prices actually fell at an annual rate of 1.7 percent, which could mean lower inflation ahead.

But the lower inflation rate is little comfort to millions of Americans struggling to cope with prices that have risen a cumulative 19 percent since Biden took office. On Friday, the University of Michigan’s June consumer sentiment index fell for the third straight month, reaching a seven-month low. Americans’ expectations of the inflation rate one year from today also ticked up to 3.3 percent from 2.9 percent in March.

The sour public mood, which is at odds with consumer spending data, is taking a political toll. In a recent Gallup poll, only 38 percent of U.S. adults reported having confidence in Biden to do the right thing for the economy, among the worst presidential scores since 2001.

Other advanced economies, including Europe and the United Kingdom, also suffered soaring prices in recent years (and low approval ratings for political leaders). To White House officials, the similar rise-and-fall of inflation in countries with different consumer and business spending levels is further proof of the dominant role of supply considerations.

The European Central Bank and the Bank of Canada approved their first pandemic-era rate cuts last week. But Powell said he wants to see signs of additional cooling before joining them.

If the Fed waits too long to act, the economy could tumble into recession under pressure from borrowing costs. On Thursday, first-time claims for unemployment benefits hit 242,000, the highest level in 10 months, a sign the labor market may be tightening.

Sens. Elizabeth Warren (D-Mass.), Jacky Rosen (D-Nev.) and John Hickenlooper (D-Colo.) wrote to Powell last week urging him to cut rates. Higher borrowing costs are making inflation worse by discouraging new home construction amid a housing shortage, the lawmakers said.

“You have kept interest rates too high for too long: it is time to cut rates,” they wrote.

The inflation problem that first flared in the spring of 2021 was a blend of overheated consumer demand and clogged supply lines. Stuck at home, Americans binged on home furnishings, electronics and clothing. Many of those goods, made in Chinese factories, sailed across the Pacific Ocean only to become stuck at port and rail yard bottlenecks.

Product scarcity was aggravated by one-time shocks like an unusual deep freeze in Texas that idled key petrochemical plants. The auto industry was particularly hard-hit: A shortage of semiconductors depressed new car production, leaving dealers short of inventory. That sent many consumers into the used car market, where prices jumped 40 percent in a year.

In some cases, the Fed’s rate hikes and subsequent supply improvements have been linked. The first rate increase in March 2022 caused an immediate jump in mortgage costs and sent new housing starts plunging to fewer than 1.4 million in July from more than 1.8 million units in April.

The slowdown in starts took pressure off overwhelmed supply chains, as home builders placed fewer orders for material that needed to be shipped or trucked to a job site, allowing construction to proceed more smoothly, according to Baker. Despite the stop in starts, the number of homes completed remained steady.

It takes time for the Fed’s interest rate increases to affect actions by consumers and businesses. In recent months, as the pandemic’s supply issues have faded, the Fed’s rate hikes have made more of a mark.

“It’s essentially been a one-two punch, where initially it was supply-driven, but increasingly it’s been demand-driven,” said Greg Daco, chief economist for Ernst & Young LLP.

Retailers such as Target and Walmart have responded to consumer grumbling by reducing prices on thousands of products, fearing they would otherwise lose sales.

When the central bank finally began raising its benchmark lending rate in March 2022 — and then lifted it 10 more times — many Wall Street forecasters placed their bets on an imminent recession.

Based on previous Fed tightening cycles, the economy should have fallen into recession in the first quarter of 2023, strategists at PGIM Fixed Income told clients in December of that year.

But the pandemic era made the economy less sensitive to interest rate movements than it had been.

Millions of businesses and consumers had taken advantage of ultralow interest rates in the years before the Fed hiked to lock in low-cost credit.

As 30-year mortgage rates fell below 3 percent, 14 million homeowners refinanced their loans in 2020 and 2021, according to the Federal Reserve Bank of New York. About one-third of them used the cheaper loans to withdraw $430 billion in home equity, which supported their spending.

More than 60 percent of homeowners now carry a mortgage with a rate of 4 percent or less, up from 38 percent before the pandemic, and thus have been untouched by higher rates, according to Apollo Global Management.

The shutdown and reopening of the economy, coupled with generous government relief payments, changed spending patterns. Even as the Fed was raising rates, easing supply chains enabled cash-flush consumers to keep spending.

Government backing for new factories to produce semiconductors and clean energy products was another source of cash that was impervious to rate movements, said Martha Gimbel, executive director of the Budget Lab, a nonprofit research center.

“Today, we’ve got a very specific economy with all kinds of shocks we’re still getting over from the pandemic,” Powell told reporters last week.