Jerome Powell’s Dilemma: What If the Drivers of Inflation Are Here to Stay?

The Federal Reserve’s current round of interest-rate increases, which economists say have pushed the U.S. to the brink of a recession, could be a taste of this new environment.

“The global economy is undergoing a series of major transitions,” said

Mark Carney,

former Bank of Canada and Bank of England governor, in a speech at an economics conference in March. “The long era of low inflation, suppressed volatility and easy financial conditions is ending.”

Consumer prices, change from a year earlier

Target rate for

many central banks

Target rate for

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This new era would mark an abrupt about-face after a decade in which central bankers worried more about the prospects of anemic economic growth and too-low inflation, and used monetary policy to spur expansions. It also would be a reversal for investors accustomed to low interest rates.

The challenges for policy makers will take center stage from Thursday to Saturday when they gather for the Kansas City Fed’s annual retreat in Jackson Hole, Wyo., being held in person for the first time since 2019.

The Fed could still succeed at curbing inflation by raising interest rates. Postpandemic headwinds might abate or fail to materialize if protectionism and geopolitical risks recede, labor productivity improves, a slowdown in China’s economy reduces demand for global commodities, or new technologies reduce the costs of developing new energy sources.

“Since the pandemic, we’ve been living in a world where the economy is being driven by very different forces,” Fed Chairman

Jerome Powell

said on a June panel discussion in Portugal. “What we don’t know is whether we will be going back to something that looks more like, or a little bit like, what we had before.”

European Central Bank President

Christine Lagarde

on the panel offered a more pessimistic appraisal: “I don’t think that we are going to go back to that environment of low inflation.”

The new environment reflects the stalling or potential reversal of three forces that pushed inflation down in recent decades by limiting workers’ ability to win higher wages and companies’ ability to raise prices.

• Force 1: Globalization. Increased flows of trade, money, people and ideas flourished with the Cold War’s end and China’s entry into the international trading system in the 1990s. Multinational companies using new technologies constructed global supply chains focused on driving down costs by finding the cheapest place and workers to produce products. Worldwide competition drove prices lower for many goods.

This helped keep U.S. inflation stable. Over the 20 years ending in 2019, U.S. goods prices rose an average of 0.4% a year, while services prices grew 2.6% annually, leaving “core inflation”—which excludes volatile food and energy prices—around 1.7%.

After the pandemic and the Ukraine war disrupted supply chains, many business leaders adopted new processes to increase reliability even if they cost more, such as by moving production closer to home or buying from multiple suppliers. And tensions between Western democracies and Russia and China raise concerns about a possible further retreat from globalization and rise of protectionism, which would raise production costs.

“If you had all of your supply chain in just one country, you have to question why take that risk in a world where pandemics could hit or country relations could deteriorate or wars could happen between countries,” said Richmond Fed President

Tom Barkin,

a former McKinsey & Co. executive. It is difficult to predict just how durable such changes will be, he added.

• Force 2: Labor markets. In an August 2020 book, “The Great Demographic Reversal,” former British central banker

Charles Goodhart

and economist Manoj Pradhan argued that the low inflation since the 1990s had less to do with central-bank policies and more with the addition of hundreds of millions of low-wage Asian and Eastern European workers, which held down labor costs and prices of manufactured goods exported to richer countries.

Mr. Goodhart wrote that global labor glut was giving way to an era of worker shortages, and hence higher inflation.

Meanwhile, the U.S. labor force has roughly 2.5 million fewer workers since the pandemic began, compared to what it would have if the prepandemic trend in workforce participation had continued and after accounting for the aging of the population, according to an analysis by Didem Tüzemen, an economist at the Kansas City Fed. Its growth had already slowed before Covid-19, reflecting an aging population, declining birthrates and less immigration. The slower growth rate of the U.S. workforce could force wages higher, feeding inflation.

Wages rose about 3% annually before the pandemic. Average hourly earnings grew 5.2% in the year ended in July.

Missing Workers

Slower population growth and an aging workforce don’t explain all of the U.S. labor-force losses since the pandemic, according to a Kansas City Fed analysis. About two million workers are still missing compared with estimates that account for those factors.

U.S. labor-force level and alternate projections starting in March 2020

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Without impacts of

aging labor force and

declining population

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Without impacts of

declining population

growth

Dotted lines are estimates

Without impacts of

aging labor force

and declining

population growth

Without impacts of

declining population

growth

Dotted lines are estimates

Without impacts of

aging labor force and

declining population

growth

Without impacts of

declining population

growth

Without impacts of aging labor force and declining

population growth

Without impacts of declining population growth

Dotted lines

are estimates

Without impacts of aging labor force and

declining population growth

Without impacts of declining

population growth

Dotted lines

are estimates

Roughly a million people moved to the U.S. annually in the years after the 2007-09 recession. That pace began to taper during the Trump administration and turned into a trickle after the pandemic started. The slowdown left the U.S. with 1.8 million fewer immigrants of working age—about 0.9% of the working-age population—than if pre-2019 immigration trends had continued, according to research by Giovanni Peri, a labor economist at the University of California, Davis.

Mr. Powell in a May interview pointed to the potential for reduced immigration to create a “persistent imbalance between supply and demand in the labor market.” He added: “If you have a slower growing labor market, you’re going to have a smaller economy.”

• Force 3: Energy, commodity prices. Energy and commodity firms haven’t heavily invested in new production over the past decade, creating risks of more persistent shortages when global demand is growing. When the Fed broke the back of high inflation in the early 1980s, then-Chairman Paul Volcker enjoyed some helpful tailwinds in the form of decadelong investments in oil.

Before the emergence of these three factors, the Fed could raise rates at a leisurely pace and could pursue policies that simultaneously kept unemployment and inflation low, something economists later dubbed the “divine coincidence.”

That was possible when the main threats to the economy were “demand shocks”—pullbacks in hiring, consumer spending and business investment—which slow both inflation and growth, as in the recessions of 2001 and 2007-09.

The Fed cut rates to near zero in 2008 to stimulate economic activity, held them there until 2015, then raised them at a glacial pace by historical standards. The unemployment rate fell below 4% in 2018, and inflation stayed at or just below the central bank’s 2% target. After raising the fed-funds rate to around 2.4% at the end of 2018, Mr. Powell cut rates slightly following a growth scare in 2019.

Those experiences heavily shaped the Fed’s initial response to the pandemic in 2020. Fearing another decade of sluggish growth and too-low inflation, it cut rates to near zero and promised to keep providing stimulus even after the White House and Congress aggressively boosted federal spending.

‘Supply shocks’

Rather than reducing economic demand, the forces that emerged during the pandemic were what economists call “supply shocks”—events that curtail the economy’s ability to provide goods and services, which in turn hurt growth and spurred inflation. Covid-19 lockdowns and stronger demand for goods disrupted supply chains, as did Russia’s Ukraine invasion and the West’s financial counterassault. Labor shortages emerged across the U.S.

With supply shocks, the Fed faces a harder trade-off between growth and inflation, because attacking inflation invariably means damping growth and employment. In such an environment, “there is no divine coincidence anymore,” said

Jean Boivin,

a former Bank of Canada official who heads the BlackRock Investment Institute.

The Fed and most other central banks initially misread the economy because, in early 2021, price increases could be traced clearly to the effects of the pandemic, affecting a small number of goods, such as used cars. By the end of the year, however, higher inflation had become increasingly broad-based.

One measure produced by the Dallas Fed, called a “trimmed mean” annual inflation rate, which excludes the most volatile categories to capture an underlying trend, rose from 2% last August to 3.5% in January and 4.3% in June.

“This is looking like the 1990s turned on its head,” said Stephen Cecchetti, a Brandeis University economics professor. “Every forecaster back then underestimated growth and overestimated inflation systemically for almost the whole decade. Now, it looks like we’re in for the reverse of this, which will be very, very unpleasant because it means we’re suddenly going to hit trade-offs.”

The low-inflation environment of the past 30 years caused consumers and businesses to not think much about price increases. Fed officials now worry that even if prices rise temporarily, consumers and businesses could come to expect higher inflation to persist. That could help fuel higher inflation as workers demand higher pay that employers would pass onto consumers through higher prices.

“The risk is that because of a multiplicity of shocks, you start to transition to a higher-inflation regime,’’ Mr. Powell said on the June panel. “Our job is literally to prevent that from happening. And we will prevent that from happening.”

Last year, Mr. Powell suggested he was skeptical of the idea that the forces underpinning globalization would shift overnight, as Mr. Goodhart suggested. But he has given more attention to the idea in the aftermath of the Ukraine war, which has highlighted the potential for significant economic and financial fallout from geopolitical conflicts.

By sending inflation, and especially energy prices, to such elevated levels, the war could serve as a trigger “to make people realize that inflation—and quite high inflation—is a real possibility,” said Mr. Goodhart. In turn, that could weaken the public’s confidence that “everything will go back to normal.”

“The argument of central banks, that they will get inflation back to target at 2% two years from now, is becoming increasingly implausible because they’ve said that all along and, of course, they haven’t achieved it,” he said.

Recession risk

The Fed’s aggressive interest-rate increases this year could be the first example of what happens with U.S. monetary policy in this new environment. Faster and bigger rate rises create greater risks of recession and could upend popular investment strategies by leading to more frequent losses for the two main components of traditional asset portfolios—stocks and long-term U.S. Treasury bonds.

Fed officials have raised the fed-funds rate by a cumulative 2.25 percentage points this year, the fastest pace since they began using the rate as their primary policy-setting tool in the early 1990s. The rate influences other borrowing costs throughout the economy.

The Fed began with a quarter-point increase in March, followed by a half-point rise in May and increases of 0.75 point each in June and in July. At their meeting last month, officials debated how and when to dial back the pace of those increases, according to minutes of the meeting released Aug. 17.

An important shift occurred between Fed officials’ May and June meetings, when Mr. Powell secured consensus that they would need to raise rates high enough to slow growth. Through the summer, Fed officials have been unusually united over their goal, but if the labor market cools and the economy slows, Mr. Powell could face a trickier task forging agreement.

Several former Fed officials who have worked closely with Mr. Powell say he is likely to err on the side of raising rates too much, rather than too little, because tolerating excessive inflation would represent a much greater institutional failure for the central bank. Mr. Powell has hammered home the primacy of lowering inflation to the Fed’s 2% target.

“We can’t fail on this,” Mr. Powell told lawmakers on June 23, describing the Fed’s commitment as “unconditional.”

Write to Nick Timiraos at nick.timiraos@wsj.com