In response to continuing core inflation, the Federal Reserve raised the federal funds rate by 75 basis points during this week’s meeting of the Federal Open Market Committee. This will raise the cost of credit throughout the economy, reduce aggregate demand, and lead to declines in output and employment.
This week’s rate hike may not be the last, given its price-stability mandate, the Fed will keep to its standard script, raising rates until declining economic activity translates into a lower core rate.
Supply shocks, bloated profits
Unfortunately, exclusive reliance on Fed demand management ignores important realities. The current episode owes a lot to supply conditions that have been anything but normal. COVID-19 has thoroughly disrupted manufacturing and reduced labor supply. Crude oil markets have been strongly affected by OPEC’s 2020 decision to lower production. Food supplies have been hit both by Russia’s invasion of Ukraine and by extreme weather.
Moreover, corporations with market power have exercised it freely during the recovery.
These supply problems are unlikely to resolve themselves quickly or completely. COVID-19 continues to disrupt markets for labor, products, and services. OPEC continues to have a dominant role setting world crude oil prices
Climate change continues to produce extreme weather. And domestic corporations continue to exercise monopoly power whenever they see the chance.
Under these circumstances, it may take a lot of demand reduction before inflation is reduced. And that can translate into really undesirable economic loss. Fortunately, there are additional steps we can take to push back supply constraints.
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Steps we can take
Consider, for example, labor supply. It has been reduced because the labor-force participation rate is still below its 2020 level and working-age immigration has been well below the pre-2020 trend, subtracting millions of workers from the labor force. This has helped make labor markets very tight, raising money wage growth above prerecession rates, although there is yet no evidence of acceleration.
But these limitations can be addressed. Greater efforts to expand the uptake of COVID-19 vaccines are likely to mean increased participation and less disruption of normal employment. Increased access to quality child-care and home care for adults is a proven way to increase labor-force participation and labor supply. Returning working-age immigration to its trend value would also make a major contribution to labor supply.
More vigorous antitrust enforcement also could make a difference. Evidence from this recession and recovery demonstrates that general supply shocks create novel opportunities for incumbent firms exercise market power and raise margins, adding to price increases. Effective antitrust would increase entry of new competitors increase effective supply, and reduce the market power of incumbent firms.
And while energy prices generally have a limited impact on core inflation, increasing the supply of renewable energy and reducing reliance on fossil fuels can help reduce the risk of energy-related supply shocks that add to overall inflation and interfere with the economy. OPEC’s reduction in crude-oil production in 2020, which has only gradually been relaxed, has contributed heavily to the large run-up in the prices of crude oil
Natural gas prices
are under pressure because winter weather has left stocks below normal levels, and Russia’s decision to cut supply to the EU. Increased supply of renewable energy, however, would allow substitution away from fossil fuels, and diminish the effects of these kinds of shocks.
The cost of relying on the Fed
Marshaling supply policies to mitigate inflation is unconventional, and most measures cannot be implemented as rapidly as interest-rate increases. But passive reliance on contractionary monetary policy has real economic costs, measured in lost employment and income. These costs fall disproportionately on those most vulnerable in the labor market—people of color, workers without a college degree, disabled workers, and others. And because of the role of supply in generating this inflationary episode, these costs may be higher than we would otherwise anticipate.
Given the changed economic landscape, we need to augment the tools we deploy to handle inflation. We will do better if economic policy addresses the supply issues brought into high relief during this recovery.
Marc Jarsulic is a senior fellow and chief economist at the Center for American Progress.