The Federal Reserve attacks Trump and stubborn inflation

For most of the past year, most economists’ baseline forecasts have been fairly optimistic. For example, when the Fed last released its quarterly outlook in September, a solid majority on its Monetary Policy Committee expected its main inflation gauge to decline to 2.2% next year. This, they believed, would allow them to cut rates by a percentage point in 2025, before lowering them even further in 2026. In such a scenario, Mr. Trump would probably be happy enough with the central bank to not feel hardly necessary to shoot it. against Jerome Powell, the chairman of the Fed, or, worse yet, engage in a legal battle trying to oust Mr. Powell before his term expires in May 2026. With the possibility of unrest at the table, the Markets could breathe a sigh of relief.

However, in recent months, a more delicate situation has emerged. Some economists, including Sarah House of Wells Fargo, a bank, now fear that inflation, after falling sharply since mid-2022, will stagnate around 3%. The often headline-grabbing Consumer Price Index (CPI) rose 2.7% in November from a year earlier, reversing some of the observed slowdown. a few months earlier, the core CPI, which excludes the volatile costs of food and energy, proved even more stubborn, hovering around 3.3% year-on-year since late spring (see chart 1). The personal consumption expenditures (PCE) price index, which the Fed watches more closely, has been moving in the wrong direction: it rose at an annualized rate of 3.3% in October, its highest level in six month.

View full image

Graphic: The Economist

Optimists blame these uncomfortable numbers on inevitable volatility. Prices are unstable from month to month and inflation tends not to fall linearly. Additionally, there is also a statistical lag: the lagged effect of an increase in property rents in 2021 and 2022. This is now the main contributor to the high inflation data. Housing costs accounted for just over half of the annual increase in the core CPI in November. Although rent increases have slowed significantly since the height of the covid-19 pandemic, house price measures in inflation indices remain frustrating because they are based on rents for all tenants and, As rental contracts can be multi-year, increases in previous rules take time to pass. The measures have started to slow down, but slowly. “There is a strong argument that housing prices are just ridiculous. It’s a technical question, and it needs to be felt,” says Luke Tilley of Wilmington Trust, an investment firm.

The reasons for concern are broader. It may be true that housing inflation is bound to slow, but researchers at the Fed’s Cleveland branch estimate it won’t return to its pre-pandemic norm until mid-2026 — a long time waiting. Meanwhile, the sharp decline in goods prices, the main disinflationary force of the past year, is almost over as supply chains recover. Mr. Trump, for his part, has promised a trio of policies — higher tariffs, an immigration crackdown and tax cuts — that could well combine to drive up prices, at least temporarily. And any upward pressure on prices would apply to an economy that may be better prepared for higher inflation than it was before the pandemic hit. “You’re in a different environment where companies have rediscovered pricing leverage, and I think they’re more likely to use it,” Ms. House says. This creates a potentially combustible mixture.

Some Fed officials have expressed discomfort with inflation trends. On December 2, Fed Governor Christopher Waller compared the central bank’s efforts to a mixed martial arts fight, a metaphor that might appeal to Mr. Trump, a wrestling enthusiast. “Overall, I feel like an MMA fighter who keeps pumping himself up, waiting for it to go off, but it keeps slipping away from me at the last minute,” Mr. Waller said. “But let me assure you that submission is inevitable: inflation does not leave the octagon.”

What type of choke is necessary? Based on market prices, the Fed is almost certain to cut rates by a quarter point after its December 18 meeting, which would be its third consecutive reduction. These developments are based on the belief that interest rates remain in restrictive territory because they are well above the neutral interest rate – a level that would neither stimulate nor constrain activity. The central bank estimates the nominal neutral rate to be around 2.9%, which would give it some room to further reduce the federal funds rate, currently at around 4.6%.

View full image

Graphic: The Economist

In reality, there is much uncertainty about the precise level of neutrality. Many Fed officials and other economists say it may have drifted higher, in part because of stronger productivity growth. This would mean that rates are no longer particularly restrictive and would therefore require the Fed to keep them at a relatively high level in order to avoid excessive easing (see chart 2). Lorie Logan, president of the Fed’s Dallas branch, concocted another metaphor to explain the Fed’s challenge in this regard, likening her job to that of a ship captain whose fishfinder might mistake mud for water. ‘water. “In these uncertain but potentially very shallow waters, I think it is best to proceed with caution,” she advised in a speech last month.

It is easy to imagine that such caution would anger Mr. Trump. During his first term in the White House, he lambasted the Fed for raising rates, even questioning at one point whether Mr. Powell or Xi Jinping, the Chinese leader, was America’s greatest enemy . During this year’s election campaign, Mr. Trump suggested he could expect another fight with the Fed, saying that as president he should have a say in decisions in rate matter. Scott Bessent, Mr. Trump’s nominee for Treasury secretary, suggested that Mr. Trump could appoint a “shadow” president to keep Mr. Powell in check, although he abandoned the idea after the Investors opposed it.

Enter the octagon

Recently, Mr. Trump has been reassuring. In an interview with NBC broadcast on December 8, he said he did not “think” he would seek to impeach Mr. Powell. Nevertheless, it is worth paying attention to Mr. Trump’s words. In another interview, in June, he also said he would let Mr. Powell complete his term, before adding a crucial caveat: “especially if I thought he was doing the right thing.” In other words, Mr. Trump’s pardon is based on performance. If inflation proves persistent and the Fed opts for few, if any, rate cuts next year, Mr. Trump may well conclude that Mr. Powell’s performance is not to his liking.

It’s unclear whether Mr. Trump can actually fire him. Mr. Powell insisted that the White House does not have the legal authority to fire the Fed chairman and that the courts may ultimately side with him. But if things got to that point, the dispute would surely have become complicated, damaging the central bank’s reputation as an institution remaining above the political fray. If, on the other hand, Mr. Trump simply criticizes Mr. Powell in interviews and on Truth Social, his social media platform, markets will likely take his comments with equanimity. “We have suffered these reprimands before. There is experience and discounts,” says Matthew Luzzetti of Deutsche Bank.

Much will depend on the context. “Tensions would clearly arise if the Fed reacts to high inflation while the labor market is weakening,” said Mr. Luzzetti. The opposite — inflation fading even as the labor market remains robust — would be a much more palatable scenario for the Fed, Mr. Luzzetti said. Trump and everyone else with a stake in the economy. The problem is that right now, inflation seems terribly stubborn. America faces both a monetary dilemma and a political conundrum.

For more expert analysis of the biggest news in economics, finance and markets, subscribe to Money Talksour weekly newsletter reserved for subscribers.