The Federal Reserve has raised interest rates 11 times since it began fighting inflation two years ago, pushing up borrowing costs at the fastest pace in 40 years.
But the pandemic-warped economy didn't respond as it usually does: Businesses continued hiring at a brisk pace, defying expectations that the unemployment rate would soar. Consumers didn't save more to prepare for higher interest rates, and sales of big-ticket items like cars remained strong.
But inflation has fallen anyway as disrupted supply chains have been repaired and more workers have joined the workforce, a development the Fed has no control over. Consumer prices are currently rising at a 3.3% annual rate, down from a peak of more than 9% in mid-2022.
The central bank’s campaign against soaring prices, perhaps the biggest threat to President Biden’s reelection, has effectively become a two-front war, and Fed Chairman Jerome H. Powell controls only half the battlefield.
Supply chains recovering from disruptions caused by the coronavirus and the Ukraine war are doing more to keep inflation in check than rising interest rates. Going forward, the relative impact of supply-side gains and interest rates will likely shape the Fed's decisions about when and how much to cut borrowing costs.
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“Solving the supply chain was overwhelmingly important. I don't think anybody would dispute that,” said Dean Baker, an economist at the Center for Economic and Policy Research.
The central bank's interest rate hikes helped cool parts of the $28 trillion U.S. economy. Sales of single-family homes fell by a third in five months as the Fed's initial actions caused 30-year mortgage rates to jump from less than 4% to more than 6%.
But improving supply chain performance through March, either on its own or in conjunction with increased availability of dock workers and truck drivers, accounted for 86% of the decline in inflation beyond 2022, according to calculations by the White House Council of Economic Advisers.
“I think the supply side is really important,” said National Economic Council Director Lael Brainard.
A February study by three Federal Reserve economists agreed, noting that “supply factors play an important role in driving commodity price increases and decreases.”
The Federal Reserve signaled last week that it is likely to cut rates once this year, and investors are expecting a cut when it meets in September. After a surprise resurgence in inflation earlier this year, the latest economic data has offered encouraging signs.
Import prices fell 0.4 percent in May due to lower fuel costs, the government said Friday. The report came a day after the Labor Ministry reported that wholesale prices fell 0.2 percent and had risen just 2.2 percent over the past year.
The supply side of the economy has been driving the improvement. The labor market has cooled in recent months, easing some pressure on wages. More than 3 million workers have joined the labor force since March 2022, partly due to increased immigration.
Supply chains are functioning well, according to the Federal Reserve Bank of New York's index. An improvement in the index would result in about six months of price declines. Durable goods prices actually fell at an annual rate of 1.7% in April, which could mean lower inflation going forward.
But the drop in inflation is little comfort to millions of Americans struggling with prices that have risen a cumulative 19 percent since Biden took office. On Friday, the University of Michigan's consumer confidence index for June fell for the third straight month to its lowest level in seven months. Americans' expectations for inflation one year from today also rose to 3.3 percent, up from 2.9 percent in March.
The nation's sour mood, at odds with consumer spending data, is taking a toll on politics: A recent Gallup poll found that just 38% of U.S. adults trust Biden to do the right thing for the economy, the worst score in a presidential election since 2001.
Other developed countries, including Europe and the UK, have also struggled with rising prices (and declining approval ratings for their political leaders) in recent years. For White House officials, the fact that inflation rates have risen and fallen similarly in countries with different levels of consumer and business spending is further evidence that supply considerations play a big role.
The European Central Bank and the Bank of Canada last week approved their first interest rate cuts of the pandemic era, but Powell said he wanted to wait for signs of further cooling before joining in the cuts.
If the Fed waits too long to act, borrowing costs could push the economy into recession.New claims for unemployment benefits rose to 242,000 on Thursday, the highest level in 10 months, a sign that the labor market is tightening.
Sens. Elizabeth Warren (D-Mass.), Jacky Rosen (D-Nev.) and John Hickenlooper (D-Colo.) wrote Powell last week urging him to lower interest rates. They said rising borrowing costs are discouraging new home construction at a time of a housing shortage and exacerbating inflation.
“You have kept interest rates high for too long. It is time to lower them,” they wrote.
The inflation problem, which first emerged in the spring of 2021, was the result of a combination of overheated consumer demand and clogged supply lines: Americans stuck at home bought loads of furniture, appliances, and clothing. Many of these goods, manufactured in Chinese factories and shipped across the Pacific, got stuck in bottlenecks at ports and rail yards.
Shortages were exacerbated by temporary shocks, such as an unusually cold snap in Texas that shut down major petrochemical plants. The auto industry was hit particularly hard. A shortage of semiconductors sapped new-car production and left dealers short on inventory. As a result, many consumers flocked to the used-car market, causing prices to rise by 40 percent in a year.
In some cases, the Fed's rate hikes and subsequent improvements in supply have been linked: The first rate hike in March 2022 caused mortgage costs to spike and new housing starts to plummet from more than 1.8 million in April to less than 1.4 million in July.
Baker said the drop in construction starts has encouraged homebuilders to order fewer materials that need to be shipped by boat or truck to job sites, easing pressure on an overburdened supply chain and allowing construction to proceed more smoothly. Despite the drop in construction starts, the number of completed homes has remained steady.
Fed rate hikes take time to affect consumer and business behavior, and their impact has grown in recent months as supply problems caused by the pandemic have faded.
“It's basically a one-two punch. It started out supply-driven and is increasingly becoming demand-driven,” said Greg Daco, chief economist at Ernst & Young.
Retailers including Target and Walmart have responded to consumer complaints by slashing prices on thousands of products, fearing they will lose sales.
When the central bank finally began raising its benchmark lending rate in March 2022, and then increased it 10 more times, many Wall Street forecasters predicted a recession was imminent.
PGIM Fixed Income strategists told clients in December that the economy would have been in recession by the first quarter of 2023, given the Fed's past tightening cycles.
But the pandemic era has made the economy less sensitive to interest rate fluctuations than before.
In the years before the Federal Reserve raised interest rates to ensure low-cost credit, millions of businesses and consumers benefited from ultra-low interest rates.
With 30-year mortgage rates below 3%, 14 million homeowners refinanced their loans in 2020 and 2021, according to the Federal Reserve Bank of New York. Roughly one-third of those who refinanced took advantage of the lower-interest loans and pulled down $430 billion in home equity to support their spending.
More than 60% of homeowners currently have mortgages with interest rates below 4%, up from 38% before the pandemic, making them immune to rising interest rates, according to Apollo Global Management.
Economic shutdowns and reopenings, along with massive government bailouts, have shifted spending patterns: Easing supply chains have allowed cash-rich consumers to keep spending while the Fed has been raising interest rates.
Government support for new factories making semiconductors and clean-energy products is another source of funding that is not affected by interest rate fluctuations, said Martha Gimbel, executive director of the Budget Lab, a nonprofit research center.
“We have a very unique economy right now, and we're still recovering from all kinds of shocks from the pandemic,” Powell told reporters last week.