The Fed can’t pin inflation on Trump

Blaming inflation on external factors like tariffs and global disruptions deflects from the real issue of fiscal excess and monetary mismanagement. (Photo: AFP)
Blaming inflation on external factors like tariffs and global disruptions deflects from the real issue of fiscal excess and monetary mismanagement. (Photo: AFP)

Summary

The central bank has the power to maintain stable prices, and there is more to the President-elect’s economic policy than tariffs.

The Federal Reserve first blamed high inflation on the Covid-19 pandemic. Then the war in Ukraine became the accepted contrivance. The Fed’s stories came wrapped in gauzy rhetoric about supply-chain disruptions. Now that these excuses have grown tired and outdated, leading monetary policymakers have developed a new scapegoat for inflation: President-elect Trump’s proposed tariffs.

These explanations are untrue. Inflation didn’t arise from war or pestilence. At the risk of speaking plainly, inflation arose from a government that spent too much and a central bank that printed too much. If the government lived with less, its citizens would live with more.

It’s worth clearing up some confusion about inflation. One-off changes in prices—owing to shocks and shifts—happen frequently. When a factory slows production or a port’s operations are interrupted, the supply of the affected goods shrinks and prices rise. It isn’t the Fed’s job to interfere with price-setting in a market economy.

But it is the Fed’s duty—designated by Congress—to ensure that changes in relative prices don’t become embedded in the economy. The Fed’s job is to stop second-order effects of price changes. If high and rising prices beget still higher prices, the Fed hasn’t upheld its end of the bargain.

That’s the real story of the past five years. Inflation has risen about 23% since January 2020. According to the Fed’s often-favored core personal-consumption-expenditures price index, inflation is still running 40% higher than its own 2% inflation target. By other metrics, inflation is running hotter. The American people aren’t fooled by the suspect suppositions of economic experts who promised otherwise; nor by politicians who tell them they are mistaken that inflation is high.

The Trump administration is inheriting a fiscal and monetary mess. Compare the U.S.’s current fiscal and monetary position to just before the pandemic. The federal government’s spending is about 52% higher than in 2019, and the budget deficit has risen by more than $849 billion. Since January 2020, the national debt is up more than 50%, and the cost of interest on the debt has nearly tripled to about $3 billion a day. In the same period, the Fed’s balance sheet has grown by about 65%, and the country’s monetary base, which includes bank reserves and the currency in circulation, has risen by 63%. M2, another measure of money supply, is up 39%.

To adapt a line from Adam Smith, there is a great deal of ruin atop the Treasury Department and Federal Reserve.

To address this crisis, Fed leadership should first take ownership of inflation. Jerome Powell’s Fed shouldn’t mimic the anguish of his predecessors in the 1970s, who claimed forces outside of their control were responsible for inflation’s surge. To blame others is an unbecoming declaration of impotence. The Fed has the power to ensure low and stable prices, so long as it sets monetary policy wisely and its credibility is unimpaired.

Second, the Fed should steer clear of political prognostications, not just in word but in deed. Minutes released from the Federal Open Market Committee’s December meeting reveal that many Fed officials believe Mr. Trump’s proposed policies will elevate inflation: “All participants judged that uncertainty about the scope, timing, and economic effects of potential changes in policies affecting foreign trade and immigration was elevated. . . . A number of participants indicated that they incorporated placeholder assumptions to one degree or another into their projections." Apparently, high inflation in 2025 has a fall guy. No wonder the Fed’s institutional neutrality is being questioned.

If playing politics is too tempting, officials should at least feel compelled to assess the full range of new policies in the offing. Certain government policies, like tariffs, shouldn’t be cherry-picked for opprobrium. I believe, for example, the Trump administration’s strong deregulatory policies, if implemented, would be disinflationary. Cutbacks in government spending—inspired by the Department of Government Efficiency—would also materially reduce inflationary pressures.

Further, any inflationary effect of tariff policies will likely be of smaller magnitude than the disinflationary influence of deregulation and spending cuts. Trade accounts for only about 25% of the U.S.’s gross domestic product. A 10% universal tariff proposed by Mr. Trump would have a minor, one-time effect on the overall price level. In my time as a governor at the Fed, we would look through one-off price changes. So long as Mr. Powell’s Fed hasn’t suffered from a loss of inflation-fighting credibility, the effect of a 10% tariff shouldn’t be statistically significant.

Larger tariffs might be imposed on geopolitical rivals. But the likely inflationary effect of these tariffs is also overstated. China’s economy has slowed markedly. Amid economic uncertainty, Chinese citizens have significantly increased their savings to the detriment of domestic consumption. China’s reliance on exports, especially to the U.S., is far greater than it was in prior trade skirmishes. China would likely have to pay most of the cost of any new tariff.

Third, the Fed must act like it’s serious about winning the war on inflation. Its most recent fine-tuning of interest rates has been counterproductive. The Fed has lowered rates by a total of one percentage point, starting with an ill-timed emergency rate cut of 0.50% in September. Yet the average 30-year fixed-rate mortgage is currently slightly above 7%, about 1% higher than it was in September. The purpose of cutting rates is to cut rates—clearly, that hasn’t occurred.

The Fed must recognize that money matters to the conduct of monetary policy. Its bloated balance sheet has contributed significantly to inflation. By draining as much as $2.5 trillion in excess reserves, the Fed would mitigate inflation and return its size and scope to pre-pandemic levels, hardly a period of restraint or austerity. Call it a practical monetarism to restore Fed credibility.

Finally, the U.S. needs to recommit to the principles of the 1951 Treasury-Fed Accord, which separated the Fed’s responsibility to set monetary policy from the Treasury’s responsibility to manage government debt. This accord allowed the Fed the ability to keep prices stable and unemployment low while the Treasury effectively dealt with debt accumulated during World War II.

A smaller, less political, more effective Fed is of a piece with a stronger Treasury and, most important, a brighter American future.

Mr. Warsh, a former member of the Federal Reserve Board, is a distinguished visiting fellow in economics at the Hoover Institution.

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