While unemployment and inflation usually run counter to each other, the COVID-19 pandemic created a unique set of circumstances. During the pandemic and recovery, unemployment has remained well above the FOMC’s target and inflation has increased at a staggering rate. In response, the Federal Reserve has kept interest rates near zero and has made significant ongoing purchases of Treasury and mortgage-backed securities. These policies are intended to continue until the economy has recovered from the pandemic and the Fed’s goals of price stability and employment are met.
At the recent FOMC conference, Federal Reserve Chair Jerome Powell indicated that many FOMC members believe that substantial progress has been made toward the goals of stable inflation and full employment. So, what are the expectations for the future of interest rates, and when should businesses expect to see changes to policy?
Inflation Metrics Continue to Show Higher Prices
Inflation, as measured by the Consumer Price Index [CPI], has increased drastically over the past year. The pandemic and the speed of reopening created supply shortages and delivery bottlenecks that have driven prices upward. Since July 2020, CPI has risen 5.4% and we continue to see monthly increases in CPI data. Several factors are contributing to increased inflation including higher production costs, changing consumer behavior, and reporting challenges.
Increases in production prices usually lead to increases in CPI as manufacturers raise prices to compensate for the higher costs of making their goods. The Producer Price Index [PPI], measures the cost of production and is therefore a leading indicator of consumer prices. PPI has also increased 7.8% from July 2020 to July 2021. With PPI continuing to increase, consumer prices are likely to follow.
Consumer Behavior Shifts
Another factor affecting the U.S. economy is a shift in consumer behavior. Lately, consumers are buying more goods and fewer services. Personal consumption of goods rose $921.4 billion from 2019 to Q2 2021. On the other hand, personal consumption of services fell $232.6 billion during the same time frame.
The service industry has not recovered as quickly from the pandemic, and it is seeing new setbacks as the delta variant becomes more widespread. The increase in purchases of goods, coupled with the rising producer costs, continues to contribute to inflation as more demand for goods – in the absence of an offsetting increase in supply – equals higher prices.
Durable Goods Experiencing Rare Inflation
Some sectors have seen more drastic price increases than others. For example, prices for food have risen 3.4% over the past year, and energy prices have seen a spike of 23.8%. Durable goods have also seen a particularly large price increase. Inflation in this area has been negative over the past 25 years but has rapidly increased in 2021 – with spending on durable goods 20% higher than pre-pandemic levels.
Keep in mind that price increases in durable goods purchases are expected to be temporary. The spikes in the prices of over-inflated sectors should abate as supply grows and production bottlenecks ease, and that should result in durable goods prices coming back to a more normal range.
Inflation Numbers Somewhat Misleading
Annual inflation rates may not accurately reflect the actual price increases that consumers are experiencing for two reasons. First, a few sectors are driving the overall inflation numbers higher. Durable goods added about 1% to the year-over-year inflation reading and energy contributed another 0.8%. Prices in both of these sectors are expected to ease as the pandemic related factors are resolved. Secondly, annual price increases for some sectors are misleading. Some industries, like airline tickets and hotel rooms, were significantly impacted by the pandemic and prices in these sectors fell sharply during the first few months of the pandemic. The increase in prices for these from July 2020 – July 2021 are overstated because they include the rebound in prices that dropped between March and July 2020.
The FOMC recognizes the impact of certain over-inflated industries and the overstated price increases in pandemic effected sectors, and they adjust their measurements accordingly. At the recent FOMC conference, Fed Chair Jerome Powell said, “(w)e consult a range of measures meant to capture whether price increases for particular items are spilling over into broad-based inflation. These include trimmed mean measures and measures excluding durables and computed from just before the pandemic.” These altered measurements reflect inflation closer to the target rate of 2%, which lends credence to the FOMC’s stance that the current inflation is transitory.
Employment Rebounding
Employment took a huge hit across all sectors during the pandemic but is recovering quickly. In April 2020, unemployment reached 14.8%, the highest level since the data was first recorded in 1948. As of July, the national unemployment rate is 5.4%. Prior to the pandemic, employment was extremely strong. In fact, 2019 saw the lowest unemployment rate since 1969 at 3.5%.
According to the FOMC, employment is currently 6 million below the February 2020 level. Of the enduring job losses, 5 million are in the service sector. Increased vaccinations, schools reopening, and the end of enhanced unemployment benefits are expected to assist in bringing employment back to pre-pandemic levels.
Fed Expected to Begin Tightening Later This Year
Federal Reserve Chair Jerome Powell noted in his remarks at the recent FOMC conference that Fed intervention into temporary shifts in inflation can cause more harm than good to the economy. Based on this fact and the difficulties in accurately reporting price increases, the Fed is not rushing to implement tighter policy to combat the high inflation that the country is currently experiencing.
During the pandemic, the Fed began the process of quantitative easing, or buying securities in order to increase the money supply. Currently, the Fed is purchasing $80 billion per month of Treasury securities and $40 billion per month of agency mortgage‑backed securities. However, they are expected to begin tapering these asset purchases later this year.
The Fed has previously stated that they will maintain their asset purchase strategy until “substantial further progress toward our maximum employment and price stability goals” is met. At the recent conference, Powell indicated that he believes substantial further progress has been met regarding inflation and that clear progress has been made toward employment goals. If the economy continues to improve as it has in the past few months, Powell indicated that he would support tapering the asset purchases this year. Even if purchases stop, the Fed chair noted that the FOMC’s elevated holdings of longer-term securities will continue to support accommodative economic conditions.
Interest Rate Increase Expected in 2023
Four times a year, the members of the FOMC report their projections for GDP, inflation, and interest rates. The latest FOMC projections in June show the first expected interest rate increase to be coming in 2023. As inflation continues to outpace estimates, some economists are pushing for rate increases as early as 2022. Tightening monetary policy tends to lead to an increase in unemployment, so striking a balance between inflation and unemployment will be the objective of monetary policy in the near future and will determine when interest rate increases finally occur.
While the Fed’s discussion around the tapering of bond purchases shows that they have more confidence in the economy, it does not mean that an interest rate increase will follow immediately. At the recent FOMC conference, Powell noted that the tapering of purchases will not be a direct indicator of interest rate increases. Interest rate increases will be based on “a different and substantially more stringent test.” The Fed chair did not specify the parameters for this test but reiterated the FOMCs goals of 2% annual inflation over the long term and maximum employment.
In the meantime, interest rates are expected to remain near zero. While the current accommodative monetary policy makes it easier for businesses and individuals to borrow funds, low interest rates limit investment returns for debt securities and cash accounts. Low investment income coupled with rising prices and supply chain constraints can create challenges for businesses attempting to navigate this new market and stave off inflation.
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