After decades of low inflation, the sudden rise in prices in 2021 and 2022 came as a shock to many. So it was understandable to a certain extent that many observers panicked, more or less, when they saw a return to the 1970s lurking under every bed and behind every closet door.
What is hard to understand, or at least inexcusable, is why many commentators continue to blame the inflation demon for all our economic woes. I have come to call this “inflation brain.” And I fear that this has rubbed off on the Federal Reserve, leading it to keep interest rates too high for too long.
Let me give you two recent examples of inflation brain in action.
This month, the highly-anticipated University of Michigan Survey of Consumers released preliminary data reporting a significant decline in consumer sentiment. Consumers cited a number of reasons for their decline in optimism, but every news article I saw attributed their pessimism to a sharp rise in expected inflation rates over the next 12 months and five years.
The final May report was then released, and the initially reported spike in inflation expectations had all but disappeared. Consumer confidence was still significantly lower, but the survey news release attributed the decline primarily to concerns about the labor market and interest rates, rather than inflation concerns.
To take another example, Target, Walmart and other major retail chains have recently announced several temporary and permanent price cuts. Presumably they are taking these measures due to concerns about falling demand. However, many of the reports I have seen have framed the price declines as a sign of inflation. They simply assume that inflation is eroding consumer purchasing power, when in reality wages have been consistently outpacing inflation since the summer of 2022. Could there be other reasons why demand is weakening?
In both cases, commentators seemed determined to portray everything (even falling prices!) as an inflationary problem, ignoring other concerns and risks.
Now, let me talk about the Federal Reserve. The Federal Reserve is the most important central bank in the world, the European Central Bank is the second. Both faced a spike in inflation in the aftermath of COVID-19 and Russia's invasion of Ukraine. Both raised interest rates to fight inflation.
But while the ECB is expected to start cutting rates on June 6, few expect the Fed to cut rates at its next policy meeting in just a few days. Why the difference?
As far as we know, the US and the Eurozone have made similar progress on inflation. Europe measures inflation with the Consumer Price Index, which has risen just 2.4% over the past year. This figure cannot be directly compared to the European Consumer Price Index, mainly because the CPI includes prices that no one pays. That means owner-equivalent rent, an estimate of what homeowners would pay if they were renters, accounts for more than a quarter of the European Consumer Price Index.
However, the Bureau of Labor Statistics does release an estimate of the HICP for the US, and while for some reason the April figures are delayed, my own estimate from the consumer price data puts it at 2.5%, roughly the same as Europe.
The Fed knows this, and recognizes that housing costs in general are a lagging indicator of inflationary pressures, especially as the average rent paid by tenants is still catching up with a surge in rents for new tenants that ended more than a year ago.
So why is the Fed being as reluctant to cut rates as the ECB? Much of the reason has to do with the fact that there were several months of reports of “high inflation” in early 2024. But there are serious doubts about whether inflation has really accelerated.
This is a really technical issue, involving both questions about whether the official data is fully adjusted for seasonal effects (such as the tendency for many companies to increase prices at the start of the year) and some odd issues with things like financial services prices.
I don't claim to be an expert on these details, but I will point out that if inflation was truly accelerating, there would be clearer signs of that acceleration beyond official price data. But there isn't. For one thing, mentions of “inflation” on corporate earnings calls have plummeted, and purchasing managers' surveys, which often portend official inflation data, suggest continuing deflation.
Are we convinced that the inflation spike earlier this year was a statistical illusion? Of course not. But the Fed must navigate between two risks: the risk of cutting rates too early and letting inflation re-accelerate, or the risk of waiting too long until the economy starts to crumble under the stress of high interest rates. This possibility is suggested by consumer surveys, price cuts at big-box stores, and signs of a softening job market. And I worry that the Fed is too focused on the first risk and not paying enough attention to the second, which is to say, that it has fallen into at least mild inflation-brain mode.
And at this point, we have to talk politics. If the Fed does end up cutting rates, as you know, Donald Trump and his allies will vigorously attack the Fed for plotting to re-elect President Biden. After all, they wanted the Fed to cut rates on their behalf before the last election. I don't think that's weighing on the Fed yet, but I am concerned that it will as the election approaches.
So let's be clear: now is really the worst time for the Fed to succumb to political pressure from the right. It shouldn't be done in any case, but especially now it's clear that any attempt to appease the MAGA faction would be futile. If Trump forces win, the Fed (along with many other US institutions) would quickly lose its independence. Former Trump aide Peter Navarro, interviewed in prison, recently asserted that Fed Chairman Jerome Powell would step down within 100 days if Trump wins.
I understand that Fed officials cannot discuss these political considerations, but I hope they are aware of it.
If it were up to me, I would cut rates a little next month. Spooked by the possibly misleading inflation numbers, it seems likely the Fed will wait until at least July for more numbers. But I really, really hope we don't wait any longer. We can't afford to succumb to the Fed's inflation brain.
