The Fed can’t fix inflation alone. Here’s why

The Federal Reserve continues to hike interest rates in its fight to bring an end to historic inflation. 

The central bank has driven up borrowing costs and slowed the economy in an effort to reduce demand for goods and services, which leads to lower prices. 

But several other factors that weigh on prices, such as geopolitical conflicts and natural disasters, are outside of the Fed’s control. And the Fed can only go so far with interest rate hikes without cooling the economy too much and causing a recession.

Rate hikes making an impact

The Fed on Wednesday hiked rates by 25 basis points, the smallest increase since March 2022. Fed officials say that while the rate hikes are slowing inflation, more increases are likely on the way. 

Prices rose 5 percent annually in December, down from 5.5 percent in November and 6.1 percent in October, according to the personal consumption expenditures (PCE) price index, the Fed’s preferred inflation gauge. 

“We’re not done by any stretch. But inflation has cooled and more quickly than I and others who were so upset when the Fed was late intervening,” said Karen Petrou, managing partner at policy research firm Federal Financial Analytics.

Other data points indicate that the rate hikes are having the intended effect of reducing demand and slowing the economy. 

Consumer spending has fallen for two straight months. Oil prices are hovering around their lowest level in a year. Ocean freight rates, which skyrocketed in recent years, have returned to late 2020 prices.

Wages and employee benefits, another key indicator closely watched by the Fed, grew just 1 percent in the fourth quarter of 2022, the smallest gain in a year.

Demand in the housing market has slowed as higher mortgage rates make it harder to buy a home. 

Existing home sales have fallen for 11 straight months, according to the National Association of Realtors. Home price growth has slowed dramatically from the extreme gains in recent years and has turned negative in some parts of the U.S.

“Mortgages are where the Fed has the heaviest foot in terms of slamming on the brakes and having very little lag time between what it does and how a market cools,” Petrou said. 

Still, economists note that the Fed can only go so far without plunging the U.S. into a recession. Higher interest rates could lead to 1.6 million job losses by the end of the year if the Fed’s projected increase in the jobless rate comes true, while other economists predict higher unemployment figures.

“Pushing millions of people out of work is not the answer to tackling inflation. Additional rate hikes could jeopardize our strong labor market — and low-wage workers and Black and brown workers would suffer the biggest economic consequences,” Rakeen Mabud, chief economist at the progressive non-profit Groundwork Collaborative, said in a statement. 

Other factors outside of Fed’s control

While overall inflation is easing, food prices remain stubbornly high — rising 0.3 percent in December and 10.4 percent on the year, according to the Labor Department’s Consumer Price Index (CPI) — and there’s not much the Fed can do about it. 

The price of a dozen eggs, for example, skyrocketed from $1.79 to $4.25 from 2021 to 2022, according to Labor Department data. That’s largely driven by an outbreak of bird flu that has led to the death of 58 million egg-laying hens.  

Russia’s invasion of Ukraine, a major grain supplier, sent wheat and vegetable oil prices soaring last year. While prices have come down, they still remain above pre-pandemic levels. The war also spiked the price of fertilizer, a top Russian export, costs that have passed down to consumers at the grocery store. 

Barb Smith, 71, a volunteer at Feeding Tampa Bay, said that sky-high prices forced her to buy less at the grocery store and take home some items from the food bank for herself.  

“You don’t buy groceries like you normally do. You just get what you need, and that’s it,” Smith said. 

Extreme droughts in the U.S. drove up the price of vegetables and tree nuts, while poor weather in Brazil caused coffee prices to rise 14.3 percent over the last year.  

“These are all markets with tremendous externalities. The Fed really has no control over the weather, or how much grain is getting out of Ukraine,” Petrou said.

Part of the Fed’s goal is to slow wage growth to reduce demand for products and services. Federal Reserve Chairman Jerome Powell estimates that the U.S. workforce is missing 3.5 million people, which boosts workers’ leverage over their salary and increases costs for businesses. 

But even Powell acknowledges that the Fed can’t do much about the roughly 2 million early retirements that came during the pandemic. Excess deaths and lower immigration driven by COVID-19 have also weighed on the labor market. 

Other global events have the potential to impact prices, such as China’s rapid shift toward ending yearslong COVID-19 restrictions and reopening its economy.

Oil demand could surge to record levels this year, with pent-up demand in China accounting for most of the increase, according to a recent report from the International Energy Agency.

Fed can’t stop corporate markups

While costs are rising for businesses, corporate profits have surged to record highs, indicating that certain price hikes are going well above the added costs. 

A January study from economists at the Kansas City Fed found that corporate price markups accounted for more than half of inflation in 2021.  

Federal Reserve Vice Chair Lael Brainard, one of the board’s more liberal economists, pointed to corporate profit margins in recent remarks, noting that “final prices have risen by more than the increases in input prices.”

Corporations, especially those in highly consolidated industries, were able to raise prices due to strong demand that outpaced the supply of goods and services. 

Consumer pain has translated into all-time high profits in a number of sectors. ExxonMobil on Tuesday posted a $56 billion profit for 2022, smashing oil industry records. 

Lawmakers have accused some companies of using supply shortages and inflation to raise prices to unreasonable levels. 

Sen. Jack Reed (D-R.I.) recently asked the Federal Trade Commission (FTC) to investigate allegations of price gouging and collusion by egg producers.

That came after progressive farmers’ group Farm Action called out dominant egg producer Cal-Maine Foods for hiking prices and boosting its year-over-year profits by 600 percent despite not reporting any cases of bird flu. 

“In a truly competitive market, one would have expected rival egg producers to respond to a near-tripling of average prices with efforts to undercut Cal-Maine’s skyrocketing profit margin and capture market share. Yet we have found no evidence of aggressive price competition among the largest egg producers over the past year,” the group wrote in a letter to the FTC.