There is no sign that the U.S. is headed toward 2 percent inflation, the Fed’s supposed target, making its decision to cut rates a curious one (even allowing for labor market uncertainty).
Pondering this last week, I put forward a number of possible explanations, which are not necessarily mutually exclusive:
In no order, one is that Trump agrees that signs of weakness in the jobs market — a Fed concern — will still be reason for action next year. Another is that Trump, a man of the real estate market after all, has — let’s put this politely — a strong, and near perpetual, bias in favor of lower interest rates. The third is that the president believes that the only way out of the country’s fiscal fix is to juice up the economy, regardless of the increased inflationary risk. The fourth, not entirely distinct from the third, is that we are in the early stages of “default” by inflation, which — if it goes far enough — will mean that we are entering the age of fiscal dominance.
Writing on his Substack, economist David Beckworth discusses the rate cut, noting comments from Austan Goolsbee of the Chicago Fed:
Waiting to take this matter up in the new year would not have entailed much additional risk and would have come with the added benefit of updated economic data which have been absent lately. Given that inflation has been above our target for four and a half years, further progress on it has been stalled for several months, and almost all the businesspeople and consumers we have spoken to in the district lately identify prices as a main concern, I felt the more prudent course would have been to wait for more information.
(Beckworth’s emphasis.)
The question posed by Beckworth is whether 3 percent is the new 2 percent. The Fed denies it (of course!), but:
The Blue Chip consensus forecast expects personal consumption expenditure inflation — the Fed’s preferred measure — to hover near 3% through 2026. It won’t fall to 2.1% until 2030. The Philadelphia Fed’s Survey of Professional Forecasters shows even more drift: Both the 5-year and 10-year expected PCE inflation rates are edging higher, moving further away from the 2% anchor the Fed once took for granted.
Beckworth points out that inflation seemed “stuck” before the Trump tariffs. This is one reason why blithely assuming that the tariffs effect (supposedly a one-off) will be transitory may be optimistic. I have never been sure of that, due to what the tariffs might mean for inflationary expectations, especially after Bidenflation.
Beckworth:
Fed officials often cite bond market forecasts of inflation as evidence that inflation expectations remain well-anchored. But professional forecasters, as seen above, are beginning to mark up their inflation projections in this area, too.
Even more concerning, households appear to be responding as if the new tariffs will raise future inflation more persistently. Inflation from the Covid-19 pandemic left them scarred, more sensitive to price shocks, and less confident in the Fed’s ability to anchor inflation. Supply shocks, if anything, may now be making inflation stickier than fleeting. . . .
If supply shocks and inflation psychology explain the current stickiness of prices, fiscal pressures explain why they may stay that way. The U.S. is entering a period where fiscal policy, not monetary resolve, increasingly determines the inflation path. With debt projected to climb well above 120% of gross domestic product under current law, and interest costs approaching $2 trillion by the early 2030s, the fiscal math is diminishing the Fed’s room to maneuver.
In such an environment, a 3% inflation rate is less a policy failure than an adaptation — the by-product of an economy adjusting to a chronic government deficit and the political impossibility of fiscal consolidation.
The early warning signs of fiscal dominance are already visible. Trump’s open calls for rate cuts on the grounds that they would “save $800 billion per year” are the clearest expression yet of monetary policy being viewed through a fiscal lens.
And, as Beckworth points out, those signs are not alone:
These are the institutional tremors of a shift from monetary to fiscal dominance, small in isolation but revealing when considered cumulatively…
If this drift continues, the Fed may find that the last mile of disinflation is not just difficult, but unreachable. Once the consolidated government budget constraint begins to bind, the arithmetic of debt service, not the resolve of central bankers, will dictate the equilibrium inflation rate. Higher inflation becomes a feature, not a bug. It is a necessary lubricant for an over-leveraged fiscal state.
“Necessary lubricant” is a clever euphemism for describing the creeping “default” that is inflation. Three percent may become a happy memory.
The problem with this, of course, is that sooner or later investors will demand higher interest rates in an attempt to preserve the value of the money they are prepared to lend to Uncle Sam. Indeed there are indications — no more than that — at the longer end of the yield curve that such concerns are on the rise.