Summary of Key Points
The new chairman of the Federal Reserve, Jerome Powell, supported interest rate cuts before taking office, but at his first meeting, he shifted to a focus on "fighting inflation" over the traditional goal of "maximizing employment," placing less emphasis on this latter objective and instead stressing the return to an inflation target of 2%. Mihov, a professor at INSEAD (Bernanke's former student), believes that Powell's change in stance is due to the lack of data supporting the theory that low interest rates do not lead to inflation. He also suggests that Powell successfully convinced Trump that inflation is the biggest threat in the midterms, and that cutting interest rates could exacerbate inflation, which would be detrimental to Trump's campaign. The current inflation is driven by excessive demand in the economy (not geopolitics) and may represent a structural issue. According to the Taylor Rule, current interest rates are still below what would be considered appropriate.
1. Key Signals from Powell's First Meeting: From Supporting Cuts to Prioritizing Inflation
Before taking office, Powell repeatedly stated that interest rate cuts were beneficial and was therefore favored by Trump, who hoped for such reductions. However, at his first meeting, he backpedaled, clearly indicating a return to "price stability" (i.e., the 2% inflation target) and downplaying the Fed's dual mandate of maximizing employment. Mihov notes that this is the first time in recent years that the Fed has signaled such a shift, revealing Powell's more hawkish stance, willing to take action against inflation (even by not cutting rates or possibly raising them). Why is this important? Because inflation has exceeded the target for five years, and many people may not realize that it is eroding their savings. For example, if you save $100 and earn 3.6% in interest per year, but prices rise by 3.8%, you are actually losing money. Fighting inflation is about preserving everyone's purchasing power.
2. The Theory That Low Interest Rates Do Not Trigger Inflation: Valid in Theory, but Not in Reality
Powell previously argued that low interest rates do not cause inflation because U.S. productivity has significantly increased, allowing companies to meet demand without raising prices. This theory made sense logically (for example, during the Greenspan era when high productivity meant low inflation). However, current data disputes this claim. Mihov explains that there are four sources of productivity growth, and "total factor productivity" (the ability to increase output with less labor and more technology) is at its lowest level in history. Without this, companies need to hire more workers, which raises wages and leads to price increases, thus causing inflation. Therefore, Powell no longer relies on this theory.
3. How Powell Persuaded Trump Not to Cut Rates Temporarily
Trump has been pushing for rate cuts, but he responded positively to Powell's speech. Mihov speculates that Powell convinced Trump of the following:
- Cutting rates might further heat up the economy, but with the unemployment rate already at 4.1%, a small increase (to 4.3%) would not be noticeable to voters.
- Inflation, on the other hand, is evident in rising food prices, gas costs, and rent; people complain about it every day. If cutting rates made inflation worse, voters would blame Trump (which contributed to Biden's defeat).
Thus, Trump has temporarily agreed to a strategy of focusing on fighting inflation first before considering rate cuts.
4. Is Current Inflation Short-Term or Structural?
Mihov believes that inflation is not caused by geopolitical factors (such as wars) but by economic overheating—excessive demand. Looking at employment data, the latest job gains (172,000) were mostly in hospitality and healthcare, with only a small increase in manufacturing (7,000 jobs). The growth in the service sector is not due to high productivity but because people are willing to spend on hotels, flights, and medical services. This demand-driven growth can easily lead to inflation. Additionally, there is a "shrinkage of savings cycle": with interest rates at 3.6% and inflation at 3.8%, saving money is actually losing value. People prefer to consume, which further drives up prices, creating a vicious cycle. This indicates that inflation is likely a structural issue rather than a short-term phenomenon.
5. The Taylor Rule Indicates That Current Rates Are Not Enough to Fight Inflation
Mihov mentions the "Taylor Rule," a tool used to determine appropriate interest rates based on economic conditions. According to this rule, the rate should be around 4.4%, but the actual rate is only 3.6%. While the difference is small (less than 100 basis points), if it widens (for example, if the recommended rate of 4.85% does not lead to a rise in inflation), it could be dangerous, leading to inflation spiraling upward, as happened in 2022. In short, current interest rates are not sufficient to curb inflation, and Powell may need to maintain or even raise them to combat it. Therefore, rate cuts are unlikely in the near term.
Conclusion: Powell's change in stance is aimed at fighting inflation, and his persuasion of Trump was crucial. The current inflation is a structural issue driven by excessive demand, and interest rates need to remain high. Ordinary people should be aware that saving money is not profitable in this environment, but overconsumption can exacerbate inflation—this is the dilemma facing the economy.