US Federal Reserve Cuts Interest Rates

The past few years have seen a significant rise in inflation across the US and Europe. Many have attributed this to supply chain disruptions and increasing energy costs following the pandemic. However, recent analysis suggests that unexpectedly strong demand forces were the primary driver of inflation in both regions.

Inflation will probably prevent the Fed from lowering interest rates as much as expected in coming years.https://t.co/EFZzGQzWVp via @economics

— Lawrence H. Summers (@LHSummers) September 19, 2024

From @jeannasmialek’s article, “America’s Inflation Fight Is Ending, but It’s Leaving a Legacy: As inflation cools and the Federal Reserve cuts rates, an era of economic upheaval is coming to a close, but not without lingering marks.”#economy #inflation #centralbanks… pic.twitter.com/D3au2YIkHI

— Mohamed A. El-Erian (@elerianm) September 19, 2024

The US and euro area experienced remarkably similar patterns in headline, energy, goods, and services inflation, with the euro area lagging by about six months. This indicates that common demand forces were at play. A structural vector autoregression model showed that while adverse supply shocks negatively impacted economic activity, especially in the euro area, their contribution to inflation was limited.

Instead, inflation was largely driven by robust demand. This challenges the popular belief that supply chain disruptions were the main cause of inflation.

My thoughts on the Fed's rate decision in @USNewsOpinion (although I would not actually recommend central bankers pop the champagne). https://t.co/a8deKukO9a

— Jason Furman (@jasonfurman) September 18, 2024

The aggregate demand curves in the US and euro area are relatively flat due to central banks maintaining low and stable inflation.

Fed lowers interest rates again

When supply curves shifted left, it depressed output but did not produce significant inflation.

What would the PCE inflation rate be now if the Fed hadn't acted aggressively? I would guess 3.5% or even higher.

What would the PCE inflation rate be now if the FTC and DOJ Antitrust hadn't acted aggressively? I'm reasonably confident the answer is 2.5%.

— Jason Furman (@jasonfurman) September 18, 2024

However, the combination of strong pent-up demand following the pandemic and expansionary fiscal policies led to an upward shift in the aggregate demand curve, causing inflation to climb.

Rising energy prices also contributed to inflation, but primarily in an accounting sense. The increase in energy prices itself was largely demand-driven in both regions. Energy supply shocks, especially around the time of the Russian invasion of Ukraine, had a limited overall impact on inflation.

This challenges the narrative that US-originated demand shocks triggered global energy price increases, leading to higher inflation in the euro area. Had the European Central Bank not accommodated inflationary pressures and kept inflation closer to 2%, the inflation path could have been significantly different. Central banks traditionally respond vigorously to demand shocks to neutralize their impact on real activity and inflation, while tending to ‘look through’ temporary supply shocks due to the trade-off between inflation and output stabilization.

This analysis highlights the importance of understanding the complex drivers of inflation to better address future economic challenges. The unexpectedly strong demand forces, resulting from pent-up demand, expansionary fiscal policies, and accommodative monetary stances, played a crucial role in the recent inflation surge across the US and Europe.