Written by Cameron Maddock
On September 18th, 2024, the Federal Reserve cut the federal funds rate by 0.5% to a target range of 4.75% to 5%, finally starting the rate cut cycle after raising rates to fight inflation during the pandemic. To understand where we are now, it is useful to look back at the history of pandemic-era inflation to inform our view of the future.
Inflation began to spike in 2021, but the true reasons for the spike were not immediately clear. Two main camps emerged: those who believed that it was primarily supply-side and those who believed it was demand-driven (Bernanke & Blanchard, 2024). Those on the supply side were concerned with the multitude of supply shocks that occurred in quick succession. The pandemic upended global supply chains and as a result, shipping goods became incredibly slow and expensive. It is estimated that international shipping costs were approximately seven times above normal levels during the pandemic (Himes, 2023). On the other hand, those in the demand shock camp believed that the stimulus checks of the pandemic caused pent-up savings that led to an increase in aggregate demand. This demand then fueled excessive spending when combined with the expansionary monetary policy that the Federal Reserve had at the time.
These different perspectives also influenced whether one believed inflation was temporary or more permanent. Aggregate demand factors tend to be more permanent but are also much more manageable by central bankers. By adjusting the federal funds rate, they can very effectively shift demand in either direction. On the other hand, Supply-side factors are generally much more difficult to correct with monetary policy, and sometimes must subside on their own. Ultimately, the Federal Reserve sided with the supply-side argument and chose not to raise rates at the onset of explosive inflation during 2021 (Bernanke & Blanchard, 2024).
In hindsight, the majority of pandemic-era inflation can be attributed to supply-side disruptions. In an analysis of pandemic-era inflation, Adam Shapiro sorted the 124 categories that make up PCE inflation and classified them as either demand-sensitive or supply-sensitive. This exercise found that all but one of the demand-sensitive categories experienced disinflation, while nearly all of the supply-sensitive categories experienced price inflation (Shapiro, 2024). While there were certainly demand-side factors that influenced inflation, it is clear today that supply disruptions were the main drivers of inflation.
Now, let’s examine the come down from inflation. As established earlier, supply chain disruptions were among the main causes of inflation. Consequently, most of the alleviation in inflation stemmed from normalization in this area. Although this took some time, global supply chains are no longer a major concern today; the real focus has been on the last mile of inflation. From mid-2022 to mid-2023, inflation steadily ticked down from its historic highs, but then it stalled at around 3-3.5% for nearly a year (Calhoun 2024).
There were two main factors that contributed to this stubborn last mile of inflation: housing inflation and wage inflation (Bernanke & Blanchard, 2024). Housing prices skyrocketed at the onset of the pandemic. The Case-Shiller Home Price Index—a metric that measures housing costs with January 2000 normalized to 100—measured at 213 as of February 2020, but shot up to 308 in June 2022, an unprecedented increase. Unlike supply chains, there is no simple solution to elevated housing costs. The current state of home prices is rooted in a trend of insufficient home construction dating back to the fallout of the Great Recession in 2008 (Ullrich, 2024). While there has been more congressional focus on housing policy in recent years, president-elect Trump has not yet laid out any plans that would address these supply issues. Ultimately, housing demand still greatly outweighs housing supply and is expected to remain so for years to come.
On the other hand, wage inflation was more controllable in the short run. The labor market was historically tight during the pandemic recovery, meaning there were more job vacancies than unemployed people. As measured by the Bureau of Labor Statistics, the job openings rate reached a peak of 7.4% in March 2022 while the unemployment rate was only 3.6%. This mismatch made the labor market exceptionally tight, and wages skyrocketed as a result. The comedown from these highs has been slow. The high federal funds rate has been eroding this labor market tightness since 2022, and as of today, the job openings to unemployment ratio is a rather moderate 1.1, far below the highs we saw only two years ago (Gascon & Martorana, 2024). But has the labor market loosened too much?
As we examine our surroundings today, we find ourselves in an environment where inflation has mostly been beaten. Although inflation still sits above the Fed’s 2% target, the underlying factors driving it have cooled to an acceptable level. According to the Summary of Economic Projections, forecasts created by the members of the Federal Open Market Committee, inflation is expected to slowly subside over the next year and reach the 2% target by early 2026. What concerns economists right now is the labor market. While labor market cooling was welcomed for most of the last 3 years, it is now reaching a state that is concerningly weak. Monthly nonfarm payrolls, an indicator that measures the number of employed people in the economy, has only averaged an increase of 115,000 over the last 5 months compared to 225,000 from January to May. Overall, the high interest rates have had their intended effect, but it is clear to the Fed that, to preserve the health of the labor market, it is time to begin the rate cutting cycle (Powell, 2024). This was shown at their September meeting when they made their aggressive half-point cut.
The Fed cut rates by an additional .25% at their November meeting, and CME Fedwatch projects a 65% chance as of November 11th that they will cut by .25% again at their December meeting, which would bring the target range down to 4.25% to 4.5%. However, even after these cuts, the federal funds rate will likely still be restrictive and will require further cuts to bring down to a neutral rate. Looking once again at the Summary of Economic Projections, the median projection puts the federal funds rate in the range of 3.25% to 3.5% by the end of 2025 and 2.75% to 3% by the end of 2026, a much more neutral rate. Although the timeline for these cuts is unclear and the economic outlook could change, one thing is certain: the rate cut cycle has started, and pandemic-era inflation is likely behind us.
References
Hale Shapiro, Adam. 2022. “A Simple Framework to Monitor Inflation,” Federal Reserve Bank of San Francisco Working Paper 2020-29. https://doi.org/10.24148/wp2020-29
Blanchard, O., & Bernanke, B. (2024). An Analysis of Pandemic-Era Inflation in 11 Economies. https://doi.org/10.3386/w32532
Calhoun, G. (2024, February 19). The verdict on the inflation in 2021-2023: “transitory,” on all counts. Forbes. https://www.forbes.com/sites/georgecalhoun/2024/02/05/the-verdict-on-the-2021-2023-inflation–transitory-on-all-counts/
Gascon, C., & Martorana, J. (2024, July 18). Federal Reserve Economic Data. FRED Blog. https://fredblog.stlouisfed.org/2024/07/the-job-openings-to-unemployment-ratio-labor-markets-are-in-better-balance/
Himes, D. (2023, September). Shipping prices, import price inflation, and the COVID-19 pandemic. U.S. Bureau of Labor Statistics. https://www.bls.gov/opub/mlr/2023/beyond-bls/shipping-prices-import-price-inflation-and-the-covid-19-pandemic.htm
Powell, J. (2024, September 18). Transcript of chair Powell’s press conference. Federal Reserve Board. https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20240918.pdf
S&P corelogic case-shiller U.S. national home price index. FRED. (2024, October 29). https://fred.stlouisfed.org/series/CSUSHPINSA
Summary of economic projections, September 18, 2024. (2024, September 18). https://www.federalreserve.gov/monetarypolicy/files/fomcprojtabl20240918.pdf
Ullrich, J. (2024, October 18). Why is there a housing shortage in the U.S.?. Bankrate. https://www.bankrate.com/real-estate/low-inventory-housing-shortage/
EpicTop10.com. (2024, November 25). Inflation. Flickr. https://www.flickr.com/photos/182229932@N07/48277252272