Craig Allen: Understanding Inflation and the Risk of Higher Interest Rates

The Federal Reserve recently has been indicating that it is likely to raise interest rates at least once before the end of this year.

That interest rate increase could come as soon as the next Fed meeting, July 28-29.

Just a few months ago, before the war with Iran and the associated jump in energy prices, the Fed was considering at least two interest rate cuts in 2026.

The reason the Fed would typically raise interest rates would be to curtail inflation driven by increased consumer spending.

Since inflation is increasing, not because consumers are buying more, but because energy prices are driving up the price of almost everything, an interest rate increase by the Fed right now would be a double-negative for consumers and the economy.

The Fed is data driven. What this means is that the Fed relies on a wide array of sophisticated mathematical models that generate a bunch of statistical data, and it uses this data to track various factors in the economy, the most important of which is inflation.

In the typical scenario, the Fed would look to increase interest rates because the data it follows is indicating that prices are increasing, and inflation is therefore increasing, to a level that the Fed believes is too high.

The Fed's favorite inflation indicator is the PCE, or Personal Consumption Expenditures Price Index. This is a measure of the prices that the typical consumer pays for goods and services.

There is a "headline" PCE and a "core" PCE. The headline number includes a complete basket of goods and services that U.S. consumers buy. The core PCE excludes food and energy.

The reason food and energy are excluded for the core PCE is specifically because food and energy prices are so volatile that they can make the PCE bounce up and down from month to month.

By excluding food and energy, the core PCE is usually a better indicator of the true amount of inflation, and the ongoing trend of inflation.

Here is the problem: When you have a situation like we find ourselves in today, where energy prices have spiked by a huge amount in a very short time period, that sizable increase in energy prices permeates the entire economy.

Just about every product we buy has an energy component, because that product has to be shipped to get it to market, or to the end consumer.

Think about Amazon. It ships everything right to your door, but the truck that brings that product to you uses energy to get it to you, so there is a cost of moving that product from the manufacturer to your door in the form of the energy used.

When energy prices spike, that cost also spikes. If you have to pay a higher price for that product because of that increased energy cost, you are not getting any more benefit for that higher price you are paying, but the calculation of the PCE goes up — even the core PCE — due to that increased price you pay.

What this means is that the PCE number shows that inflation is increasing, but that increase is not due to increased demand from consumers spending more and getting more, but rather strictly because of the increase in energy prices.

As an example, let's say you bought a $100 health supplement from Amazon prior to the war with Iran.

Now let's assume that, for that same health supplement, the price has increased to $105 because of the added cost of the energy required to make the product and get it to you.

The raw materials have to move to the manufacturer, and then the finished product has to get shipped from the manufacturer to your door.

You are not receiving any additional value for that extra $5 you had to spend — you are getting the same health supplement.

What's worse, is that you have five fewer dollars to spend on something else, so the increase in the cost of the product you bought actually works to reduce overall spending in the economy because you have less money to spend on something else.

However, the PCE calculation would show that there was a 5% increase in spending ($105 instead of $100), making the Fed believe, due to the data (the PCE) that inflation has increased.

As these price increases spread across the economy, consumers are forced to spend more money to get the same amount of goods, so they have less money to spend, yet the Fed sees inflation increasing.

If the Fed then raises interest rates, consumers are not only getting less due to higher prices, but they are going to pay higher interest on their credit cards, car loans, etc.

This is the double-negative I referred to previously.

If the Fed raises interest rates in an attempt to reduce inflation, it is very likely that the increase will cause a recession next year, as consumers will be forced to curtail spending even further.

Less spending will mean lower corporate revenues and profits, more job losses, less government revenues from taxes, all of this adding up to a very difficult economic environment for all of us.

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