What really drives inflation?

Every month, after the FOMC meeting, Fed Chairman Jay Powell fronts the media and tells everyone how the Fed is determined to maintain the fed funds rate in the same 5.25% – 5.50% range in order to contain inflation. But he is well aware that the Fed funds rate has had close to zero impact on inflation.

CPI peaked in June 2022 when the fed funds rate was an eye-watering (sic) 1.25%. CPI then plunged sharply when the Fed was still in the early stages of hiking rates. The lag between rate hikes and the resultant decline in inflation is normally 12 to 18 months. Now the Fed would have us believe that CPI declined in anticipation of rate cuts.

CPI & Fed Funds Rate Target (Minimum)

Financial conditions did tighten when the Fed introduced QT, with the Chicago Fed Financial Conditions Index (FCI) rising to -0.1%. But then FCI started a sharp decline in June 2023, when the Fed was still hiking rates, indicating monetary easing.

Chicago Fed Financial Conditions Index

Rising interest rates and tighter financial conditions had even less than usual impact on consumer spending because of a strong upsurge in personal savings during the pandemic. A large percentage of government transfers were not spent but went to increase bank deposits.

Government Transfers & Commercial Bank Deposits

Energy is driving inflation

The primary cause of the strong upsurge in CPI in ’21/22 was energy prices. The chart below shows how energy CPI (orange) led CPI (red) higher, reaching a peak of 41.5% in June 2022 — the same month that CPI peaked at 9.0%. Energy prices then plunged to a low of -16.7% in June 2023. CPI followed, reaching a low of 3.1% in the same month. Since then, CPI energy has recovered to close to zero, producing a floor in the annual CPI rate.

CPI & Energy CPI

Energy CPI is a relatively small component of CPI — 6.6% of total CPI — but it is a major cost component of most other variables. Food, for example, requires energy for planting, irrigation, harvesting, processing, refrigeration and transport. Cement requires energy for heating limestone in kilns, crushing and transportation. Steel needs energy for extraction and transport of iron ore, smelting and transportation. Even online services. The latest AI data centers require up to 1 GW of electricity capacity — enough to power 300,000 homes.

The most important determinant of energy prices is crude oil. Nymex light crude peaked between March and June 2022 at prices of $100 to $120 per barrel before commencing a prolonged decline to between $70 and $80 by December of the same year.

Nymex WTI Light Crude


Raising the fed funds rate has had little impact on actual inflation. Rate hikes are more about restoring the Fed’s credibility as an inflation hawk after a disastrous performance in 2021. High energy prices and easy monetary policy and were a recipe for inflation.

CPI & Fed Funds Rate Target (Minimum)

The sharp decline in CPI in the 12 months to June ’23 was caused by falling energy prices. Energy CPI fell from an annual increase of 41.5% in June 2022 to a low of -16.7% a year later.

Nymex light crude has now broken resistance at $80 per barrel. Expect retracement to test the new support level but respect is likely and would confirm another advance, with a target of $90 per barrel.

Nymex WTI Light Crude

A sharp rise in crude prices would be likely to cause a significant upsurge in CPI — and long-term interest rates. With bearish consequences for stocks and long-duration bonds.

2 Replies to “What really drives inflation?”

    1. Hi Graeme,
      Yes. I am sure there are differences but the main themes are similar: government stimulus, high energy prices, and easy monetary policy.

Comments are closed.