As inflation in the United States moderates from its peak last summer, nearly all reporting and analysis on the state of the economy is asking the same question: Has the Federal Reserve declared victory in its fight against rising prices?
The assumption motivating this question, widely shared among journalists and economists, is that the Federal Reserve’s discretionary monetary policy influences the price level by reducing demand and creating slack in the economy. Yet there has been little slack to speak of, either in the months before inflation peaked in June 2022 or in the year since. Unemployment remains low, and labor-force participation is high. The prices that have slowed the most have been in energy and food — outside the “core inflation” rate that the Fed says is its policy target.
In response to a reporter’s question about “the reasons why inflation has fallen” and how the Federal Reserve evaluates “factors that don’t stem directly from rate hikes . . . like easing supply chains and a drop in energy prices,” Powell said that “monetary policy is working about as we expect.” Higher rates will help lower demand in the future, Powell explained: “We think it’ll play an important role going forward, in particular in nonhousing services. That’s where the labor market will come in as a very, very important factor.”
Powell’s reference to “nonhousing services” — the vast nonmanufacturing sector that employs 86 percent of US workers — reveals the persistence of the idea that the Federal Reserve influences the price level through the labor market. But if the central bank admits that its interest rate policy has not yet slowed down this portion of the economy, then why has inflation moderated?
The answer to this question is important, for upon it rests our understanding of the problem of how to maintain price stability in a growing economy with tight labor markets, in which public investment is necessary to fulfil many social goals —from production of low-income housing to adequate provision of health care and education — that private capital is incapable of achieving.
As the government’s fiscal stimulus has subsided over the past year, the lower inflation we’ve seen has been the result not of the Fed’s rate hikes but of the gradual subsiding of downstream adjustments to price shocks that occurred at the beginning of the inflation. The Fed’s commitment to continuing to raise interest rates recognizes this fact. The “likely outcome,” Powell said, is a further “softening in labor market conditions” — Fed-speak for a slowdown in wage growth and an increase in unemployment.
The Federal Reserve Has Not Created Slack
Credit has contracted, to be sure. But the contraction of credit markets — commercial bank loans and leases, real estate loans, and commercial and industrial loans — did not pass through to fixed investment when inflation peaked in June 2022.
Nonresidential construction spending (value put in place) continued to grow steadily through 2022, after interest rates began rising, as has real private fixed investment in manufacturing structures. Real private fixed investment in nonresidential equipment and intellectual property also continued to grow unabated through 2022. Private domestic final purchases for the first half of 2023, as the Federal Open Market Committee noted in June, “seemed to be more resilient than in the second half of last year.”
The one unambiguous area where the Federal Reserve’s monetary policy has contracted spending is in residential construction. But as important as the home-building market is to the US economy, this decline in nominal spending doesn’t explain the slowdown in price increases generally. The decline in home starts hasn’t affected labor markets: construction industry employment grew steadily before inflation peaked and kept growing after. The producer price index for construction materials has been rising since January, but rising prices for building materials have not coincided with a return to an accelerating price level.
Pricing Problems Lay Outside Conventional Monetary Policy
If tighter credit has not caused a slowdown in investment outside residential construction, and if residential construction does not explain short-term changes in the general price level, then why did inflation start falling in June 2022?
For both producers and consumers, the largest price increases during this bout of inflation were in energy, specifically refined petroleum products. During 2021, the Consumer Price Index (CPI) rose 6.9 percent; gasoline prices rose at the pump 41 percent, and at the refinery 46 percent. Over the first half of 2022, the CPI rose another 5.3 percent to 12.2 percent above its January 2021 level, while gasoline prices rose to 84 percent above, and refinery prices to 262 percent of, their January 2021 levels.
What drove this increase in energy prices? Crude oil is a major part of the equation. Refinery prices rise and fall with crude prices, leading some to argue that refineries merely pass rising crude oil prices along to consumers. Yet price decisions are a function of not only costs but volumes, and during the year capacity utilization returned from its lockdown lows.
A more appropriate measure of refinery operations is margins — the ratio of net income to revenue. As refinery prices rose on a growing volume, margins rose significantly during 2021. They grew a second time in the first half of 2022, as crude oil prices rose again with China’s reopening from COVID lockdowns and as the war in Ukraine began.
Crude oil prices fell after June 2022, the month inflation broke. Gasoline prices, however, have fallen more slowly. One reason for this is that refinery margins have remained elevated.
Sectoral Inflation and National Policy
Even though crude prices peaked in June 2022 and energy prices stabilized, the price level continued to rise for a year above pre-pandemic rates. Why has inflation taken so long to fall?
Conventional economic theory explains this behavior as a result of a persisting imbalance between supply and demand across the economy. Looking at margins, however, provides a contrary view. Rather than an overall equilibrium between supply and demand in all markets, the price level represents a structure of supplier-client relationships: energy users have adapted to higher upstream costs with higher prices or even greater downstream margins.
As Isabella Weber and Evan Wasner of the University of Massachusetts have argued, this kind of inflation can be understood in terms of an “impulse-propagation” model, rather than a general excess of demand. In this model an initial price shock drives up downstream prices as it propagates through customer networks.
There is evidence for this sectoral understanding of inflation. Prices received by farmers recovered rapidly during the second half of 2020 and continued rising until May 2021, when they stabilized for five months at about 35 percent above their pre-pandemic level.
In the same period of rising farm prices, food processing margins jumped significantly, and processor prices began to rise. Processors evidently saw the increase in costs as an opportunity to increase margins and prices more. As a result, food retailers’ margins initially shrank in Q3 and Q4 2020. But as retailers rebuilt their margins during 2021 on top of rising farm prices and larger processor margins, consumer food prices began to rise as well. Though farm prices today are about 11 percent below their May 2022 peak, and processor margins are falling, retail margins and prices remain elevated.
The Weber-Wasner “impulse-propagation” model is important to understanding how to sustain a growing economy with tight labor markets. Conventional macroeconomic theory sees rising incomes and tight employment as the underlying condition enabling prices to rise. Removing that condition, according to this theory of “excess demand,” is how to counteract rising prices.
But if inflation is driven by particular price shocks in commodity markets, which then propagate through downstream supply chains, then the case for restricting demand is much weaker. Margins, as in petroleum and food, may remain elevated even as input costs fall. Selective intervention near the source of the shocks, by contrast, can insulate the rest of the economy before price increases propagate without reducing demand, incomes, or employment.
How to Address Sectoral Inflation
One conclusion is that executive agencies and Congress should understand that quickly responding to price shocks — such as the growth in crude oil and refinery margins or farm prices during 2021 — is the best way to prevent subsequent inflation. Models for such intervention exist today in Europe. The German government is subsidizing natural gas suppliers the difference between a government-fixed price for consumers (covering the first 80 percent of 2022 consumption levels) and rising market prices. The French government has frozen all utility prices, providing tax relief and subsidies for energy suppliers. Spain has similarly coupled a price ceiling on electricity bills with subsidies for households and energy providers. J. W. Mason has referred to such programs as “targeted price policies” rather than “price controls,” though it is worth noting that the purpose of the subsidy is to offset income lost to government-fixed prices.
Using the public budget to absorb rising costs has a long history: it was how the United States rolled back food prices during World War II, and how the European Common Market insulated domestic food prices during the inflation of the early 1970s. The Japanese government has long made “deficiency payments” to agricultural producers and importers to pay the difference between lower consumer prices and higher producer/import prices. Such subsidies, however, only stabilize prices in the short run until production expands to meet demand.
A less administratively burdensome option is for governments to build up “buffer stocks” of commodities, which Weber and Wasner propose, allowing a countercyclical supply policy across price cycles. The Biden administration used the Strategic Petroleum Reserve this way, releasing over two hundred million barrels of oil throughout 2022. During the Vietnam War, the White House similarly used defense stockpiles of steel and aluminum to bring down market prices in those industries. An intentional policy of public stockpiles to ensure even demand in slumps and expanding supply in booms would represent a historic reform of capitalist commodity markets. Limiting financial speculation in commodities, as the Truman administration did during the Marshall Plan, could likewise dampen price cycles.
Absent such measures, we will have to wait for price increases themselves to burn off, which is what we did with the recent inflation. As Matt Klein writes, “There was never any need to squeeze inflation out of the economy at all. It simply faded away.”
And while we wait for inflation to subside, progressive policy goals may be put on pause. How we interpret the recent inflation is of upmost importance for the future, as maintaining a tight labor market, expanding investment in renewable energies, and subsidizing necessary goods and services like housing and health care remain on the national agenda.
Attributing the fall of inflation to the Federal Reserve prevents us from understanding what actually happened. It also pushes us to draw an unduly pessimistic conclusion: that our best response to unforeseen challenges is to lower our ambitions — sacrificing growing incomes and an empowered workforce — rather than to figure out how to meet them.