The Fed must lower rates and upgrade flawed data to stay effective

Jerome Powell, chairman of the Federal Reserve Board, announced last week that the board has decided to keep the discount rate unchanged, despite cooling inflation data from the Bureau of Labor Statistics that morning. 

This was a grave mistake that will perpetuate the depression in the housing sector. It will prevent many Americans from buying a home because of high mortgage rates, while also dissuading industry from making capital investments, keeping interest payments on the national debt high and dampening economic growth. 

Furthermore, the longer the Fed waits, the faster and longer Powell will have to ease rates by this fall, which coincides with the presidential election that could make the Fed an unintentional pivotal political factor. To obviate this argument, the Fed should start cutting rates in its upcoming July meeting. 

There are multiple reasons for the Fed’s stubborn stance against raising rates, including the incomplete and misleading data composition the board uses to set rates, the board’s narrow disciplinary background and a disregard for geopolitical factors — all motivating critics to call for its abolition.

The Fed’s rate-setting relies on the Consumer Price Index, calculated by the Bureau of Labor Statistics based on price changes of 80,000 products and services reflecting different categories and weights.

However, the makeup and weight of such data do not measure inflation accurately. A glaring example is the index’s equivalent rental cost component, which accounts for one-third percent of the CPI. Rental cost inflation is calculated by asking homeowners how much they think they would have to pay if they were to rent their own homes for themselves and comparing the results with past months. 

This method assumes that homeowners know their neighborhood rental market, that there are homes like theirs in the vicinity and the rental prices of those homes. It also assumes they are willing to disclose that information truthfully and that those responding represent the whole sample, including those who declined to respond. All these are unrealistic assumptions.

Imagine this: One-third of the CPI that drives interest rates in the entire U.S. economy and much of the world is based on opinion, not fact. This makes U.S. monetary policy flawed, including its harmful effects on consumer mortgage rates, credit card rates and many other borrowing costs.

As a teaching exercise, Fed board members ought to estimate how much they will have to pay if they were to rent their own homes to fully comprehend how ludicrous this measure of one-third of the CPI is.

Had this rent equivalent not been included in the June CPI, the inflation figure would have been close to the board’s 2 percent annual inflation rate target, and that would have already justified a rate reduction.

This point is further supported by the Producer Price Index, which does not include the rent equivalent, published on June 13. The index declined by 0.2 percent in May, amounting to an annual decline of 2.4 percent. Since such a PPI decline foreshadows a future decline in the CPI, it suggests the CPI may already be below the board’s annual target of 2 percent. 

Members of the Fed consider mostly economic data in making rate decisions: the CPI, the Personal Consumption Expenditures Price Index and unemployment, as well as anecdotal Beige Book information. But prices are often affected by other variables, including international conflicts, consumer expectations and anxiety, tariff battles and more. 

The exclusion of such factors makes rate decisions inaccurate and possibly misleading, as may be the case presently.

Events such as the Ukraine and Gaza wars have also increased U.S. and global inflation. 

For example, the Ukraine war has contributed 2 percent and 1 percent to inflation in 2022 and 2023, respectively, due to higher energy and agricultural commodity prices and disruption in global supply chains, making consumers and manufactures anxious and uncertain about the future. Without these wars, the Fed’s 2 percent inflation target would have already been met and growth-spurring rate reduction would have started. 

Moreover, although the Fed is an independent body whose mandate is to maintain low inflation and unemployment in the U.S. by lowering or increasing the discount rate, in practice, the Fed significantly affects the monetary policies of many countries around the globe. In a way, the U.S. Federal Reserve Board shapes global monetary policy, so the Fed should consider the effects of its rate-setting on other economies. 

For example, decreasing the discount rate by 0.25 percent would likely be followed by similar measures internationally and induce an economic growth cycle in countries such as France and Germany. Tired of waiting for the Fed to lower rates, the European Central Bank recently cut rates by 0.25 percent.

Most Fed board members have a background in economics and finance. While important, this narrow range of expertise leads to group thinking that can result in erroneous decisions. 

One example I have noted in the past is that all of the Fed Board of Governors voted the same over 18 years in 144 rate decisions. This is not a fair way to set interest rates that affect all Americans. The Fed should widen the disciplinary scope of its members to include, for example, specialists in consumer psychology, sociology and geopolitics. 

To be fair, the Fed seems aware it needs to participate in such events and activities. It has instituted programs such as Fed Listens and a community advisory council, put out an increasing number of news releases and speeches and has participated in many conferences. However, such initiatives are poor substitutes for fundamental reform. 

Without change, calls to abolish the Federal Reserve Board will likely get louder. 

In May, Rep. Thomas Massie (R-Ky.) introduced the Federal Reserve Board Abolition Act — co-sponsored by 21 Republican representatives — because “Americans are suffering crippling inflation, and the Federal Reserve is to blame.” Other representatives have voiced similar opinions in the past.

But the Fed needs to be reformed, not abolished, because an independent institution responsible for making monetary policy helps to assure non-political decision-making.

The Federal Reserve Board has a choice: Embrace change to better serve the country and the world, or cling to its ways and further motivate calls for its abolition.

The Fed should choose reform that includes replacing the cost of rent equivalent, changing the composition and type of data it considers, widening the disciplinary makeup of the board and including geopolitical factors in making monetary policy. This will make monetary policy-making more effective and thwart critics seeking to eliminate it. 

As a first step, however, the Fed must start lowering rates now.

Avraham Shama has published several books and articles about economics, politics and international affairs.