Inflation has fallen dramatically since its high point in 2022, although it has crept up in recent months. Why has progress on inflation slowed?
Prior to the new administration, the Fed was projecting that the economy would stay fairly stable over the next couple of years, with output and employment near their maximum sustainable levels and inflation falling gradually back to its 2% target—a soft landing. A natural question, though, is, what is it that is pulling inflation down to 2% in these projections, since there would not be significant slack in goods and labor markets? The answer is that the Fed believed that, with inflation expectations fairly well anchored near target, businesses and firms in their setting of prices and wages would build in a gradual move back to target. So there is a gravitational pull from expectations and that is enough to get inflation down to target over time.
The huge uncertainties about policy regarding taxes, spending, tariffs, and immigration are likely leading firms and households to reduce spending as they wait to see what policies will ultimately emerge.
This expectational story works very well in models of the economy, but one has to wonder if it will work as well in practice. The inflation data have not sent a clear signal on this. Inflation came down from very high levels over 2023 and the first half of 2024 as the strains and dislocations caused by the pandemic and the subsequent policy response ebbed. But since the middle of last year, inflation has changed little, on net, suggesting that it might get stuck near current levels (between 2.5 and 3% by the Fed’s preferred inflation measure). In that case, a period of restrictive monetary policy might be needed to get inflation down to target. As some commentators have said, the last mile of this disinflation may be the hardest.
What are the potential effects of the policies of the new administration on the economy and inflation?
Of course, the outlook for the economy has become much more uncertain since the arrival of the Trump administration in January. Tariffs could cause disruptions for parts of the economy that depend on international supply chains, and they could also boost inflation directly. And limits on immigration could cause labor shortages in some sectors. As a result, inflation may well rise, at least for a time.
Fiscal policy may also have significant effects, with proposed reductions in taxes and increases in defense spending potentially boosting output, even as reductions in spending and employment across other parts of the government could damp output and potentially inflation as well. We won’t really know how these policies shake out for a while yet, but there could well be significant effects, to which monetary policy would need to respond.
In the nearer term, the huge uncertainties about policy regarding taxes, spending, tariffs, and immigration are likely leading firms and households to reduce spending as they wait to see what policies will ultimately emerge. For example, a firm that uses some imported inputs to produce goods that are then sold both here and abroad will presumably want to wait and see where the tariffs come out before investing in new machinery or hiring new labor. But if households and businesses pull back significantly on spending, that would cause the economy to slow sharply now. Indeed, there is some evidence that the economy is slowing—some estimates of output growth in the first quarter of this year have been marked down notably. Slower growth would be good for inflation, of course, and might offset some of the inflationary effects of tariffs. So the implications for monetary policy may be mixed.
The Fed decided to hold rates steady in January. What was their reasoning? What do you expect from monetary policy going forward? Do you think the Fed will succeed in getting inflation back to its 2% target?
The Federal Open Market Committee (the monetary policy making body of the Federal Reserve), decided in January to make no change to its policy rate. The committee had cut rates by a full percentage point last fall, but with inflation still above target and no longer clearly falling, policymakers thought that further cuts were not appropriate. They still see policy as at least moderately tight, and if inflation doesn’t fall further, they will want to continue with that tight policy in order to slow economic growth and generate some slack in goods and labor markets to help put inflation back on a path to target. For now, they indicated that they want to see more evidence that inflation is returning to target before cutting rates further. They also noted that they want to see what policies are implemented by the new administration before responding. Broadly, policymakers saw policy as in a good place, with the economy performing well, and they were in no hurry to adjust policy.
How monetary policy plays this year will depend on economic developments. If inflation moves lower, I expect the Fed will ease policy to keep the economy on track. The Fed will likely also ease if the economy slows—for example, because of the current elevated uncertainty about fiscal policy and tariffs. On the other hand, if the economy strengthens or inflation moves higher, the Fed would cut rates more gradually. In any event, I’m confident that the Fed will ultimately get inflation back to target. Policymakers realize that providing low and stable inflation over time helps support investment and growth, and so leads to the best outcomes for the American people.
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