Why the Fed’s Interest Cut Won’t Matter in the Election

Post-pandemic voters: Heightened loss aversion and higher reference prices cloud perceptions of price stability

The previous charts (Chart 1 and Chart 2) suggest that the rising price levels are linked to a more negative economic outlook among American citizens, while improvements in inflation do not positively affect this perception.

In this post, I address two questions: (i) why, despite the Fed’s success in taming inflation and keeping the economy at full employment, the economic confidence outlook (according to Gallup) is quite grim; and (ii) why the rate cut might not be having an appreciable effect in turning this around (i.e. increasing Americans' positive outlook for the economy) in time to influence the outcome of the election.

Background

In the latest press conference, Fed Chair, Jerome Powell, was directly questioned on whether the 50bps rate cut might be perceived as politically motivated. Below is a relevant exchange from the transcript:

EDWARD LAWRENCE (Fox Business):

And one more, how do you respond to the criticism that will likely come that a deeper rate cut now, before the election, has some political motivations?

CHAIR POWELL:

Yeah, so, you know, this is my fourth presidential election at the Fed, and, you know, it’s always the same. We’re always — we’re always going into this meeting, in particular, and asking, what’s the right thing to do for the people we serve? And we do that, and we make a decision as a group, and then we announce it. And it’s — that’s always what it is. It’s never about anything else. Nothing else is discussed, and I would also point out that the things that we do really affect economic conditions for the most part with a lag. So, nonetheless, this is what we do. Our job is to support the economy on behalf of the American people. And, if we get it right, this will benefit the American people significantly. So this really concentrates the mind, and, you know, it’s something we all take very, very seriously. We don’t put up any other filters. I think if you start doing that, I don’t know where you stop. And so we just don’t do that.

With that in mind, it seems pretty obvious to me that the decision-making process at the Federal Reserve has always been based on thorough economic analysis and is not conditioned on any political considerations. However, the question of whether a rate cut can truly influence consumer (and voter) sentiment remains interesting and it is worth examining whether the rate cut could make consumers (and voters) happier about the economy. As I will discuss later, this question stimulates some reflections on the Fed’s mandate and its public perception with possible ramifications in economic policy.

To provide additional context, here’s another exchange from the press conference that stimulated my thinking on these issues:

ELIZABETH SCHULZE (ABC News):

What’s your message to households who are frustrated that home prices have still stayed so high as rates have been high?  What do you say to those households?

CHAIR POWELL:

Well, what I can say to the public is that we had the highest — we had a burst of inflation.  Many other countries around the world had a similar burst of inflation, and, when that happens, part of the answer is that we raise interest rates in order to cool the economy off in order to reduce inflationary pressures.  It’s not something that people experience as pleasant, but, at the end, what you get is low inflation restored, price stability restored.  And a good definition of price stability is that people in their daily decisions, they’re not thinking about inflation anymore.  That’s where everyone wants to be, is back to what’s inflation, you know?  Just keep it low, keep it stable.  We’re restoring that.  So what we’re going through now really restores — it will benefit people over a long period of time.  Price stability benefits everybody over a long period of time, just by virtue of the fact that they don’t have to deal with inflation.  So that’s what’s been going on, and I think we’ve made real progress.  I completely — we don’t tell people how to think about the economy, of course.  And, of course, people are [still] experiencing high prices, as opposed to high inflation.  And we understand that’s painful.

There are a lot of interesting elements in Chairman Powell’s response. In my opinion, the most significant ones are the following:

·       And a good definition of price stability is that people in their daily decisions, they’re not thinking about inflation anymore.

·       […] people are [still] experiencing high prices, as opposed to high inflation.  And we understand that’s painful

I would summarize these two points by stating that when inflation is under control and price increases are minimal, consumers tend not to notice the rising costs. On the other hand, a surge in inflation that is eventually brought under control can still be “painful”(as stated by Chairman Powell) if it is accompanied by a significant increase in price levels.

The Fed’s Success

After the post-pandemic recovery and the subsequent surge in inflation, triggered by a combination of supply chain disruptions and outbursts of previously pent-up demand immediately after the reopening of the economy, a series of aggressive rate hikes have successfully brought inflation down to levels close to the Federal Reserve’s target (Chart 3).

Remarkably, this price stability has been achieved with unemployment being at historically low levels (Chart 4), which are typically associated with an economy at full employment.

By taming inflation and keeping unemployment at historically low levels, the Federal Reserve is indeed fulfilling its dual mandate.

From a formal point of view and building on the logic of the New Keynesian approach, the Fed has steered the economy towards the best possible outcome. In the New Keynesian model, the best possible outcome is achieved when the economy is at its full employment level and inflation reaches its target.

There are a lot of simplifying assumptions in any model - an economic model is, per definition, a simplified description of reality -, and the New Keynesian approach to the monetary stabilization problem is no exception. Here, I will argue that building on Powell’s response above, it might be appropriate to rethink what factors matter to consumers. This might be different from what is captured by the dual mandate and the traditional New Keynesian framework.

A Prospect Theory Perspective on Inflation

As shown in Chart 1, despite the Fed’s success in steering the economy, many consumers still feel dissatisfied, and public sentiment remains low regarding the economy.  I will explore two behavioral economics concepts that are very much related to Powell’s aforementioned reply. More specifically, I will discuss the concepts of “loss aversion” and “reference price” to explain why inflation control hasn’t translated into public appreciation, particularly as election season draws near.

In Chart 5, I plot (at a monthly frequency) the level of consumer prices along with CPI inflation on a year-on-year basis (changes in the level of prices from one year to the previous one). I normalized the price level to 100 starting in January 2020. As we can see, while CPI inflation has moderated from the peak of around 9.00%, the underlying price level is more than 23% higher than in January 2020.

Chart 6 shows the same exercise for the period going from January 2016 to January 2020 with the only difference that I normalize the price level to 100 at the beginning of January 2016. During this period CPI inflation has been relatively stable, never exceeding 3% year-on-year, and the price level has smoothly increased by 8% over this time horizon.

By the last quarters of 2023 and 2024, inflation has moderated, and the price level increase has tapered out but, of course, now the price level crawls smoothly at a relatively high level compared to the pre-Covid period.

This is what is “painful” (to quote Chairman Powell).

But why?

Let me now refer to two key concepts from behavioral economics. The first one is loss aversion (Loss Aversion in Riskless Choices by D. Kahneman and A. Tversky): under loss aversion, people feel losses more intensely than equivalent gains. In the context of price levels, people are more sensitive to price increases than they are to price decreases of the same size.

Let me provide a simple example:

Imagine you're a regular customer at a local coffee bar, and you always buy the same cup of coffee for $3. I consider two scenarios.

1.     Price Increase (Loss Scenario):

One day, the coffee bar raises the price to $4. Due to loss aversion, you experience the price increase as a loss of $1. This loss feels more significant to you than the equivalent gain if the price were to decrease by $1. This increase might generate a behavior change: for example, you might consume less coffee or change your coffee bar.

2.     Price Decrease (Gain Scenario):

Now, imagine the coffee shop instead lowering the price from $3 to $2. Even though this is a $1 gain, the positive feeling from the lower price isn't as strong as the negative reaction you would have had to a $1 increase. The gain feels good, but not enough to create a strong change in behavior: you do not increase your consumption as much as you would have reduced it had the price gone up.

In the context of inflation, when prices rose during the inflationary surge, consumers perceived this as a loss in purchasing power. Even if prices have stabilized (so there is no inflation), consumers are still behaviorally anchored to the higher prices they experienced during the peak of inflation.

Consumers are less sensitive to the fact that inflation has stopped rising as they are to the fact that prices have remained higher than before. This asymmetric perception makes the stabilization of prices feels like an incomplete win, especially in the wake of the taming of the inflation surge.

The time that has elapsed since prices have stabilized does indeed matter.

The second concept that matters is the reference price (see Thaler): the price that consumers expect to pay based on past experiences. Before inflation surged, consumers had lower reference prices for goods like groceries, gas, and rent. After inflation spiked, these reference prices increased, and even though inflation is now controlled, prices remain elevated.

However, since a relatively short time has passed since prices stabilized, consumers are still comparing current prices to their pre-inflation benchmarks, feeling that they’re paying more, even if prices are stable.

Let’s review this concept within the coffee cup example:

The reference price is what you usually have paid for the coffee, $3. Now, due to inflation, the price of a cup of coffee has permanently increased from $3 to $4. This feels expensive since you pay more than your reference price. But as inflation is tamed, there are no longer changes in the price of a cup of coffee. To the extent to which you recall the lower price before inflation, this comparison to the status quo creates dissatisfaction, at least until $4 eventually becomes your new reference price.

Let’s go back now to the Federal Reserve and inflation.

Within this framework, despite the Fed indeed having succeeded in bringing down inflation, prices have not returned to pre-inflation levels. This gives consumers the impression that the benefits of lower inflation are not being felt. In other words, while from an economic standpoint inflation control is a major success, the psychological impact of price increases remains. Consumers may feel that their standard of living has been permanently reduced, even though inflation itself has slowed and even if wages have potentially increased to restore purchasing power.

As the election approaches, voters are less likely to appreciate the Fed’s technical success in curbing inflation and more likely to focus on their personal experience of higher costs. This is what might be driving part of the economic dissatisfaction recorded by Gallup, even though unemployment is lower and inflation is no longer accelerating. In this sense, the recent rate cut by the Federal Reserve hardly affects the dissatisfaction associated with the increase in price level.

Implications for the Fed’s dual mandate

It has been argued (see for example English, Forbes, and Ubide (CEPR, 2024). Monetary policy responses to the post-pandemic inflation) that the post-pandemic environment can be inflation-prone. The economy might be subject to geopolitical, structural, and climate challenges that could lead to more volatility in inflation. From a societal point of view, success in taming inflation might not be sufficient as sudden permanent increases in price level can lead to perceived losses.

I conclude with a few open questions. How should we design policy in such an inflation-prone context? Is it still sufficient to worry only about inflation (consumer price variations) or should we also care about price level increases? Should monetary policy coordinate with fiscal policy in the wake of exogenous price level shocks?

Conclusions

To conclude, does the recent Fed cut matter for the upcoming U.S. election? No, as I suggest that economic dissatisfaction might depend on high price levels as opposed to stable inflation. Another relevant dimension along which a rate cut affects consumers’ perception of the economy is by reducing the cost of borrowing (for example variable rates on loans, mortgages, and credit card payments). This is a direct channel that is important: a recent Wall Street Journal article by Nick Timiraos discussed some aspects of it but given the steep increase in interest rates in the past 2 years similar behavioral considerations might apply as well when it comes to higher interest rates relative to the past.