While all eyes are on Donald Trump and Kamala Harris, one of the largest factors influencing the mood of American voters is playing out elsewhere. The Federal Reserve’s handling of inflation is souring the public on our economy, harming vulnerable Americans, slowing our fight against climate change — and hindering the fight against inflation itself.
For the past several months, the Fed has resisted lowering interest rates in an environment that clearly demands lower rates. Take its favored inflation measure, the Personal Consumption Expenditures price index. The Fed repeatedly stated that it would not lower rates until it had confidence the P.C.E. was headed back toward 2 percent. Yet we are already there: While the annualized P.C.E. stands at 2.5 percent, the three-month annualized P.C.E. is just 1.5 percent.
While the Fed keeps waiting, the pain keeps accumulating. By jacking up rates at a speed not seen in over four decades, and then keeping them at or near 25-year highs, the Fed has all but frozen the housing market and kept a generation of potential first-time home buyers stuck in the rental market, where price spikes have been especially steep. That trend has been devastating for many people — homeownership is where many middle-class Americans store most of their wealth, and the average homeowner gained about $210,000 in equity over the last decade.
There is also the damage that unnecessarily high interest rates are inflicting on our battle against climate change. Clean energy projects typically involve heavier upfront financing costs that become more expensive with higher rates. A 2020 report estimated that raising rates from 3 percent to 7 percent could increase the cost of a renewables project by roughly a third for projects in the U.S. And of course, higher interest rates have hurt poorer consumers who depend on variable credit card rates and auto loans.
In the meantime, some economists believe the risks of recession are rising: Unemployment is now at 4.1 percent, compared with 3.7 percent in January.
Beyond all of this, there is an even more fundamental reason the Fed should reverse course sooner. It’s unclear whether interest rates are the best tool to reduce the kind of inflation the United States has been experiencing.
The inflation that has plagued both the United States and Europe since 2021 has come substantially from so-called supply-side factors, or shocks hampering the economy’s ability to churn out goods: a pandemic that closed plants, wars that raised prices of grain, climate change-induced crop failures that did the same, Houthi rebels launching drone attacks on one of the world’s busiest maritime choke points and so on. For many of these supply-side woes, higher rates are making matters worse. “The Fed’s main tool for lowering inflation,” as economist Mark Zandi told The Atlantic, “is actually doing the opposite.”
Consider housing. Rental housing recently accounted for an estimated two-thirds of the inflation above the Fed’s 2 percent target. The fix for too-high rents is to build more housing. Yet interest rates that push mortgages to historic highs are extremely counterproductive for new housing starts, because they make it more difficult and expensive for builders and developers to bankroll new construction.
The same is true of energy, another major source of recent inflation. Like any essential commodity, even small supply deficits — the sort frequently caused by refining bottlenecks or OPEC members playing geopolitics with production quotas — can cause massive price spikes. Switching U.S. energy grids to run on renewables would help immunize the economy from the run-ups that are so commonplace with oil and gas. But the current high rates are proving a real headwind to these investments, which the United States just passed legislation to hasten.
This is why for decades, policymakers routinely distinguished between different kinds of inflation and customized their responses accordingly. Where inflation stemmed more from these supply-side drivers, interest rates were seen as an attenuated, overly blunt tool; the better answer was simply to find and remedy those blockages or shortages, or prevent them in the first place.
But by the 1970s, the economist Milton Friedman began to recruit a following for his view of inflation as “always and everywhere a monetary phenomenon,” meaning inflation occurred whenever the money supply outstripped the goods or services being produced. Mr. Friedman’s restrictive monetary policies came as part of the broader revolution he ushered in across economics.
Decades later, there are real and mounting doubts about whether Mr. Friedman was right. Beyond exacerbating some drivers of inflation, the latest rate hikes haven’t done much to cool consumption, and there is plenty of confusion, even among some top economists, around how they work at all.
We need to shift back to understanding different flavors of inflation, as the world is likely to come in for many more of these supply-side inflation headaches — more geopolitical upheaval, more drought, possibly more pandemics, an aging work force. Interest rate increases — which at best are irrelevant, and in many cases are actively unhelpful to unwinding these supply kinks — are not a particularly good fix for any of them.
To address the root of the problem, the United States needs more creative use of strategic reserves and buffer stocks, especially for certain industries that straddle numerous supply chains. Just as the Biden administration expanded use of the Strategic Petroleum Reserve to damp price spikes, we should develop similar reserves for critical minerals, such as lithium and graphite, which are critical for battery manufacturing and are vexed by large price swings. Financial speculation in agricultural commodities — unleashed when the United States deregulated commodity markets more than 20 years ago — often creates price hikes disconnected from physical supply realities. Better coordinated buffer stocks could stomp out this financial gaming.
The Fed or Congress should also follow the lead of other central banks (the Bank of England, the European Central Bank and the Bank of Japan all come to mind) that have programs designed to ease financial conditions for certain pockets of the economy. Doing this for housing and clean energy projects in the United States — even temporarily, say, over the next 24 to 36 months — would help turn the Fed from antagonist to ally in easing at least two of the major culprits behind the recent inflation. In fact, in the case of clean energy, it would be using monetary policy to help sever the inflation pressures of frequent price spikes in oil and gas.
Finally, the Fed should begin cutting rates now, rather than waiting until September or later, as it has signaled thus far.
After years of living through the fog of Covid and its inflationary aftermath, it’s important that Americans, who are trying to make sense of the economy ahead of the election, benefit from the clearest possible facts. Inflation is yesterday’s battle. It is high time our government stopped relying reflexively on a tool that doles out predictably harsh consequences and unreliable benefits when a more precise and effective scalpel could well suffice.
Where we can do better, we should.
Jen Harris is director of the Economy and Society Initiative at the William and Flora Hewlett Foundation. She previously served as senior director of international economics on the National Security Council and National Economic Council.
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