Federal Reserve officials are questioning whether their longstanding assumptions about inflation still apply as price gains remain stubbornly and surprisingly rapid — a bout of economic soul-searching that could have big implications for the American economy.
For years, Fed policymakers had a playbook for handling inflation surprises: They mostly ignored disruptions to the supply of goods and services when setting monetary policy, assuming they would work themselves out. The Fed guides the economy by adjusting interest rates, which influence demand, so keeping consumption and business activity chugging along at an even keel was the primary focus.
But after the global economy has been rocked for two years by nonstop supply crises — from shipping snarls to the war in Ukraine — central bankers have stopped waiting for normality to return. They have been raising interest rates aggressively to slow down consumer and business spending and cool the economy. And they are reassessing how inflation might evolve in a world where it seems that the problems may just keep coming.
If the Fed determines that shocks are unlikely to ease — or will take so long that they leave inflation elevated for years — the result could be an even more aggressive series of rate increases as policymakers try to quash demand into balance with a more limited supply of goods and services. That painful process would ramp up the risk of a recession that would cost jobs and shutter businesses.
“The disinflationary forces of the last quarter-century have been replaced, at least temporarily, by a whole different set of forces,” Jerome H. Powell, the Fed chair, said during Senate testimony on Wednesday. “The real question is: How long will this new set of forces be sustained? We can’t know that. But in the meantime, our job is to find maximum employment and price stability in this new economy.”
When prices began to pick up rapidly in early 2021, top Fed policymakers joined many outside economists in predicting that the change would be “transitory.” Inflation had been slow in America for most of the 21st century, weighed down by long-running trends like the aging of the population and globalization. It seemed that one-off pandemic shocks, especially a used-car shortage and ocean shipping issues, should fade with time and allow that trend to return.
But by late last year, central bankers were beginning to rethink their initial call. Supply chain problems were becoming worse, not better. Instead of fading, price increases had accelerated and broadened beyond a few pandemic-affected categories. Economists have made 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 the unrelenting inflation burst.
“Of course we’ve been looking very carefully and hard at why inflation picked up so much more than expected last year and why it proved so persistent,” Mr. Powell said at a news conference last week. “It’s hard to overstate the extent of interest we have in that question, morning, noon and night.”
The Fed has been reacting. It slowed and then halted its pandemic-era bond purchases this winter and spring, and it is now shrinking its asset holdings to take a little bit of juice out of markets and the economy. The central bank has also ramped up its plans to raise interest rates, lifting its main policy rate by a quarter point in March, half a point in May and three-quarters of a point last week while signaling more to come.
It is making those decisions without much of an established game plan, given the surprising ways in which the economy is behaving.
“We’ve spent a lot of time — as a committee, and I’ve spent a lot of time personally — looking at history,” Patrick Harker, president of the Federal Reserve Bank of Philadelphia, said in an interview on Wednesday. “Nothing quite fits this situation.”
The economic era before the pandemic was stable and predictable. America and many developed economies spent those decades grappling with inflation that seemed to be slipping ever lower. Consumers had come to expect prices to remain relatively stable, and executives knew that they could not charge a lot more without scaring them away.
Shocks to supply that were outside the Fed’s control, like oil or food shortages, might push up prices for a while, but they typically faded quickly. Now, the whole idea of “transient” supply shocks is being called into question.
The global supply of goods has been curtailed by one issue after another since the onset of the pandemic, from lockdowns in China that slowed the production of computer chips and other goods to Russia’s invasion of Ukraine, which has limited gas and food availability.
At the same time, demand has been heady, boosted by government pandemic relief checks and a strong labor market. Businesses have been able to charge more for their limited supply, and consumer prices have been picking up sharply, climbing 8.6 percent over the year through May.
Research from the Federal Reserve Bank of San Francisco released this week found that demand was driving about one-third of the current jump in inflation, while issues tied to supply or some ambiguous mix of supply-and-demand factors were driving about two-thirds.
That means that returning demand to more normal levels should help ease inflation somewhat, even if supply in key markets remain roiled. The Fed has been clear that it cannot directly lower oil and gas prices, for instance, because those costs turn more on the global supply than they do on domestic demand.
“There’s really not anything that we can do about oil prices,” Mr. Powell told senators on Wednesday. Still, he added later, “there is a job to moderating demand so that it can be in better balance with supply.”
What is inflation? Inflation is a loss of purchasing power over time, meaning your dollar will not go as far tomorrow as it did today. It is typically expressed as the annual change in prices for everyday goods and services such as food, furniture, apparel, transportation and toys.
But it also means that if the supply shortages that are driving so much of inflation today fail to ease, the Fed could need a more punishing response — one that weakens the economy drastically to bring demand in line — to return annual price increases to more normal 2 percent levels.
The path to lower inflation without causing a recession “has been made significantly more challenging by the events of the last few months, thinking there of the war and, you know, commodities prices, and further problems with supply chains,” Mr. Powell said Wednesday.
Asked if containing inflation would require causing very high unemployment, Mr. Powell said on Thursday that “the answer is going to depend, to a significant extent, on what happens on a supply side.”
There’s an important reason that Fed officials cannot wait indefinitely for supply to recover. Should supply shocks and higher prices last long enough, they could persuade consumers to expect inflation to endure — changing behavior in ways that make rapid price increases a more permanent feature of the economy. Workers might ask for bigger wage growth to cover anticipated rent and grocery price increases, prompting employers to charge more as they try to cover swelling labor bills.
Plus, the jump in food and energy costs caused by the war in Ukraine could seep into other prices, making it more expensive to provide a restaurant meal, travel by air and bus, or heat a hotel room.
“Typically, there’s a sort of light at the end of the tunnel,” said Omair Sharif, founder of the research firm Inflation Insights. Usually, he explained, gas and food supplies in particular are disrupted by short-lived events rather than by wars that could drag on for months or years.
“I think their concern is: This is not the energy shock of old,” Mr. Sharif said. “The higher it stays and the longer it stays high, the more likely it will bleed into a lot of other things.”
Some supply disruptions may be getting better. Chip production has shown some signs of ramping up, which could take pressure off the car and electronic markets. Swollen inventories of some goods at retailers like Target are likely to send prices lower as the companies try to clear their shelves. But economists warn that it is too early to call any glimmers of hope conclusive.
“The supply chain is Whac-a-Mole,” Tom Barkin, president of the Federal Reserve Bank of Richmond, said during a webinar on Tuesday. “People say you solve one problem and then you have another one.”
For now, central bankers are trying to quickly lift interest rates to a place that clearly restrains the economy — at which point they will assess just how much more is needed.
“We have to find price stability in this new world,” Mr. Powell said last week.