How we get into this inflation?

The pan­demic hit eco­nomic ac­tiv­ity by mak­ing peo­ple less will­ing, or even un­able, to go to the mar­ket­place as pur­chasers and providers of goods and ser­vices. The in­ci­dence and du­ra­tion of the hit dif­fered across the two sec­tors. Be­cause the trade in ser­vices of­ten in­volves per­sonal in­ter­ac­tion, the health risks were more sig­nif­i­cant than for goods. Ser­vices, un­like goods, can­not be taken out or put into in­ven­tory nor pro­vided sig­nif­i­cantly from abroad.

As a re­sult, the de­mand for ser­vices cratered in the shadow cast by the pan­demic, and that un­used spend­ing was partly redi­rected to­ward goods. The Fed quickly cut its pol­icy rate 2.25 per­cent­age points, to zero, and mas­sively ex­panded its bal­ance sheet to pro­vide stim­u­lus. Mean­while and al­most as quickly, the Trump ad­min­is­tra­tion and Con­gress kicked the fis­cal ma­chin­ery into the high­est gear on record. In the event, the Fed more than fully ac­com­mo­dated ex­pan­sion­ary fis­cal stim­u­lus. By the mid­dle of 2020, real dis­pos­able in­come was ex­pand­ing on a four-quar­ter ba­sis at a rate in the mid­teens even as real gross do­mes­tic prod­uct was con­tract­ing. Never has the na­tion given it­self so much more than it pro­duced.

Russ­ian ag­gres­sion wors­ened this pre-ex­ist­ing con­di­tion. The di­rect ef­fect of fight­ing in Eu­rope and dis­rup­tions in the flow of en­ergy to the Eu­ropean Union sent com­mod­ity prices higher. Sanc­tions fur­ther im­paired dam­aged sup­ply chains. Higher de­mand for goods in­ter­sected with lower and more ex­pen­sive sup­ply.

Also bro­ken was the two-decade-long role of well-be­haved goods prices in re­strain­ing in­fla­tion. Goods prices have risen at a 7% an­nual clip since 2020, pulling up over­all in­fla­tion and feed­ing its mo­men­tum. At first, the Fed re­mained locked in the mind-set of the past. In­fla­tion above goal was “tran­si-tory” then, so why not now? Com­ments by Fed Chair Jerome Pow­ell at the Jack­son Hole Eco­nomic Sym­po­sium in Au­gust 2021 re­as­sured that “these el­e­vated read­ings are likely to prove tem­po­rary.”

But they weren’t, be­cause the sec­toral dis­lo­ca­tions were durable, the la­bor mar­ket was im­paired as health risks lin­gered, and con­cerns about in­fla­tion were top of mind for house­holds and busi­nesses.

With in­fla­tion by vir­tu­ally any mea­sure at a 40-year high this spring, Mr. Pow­ell and his Fed col­leagues re­tired the word “tran­si­tory” and be­gan re­mov­ing pol­icy ac­com­mo­da­tion. It took some time, but the Fed even­tu­ally picked up the pace, bring­ing the overnight rate to a tar­get range of 4.25% to 4.5% at Wednes­day’s meet­ing of the Fed­eral Open Mar­ket Com­mit­tee.