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Markets and Economy

6 Factors Moderating Inflation

The Federal Reserve’s newfound patience toward raising rates is a reminder that inflation ultimately drives monetary policy—and due to factors from globalization to the gig economy, inflation has remained remarkably tame over the course of the current business cycle.

Over the last few decades, the link between price pressures and the strength of the economy seems to have weakened, leaving prices relatively stable as the labor market grows historically tight.

In the past, periods of strong consumer demand and low unemployment often pushed prices higher, while weak aggregate demand during recessions caused prices for most goods to soften. Today, the unemployment rate rests well below the level assumed to mark full employment, yet inflation remains in alignment with the Fed’s 2 percent target. Without pressure from rising prices, policymakers are likely to take a data-driven approach when evaluating the economy’s true potential and the minimum sustainable unemployment rate.

Two Mandates, One Target

The Fed is guided by a dual mandate: to maintain price stability while promoting full employment. However, while the Fed keeps an official 2 percent inflation goal, there’s no official target for full employment; rather, full employment is considered the lowest level of unemployment the economy can sustain without creating inflationary pressure.

Assumptions about full employment have changed considerably over time. Over the past two decades, unemployment has periodically fallen below estimates of full employment without sparking an inflationary spiral.

6 Factors for Inflation’s Evolution

In the postwar era, a tightening labor market often created an unsustainable level of aggregate demand and spiraling inflation. In the current business cycle, however, inflation has remained flat even as the unemployment rate swung from the highest to the lowest levels in decades.

No single factor can fully explain inflation’s evolving behavior. But several structural changes to the economy may have contributed to the gradual taming of inflation:

  1. The Fed’s credible target: Futures markets certainly place credibility in the Fed’s inflation target, with long-term expectations for inflation resting at almost exactly 2 percent. Investors believe that, over the long run, the Fed will take the actions necessary to keep prices stable. While the Fed’s credibility helps contain long-term borrowing costs, there’s no mechanism for the market’s expectations to restrain price pressures today. A closer look at pricing data reveals considerable divergence—prices for some goods are climbing rapidly while other prices are hardly rising at all. This indicates that prices are mostly driven by the shifting balance of supply and demand, not the anticipation of future monetary actions.
  2. Globalization: The increasing availability of imported goods and services may have tempered the power of rising aggregate demand to push prices higher. When demand from American consumers outstrips the domestic economy’s capacity, foreign goods can be imported to fill the gap without disturbing price equilibriums. But not all production can be outsourced. The staffing challenges faced by businesses today—resulting in 7 million unfilled jobs—implies that domestic demand for labor is outstripping the available supply of workers, yet prices remain relatively stable.
  3. Deregulation: In the postwar decades, highly regulated industries like shipping, energy and communications were sheltered from competition. When the labor market grew tight, businesses in these sectors could pass their rising costs on to consumers, laying the groundwork for an inflationary spiral. Deregulation has made these industries more competitive, limiting the tightening labor market’s impact on prices. In recent years, the emergence of the gig economy has also boosted the economy’s supply-side potential. House-sharing and ride-hailing apps allow property holders to put previously idle assets into service, providing a one-time boost to the economy’s potential output.
  4. Technological transparency: Online shopping platforms make pricing more transparent and allow consumers to select from a wider range of vendors. This may constrain retailers’ ability to raise prices—a competitor will always be waiting to undercut any business that hikes its prices. However, this development can’t contain inflation indefinitely. Eventually, unsustainable demand will force prices higher across the market.
  5. Commodity cycles: Inflation’s unusual behavior in the current business cycle may be related to commodity supply shocks. Prices for oil and metals like iron and steel were relatively high in the years following the recession, which could have pushed up prices for a wide range of products despite relatively weak consumer demand. As the economy regained its momentum, new drilling technologies caused energy prices to plummet, and a slowdown in Chinese construction took pressure off metals markets. The counter-cyclical swing in commodities may have helped stabilize prices through the maturing business cycle.
  6. Narrow measurements: Finally, the Federal Reserve Bank of New York recently released a study showcasing alternative models of inflation that show stronger pressure building than the standard core personal consumption expenditures measure suggests. The study draws on a broad range of indicators beyond retail prices, including manufacturing activity data and financial indicators. The research shows that aggregate demand is building faster than commonly assumed.

Regardless of the factors behind inflation’s moderation, the Fed’s next move is likely to be data-dependent. As transitory supply-side factors fade, the Fed may resume hiking rates toward an eventual 3 percent target—but the pace of future rate hikes will surely be shaped by the evolution of inflationary pressure.

View our economic commentary disclaimer.

Jim Glassman

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