What the Fed is doing to the US election, the climate and the economy

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 the US economy, harming vulnerable Americans, slowing the 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 favoured inflation measure, the personal consumption expenditures (PCE) price index. The Fed repeatedly stated that it would not lower rates until it had confidence the PCE was headed back towards 2 per cent. Yet we are already there. While the annualised PCE stands at 2.5 per cent, the three-month annualised PCE is just 1.5 per cent.

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 homebuyers stuck in the rental market, where price spikes have been especially steep.

That trend has been devastating for many people – home ownership is where many middle-class Americans store most of their wealth, and the average homeowner gained about US$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 to 7 per cent from 3 per cent could increase the cost of a renewables project by roughly a third for projects in the United States.

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 per cent, compared with 3.7 per cent 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 US has been experiencing.

Making it worse

The inflation that has plagued both the US 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 those 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 per cent 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 Organization of the Petroleum Exporting Countries members playing geopolitics with production quotas – can cause massive price spikes.

Switching US energy grids to run on renewables would help immunise the economy from the run-ups that are so commonplace with oil and gas. But the current high rates are proving to be a real headwind to those investments, which the US just passed legislation to hasten.

This is why for decades, policymakers routinely distinguished between different kinds of inflation and customised their responses accordingly.

Where inflation stemmed more from those 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, economist Milton Friedman began to recruit a following for his view of inflation as “always and everywhere a monetary phenomenon”, meaning inflation occurred whenever money supply outstripped the goods or services being produced. 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 Friedman was right. Beyond exacerbating some drivers of inflation, the latest rate increases haven’t done much to cool consumption, and there is plenty of confusion, even among some top economists, around how they work at all.

Different flavours

We need to shift back to understanding different flavours 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 ageing 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 US 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 dampen 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 US 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, European Central Bank and Bank of Japan all come to mind) that have programmes intended to ease financial conditions for certain pockets of the economy.

Doing this for housing and clean-energy projects in the US – even temporarily, say, over the next 24 to 36 months – would help turn the Fed from antagonist to ally in easing at least two 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 signalled 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.

The writer 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.