Why the Drivers of Lower Inflation Matter

Recent good news on inflation has ignited a debate over how much central banks’ interest-rate increases are responsible.

The answer matters for where inflation and interest rates are headed. The Federal Reserve and the European Central Bank in the past week lifted their benchmark interest rates to 22-year highs and left the door open to additional increases.

If higher rates weren’t responsible for the progress on inflation to date, that suggests central banks may be able to lower them before a painful recession sets in.

Central banks generally see their influence on inflation coming through higher rates damping the demand for goods, services and workers, which leads to higher unemployment. That in turn puts downward pressure on prices and wages.

Only the second part of that sequence has occurred. Inflation fell to 3% in the U.S. in June, according to the Fed’s preferred gauge, the personal-consumption expenditures price index, down from 7% one year earlier. Yet the unemployment rate, at 3.6% in June, has held steady for the past year.

In the eurozone, inflation declined to 5.5% in June, the lowest level in nearly 18 months, and unemployment has drifted to the lowest in more than 25 years.

There are competing explanations for this.

One camp argues that inflation has been mostly driven by supply shocks that are going away on their own—much as a postwar surge in the late 1940s unwound by itself. The ripple effects gave the illusion of broader, more persistent price increases.

Take the auto market. Sellers weren’t able to meet pent-up demand two years ago, leading to huge price increases, which in turn spawned higher prices later on for car repairs and auto insurance.

Similarly, a surge in household formation during the pandemic sent up housing prices and rents.

The first camp attributes most of the recent decline in inflation to the ebbing of these one-time supply disruptions, not rate increases, which are supposed to work through the labor market. “It’s calling into question a lot of the old assumptions,” said Lindsay Owens, executive director at the Groundwork Collaborative, a liberal think tank.

A second camp, which includes most economists, disagrees. They say monetary policy kept demand for goods, services, and labor lower than otherwise, taking pressure off strained supply chains and allowing price pressures to ease.

Interest rates can also influence behaviour. The prospect that central bankers would risk a recession to bring down inflation may have influenced expectations of price- and wage-setters, including corporate executives who plan annual budgets for investment and hiring.

Jamie Dimon, chief executive of JPMorgan Chase, warned one year ago of an economic “hurricane” as central banks accelerated rate increases. “You’d better brace yourself,” he said in June 2022, and pledged the bank would be “very conservative” with its balance sheet.

“Inflation is coming down precisely because the Fed avoided more excess demand growth, and they anchored inflation expectations,” said Angel Ubide, head of economic research for global fixed income at Citadel, a hedge-fund firm.

Inflation would be higher now if not for Fed rate increases, “and maybe still rising,” said Karen Dynan, an economist at Harvard University.

In 2021, supply-chain constraints meant even marginal increases in demand led to unusually large price increases. The reverse might be true now: Marginal decreases in demand can bring down prices faster, particularly if more supply is becoming available.

The car market illustrates how monetary policy has been transmitted. Rising rates raised monthly payments, damping demand and robbing sellers of pricing power. In addition, since March, banks appear to be rejecting more car-loan applications.

“That’s leading to a new group of people getting squeezed out of the market, and therefore, it’s playing a role putting downward pressure on prices,” said Julia Coronado, founder of economic-advisory firm MacroPolicy Perspectives.

In Europe, economic growth has stalled since late last year. Business surveys in the past week suggest that growth is weakening sharply, especially in manufacturing, which is most sensitive to interest rates.

The net share of banks reporting increased loan demand declined to a record low in the three months through June, according to an ECB survey of banks. Credit growth to households is the lowest since mid-2016.

Asked at a news conference on Thursday about the transmission of ECB rate increases to growth and inflation, President Christine Lagarde said that in the financial system, “a lot has been transmitted. A lot. We know that. In the economy at large, not as much yet.”

A report published by German insurer Allianz identifies three different forces on the U.S. inflation rate since the second quarter of 2022. Higher inflationary pressures from consumption growth, strong labor markets and government spending added 4 percentage points; fading supply-chain disruptions subtracted five points, and Federal Reserve actions subtracted another five. The net impact was that inflation fell 6 percentage points, whereas it would have fallen only one point without the Fed’s actions.

Fed Chair Jerome Powell said rate increases are “working about as we expect, and we think it’ll play an important role going forward” in bringing down prices for the most labor-intensive services.

Monetary policy has also affected the labor market, but this has shown up in declining job-vacancy rates rather than rising unemployment, some economists say.

Hiring plans in the eurozone services sector are dropping rapidly, according to a survey this month by the European Commission, the European Union’s executive body.

“The labor market is normalising on both sides of the Atlantic, reflecting the impact of higher rates,” said Stefan Gerlach, a former deputy governor of Ireland’s central bank.

The debate over the effect of rate increases also matters for how much further, if at all, central banks need to lift them. Optimists underestimated how much strong demand lifted inflation two years ago. Pessimists may be overestimating the importance of constraining demand to bring it down now.

Gerlach expects inflation to continue declining as higher rates sap demand. “I’m worried central banks have done too much,” he said. “They may have felt embarrassed about having misunderstood inflation the first time.”

First, the good news for office landlords: A post-Labor Day bump nudged return-to-office rates in mid-September to their highest level since the onset of the pandemic.

Now the bad: Office attendance in big cities is still barely half of what it was in 2019, and company get-tough measures are proving largely ineffective at boosting that rate much higher.

Indeed, a number of forces—from the prospect of more Covid-19 cases in the fall to a weakening economy—could push the return rate into reverse, property owners and city officials say.

More than before, chief executives at blue-chip companies are stepping up efforts to fill their workspace. Facebook parent Meta Platforms, Amazon and JPMorgan Chase are among the companies that have recently vowed to get tougher on employees who don’t show up. In August, Meta told employees they could face disciplinary action if they regularly violate new workplace rules.

But these actions haven’t yet moved the national return rate needle much, and a majority of companies remain content to allow employees to work at least part-time remotely despite the tough talk.

Most employees go into offices during the middle of the week, but floors are sparsely populated on Mondays and Fridays. In Chicago, some September days had a return rate of over 66%. But it was below 30% on Fridays. In New York, it ranges from about 25% to 65%, according to Kastle Systems, which tracks security-card swipes.

Overall, the average return rate in the 10 U.S. cities tracked by Kastle Systems matched the recent high of 50.4% of 2019 levels for the week ended Sept. 20, though it slid a little below half the following week.

The disappointing return rates are another blow to office owners who are struggling with vacancy rates near record highs. The national office average vacancy rose to 19.2% last quarter, just below the historical peak of 19.3% in 1991, according to Moody’s Analytics preliminary third-quarter data.

Business leaders in New York, Detroit, Seattle, Atlanta and Houston interviewed by The Wall Street Journal said they have seen only slight improvements in sidewalk activity and attendance in office buildings since Labor Day.

“It feels a little fuller but at the margins,” said Sandy Baruah, chief executive of the Detroit Regional Chamber, a business group.

Lax enforcement of return-to-office rules is one reason employees feel they can still work from home. At a roundtable business discussion in Houston last week, only one of the 12 companies that attended said it would enforce a return-to-office policy in performance reviews.

“It was clearly a minority opinion that the others shook their heads at,” said Kris Larson, chief executive of Central Houston Inc., a group that promotes business in the city and sponsored the meeting.

Making matters worse, business leaders and city officials say they see more forces at work that could slow the return to office than those that could accelerate it.

Covid-19 cases are up and will likely increase further in the fall and winter months. “If we have to go back to distancing and mask protocols, that really breaks the office culture,” said Kathryn Wylde, head of the business group Partnership for New York City.

Many cities are contending with an increase in homelessness and crime. San Francisco, Philadelphia and Washington, D.C., which are struggling with these problems, are among the lowest return-to-office cities in the Kastle System index.

About 90% of members surveyed by the Seattle Metropolitan Chamber of Commerce said that the city couldn’t recover until homelessness and public safety problems were addressed, said Rachel Smith, chief executive. That is taken into account as companies make decisions about returning to the office and how much space they need, she added.

Cuts in government services and transportation are also taking a toll. Wait times for buses run by Houston’s Park & Ride system, one of the most widely used commuter services, have increased partly because of labor shortages, according to Larson of Central Houston.

The commute “is the remaining most significant barrier” to improving return to office, Larson said.

Some landlords say that businesses will have more leverage in enforcing return-to-office mandates if the economy weakens. There are already signs of such a shift in cities that depend heavily on the technology sector, which has been seeing slowing growth and layoffs.

But a full-fledged recession could hurt office returns if it results in widespread layoffs. “Maybe you get some relief in more employees coming back,” said Dylan Burzinski, an analyst with real-estate analytics firm Green Street. “But if there are fewer of those employees, it’s still a net negative for office.”

The sluggish return-to-office rate is leading many city and business leaders to ask the federal government for help. A group from the Great Lakes Metro Chambers Coalition recently met with elected officials in Washington, D.C., lobbying for incentives for businesses that make commitments to U.S. downtowns.

Baruah, from the Detroit chamber, was among the group. He said the chances of such legislation being passed were low. “We might have to reach crisis proportions first,” he said. “But we’re trying to lay the groundwork now.”

Why the Drivers of Lower Inflation Matter

Competing effects of central banks, healing supply chains affect recession odds

Office owners are struggling with near record-high vacancy rates