Inflation is climbing once again, and while this might not shock many, the broader economic landscape raises important questions about the Federal Reserve’s policy decisions. Let’s break down what’s happening, why inflation is rising, and why the Fed’s recent actions appear unusual.
A Temporary Deflationary Effect
Back during the pandemic, used car prices skyrocketed. Supply chain issues and decreased production of new cars forced many consumers to buy used, driving prices up. Over the past year, however, used car prices dropped dramatically, with government reports showing double-digit year-over-year declines. This had a significant impact on inflation reports, as falling used car prices helped lower the overall inflation rate. Yet, two key points were clear from the beginning:
- The decline in used car prices had only a temporary effect on inflation. Other costs—housing, healthcare, insurance—continued to rise.
- Once used car prices leveled out, they would no longer drag down the inflation rate.
And that’s exactly what’s happening now. The latest data shows that used car prices fell just 3.4% in October, compared to steeper declines earlier in the year. As the decline in used car prices slows, inflation is creeping up, from 2.3% in September to 2.6% in October.
Rising Costs Across Essential Sectors
While used car prices are stabilizing, other essential costs are rising sharply. Health insurance is up 6.8%, car insurance 14%, housing 5.2%, and daycare 6%. These key areas affect everyday expenses, and inflation in these sectors is likely to hit consumers harder than fluctuating prices in less essential goods.
The Fed’s Response: A Surprising Rate Cut
Amidst this inflationary pressure, the Fed recently cut interest rates for the second time this cycle—typically the opposite of what central banks do when inflation rises. Instead of fighting inflation by tightening, the Fed seems to have adopted a dovish stance, confident that inflation is under control. Yet, Fed Chair Jerome Powell’s decision to maintain his position despite past policy missteps raises concerns about the consistency of the Fed’s strategy.
The Fed’s actions during Powell’s tenure have already come under scrutiny. In 2021, he famously labeled inflation “transitory,” missing early signs of rising prices and delaying rate hikes until mid-2022. When the Fed eventually raised rates, these moves contributed to a banking crisis, with Silicon Valley Bank and other institutions facing severe liquidity challenges.
The Federal Government’s Debt Dilemma
One major reason for the Fed’s recent pivot to rate cuts may be the government’s mounting debt costs. Last fiscal year, the U.S. spent $1.1 trillion on interest payments alone, and that figure could balloon to $2 trillion if rates remain high. Current rates, while still low by historical standards, are increasingly burdensome. Hiking rates further would place even more strain on the government’s finances.
The Impact on Banks: Bond Losses and Unrealized Risks
Banks across the U.S. are also feeling the squeeze. Many institutions bought massive amounts of Treasury bonds at low yields during the pandemic. Rising rates since then have caused bond prices to fall, saddling banks with unrealized losses that collectively exceed $500 billion. Banks typically avoid selling bonds at a loss, and the only way to recover bond values is through lower interest rates. Lower rates could help banks minimize these losses, but they also carry risks for inflation.
The Fed’s Own Bond Losses: A Trillion-Dollar Problem
Much like the banks, the Fed itself holds trillions of dollars in Treasury securities purchased during its pandemic response. The central bank’s unrealized losses now stand at an eye-watering $1 trillion. For the Fed, rate cuts might be the only way to lessen these losses and protect its own financial stability.
Yet, cutting rates could worsen inflation or even lead to stagflation—a toxic combination of stagnant economic growth and persistent inflation. Powell has publicly acknowledged that the Fed has no contingency plan for stagflation, emphasizing that their current priority is financial self-preservation.
The Fed’s Conundrum: Prioritize Stability or Inflation Control?
The Fed is in a bind. Inflation is rising, but rate hikes would only deepen losses across both government and banking sectors. In this environment, the Fed may prioritize lowering rates, even if it means prolonged inflation or stagflation.
With inflation moving upwards in core categories and the Fed’s past forecasts coming into question, only time will tell whether the current course will stabilize the economy or exacerbate existing pressures. For now, though, it’s clear that the Fed’s rate cuts are as much about self-preservation as they are about the broader economy.
