Krugman: Irrational fear of inflation shouldn't drive Fed choices

By Paul Krugman / The New York Times

Surging prices in 2021-22, after decades of low inflation, came as a shock to many. So it was in a way understandable that many observers more or less freaked out, seeing a return to the 1970s lurking under every bed and behind every closet door.

What's less understandable, or at any rate less forgivable, is how many commentators continue to blame the inflation boogeyman for every economic problem — a condition I've come to think of as "inflation brain." And I worry that this condition may even be affecting the Federal Reserve, leading it to keep interest rates too high for too long.

Let me give you two recent examples of inflation brain in action.

This month, a preliminary release by the widely followed University of Michigan survey of consumers reported a significant fall in consumer sentiment. Consumers gave a number of reasons for reduced optimism, but every news article I saw about it attributed their pessimism to a jump in expected inflation, both over the next year and over the next five years.

Then the final version of the May report was released, and the initially reported jump in inflation expectations more or less disappeared. Consumer sentiment was still significantly down, but the survey's news release attributed this decline largely to concerns about labor markets and interest rates, not inflation fears.

Another example: Target, Walmart and other big retail chains have recently announced a number of price cuts, both temporary and permanent. They are presumably doing this because they are seeing worrisome softness in demand. But many of the reports I saw managed to frame falling prices as somehow a symptom of inflation; simply assuming that inflation must be sapping consumers' purchasing power, when the reality is that wages have consistently outpaced inflation since the summer of 2022. Maybe demand is weakening for other reasons?

In both cases, then, commentators seemed determined to frame everything — even falling prices! — as an inflation problem, while ignoring other possible concerns and risks.

Which brings me to the Federal Reserve. The Fed is the world's most important central bank; the European Central Bank is second. Both faced an inflation surge in the aftermath of covid and Russia's invasion of Ukraine. Both raised interest rates to fight inflation.

But the ECB seems set to begin cutting rates June 6, while almost nobody expects the Fed to cut at its next policy meeting a few days later. Why the difference?

As best we can tell, the United States and the eurozone have made similar progress against inflation. Europe measures inflation with the Harmonized Index of Consumer Prices, which is up just 2.4% over the past year. This number can't be directly compared with our own consumer price index, mainly because the CPI includes a price nobody pays: Owners' Equivalent Rent, an estimate of what homeowners would be paying if they were renters, makes up more than a quarter of our measure.

However, the Bureau of Labor Statistics releases an estimate of the HICP for the U.S.; for some reason the release for April data has been delayed, but rolling my own estimate from consumer price data, I come up with 2.5%, almost the same as Europe's.

The Fed knows this, and it's aware that shelter costs in general are a lagging indicator of inflation pressures. In particular, average rents paid by tenants are still catching up to a surge in rents for new tenants that ended more than a year ago.

Why, then, is the Fed less willing to cut than the ECB is? A lot has to do with the fact that we had several months of "hot" inflation reports at the beginning of 2024. But there are serious doubts about whether inflation truly accelerated.

This is a really technical subject, involving both questions about whether the official data fully adjust for seasonal effects — like the tendency of many businesses to raise prices at the beginning of the year — and quirky issues involving things like the price of financial services.

I don't fancy myself an expert on these details, but I would note that if inflation really did accelerate, you should find clear signs of that acceleration in other places besides official price data. But you don't. To take one example, mentions of "inflation" in corporate earnings calls have plunged. To take another, surveys of purchasing managers, which often prefigure official inflation data, are signaling continuing disinflation.

Am I sure that the bump in inflation early this year was a statistical illusion? No, of course not. But the Fed has to steer between two risks, that of cutting rates too soon and feeding a reacceleration of inflation and that of waiting too long while the economy starts to crack under the stress of high rates; a possibility hinted at in consumer surveys and in those big-store price cuts, as well as indications of a softening job market. And I worry that the Fed is too focused on the first risk and not enough on the second; that it's suffering from at least a mild case of inflation brain.

And at this point we have to talk about politics. If and when the Fed finally does cut, you know that it will be fiercely attacked by Donald Trump and his allies for conspiring to reelect President Joe Biden; after all, that's what they wanted the Fed to do on their behalf before the last election. I don't think that's weighing on the Fed yet, but as the election approaches I fear it will.

So let's be clear: This would be a really bad time for the Fed to give in to political pressure from the right. It shouldn't do so in any case, but especially not now, when it's clear that any attempt to appease MAGA types would be futile. If Trump's forces are victorious, the Fed (along with many other U.S. institutions) will quickly lose its independence; a former Trump aide, Peter Navarro, interviewed in prison, recently declared that if Trump wins, Jerome Powell, the Fed chair, will be gone within 100 days.

I understand that Fed officials can't talk about these political considerations. But I hope they're aware of them.

If it were up to me, I'd make a small rate cut next month. The Fed, spooked by those probably misleading inflation numbers, seems likely to wait at least until July, while more numbers come in. But I really, really hope that it doesn't wait any longer. We cannot afford a case of Fed inflation brain.

This article originally appeared in The New York Times.