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The Fed is meeting to decide on interest rates. Here’s why they should ignore inflation fears.

Jobs are growing and businesses are booming. Why throw a wrench into that?

Federal Reserve Chair Jerome Powell shown testifying before a Senate Banking, Housing and Urban Affairs Committee hearing earlier this year.
Federal Reserve Chair Jerome Powell shown testifying before a Senate Banking, Housing and Urban Affairs Committee hearing earlier this year.
REUTERS/Kevin Lamarque

The Bureau of Labor Statistics (BLS) released the November inflation estimates on Friday. The headline figure: the Consumer Price Index rose 6.8 percent between November 2020 and November 2021. This was the highest year-to-year inflation rate in forty years.

However, there was much more going on in these November BLS numbers. Let’s look at some of the details and then consider where policymakers should go from here.

Why do we care about inflation?

There are three reasons why economists think high inflation is a problem. First, inflation leads to an unexpected redistribution of wealth from creditors to debtors. Households who have taken out loans at low interest rates will do well while those who lent money at those interest rates will not earn the inflation-adjusted return they expected.

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Second, inflation can reduce household incomes if incomes don’t rise at the rate of inflation. There is evidence that this is happening. For example, the BLS releases a Real Earnings Summary along with the Consumer Price Index and the most recent report estimated that inflation-adjusted hourly earnings fell for the second consecutive month.

Third, inflation introduces noise into the price system. Prices are the signals that buyers and sellers use to decide how much they should buy and sell. Thus, inflation makes it difficult to tell whether the price of gasoline, for instance, is rising because there’s something going on in the specific market for gasoline or because prices are rising more generally. This means that, for example, if you are a commuter it’s hard to know whether you should expect to spend more on gasoline as a portion of your household budget or if everything is getting more expensive.

The national picture

Before we dig into the numbers, let’s make sure we have a clear definition of inflation and how it is measured. To begin, the inflation rate is the percentage change in the Consumer Price Index (CPI) over the course of a given period. We can therefore measure how quickly prices are rising for whatever intervals at which data are available: monthly, quarterly, or annually. We need to ask: what time frame is most relevant? The 6.8 percent figure, for instance, is an annual rate and it obscures what’s been going on from month to month.

In particular, prices rose during October by 0.9 percent but they rose at a slower rate, 0.7 percent, in November. Inflation is higher than the Federal Reserve wants it to be, but it slowed down from October to November. That’s good news because in the 1970s inflation continued to accelerate over the decade. There’s no sign that this is happening today.

The slowdown in inflation shows up more clearly when we look at the individual components of the CPI. For instance, food prices rose by 0.9 percent in September and October but only 0.7 percent in November. Energy costs, the biggest driver of current inflation, shot up 4.8 percent in October, and were still rising rapidly in November at 3.5 percent for the month. But, like food prices, the rate of increase slowed down.

When we look at all other items besides food and energy, the monthly inflation rate fell from 0.6 percent to 0.5 percent. In general, there is no evidence that inflation is accelerating at the national level. Rather, at this point, it seems to be leveling off or even dropping.

The local picture

The monthly Consumer Price Index report also contains estimates of inflation at regional and metropolitan levels. The story at this level is like the national story in some respects but differs in others.

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According to the Bureau of Labor Statistics, the annual inflation rate was 7.3 percent in the Midwest region, higher than the national rate of 6.8 percent. The annual inflation rate in the Twin Cities was 6.9 percent, about the same as the national rate.

Again, as with the national numbers, these 12-month figures obscure month-to-month changes. Just as at the national level, the monthly figures at the regional and metro levels show the rate of increase in prices to be slowing down. For example, energy prices in the Minneapolis-St. Paul metro area actually fell 3 percent in November. Just as at the national level, there is no evidence that inflation is accelerating.

Where do we go from here?

The Federal Open Market Committee, the policy-setting body at the Federal Reserve, is meeting on Tuesday and Wednesday and will announce any changes to interest rates at 1 pm Central Time on Wednesday. No matter what they choose to do, the Fed’s decisions regarding interest rates will have costs and benefits. If they choose to raise interest rates immediately to fight inflation, then this will slow down the economy and benefit those who have secure jobs and who have positive net worth, and hurt those who are seeking employment and have sizable debts. By contrast, if the Fed holds off raising interest rates the economy will continue to grow at its current clip, and higher inflation might hurt inflation-adjusted household incomes and benefit debtors.

Which option is better? We cannot know with absolute certainty, but right now it seems prudent to let the economy grow, because jobs are growing and businesses are booming. Why throw a wrench into that?

In my view, nothing in the new inflation report indicates that the Fed should change course sharply and raise interest rates rapidly. They should stay on the path they’ve charted: reduce their purchases of long-term securities, allow long-term interest rates to rise, but hold off on raising short-term interest rates. This will allow the economy to grow, but by raising long-term interest rates the Fed is taking out insurance against the possibility of higher-than-desired inflation. I’m still of the view that we should not go back to the 1970s and mistake transitory inflation for accelerating price increases.