As Fed hesitates, Americans heading for more inflation

Federal Reserve Chairman Jerome Powell is trying to thread a needle — tame inflation that peaked at 9.1% in June 2022 while avoiding an economic slowdown. He has chosen to punt: In September, the Fed policymaking committee he leads left interest rates unchanged.

He’s getting support from doves like Chicago Fed President Austan Goolsbee, who blocks and tackles for the Biden administration. Higher rates or a recession would cast a damaging spotlight on the federal government’s ballooning borrowing, debt service, and the headaches it will bequeath the next president.

Fears abound that growth in gross domestic product hit a wall after a strong third quarter. Higher interest rates are breaking auto purchases, and restarting student loan payments will drain $100 billion from consumer spending. The savings that households built up during the COVID shutdowns from government aid, which has pumped up consumer spending, is running out.

Notable progress has been achieved. Year-over-year inflation was 3.7% in August, and the core consumer price index, which excludes energy and food prices, was up 4.3%.

That’s still a long way from the Fed’s goal of 2%.

A psychiatrist friend told me several times that behavior repeats. Breaking bad habits and correcting character flaws is much tougher than getting a patient to take a specific action or decision within his control.

Mr. Powell tends to cling to hope like a 7-year-old who wants to deny rumors that Santa Claus does not exist. Just as he told us inflation was transitory when prices began to surge in 2021 and delayed acting until President Biden nominated him for a second term, he’s now telling us monetary policy may work its wonders if we are just patient.

In recent months, the services component of the core CPI has been much more important than goods. Households stocked up on computers and gas grills during the pandemic shutdown, and now travel, concerts, and hunting for homes and apartments — shelter is a service in the CPI — are the preoccupations.

Shelter is the rent on houses and apartments actually paid and the imputed rent on owner-occupied housing, with the former much affecting the latter.

Shelter is 45% of the core CPI, and Mr. Powell has repeatedly pointed out that falling rents observed in industry surveys work their way into the CPI with a lag. But the dip in apartment rents last fall and winter should have shown up in the CPI by now. It has not.

Moreover, any pullback in inflation will likely be short-lived, because apartment and home rents are rising again, both in cities and suburbs.

Working from home has increased demand for housing in the suburbs, and affluent professionals who are opting to stay near commercial centers need more space in their apartments. Unfortunately, inflation expectations are hardening.

Year-ahead expected inflation among consumers surveyed by the Conference Board has barely budged over the last seven months and stands at 5.8%.

The Fed is also losing credibility with investors.

Stock prices are expected to fall as the Fed raises interest rates. Most prominently, high-tech stocks, because the present value of their future earnings goes down if the cost of using money — interest earnings on foregone bonds — is rising.

But if investors expect inflation to stay high, all that goes out the window, because expected future profits will go up with prices too.

Voila! As the Fed raised interest rates, stocks rallied earlier this year, especially high-tech stocks.

More behavioral evidence can be found in the market for new homes. Existing homes are not turning over because too many homeowners have low-interest mortgages they don’t want to give up.

New-home sales have improved despite higher rates on mortgages. If you expect 3% or 5% inflation, those interest rates don’t seem so steep.

The Fed faces formidable challenges in financial markets over the next one to three years.

Commercial real estate in urban centers has lost its value as businesses need less space, and the banks — especially regional banks with assets of less than $250 billion — have large shares of their assets tied up in commercial real estate loans, real estate investment trusts and various forms of collateralized debt.

Many landlords can’t sell buildings for what they owe and lack the collateral to refinance, no matter where the Fed sets interest rates.

The same morality tale is playing out on the corporate debt of less-than-stellar companies and car loans.

Raising rates enough to break consumer and investor inflation expectations won’t resolve those challenges, but prolonging the fight will limit the Fed’s ability to intervene to stabilize banks. One way or another, that requires printing money.

Mr. Powell is like a child that wants to skip doses of a bitter medicine. It would be better for him to hold his nose and stop procrastinating about inflation.

• Peter Morici is an economist and emeritus business professor at the University of Maryland, and a national columnist.