The Fed was more lucky than good

Eighteen months ago, inflation reached levels not seen in four decades. Food costs were skyrocketing and a trip to the supermarket was terrifying. The cost of buying a home had surged to levels that priced many out of the market, while rents had increased so fast that families were faced with difficult budgetary decisions. And if you could find a vehicle on the lot, it was going for prices above MSRP.

Needless to say, households felt battered and depressed.

Meanwhile, at the Federal Reserve, the monetary policy experts were launching their attack on inflation. Starting in March 2022 and ending July 2023, the Fed raised the federal funds rate, the interest rate that sets the base for most other rates, a total of 11 times. The funds rate increased 5.25 percentage points.

The Fed’s tightening was sharp and quick, and if the past was any indicator of the future, a recession was likely. For most economists, it wasn’t if but when and how bad it would be.

Well, the economic forecasting profession, of which I am a part, blew it. So far, inflation has decelerated sharply without any major economic slowdown. It is too soon to say the fight against inflation is over, but as of now, the impossible looks likely.

So, should we congratulate Fed Chair Jerome Powell and his band of merry money market mavens for a job well done? Unfortunately, it isn’t that simple. The Fed may have used bad forecasting and outside factors to unwittingly create a great outcome.

It all began with COVID and the resulting shutdowns. With unemployment soaring, governments around the world passed massive stimulus packages to replace the lost income of both households and businesses. As a result, instead of cratering, demand remained strong.

But while the government could support spending, it could not change the reality that businesses globally were shuttered or operating well below capacity. The international supply chain broke and goods and services were in short supply. The laws of economics took over, and with strong demand chasing weak supply the inflation fires were ignited.

But it didn’t stop there. Once the economy began reopening, the sudden need for workers led to labor shortages. The excess demand caused wages to soar and provided employees with market power not seen in decades.

The result: Businesses pushed up prices, and workers demanded and got higher wages.

But there was more. Russia invaded Ukraine, the markets panicked, and oil and grain prices jumped. Food and gasoline expenses followed.

Meanwhile, housing costs rose as high rates led to limited home construction. Homeowners, having few choices and facing high mortgage rates if they sold, refused to bring their homes to market, limiting supply. The laws of economics were all working against price stability. It was a perfect storm.

First, consider how Fed policy works. Rising rates impact the so-called “interest sensitive” sectors. They are the ones which require significant borrowing, meaning interest costs matter greatly. Housing, business investment, and vehicles are the major sectors generally considered to be the most interest sensitive. Rapidly rising rates are supposed to slow these areas down, and sharp increases should crater them.

The Fed rate hikes did slow activity to some extent, especially when it came to housing. Housing starts fell by nearly 25% from when the Fed started raising rates. Home purchases declined by about one-third over that period. Growth was restrained, though modestly.

However, since the tightening process began, vehicle sales have increased over 10% while business investment has remained solid.

Weren’t higher rates supposed to suppress vehicle and business investment demand? Yes, but factors other than interest rates also matter.

As the supply chains untangled, the supply of vehicles rose — and so did sales. Meanwhile, strong consumer spending supported the need for business investment.

And maybe most importantly, rates were so low to begin with that the first few percentage points of increases only brought the rates back to normal levels. There really wasn’t that much true tightening, so the impact of the higher interest rates was limited.

Instead, it was the consumer that took over the economy. Over 6.3 million new jobs have been created since the rate hikes started, adding greatly to household income. The low unemployment rates have allowed workers to keep using their pricing power to drive up earnings. In addition, savings built up from the government’s stimulus packages are still being put to use.

Households may be depressed by the high prices created by the high periods of inflation, but they have the income to spend, and they are doing just that.

Interestingly, though the economy expanded solidly over the past two years, inflation decelerated.

Again, why?

The supply chains became untangled, the government stimulus ended, and the panic-driven increases in oil prices and food faded. Housing prices and rents are also decelerating. Units have been priced out of range for many families, lowering demand and forcing builders and landlords to slow their price increases if not lower prices. Finally, growth, while solid, has not been so strong as to create excess demand in the economy.

Little of that had to do with Fed policy.

Yes, the Fed helped slow inflation while growth remained solid. But factors not under the Fed’s control eased inflation considerably while the rate hikes restrained growth significantly less than the Fed expected. In short, the Fed got lucky.