Cecil Bohanon and John Horowitz: Fed faces tough decision as inflation hovers higher than desired

The recent inflation data is mildly encouraging. The year-on-year inflation rate was 2.4% in May, essentially unchanged from April (2.3%) and March (2.4%) but well below the 3.0% and 2.8% from the January and February reports, respectively. The trend is down, which is reassuring.

The Federal Reserve Bank of St. Louis calculates the five-year expected inflation rate by comparing yields on five-year Treasury constant maturity securities with those on five-year Treasury inflation-protected securities. Since early May, this measure has stayed within a narrow range of 2.3% to 2.44%. After the most recent Consumer Price Index report, it dipped to 2.28%, suggesting that investors believe inflation will continue to ease.

So, should the Federal Reserve start cutting interest rates? It’s a tough decision. We agree with our Texas Tech colleague Professor Alex Salter: “I would not want to be a central banker right now.”

The Federal Reserve lowers interest rates by reducing the federal funds rate—the rate at which banks lend to one another overnight. The Federal Reserve has maintained the federal funds rate in a range of 4.25% to 4.5% since December 2024.

In our opinion, the most important policy goal for the Federal Reserve should be to ensure a long-term inflation rate of 2%. The Fed has made this a public target, and failure to deliver on this promise would inflict enormous long-term damage on the U.S. and world economies.

Just as doctors advise a patient to continue a course of antibiotics even if she is feeling well, a consistent level of expected inflation of around 2% is essential to economic health. We are not quite there yet, so the Fed needs to finish the course, especially as tariff policy is likely to boost inflation at some point.

On the other hand, real interest rates—the nominal rate (4.25% to 4.5%) minus expected inflation (2.3%)—are relatively high (1.95% to 2.2%) and could trigger an economic downturn. Economists estimate that the “natural” real interest rate—the rate that balances savings and investment without increasing inflation or causing an economic downturn—falls between 0.78% and 1.76%. If the current real rate is above that range, the risk of an economic slowdown increases. If the current real rate is below that range, the risk of inflation increases. So the Fed has to pick its poison. Lower rates and risk increasing inflation. Keep rates steady and risk an economic slowdown and a rising unemployment rate.

There’s little margin for error and no easy choice.•

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Bohanon and Horowitz are professors of economics at Ball State University. Send comments to [email protected].