The euro area and the United States both adopted highly expansionary fiscal and monetary policies to mitigate the economic impact of the pandemic and support workers affected by business closures. But the United States is now recording much higher inflation than the euro area. In October 2021, the United States recorded 24-month inflation at an annualized rate of 4.0 percent, around 2 percentage points higher than in the euro area.
Many international drivers of inflation are likely to wane in 2022. Global energy prices should level off and fall, supply chain bottlenecks will gradually ease, and lingering pandemic fiscal support will lapse.
But several indicators suggest that inflation in the United States could persist above the Federal Reserve's 2 percent target. Demand will likely remain elevated as reduced consumption during the pandemic and fiscal stimulus measures have bolstered personal savings. US labor force participation remains well below its expected level given demographic changes. Higher home and rental prices, which often take time to show up on measurements of inflation, could be coming. Finally, wage growth expectations have shifted up, which could pass through to higher prices.
In light of these market conditions, the Fed should recalibrate monetary policy accordingly and pivot towards a less expansionary approach now in order to prevent the need for drastic and painful steps in the future.
This PIIE Chart is based on research in Jason Furman's paper delivered at the Peterson Institute for International Economics, What the Federal Reserve should do now: An elaboration.