Reasons why inflation in the US is still runninghot despite Fed’s aggressive rate hikes
On October 13, 2022, the Bureau of Labor Statistics released another higher-
than-expectation Consumer Price Index (CPI) data. It came in at 8.2 percent
implying that the price of goods and services increased by 8.2 percent compared
to the price 12 months ago. The index for all other items less food and energy
which are more volatile rose 6.6 percent. The Fed Chair Jerome Powell
announced another 75basis points rate hike and dismissed the idea of slowing the
pace of tightening soon on Nov 2 after the Federal Open Market Committee
(FOMC) meeting. So, why is the inflation still stubbornly high despite the US
Fed hiking the interest rate to its highest level since early 2008?
What Causes the Inflation at First
On March 11, 2020, the World Health Organization (WHO) declared
Covid-19 a global pandemic. Countries across the globe responded with
lockdowns, quarantine measures, and social distancing to contain the virus.
Economic activities slowed down quickly and the market plunges due to the
uncertainty. Since then, the unemployment rate raised sharply with economies
across the world experiencing the worst recession since the Great Depression.i
Mandated to keep unemployment low, the Fed cut rates to zero and
launched a massive quantitative easing program to boost the economy. The
Fed’s balance sheet increased quickly as trillions of dollars are pumped into the
market. The low rates allowed businesses and consumers to invest and consume
with borrowed money at a cheap price. The stock markets surged from the low
on April 7, 2020, alongside with price of different assets such as real estate,
cryptocurrency, etc. Thanks to the wealth effect, a theory that says people tend
to spend more as the value of their assets rises, the demand increased as the Fed
loosen its monetary policy.
The US Government
On the other hand, the US government responded to the crisis with relief
packages and stimulus. For example, the 2.2$ trillion Coronavirus Aid, Relief
and Economic Security Act (CARES) signed on March 27, 2020, provides
direct cash payment, unemployment benefits, tax credits for firms, and
investment in the healthcare sector. The debt ceiling increase signed into law in
2021 by President Joe Biden is another firm evidence that the fiscal policy by
the US government is enormous. Hence, the demand in the US economy
quickly rises and is perhaps higher than the pre-Covid level.
Chart showing the correlation between inflation with low interest rate and Fed’s balance sheet.
Source: Refinitiv Datastream, Reuters, Sept. 21, 2022, By Vincent Flasseur
Due to the Covid-19 prevention and control measures in 2020, most non-
essential businesses are required to close their physical operation. As the firms
are importing raw materials and producing their product in different countries,
the lockdown and closed border no doubt cause disruption in their supply chain.
Besides, the production lines are also affected by labour shortage as workers are
required to stay at home after tested positive for the virus. Fortunately, the
supply-side pressure is slowly easing as countries loosen their control measure.
However, is that the case?
China’s zero-Covid Policy
China has positioned itself as ‘the world’s factory’ since joining the
World Trade Organization (WTO). According to UN Comtrade, China alone
accounted for 13.45 percent of global export in 2018. As other countries are
easing their Covid-19 control measures, the Chinese authorities are still firm
with their goal to eradicate the virus with lockdowns and quarantine measures.
The supply chain of firms importing raw materials and producing their products
from China is also affected. For evidence, thousands of factory workers at
Foxconn, the major assembler of iPhones for Apple, quit their jobs to escape the
deteriorating working environment due to the lockdown by the Chinese
authorities.ii The pressure on the supply side remains as there’s still no sight of
the Chinese policymakers easing the policy.
On February 24, 2022, Russian President Vladimir Putin addressed his
nation, announcing a “special military operation” against Ukraine. Before the
war, Ukraine was known as “the food basket of the world”. It is the world’s top
producer of sunflower meal, and oil as well as a major exporter of grains,
chemicals, and petroleum products. The production in Ukraine dropped
drastically since the war causes the price of agricultural products to surge across
the world. Furthermore, the US and its allies implemented a series of sanctions
on Russia from the energy sector to the financial sector to cripple the Russian
economy. As Russia is one of the largest oil and natural gas producers, the
sanctions worsen the initially high oil price and caused the energy prices to
skyrocket with both Brent and US oil topping 100 dollars. The situation is not
getting better in the short term as both the Russian President and the Ukrainian
President rule out a peace deal.
Reasons for the High Inflation
After realizing that inflation is not transitory, the Fed started to increase
the Federal Funds Rates to 0.5 percent on March 16. It also raised the rate by 75
basis points three consecutive times after the Federal Open Market Committee
(FOMC) meeting in June, July, and September respectively. Higher rates
strengthen the US Dollar and lowered the price of imports from foreign
countries easing inflation. Starting in September 2022, the Fed also started
quantitative tightening by rolling off treasuries and mortgage-backed securities
without reinvesting them. With these policies, the cost of borrowing is now
higher and asset prices dropped drastically with S&P 500 plunging 20 percent
year-to-date. The demand of households and firms should start to slow down
since then. However, why is the inflation still unacceptably high at 8.2 percent
compared to 12 months ago?
The US Dollar Currency Index is up 15.75% year-to-date. Source: tradingview.com
One of the main reasons is the time lag of monetary policy. For
example, it takes time for the increase in the overnight policy rate to pass
through into other rates such as mortgage rate, personal loan rate, and business
loan rate. Research also shows that it takes over a year before monetary policy
actions have their peak effect on inflation.iii Furthermore, inflation may have
been transmitted into wages and rent which are harder to curb. In the worst case,
a wage-price spiral may occur which elevates inflation repeatedly. To prevent
the wage-price spiral and to restore its credibility, the Fed is aggressively
tightening its monetary policy to bring inflation down.
In August 2022, President Joe Biden signed the Inflation Reduction Act
and the CHIPS Act funded by taxing the rich. The provisions include numerous
investments in climate protection and clean energy, research and development
in the semiconductor supply chain, and medical insurance to bring down
prescription drug prices to cool inflation. These policies aimed to reduce the
dependence of the US on foreign countries, especially in manufacturing
semiconductors. These investments aim to create more jobs and increase the
long-run supply hence cooling inflation. However, massive government
spending will also increase the demand in the economy further, it is
questionable whether the policies help in reducing inflation with strong
consumer spending and unemployment level at a historical low. Some also
suggested that President Biden should encourage peace talks between Russia
, or perhaps persuade the Chinese authorities to ease their zero-
Covid policy instead of continuing his expansionary fiscal policy.
The Fed is expected to maintain its hawkish stance on combating
inflation as the unemployment level in the US is still low. On the other hand,
President Biden is expected to continue his expansionary fiscal policy to remain
politically famous in the coming mid-term election. Inflation in the US should
start to fall soon with a higher rate and a stronger dollar. Nevertheless, other
countries are still not out of the woods yet due to the strong dollars. As the
saying goes, ‘it’s our dollar but your problem’.
i Gopinath, G. (2020, April 14). IMF BLOG. Retrieved from imf.org:
ii Lew, L. (2022, October 31). Bloomberg. Retrieved from bloomberg.com:
iii Nelson, N. B. (2002, January -). www.bankofengland.co.uk. Retrieved from
iv Clark, J. (2022, October 24). The Washington Times. Retrieved from washingtontimes.com: