John Williams, Speech: Peeling the Inflation Onion

Inflation Explained
“In this allium analogy, there are three distinct layers. The outermost layer consists of prices of globally traded commodities—such as lumber, steel, grains, and oil. When the global economy rebounded from the pandemic recession, there was a surge in demand for these critical goods, leading to sizable imbalances between supply and demand and large price increases. Then, energy and many commodity prices soared again as a result of Russia’s war on Ukraine and consequent actions. Skyrocketing commodity prices led to higher costs for producers, which in turn got passed on as higher prices for consumers.”

“The middle layer of the inflation onion is made up of products—especially durable goods like appliances, furniture, and cars—that have experienced both strong demand and severe supply-chain disruptions. There were not enough inputs to manufacture products, which meant not enough products to sell—all at a time when demand has been sky-high. This imbalance contributed to outsize price increases.”

“If we continue paring the onion, we’ll reach the innermost layer: underlying inflation. This layer is the most challenging of the three, reflecting the overall balance between supply and demand in the economy and the labor market. Prices for services have been rising at a fast clip. Measures of the cost of shelter, in particular, have increased briskly, as an earlier surge of rents for new leases filtered through the market. And widespread labor shortages have led to higher labor costs. And this is not limited to a few sectors—inflation pressures have become broad-based.”

GDP
“We are already seeing some of the effects of tighter monetary policy. Broad measures of financial conditions, including borrowing and mortgage rates and equity prices, have become significantly less supportive of spending. This has led to a decline in activity in the housing market and signs of general slowing in consumer expenditures and business investment spending. As this continues, I expect real GDP to increase only modestly this year and in 2023.”

Forecasts
“The labor market remains remarkably tight: Hiring is robust, and we still are seeing rapid wage gains. But with growth slowing, I anticipate that the unemployment rate will climb from its current level of 3.7 percent to between 4-1/2 and 5 percent by the end of next year.”

“Turning to inflation, I expect cooling global demand and steady supply improvements to result in declining inflation for goods that rely heavily on commodities, as well as for those that have been heavily affected by supply chain bottlenecks. These factors should contribute importantly to inflation slowing from its current rate to between 5 and 5-1/2 percent at the end of this year, and to slow further to between 3 and 3-1/2 percent for next year.”

“Bringing down underlying inflation—the inner layer of the inflation onion—will take longer. But further tightening of monetary policy should help restore balance between demand and supply and bring inflation back to 2 percent over the next few years.”