Inflation happens when too much money is chasing too few items, and that is just what happened with stimulus spending following the pandemic, the Ukraine war, and supply-chain issues—and it is unclear what happens next.
- The U.S. has experienced a year of runaway inflation, with a year-to-year increase of 7.1% as of November and a peak of 9.1% in June. Some cities like Phoenix, Arizona experienced inflation as high as 13%.
- The COVID pandemic, trillions of dollars in stimulus spending, and Russia’s invasion of Ukraine contributed to economic stress, supply-chain issues, and a rapid devaluation of the dollar, causing prices to skyrocket.
- The Wall Street Journal’s Vincent Reinhart says the pandemic incentivized goods over service industries, creating a high demand that subsequently tightened the market following the ongoing war.
Why it’s Important
As pandemic spending began and supply began to fall, the Fed insisted inflation was “transitory”—temporary because of sudden surge to the economy. In August 2021, Fed Chair Jerome Powell at the Jackson Hole Economic Symposium said: “These elevated readings are likely to prove temporary.”
But they weren’t, says WSJ’s Reinhard: “The sectoral dislocations were durable, the labor market was impaired as health risks lingered, and concerns about inflation were top of mind for households and businesses.”
Eventually, the Fed dropped the “transitory” argument and began to raise rates to slow things down.
The Fed has responded with seven consecutive interest rate hikes, raising rates from near zero to record highs of 4.25% to 4.5% as of Wednesday, in an effort to slow entrenched inflation. The Fed is only going to continue raising interest rates incrementally until private consumer spending slows and inflation drops due to lower demand. Its goal is 2% year-to-year inflation, which may not be possible before 2024 given current trends.
The important question after two years of instability is how the economy is going to react going forward, and at the moment there are multiple competing pressures between high demand and high inflation that threaten to drag out and entrench the inflation crisis.
“The target range still implies a negative interest rate in real terms, even with an optimistic take on inflation expectations. A negative real interest rate won’t slow demand growth, which means that more tightening is needed to reduce pressure on resources to reduce inflation,” says Reinhart.
The Fed’s goal is to slow the market through an artificial recession, taking short-term pain in exchange for long-term pain. That is a hard sell coming from the Fed but Chair Jerome Powell has committed to holding the line as long as it takes, continually raising interest rates. It is unclear how long this process will take so long as consumer confidence is high and unemployment is low. The American people have alot of cash on hand and they are eager to enjoy post-COVID entertainment and goods.
“The business cycle doesn’t always shift gears smoothly, and economic recession is a probable outcome of the attempt. When inflation is high and the unemployment rate low, policy firming is an appropriate step, but one with potentially painful consequences,” says Reinhart.