The Fed’s View on US Inflation Could Be Wrong – and What Does That Mean?

Jerome Powell, the chairman of the Federal Reserve, says there is no “risk-free path” for the central bank now that the job market has cooled and inflation is rising again. If authorities focus on eliminating price pressures by keeping interest rates high, they risk harming the labor market. If they take steps to support the labor market by cutting borrowing costs, inflation may prove more difficult to contain.

So far, Powell seems more willing to take risks on inflation. Their justification is that the risks to the job market have become much more pronounced following a sharp slowdown in hiring.

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All signs point to the Fed cutting interest rates for the second time this year when it meets at the end of the month. Projections released in September showed that most authorities saw room for another reduction of 0.25 percentage points at their last meeting of the year, in December.

But the Fed may not have much leeway to cut interest rates if the labor market doesn’t weaken. Doing so would risk inflation becoming stuck above the 2% target, some economists warn.

“The idea that we remain at levels that are significantly off target is a real risk for the Fed,” said Matthew Luzzetti, chief U.S. economist at Deutsche Bank. “Marginal interest rate relief will help keep inflation at higher levels for longer.”

Impact of Trump tariffs

Powell’s more optimistic view on inflation – which is shared by other members of the Federal Open Market Committee – stems from his belief that President Donald Trump’s tariffs will only result in a one-off increase in consumer prices, rather than successive hikes that will lead to persistently higher inflation.

He also argued that a weaker labor market will limit how much consumer prices can rise, especially as wage growth remains subdued, unemployment rises and spending slows overall.

So far, the impact of the president’s impositions — which include across-the-board tariffs on nearly all of the country’s trading partners as well as specific levies on certain products — has been milder than Fed officials initially expected.

Not only did it take longer to appear in consumer price data than anticipated, but the rise in prices for everyday items was also less intense than expected.

Inflation in the long term does not recede

But what has left some economists, and indeed some Fed officials, cautious is that measures of underlying inflation show that progress has stalled toward the Fed’s target. (underlying inflation excludes more unstable items like food and energy and shows the long-term trend).

“This is a sign that there is more going on with inflation than just tariffs,” said Loretta Mester, who was president of the Cleveland Fed until last year.

One indicator, which excludes volatile food and energy prices, is currently at an annualized pace of 3.5%.

Stephen Stanley, chief US economist at Santander, argues that an even more accurate metric is one that removes travel-related components such as airline tickets and hotel rates, as they tend to “fluctuate wildly”.

That measure is at an even higher annualized pace of 3.9%, according to August data, which is the most recent due to the government shutdown.

Stanley said this metric suggests that “progress towards 2% is substantially less than it appears and certainly insufficient to allow the FOMC (US Monetary Policy Committee) Let your guard down on inflation for now.”

What will the jobs look like?

Another point of concern is what happens if the job market stabilizes rather than deteriorates further from here, which is a possibility as part of the recent slowdown in monthly job growth results from a reduction in the supply of workers due to Trump’s crackdown on immigration, as opposed to a pullback in demand for new hires.

“The risk here is that we never have enough weakness to get inflation back to 2%,” said Dean Maki, chief economist at Point72, a hedge fund.

A “full-scale recession” would eliminate any lingering concerns about services inflation, he added, but so far no Fed official predicts such a significant slowdown. Not Maki.

Instead, he expects underlying inflation to remain above 3% for most of next year as the unemployment rate rises to 4.8%. In August, it was 4.3%.

Consumers still optimistic

What has given Fed officials some comfort is that consumer and investor expectations about future inflation over a longer time horizon have remained subdued thus far, suggesting that people are not yet losing faith in the Fed’s ability to eventually control price pressures again.

But for former officials like Mester, the main concern is whether that will begin to change. She said the Fed has already lost some of its credibility with the public after inflation soared in the wake of the pandemic. It’s been about five years since inflation has been at the Fed’s 2% target.

Some Fed officials have echoed that concern. “Two more years would be too long to wait for a return to our target, and that possibility weighs on my judgment about appropriate monetary policy,” Fed Governor Michael Barr said recently.

Others joined him in expressing caution about how much further to lower interest rates, including several regional bank presidents such as Lorie Logan, Beth Hammack and Jeffrey Schmid.

Even Stephen Miran — the most recent Trump-appointed governor who has called for substantially lower interest rates — said at a CNBC event that he did not expect inflation to reach the 2% target for another year and a half.

“If credibility is lost, then the work to get back to 2% inflation and full employment becomes much more difficult, because part of what you are doing is trying to change behavior,” Mester said.

“People have to believe that inflation will be 2% or else they will start acting on higher expectations,” he added, “and that makes it much harder to lower inflation.”

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