The End of the Post-Pandemic Inflation?

The Consumer Price Index (CPI) numbers for the month of July came out today with some good news: inflation has finally fallen below 3%. Over the last three years the U.S. economy has been ravaged by inflation. It began in the spring of 2021 when inflation indicators showed sustained increases in prices, with the year-on-year change in the CPI having increased sharply to 4.2% in April. Inflation continued to increase, eventually peaking at 9.1% in June 2022. Since then, in part due to tight monetary policy, a stubbornly slow disinflation has been ongoing, culminating in today's inflation reading.

The U.S. Bureau of Labor Statistics (BLS) CPI release today showed a year-on-year increase in the CPI of 2.9% for the month of July. Inflation has now fallen below a threshold that suggests that the three-year inflation problem is now under control and within the acceptable range desired by the monetary authorities.

The Federal Reserve System (The FED) determines and implements monetary policy in the United States and has an inflation target of about 2%. So, given this development it will likely consider inflation rates as having moved sufficiently in the direction of this target and is expected to reverse their monetary policy stance from tightening to easing.

It is also likely that the Personal Consumption Expenditures (PCE) price index, which is the FEDs preferred gauge for inflation, will come in much lower than the CPI’s 2.9% inflation rate, as the former tends to run lower compared with the CPI. It was 2.5% for June and the information for July will be released later this month. The expectations are now that the FED will start to cut their benchmark interest rates beginning at their next meeting in mid-September, with some economists expecting a cut of up to 50 basis points (0.5%).

A Primer on rate hikes and cuts

The FED has a dual mandate from Congress to ensure full employment and price stability. It is in line with this mandate that the FED conducts monetary policy. Monetary policy in its most common form involves the buying and selling of government securities, what is called Open Market Operations (OMO), in transactions between the FED and primary dealers in secondary markets. The FED has other tools it employs in the conduct of monetary policy, but OMO is the primary and historically most effective tool. It works by the FED announcing a target for its benchmark interest rate, usually at the end of its Federal Open Market Committee (FOMC) meetings, which occurs eight times a year.

The FOMC comprises all seven members of the Board of Governors, with the FED Chair, who is one of them, doubling as the FOMC chair, the New York regional FED president, who serves as the vice chair of the FOMC, and four other regional Reserve Bank presidents, who rotate their membership on a yearly basis with the other seven regional Bank presidents. The FOMC meets and discusses economic conditions including impacts of prior policies, and vote on changes to their benchmark interest rate. The decision arrived at becomes the policy that is announced, and it usually is a decision to keep the benchmark rate unchanged, increase it, or decrease it, and by some percentage (basis points) for the latter two.

The Benchmark interest rate is formally called the Federal Funds Rate (FFR), and it is the interest rate on overnight loans taken by banks from FED member bank excess reserves (federal funds) held at the FED. These funds provide banks the most directly accessible liquidity needed for their various short-term transactions and to meet regulatory requirements.

The decision by the FOMC on the benchmark rate affects the supply of these funds and thus the benchmark rate. For instance, if the current FFR is 5% and the FOMC votes to raise interest rates by 50 basis points (0.5%), then the FED would carry out open market bond sales in which it sells bonds to primary dealers (which are themselves also member banks of the FED with excess reserves held at the FED), and debits their accounts by the amount of their purchase, as payment for the bonds. These debits reduce the supply of excess reserves and, for a given level of demand for excess reserves, raises the benchmark rate toward the 5.5% target. As demand for excess reserves may move about, the task of the New York FED’s trading desk is to carry out bond sales (and purchases) in such a way as to ensure that the benchmark rate adjusts to these changes and maintains the target rate at 5.5%.

Similarly, if the FOMC had voted instead to cut interest rates, say by 25 basis points (0.25%), then the New York FED's trading desk would be instructed to purchase bonds from the primary dealers, and pay for them by crediting their accounts by the amount of the purchases made, thus increasing the excess reserves in the federal funds market, which would, for any given level of demand for these funds, lower the federal funds rate. Bond purchases would continue until the target rate of 4.75% is arrived at, and purchases (and sales) would continue as demand levels change, to maintain that target rate.

Transmission to the Economy

The ultimate objective of this policy, whether rate hikes (increases in the benchmark rate) or rate cuts (decreases in the benchmark rate), is to influence market interest rates and through those, to influence economic conditions. With a rate hike, of which we have had a total of 12 between March 2022 and July 2023 (the FED has held interest rates steady since then with no further hikes, and no cuts), the resulting higher federal funds rate makes it expensive for banks to take out these overnight loans. As this raises their cost of doing business, they are incentivized to also raise the interest rates on the short- and medium-term loans which they make to the public, to break even or maintain their profit margins.

This is why it appears as though the FED by announcing a policy of raising interest rates, seems to be raising market interest rates even though it does not do that by fiat. The higher borrowing costs reduces credit based economic activity, which is a nontrivial part of the economy both directly and indirectly and this effectively reduces demand and spending on output. Output prices throughout the economy start falling to get rid of the excess supply, and as businesses reduce prices they also cut back on production. To be precise, the "falling prices" actually means prices do not rise as quickly as they would have, hence inflation, still existent, falls.

It is straightforward to see why during this period of inflation the FED has been raising interest rates, as the goal is to ultimately bring down prices even though there is the risk of a subsequent fall in production, and a potential economic slowdown or recession. As you also might have surmised, this is also why rate cuts are now anticipated, because to fight an economic slowdown and prevent a recession from taking hold, the FED would have to boost spending, so that production improves, and businesses have no incentive to lay off workers or cut their hours but to maintain or increase their production levels. The most recent data for unemployment rates showed it ticked up in July to 4.3% from 4.1% in June. It has been rising albeit sluggishly since an April 2023 low of 3.4%. Further, the pace of job additions has now fallen for three straight months.

The Tradeoff

The astute, even if economically naïve, reader would have observed the seeming dilemma the FED faces. Inflation or Unemployment? To bring inflation down, the FED wants to reduce spending, yet to stave off an economic recession and unemployment, it would need to boost spending. This is the challenge of monetary policy, which is why as I noted above the last rate hike was over a year ago. Policies take time to work their way to affecting the economy in concrete ways, which is why inflation has continued to fall even through this “hold steady” phase for interest rates, because of prior period rate hikes.

This is why some economists expect the FED to cut rates by as much as 50 basis points (0.5%) in September to make up for lost time and the fact that the economy would likely keep slowing down between now and then and beyond that before any interest rate cut works its way through the economy to stimulating spending. The good news though is that expectations may help speed this process as market agents expecting a rate cut may start making spending plans ahead of time consistent with these expectations, so that any slowdown in the economy may only be transient, if at all.

Why has it taken so long to tame Inflation?

There are two, possibly three, reasons I would advance for it has taken so long to bring inflation down. The first is the FED only began to raise interest rates in March 2022 a full year from when inflation rates had started rising in a significant manner above the 2% target. Why did the FED wait that long before taking action? One reason was the uncertainty associated with the Covid-19 pandemic. The pandemic had already thrust the U.S and global economy into a recession in 2020, and though the recovery was already underway by the summer of that year, there were concerns about the covid virus mutating and potential future lockdowns and continued disruptions in global supply chain networks. Further, unemployment rates were mostly in the 5- 6% range for most of the year, only gradually falling to 3.9% in December 2021 and ticking up to 4% in January 2022. So, the FED maintained its monetary easing stance all through 2021 until it realized by the Spring of 2022 that there was no double dip economic recession in the offing but rather we had a full-blown inflation on hand.

The second reason is that the economic slowdown from the pandemic persisted globally well into 2021 leading to supply side reductions in output due to broken global supply chain networks. Businesses scrambled to find inputs, and where they did, at very costly prices due to the scarcity. Supply side inflation from higher business costs added to the demand pull inflation coming from increased spending as the economy opened up. As monetary policy has limited effect on supply side inflation, and with the ensuing wage-price pull that resulted from workers being sluggish in returning back to work (in a traditional sense, as some had found nontraditional forms of work to engage in, including many in-demand online services), the persistent supply side inflation kept the overall inflation rate high despite the FED's continued interest rate hikes. As a Reuters article from 2022 also notes, wages continued to rise at a faster rate than prices over this period, which meant consumers continued spending even as inflation raged on.

A plausible third reason is political but nevertheless important to consider. Monetary policy may have been undermined by the fiscal policy provision put in place by the Biden Administration. In response to the need to act, Congress passed, and President Biden signed into law the Inflation Reduction Act of 2022 in August of that year. While it had the label of being designed to reduce inflation, its content could not be further from that. First, beyond the fact that much of that policy is future oriented having limited impact on the current period from when it was passed, it included policies that incentivized increased spending (in line with partisan political agenda on clean energy and similar), which is what you do not want during inflation (even if the cause is a good one), and higher taxes on the segments of society having the ability to shift the burden of that tax to consumers through higher priced products or/ and services. I will not go into the details of these assertions, and I could elaborate further in a different article, but these policies may have served to add gasoline to the inflation fires, even as the FED sought to put them out through higher interest rates.

What to expect next?

Inflation has now fallen below 3%. The Jerome Powell led FED is expected to begin interest rate cuts. They may however wait to do so until the election is past so as not to appear to influence the elections through its policies, which are supposed to be non-partisan. The danger though is that it would have waited a bit too long and would be behind the curve in a potential battle against an economic recession it could have mitigated by acting on time.  Some believe the FED would act immediately, I think so as well, and I also think that unless the job numbers are horrible for August, the FED would cut the federal funds rate by just 25 basis points.