The Federal Reserve’s September 16-17 policy meeting may well be one of the most contentious in years. Although financial market investors see a 25 basis point interest rate cut as close to a lock, some participants in the Federal Open Market Committee (FOMC or Fed) remain on the fence. Barring any conclusive new data releases between now and then, there will be cogent arguments both for cutting rates and standing pat. On top of that, the Trump administration is putting tremendous pressure on the Fed to loosen policy—this will be viewed by some FOMC members as a reason to cut rates and by others as a reason not to. All told, we think the risks from cutting rates are currently higher than those from standing pat. A central factor in our view is the possibility that, coming off the inflationary surge of 2021–22, Americans’ expectations of future inflation are prone to being de-anchored by a further bout of inflation driven by tariffs. Indeed, inflation expectations have already ratcheted up this year. As discussed below, our concern is supported by research showing that inflation and inflation expectations are importantly influenced by long histories of prior inflation behavior.
President Donald Trump has called on the Fed to cut rates by 3 percentage points. Treasury Secretary Scott Bessent noted that “any model” would put the benchmark federal funds rate at least 1.5 percentage points lower than its current level of between 4.25 percent and 4.50 percent. Any FOMC member seeking Trump’s nod as the next Federal Reserve chair surely feels pressure to advocate for rate cuts. Indeed, while the FOMC decided to hold rates steady at its July meeting, Fed governors Michelle Bowman and Christopher Waller dissented in favor of a small rate cut and took the unusual step of issuing statements (here and here) defending their votes on the Fed’s website.
At present, the latest economic data have been sufficiently mixed as to support either policy alternative. The case for a rate cut is driven by the pronounced slowing in job creation, the failure of inflation to respond much to the initial tariff increases, and the fact that most FOMC participants view the current stance of policy as slightly tighter than neutral. On August 1, the Bureau of Labor Statistics released the largest downward revision in payroll employment since the COVID-19 pandemic of 2020; monthly job growth since May has now fallen to a paltry average of 35,000. As these payroll data may signal a coming recession, proponents of a rate cut argue that, in light of the normal lags in monetary policy, it is past time to return rates to neutral or even below. The neutral federal funds rate, defined as the rate consistent with an economy at full employment and on-target inflation, is assessed by the Fed at around 3 percent, compared to its current level of roughly 4.4 percent.
On the inflation side, inflation has been inching back up just a bit—to around 3 percent for the core consumer price index (CPI), which excludes volatile food and energy items. Both Bowman and Waller acknowledge that increases in tariffs this year could well push consumer prices up further, but they argue that any tariff effect is a one-time adjustment and not the start of ongoing higher inflation. The Fed often “looks through” price changes caused by volatile commodity prices, and they argue it should do the same for the tariffs.
The case for holding rates steady focuses on the inflationary effects of Trump’s policies. Even before any tariff effects started to show up in consumer prices, inflation was moderately above its 2 percent target, and progress toward that goal had slowed noticeably. Price pressures are likely to pick up in coming months as businesses are forced to pass on higher tariff costs to protect their profit margins. On top of that, deportations and reduced immigration have reduced new entrants to the labor market roughly as much as the reduction in job creation—with the unemployment rate roughly unchanged and at a historically low level, this slowdown in growth may exert less drag on prices than would ordinarily occur. Moreover, the federal funds rate is close to or slightly below the levels implied by different variations of the Taylor rule for monetary policy on the website of the Federal Reserve Bank of Atlanta, suggesting limited room for cuts.
Although, as noted above, the tariff hikes should exert only a one-time rise in prices, this ceases to be the case if price increases become embedded in higher inflation expectations. Many economists believe inflation expectations can become self-fulfilling, influencing actual inflation. During the inflation surge of 2021–22, long-term inflation expectations were remarkably stable: People broadly accepted that the economy would return to low inflation after a year or two. This expectation was critical in enabling inflation to fall without any notable rise in unemployment. However, a new surge in inflation so soon after the COVID-19 surge puts those stable long-run inflation expectations at risk.
Our recent working paper provides strong evidence of this risk. We show that countries where inflation in the previous 20 years had been higher than elsewhere saw larger increases in inflation during the COVID-19 pandemic. And countries like Japan, where inflation had been exceptionally low during the previous 20 years, saw very little increase in inflation. We believe this result importantly reflects differences in the stability of long-run inflation expectations: When confronted with a new development in inflation, people look back over their previous lived experiences to assess where inflation is likely to go in the future. The significant correlation between much-earlier inflation and movements in bond yields during COVID-19 strongly supports that view.
The risk going forward is that the COVID-19 inflationary surge of a few years ago has made long-run inflation expectations less stable than before. Faced with another surge in prices caused by tariffs, consumers, workers, and businesses may have less confidence of a quick return to low inflation and may be more likely to raise their own prices and wage demands, turning a one-time tariff increase into a self-sustaining rise in inflation. Indeed, as shown in the figure, five-year inflation expectations measured by the University of Michigan survey have jumped to 4 percent, well above the levels reached during the COVID-19 surge. If these high readings persist and translate into greater price pressures, the Fed will have no choice but to raise its policy rate to bring inflation back down to its inflation target, possibly tipping the economy into recession.
Data Disclosure
This publication does not include a replication package.
