Inflation slowed to 0.1% in May, providing another opportunity for the Federal Reserve to rethink its behind-the-curve interest rate policy. Many signs indicate that rates should be lower, but the Fed has chosen to keep the interest rate steady because of its limits-to-growth economic models.
The Labor Department’s May survey of households found 700,000 fewer people with jobs than in April, a clear sign of strain in small businesses. The prime interest rate is 7.5%, too high for most businesses. Credit-card interest rates are above 20%, a record high. The mortgage rate is prohibitive, driving up housing costs and rents. Monthly mortgage payments are at a record high, and builder confidence is down.
Other major central banks, including the European Central Bank and the Bank of England, have cut their rates repeatedly in recent months, recognizing the global trend toward disinflation. The fed-funds rate, at 4.3%, is at least double the policy interest rates in Europe and Japan. President Trump’s tariffs have stopped China from dumping products here, but rather than reduce excess manufacturing, China has responded by dumping its products worldwide, exporting deflation. Global growth forecasts have slowed markedly, with the U.K. reporting a contraction in gross domestic product on Thursday.
This leaves the Fed as far behind the global disinflation trend as it was behind the inflation trend during the 2023-24 election cycle. These repeated lags in interest rates—driving through the rear-view mirror—harm the economy by widening the swings in inflation and interest rates.
A clear path is available to the Fed to lower interest rates as Mr. Trump’s policies add critical manufacturing and energy capacity and give priority to a stable dollar as the world’s reserve currency. Strong growth based on increased market-based production is fully consistent with the Fed’s dual mandate of price stability and full employment. Price stability leads to strong private-sector investment and job growth, which in turn fosters the robust production needed for price stability. It’s a virtuous circle that leads to lower interest rates, higher wages and improved affordability.
Voters elected Mr. Trump not only to boost the economy but also to fix broken monetary policy, promote after-tax wage gains, and protect the dollar. The president champions the forgotten man, and his economic policies so far have been a home run. In a growth economy, small businesses can offer more jobs at higher wages and still make a profit.
By contrast, the Fed’s models depend on slowing the growth rate to avoid overheating. The Fed is locked into high rates by a “limits to growth” fallacy—the idea that the U.S. economy has a low potential growth rate that shouldn’t be exceeded.
This hurts the economy, especially the small business investment needed to build the domestic supply chain. The amount of commercial and industrial loans outstanding—the lifeblood of small business working capital—is less now than in January 2023, even in nominal terms. That isn’t enough to power economic growth or even keep up with inflation.
The Fed has created multiple obstacles to small business lending. The Fed’s regulatory policies guide banks away from small business loans. Further, its post-2008 balance-sheet policy of owning long-term government bonds favors government and big business at the expense of small and new businesses. The Fed is offering such high interest rates to banks (4.4%) and money-market funds (4.3%) that it crowds out small businesses. This limits the growth that is needed to pay for wage increases.
The Trump administration is transforming the economy for the better by deregulating, encouraging businesses to invest, cutting tax rates and empowering domestic producers in the energy sector and other industries. As growth prospects improve, especially if the reconciliation bill makes the tax cuts permanent, the Fed’s antiquated models will likely argue against rate cuts. Many innovative small businesses are confident in what they have to offer but can’t afford new investment, so they wait too. The risk is that underinvestment could impede necessary growth in domestic supply chains.
As the Fed drags its feet, taxpayers also bear a huge cost because the U.S. government and the Federal Reserve are the world’s biggest borrowers in short-term credit markets. The Fed’s choice of high rates is adding rapidly to the government’s interest expense and the national debt. The Fed uses the loans it gets from banks and money-market funds to hold on to a $6 trillion bond portfolio that is deep underwater. Today’s Fed is effectively the world’s biggest hedge fund. Its losses are already $1 trillion and will grow until interest rates come down.
The Fed is using the same demand-side models that have caused cycles of inflation and deflation since the 1970s. In these pages in 2002, I argued that the Fed hadn’t analyzed its deflation mistake of the late 1990s—the mistake that led to the Asian financial crisis and the 65% decline in the Nasdaq index—and was at risk of making repeated mistakes in inflation and deflation because of the lagging nature of its indicators. Those models need to be replaced with pro-growth, stable-dollar principles that can achieve both the Fed’s dual mandate and Mr. Trump’s vision of a strong, productive, high-wage economy.
David Malpass was an undersecretary of the U.S. Treasury 2017-19 and president of the World Bank 2019-23. He is a distinguished fellow in international finance at Purdue’s Mitch Daniels School of Business.
https://www.wsj.com/opinion/the-fed-is-behind-the-curve-on-cutting-interest-rates-2dbe71ac?st=ubzK1w
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