Yet inflation still fell as congested supply chains recovered and more workers joined the workforce, a development the Fed did not control. Consumer prices are now rising at an annual rate of 3.3%, down from a peak of more than 9% in mid-2022.
The central bank’s campaign against surging prices, which poses perhaps the greatest threat to President Biden’s re-election, has actually been on two fronts — and Fed Chairman Jerome H. Powell, only controls half of the battlefield.
Supply chains recovering from disruptions caused by Covid and the war in Ukraine have done more to reduce inflation than rising interest rates. Now, the relative impact of supply-side and interest rate gains will shape the Fed’s decision on when and how much to cut borrowing costs.
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“By far, the main thing was to solve the supply chain. I don’t think you can really argue with that,” said economist Dean Baker of the Center for Economic and Policy Research.
The central bank’s interest rate hikes have helped calm part of the US economy, estimated at $28 trillion. Single-family home sales fell by third in five months as the Fed’s initial decision sent bonds back to 30 years mortgage rates rose from less than 4 percent to more than 6 percent.
But through March, improved supply chain performance, alone or in conjunction with greater availability of dockworkers and truck drivers, accounted for 86% of the reduction in inflation since 2022, according to the calculations of the White House Council of Economic Advisers.
“I think the supply is extremely important,” said Lael Brainard, director of the National Economic Council.
A A February study by three Federal Reserve economists agreed: identifying “an important role of supply factors in the rise and fall of prices of goods”.
The Fed signaled last week that it would likely cut rates once this year, with investors expecting it to do so at its September meeting. The latest economic data is encouraging, after an unexpected resurgence of inflation at the start of the year.
On Friday, the government announced that import prices fell 0.4 percent in May, helped by lower fuel prices. This report came a day after the Labor Department announced that wholesale prices fell 0.2 percent and were rising. just 2.2 percent over the past year.
The supply side of the economy was behind this improvement. The labor market has cooled in recent months, easing pressure on wages. More than 3 million workers have entered the job market since March 2022, partly thanks to immigration.
Supply chains are operating smoothly, according to an indicator maintained by the Federal Reserve Bank of New York. Improving readings of this index cause prices to fall by approximately six months. In April, prices of durable goods fell at an annual rate of 1.7 percent., which could result in a fall in future inflation.
But the falling inflation rate is little comfort to the millions of Americans struggling to cope with prices that have risen a combined 19% since Biden took office. The University of Michigan Consumer Confidence Index for June fell for the third straight month on Friday, hitting a seven-month low. Americans’ expectations for the inflation rate a year from now also increased, from 2.9 percent in March to 3.3 percent.
The sour public mood, which is at odds with consumer spending data, has political consequences. In a recent Gallup poll, only 38% of American adults said they had confidence in Biden to do the right thing for the economy, one of the worst presidential scores since 2001.
Other advanced economies, notably Europe and the United Kingdom, have also suffered from soaring prices in recent years (and low approval ratings from political leaders). For White House officials, the similar rise and fall of inflation in countries with different levels of consumer and business spending is further evidence of the dominant role of supply-side considerations.
The European Central Bank and the Bank of Canada approved their first rate cuts during the pandemic last week. But Powell said he wanted to see signs of further cooling before joining them.
If the Fed waits too long to act, the economy could slide into recession under pressure from borrowing costs. On Thursday, initial applications for unemployment benefits reached 242,000, the highest level in 10 months, a sign that the job market could be tightening.
Senators Elizabeth Warren (D-Mass.), Jacky Rosen (D-Nevada) and John Hickenlooper (D-Colorado) wrote to Powell last week urging him to cut rates. Higher borrowing costs worsen inflation by discouraging the construction of new homes amid a housing shortage, lawmakers said.
“You’ve kept interest rates too high for too long: it’s time to cut them,” they wrote.
The inflation problem that first erupted in spring 2021 was a mix of overheated consumer demand and clogged supply lines. Stuck at home, Americans indulged in furniture, electronics and clothing. Many of these goods, made in Chinese factories, crossed the Pacific Ocean only to get stuck in bottlenecks at ports and rail yards.
The product shortage has been compounded by one-off shocks, such as an unusual freeze in Texas that idled key petrochemical plants. The auto industry has been particularly hard hit: a shortage of semiconductors has slowed production of new cars, leaving dealers short of inventory. This pushed many consumers into the used car market, where prices jumped 40% in a year.
In some cases, Fed rate hikes and subsequent supply-side improvements have been linked. The first rate increase in March 2022 caused an immediate rise in mortgage costs and caused housing starts to plunge to less than 1.4 million in July, from more than 1.8 million units in April.
The slowdown in housing starts eased pressure on overwhelmed supply chains as homebuilders placed fewer orders for materials that needed to be shipped or trucked to a job site, allowing construction to proceed more easily, according to Baker. Despite the halt in construction starts, the number of completed housing units remained stable.
It will take time for the Fed’s interest rate hikes to affect consumer and business actions. In recent months, as pandemic-related supply concerns have eased, the Fed’s rate hikes have carried more weight.
“It’s essentially a duet-double, initially driven by supply, but increasingly by demand,” said Greg Daco, chief economist at Ernst & Young LLP.
Retailers such as Target and Walmart have responded to consumer grumbling by slashing prices on thousands of products, fearing they would otherwise lose sales.
When the central bank finally began raising its benchmark rate in March 2022 — and then raising it ten more times — many Wall Street forecasters bet on a looming recession.
Based on previous Fed tightening cycles, the economy should have fallen into recession in the first quarter of 2023, PGIM Fixed Income strategists told clients in December of that year.
But the pandemic era has made the economy less sensitive than it was to interest rate movements.
Millions of businesses and consumers had taken advantage of extremely low interest rates in the years before the Fed hike to secure low-cost credit.
As 30-year mortgage rates fell below 3%, 14 million homeowners refinanced their loans in 2020 and 2021, according to the Federal Reserve Bank of New York. About a third of them used the cheapest loans to take out $430 billion in home equity, which supported their spending.
More than 60% of homeowners now have a mortgage at 4% or less, compared to 38% before the pandemic, and therefore have not been affected by higher rates, according to Apollo Global Management.
The shutdown and reopening of the economy, coupled with generous government aid, have changed spending habits. Even as the Fed raised rates, loosening supply chains allowed cash-starved consumers to continue spending.
Government support for new factories to produce semiconductors and clean energy products was another source of liquidity insensitive to rate movements, said Martha Gimbel, executive director of the Budget Lab, a nonprofit research center .
“Today we have a very specific economy with all kinds of shocks that we are still recovering from from the pandemic,” Powell told reporters last week.