Viewpoints: July 2025

Federal Reserve monetary policy has enormous effects on the behavior of the business cycle. These business-cycle effects, in turn, affect the political environment. For example, the surge in consumer price inflation in 2021-22 appeared to be an important factor in the 2024 presidential election. In previous commentaries, I have argued that Fed monetary policy in 2020-21 exacerbated the inflationary environment in 2021-23. In my July 8, 2025 commentary “Fed Operating Behavior – Don’t Let the Perfect Be the Enemy of the Good”, I argued that the Fed should act so as to have the sum of the monetary base plus loans and securities on the books of depository institutions (thin-air credit) grow at a constant annual rate of 5 percent. Would the business cycle be eliminated under these circumstances? No. Would the amplitude of business cycles be damped? Yes. Could the Fed legitimately be criticized for political bias if it maintained thin-air credit growth at 5% per annum, regardless of what political party held the presidency? No. Would the Fed lose its mystique? Yes.

Let’s take a trip down memory lane to see how Fed monetary policy has exacerbated the business cycle. The Fed opened its doors for business in 1914, the same year that World War I started. Although the US did not enter WWI until April 1917, we were supplying war materiel and foodstuffs to the Allies prior to our entry. Plotted in Chart 1 are the year-over-year percent changes in the annual average M2 money supply (annual data for thin-air credit did not become available until 1946) and the annual average CPI. Growth in the M2 money supply accelerated to 8.5% in 1915 from 3.4% in 1914. In the six years ended 1920, M2 grew at a compound annual rate of 11.9%. And you know what else grew rapidly in these six years? The CPI. In the six years ended 1920, the CPI grew at a compound annual rate of 12.2%. So, right out of the box, the Fed was aiding and abetting consumer price inflation.

How significant is a 15% tariff on imported consumer goods? It's substantial enough to cause an increase in consumer inflation, yet not substantial enough to encourage a shift in production to the US. While investors might express "good cheer" over tariffs averaging 15% instead of a much higher rate, the end result will be higher inflation rather than an expanded U.S. manufacturing sector, which was the primary aim of Trump's tariff policy.

The Trump administration recently reached several trade agreements with major trading partners, implementing a 15% tariff on a broad array of imported goods, many of which are consumer items.

Is that significant? According to consumer price index data, prices for consumer goods, excluding food and energy, were unchanged from 2000 to 2020. However, they rose by nearly 15% in 2021 and 2022 due to product shortages and supply disruptions stemming from the pandemic. Consequently, a potential 15% price hike on non-energy and food consumer goods is notably large, as it matches the total price increase over the past 25 years. There is no doubt that consumer prices for these goods will increase over time as these tariffs are factored into the pricing structure.

However, is the 15% tariff hike on consumer goods significant enough to compel companies to relocate production to the US? While it might attract some new investment, the cost difference between manufacturing in the US and other countries vastly exceeds 15%. Additionally, the expenses associated with new investments, as well as the time required to secure locations, acquire permits, and finish construction, are considerable. By the time these processes are completed, many of these tariffs might be eliminated under a new administration.

Assessing the results of Trump's tariff policy will take months and years, but it is very probable will lead to increased consumer inflation and minimal changes in global manufacturing.

The Federal Reserve Bank of Philadelphia’s state coincident indexes in June were again generally lackluster. In the one-month changes, no state had an increase as large as .5 percent (Illinois was up .49 percent). Six states saw declines. These were spread across the nation, with Massachusetts down .52 percent. Over the three months ending in June nine states were down, with Massachusetts on the bottom (down .84 percent) here as well. Indiana’s 1.48 percent was the largest gain, while only three other states had increases above 1 percent. Over the last twelve months, Massachusetts and Iowa were down, and five others saw increases of less than one percent. South Carolina was the only state with an increase higher than four percent (Idaho was up 3.62 percent), and six others were at or higher than three percent.

The independently estimated national estimates of growth over the last three and twelve months were, respectively, .74 and 2.56 percent. Both measures appear to be roughly in line with what the state numbers would have suggested.

Federal Reserve Governor Christopher J. Waller's speech, "The Case For Cutting Now," delivered at the Money Marketeers of New York University, was intriguing from both political and policy perspectives. His economic rationale for a formal rate reduction at the July 29-30 FOMC meeting was, at best, puzzling, and the timing appeared politically motivated. With the Fed's independence facing substantial pressure, it is crucial for those making monetary policy decisions to remain apolitical.

It is exceedingly uncommon for a Fed Governor to dissent at an FOMC meeting, as demonstrated by the fact that there have only been a few dissents by Fed Governors in the past decade or more. It is even rarer for the rationale behind a dissenting vote to be expressed and made public before the FOMC meeting.

Considering the political pressure aimed at Fed Chair Powell in recent days and weeks, it is worth considering if there was a political agenda influencing the timing and content of Mr. Waller's speech, particularly because he was named by the current administration as a candidate for the Fed Chair role. (On CNBC last week, Mr Waller stated, "If the President asked me to do the Fed chair job, I would say yes.")

Mr. Waller's rationale for a rate cut at this time is questionable, even when political factors are set aside. For instance, Mr. Waller asserts, "tariffs are one-off increases in the price level and do not cause inflation beyond a temporary spike." Yet, he offers no evidence to support this claim.

Mr. Waller's assertion regarding tariffs being a one-time impact on inflation might hold some truth if the tariffs implemented by the Trump administration were consistent, even, and applied simultaneously. However, the tariff policy is erratic and uneven, with some of the largest increases affecting essential materials like steel, aluminum, and copper, which will continually elevate production costs and price pressures in the US.

However, Mr. Waller states that even if tariffs have a greater effect on inflation, it will not alter or affect his perspective on the implications for monetary policy. Why? Mr. Waller contends that, despite recent increases in individual price expectation surveys, there is no evidence of an "unanchoring of inflation expectations." He considers surveys of people's inflation expectations, which have shown a significant jump in recent months, two or three times above the Fed's 2% inflation target, to be "unreliable." Rather, he relies more on those who predict inflation expectations in the financial markets. In other words, he trusts individuals who wager on future inflation rather than those who deal with it daily.

Mr. Waller cites labor market trends as a reason to lower rates now, stating that "private sector job gains are near stall speed and flashing red." However, he overlooks that the Fed's labor market mandate focuses on the unemployment rate, not private sector jobs, which, at 4.1%, is below the Fed's long-term target. He mentioned that a significant slowdown in "net immigration" might be contributing to the sluggish growth in private sector jobs, but acknowledged that understanding its impact on employment will take time.

Additionally, Mr. Waller does not address how "uncertainty" over tariff policy is affecting hiring decisions, despite it being a common theme in the Fed's July Beige Book report.

Nevertheless, Mr. Waller is willing to wait and see how immigration affects the labor markets, but is not prepared to wait to evaluate the impact of Trump's tariff policy on current and future inflation.

Mr. Waller has only one vote at the FOMC, but his vote could be very "LOUD" because the Administration is likely to use it as an additional tool to influence Fed policy. Federal Reserve independence can only be preserved if those responsible for implementing monetary policy decisions avoid political involvement.

In Samuel Becket’s renowned play, Vladimir and Estragon wait for Godot, who never arrives. It’s like waiting for the inflation impact of recent tariff increases…or is it?

On April 2, “liberation day,” the Trump Administration announced a baseline 10% tariff on most imported goods and additional “reciprocal” tariffs, quickly delayed until August, on select countries. This was on top pf other new tariffs on vehicles, parts, steel, aluminum, and other select commodities. I estimate that by June these initiatives increased the import-weighted average of tariff rates on goods - call it the “statutory” tariff rate - by 17.5 percentage points, to 20%. At May’s volume of imports, that implies an increase in the “run rate” of customs duties of nearly $600 billion at an annual rate, a staggering rise. If passed fully forward, it would lift the aggregate price level by roughly 1.7%. Yet so far, despite economists’ warnings, any impact on inflation has been difficult to discern. Why?

One reason is that imports temporarily surged early this year as importers rushed to beat the anticipated increase in tariffs (Chart 1). Until the resulting excess stocks are worked down, merchants can postpone selling goods subject to the new tariffs, delaying price pressures arising from the recent increases. But is there even more to it than that?

State labor markets were very little-changed to soft in June. Alaska reported a statistically significant increase in jobs (3,100, or .9 percent) while there was no statistically significant change anywhere else. However, many states reported declines, and the sum of job changes among the states was only 3,100, compared to the national increase of 147,000. No state reported a statistically significant change in jobs. The unemployment rate fell a significant .2 percentage points in Illinois, and one percentage point in Maine, while increasing .1 percentage point in Virginia. The highest unemployment rates were in DC (5.9%), Nevada (5.4%), California (5.4%), and Michigan (5.3%),and Kentucky (5.0%), though Kentucky’s rate is not deemed statistically different than the national average of 4.2%. Hawaii, Montana, North Dakota, South Dakota, and Vermont had unemployment rates under 3.0%, while South Dakota’s 1.8% was yet again the lowest in the nation.

Puerto Rico’s unemployment rate was unchanged at 5.5% and the island’s job count edged down by 800.

The Federal Reserve currently is involved in one of its periodic navel-gazing exercises to try to improve its monetary-policy procedures. Most likely this introspection will involve issues such as identifying the level of the “neutral” federal funds interest rate, the lags between a change in the federal funds rate and the cumulative effect on the inflation rate and the unemployment rate, how to move the federal funds rate in periods of heightened uncertainty and how to more effectively communicate with the public on monetary-policy issues. But, it is doubtful that the Fed will contemplate abandoning the federal funds rate as its primary policy tool. In what follows, I am going to propose that a lot of the Fed’s monetary-policy conundrums could be solved by targeting a monetary quantity, rather than an interest rate. The monetary quantity I would propose the Fed target and hit is the sum of the monetary base (which is the sum of cash reserves of depository institutions plus currency in circulation) plus the loans and securities held by depository institutions (commercial banks, savings and loans and credit unions). I have called this monetary quantity thin-air credit because it is credit that is created, figuratively, out of thin-air. In what follows, I will present a theoretical argument for proposing thin-air credit as the Fed’s operating tool as well as empirical evidence for supporting thin-air credit. I will argue that targeting and hitting a steady rate of growth in thin-air credit in periods of exogenous shocks to the economy, such as pandemics, tariffs, etc., will prevent the Fed from making policy moves that will exacerbate the effects of these exogenous shocks on the economy. The proposal that the Fed target a monetary quantity rather than an interest rate was popularized by Professor Milton Friedman. The only difference between my proposal and Friedman’s is that the monetary quantity I prefer is thin-air credit rather than some money supply definition.

What does it mean that the sum of the monetary base and the loans and securities of depository institutions are created “out of thin air”? When the Fed purchases securities in the open market, from where do the funds come that the sellers of these securities to the Fed receive? They come from bookkeeping entries on the Fed’s balance sheet. On the asset side of the Fed’s balance sheet, “securities held” increase by the amount of securities purchased by the Fed in the open market. On the liabilities side of the Fed’s balance sheet, “deposits of depository institutions” increase by the same amount. These deposits of depository institutions are also referred to as reserves held by depository institutions at the Fed. These reserves were created by nothing other than Fed balance-sheet entries. On the balance sheet of the depository-institution system, the asset item “reserves held at the Fed” increase by the amount of the securities purchased by the Fed and the liabilities item “deposits” increase by the same amount. Again, nothing but bookkeeping entries. The sellers of the securities to the Fed now have deposits that they can use to purchase goods, services and/or assets. Moreover, the depository-institution system has additional funds that can be used to make additional loans and/or purchase additional securities. The recipients of these additional loans issued by depository institutions are able to purchase goods, services and/or assets. Because depository institutions desire to hold only a proportion of their assets as reserves, the depository-institution system is able to increase its holdings of loans and securities by some multiple in excess of the reserves created by the Fed. This enables the recipients of funds from increased depository institutions loans and securities to purchase goods, services and/or assets without any other entity needing to reduce its current purchases of goods, services and/or assets. It is as though the Federal Reserve and the depository-institution system are legal counterfeiters. They can create additional credit, not with a literal printing press, but by bookkeeping entries. The Fed and the depository-institution system are able to create credit, figuratively, out of thin air.

Now, let’s rewind the tape. Instead of the Fed purchasing securities in the open market, assume that the purchaser of securities was some entity other than the Fed or the depository institution system. From where did this entity get the funds to purchase the securities? This entity might reduce its current spending on goods, services and/or assets by the amount of its purchase of these securities. This is often referred to as an increase in saving. In this case, the seller of securities can purchase goods, services and/or assets. But the buyer of these securities is reducing its purchases of goods, services and/or other assets. In this case, the purchaser of securities is transferring purchasing power to the seller of securities. Under these circumstances no net increase in the purchases of goods, services and/or assets occurs. In contrast, the sale of securities to the Fed set in motion a series of bookkeeping entries that did result in a net increase in the purchases of goods, services and/or assets. To a borrower, it makes no difference whether the lender is the Fed or a depository institution. But to the borrowers’ effect on the aggregate economy, it makes all the difference in the world whether or not the lender was the Fed and/or the depository institution system.

The Fed’s so-called dual mandate is to promote low unemployment and low inflation. Real GDP growth is related to the unemployment rate. All else the same, if real economic growth is close to its potential, which is a function of available productive resources and the productivity of those resources, a low unemployment rate would likely result. In the past 70 years, the compound rate of growth in real GDP has been 3.03%. In the past 70 years, the compound rate of growth in the Congressional Budget Office’s estimate of real potential GDP has been 2.99%. So, let’s say that growth in real GDP of 3% would come close to generating an acceptably low unemployment rate. For reasons unknown to me, the conventional wisdom is that the consumer inflation rate ought to be around 2% annualized. In the past 70 years, the compound annualized rate of growth in both the GDP and Personal Consumption chain prices indices has been 3.2% on a rounded basis. What I am suggesting is that if the Fed could conduct policy such that the growth rate in nominal GDP were around 5% (3% real and 2% GDP price inflation), the Fed would come close to meeting its dual mandate of low unemployment and low inflation.

If only there were some monetary quantity whose behavior would be relatively highly correlated with the behavior of nominal GDP. Oh wait, there is. It is the sum of the monetary base plus depository institutions’ holdings of loans and securities, i.e., thin-air credit. Plotted in Chart 1 are the year-over-year percent changes in annual averages of nominal thin-air credit (blue bars) and nominal GDP (red line) starting in 1955 and ending in 2019. That “r = 0.65” in the upper left-hand corner of the chart is the correlation coefficient between the two series. If the two series were perfectly correlated, the absolute value of the correlation coefficient would be 1.0. Because there is an implicit “+” sign in front of the 0.65 correlation coefficient, it means that when thin-air credit growth increases, nominal GDP growth also increases and vice versa. An absolute value of 0.65 for a correlation coefficient is not bad for government work. Why did I truncate the series to 2019 rather than 2024? Because the correlation coefficient is higher for the truncated period. How’s that for honesty? My deceased friend and former colleague, Robert “Bob” Laurent, remarked that I was the most honest economist he had ever encountered. NOT the BEST, but the most honest. The correlation coefficient drops to 0.45 when the years 2020 through 2024 are included. This is because of the record growth and near-record growth in nominal thin-air credit in 2020 and 2021 and the unusual contraction in nominal GDP in 2020. All of this was due to the once-in-a-century (I hope) pandemic and the Fed’s errant response to it.

There's an interesting article in today's July 7 South China Morning Post that has far-reaching implications for China’s efforts to stimulate its economy and its imperative to strike a trade deal with the U.S.: "China urged to take bolder steps to tackle price wars, deflation and weak demand". The article reports that China's Central Financial and Economic Affairs Commission, the Communist Party's highest economic policymaking body, has identified "disorderly low-price competition" as a substantial negative, and argued for the need to end the cycle of mild deflation and weak demand.

This officially acknowledges that China's domestic economy remains quite weak, well below where China's leaders’ desire. The article also implies and describes how Chinese leaders rely on central command efforts to manage and guide the economy, rather than market forces. Their policies created the excesses in real estate and China’s economic slump, and are now inhibiting the recovery.

One important issue created by China's weak domestic demand is the admission by its leading policymakers that the trade war with the U.S. imposes a heavy negative weight on China. As the article states, the ongoing trade war with the U.S. "could further intensify China's "involutionary dynamics", an awkward term used to describe what its leaders perceive as intense and self-defeating domestic competition. While its leaders understand that the basics of market supply and demand work to affect economic outcomes, they rely on central control, directives and coercion to achieve desired economic and social objectives. This generates inefficiencies and undercuts the government’s credibility, as Chinese citizens understand the shortcomings of the policies. China is extraordinarily good at certain things—it is a true world leader in efficient manufacturing, with striking advances in high technology, including AI. But its Communist dictatorship that eschews free markets and U.S.-style capitalism undercuts China’s economic performance.

In 2021-2022, I argued that China's strong growth was unraveling, and its economy would weaken sufficiently to challenge its role as global leader of economic growth and trade (China Is About to Fall Into the Middle-Income Trap, October 26, 2022). In 2023, after China's real estate excesses had crumbled and major land developers had filed for bankruptcy, I argued that the Chinese economy would be in the doldrums for many years, similar to Japan's following its asset-price bubble in the late 1980s and the U.S. following its debt-financed housing bubble of the early-2000s (China’s Bill Comes Due, September 19, 2023). All of that is now unfolding, as western companies and nations reduce their supply chain exposures to China.

At least two implications seem clear. First, while China is a tough global negotiator, it clearly would benefit from a favorable trade agreement with the U.S. that would lower tariffs and trade barriers on their imported goods. Doing so would be a plus for China, the U.S. and global trade. Second, similar to Japan's and the U.S.'s historic experiences, China will have to stimulate its domestic economy through increases in deficit spending to lift consumption and businesses. As China stimulates, it will provide interesting investment opportunities in its stock market.

Mild deflation and domestic demand. China is experiencing mild deflation: its GDP deflator has been falling since the third quarter of 2023 and the year-over-year percentage change in its CPI has fallen for four consecutive months (Chart 1). This is a direct reflection of insufficient domestic demand relative to productive capacity. The Chinese leaders’ public allegation that the deflation is due to destructive price competition is misguided by ideology and misleading.

It’s hard to provide a clear numeric analysis because the China’s National Bureau of Statistics (NBS) provides statistical data that are not reliable, and occasionally stops providing the data public, or changes its definition, if the trend of the data is inconsistent with the objectives of the Communist Party. Its official data on GDP growth are far too strong to be realistic with its components and economic logic.

Three trends are clear: 1) China’s mild deflation is a direct result of insufficient domestic demand, 2) the weak demand stems from the earlier excesses in real estate that have unraveled and severely harmed household balance sheets and forced consumers to save rather than spend, and 3) residential real estate remains in the doldrums, with low expectations, despite government efforts to stimulate it.

Prior to and into the Covid pandemic, at the direction of China’s leading economic policymakers, different layers of China’s government pumped up real estate investment through a variety of equity and debt schemes in an ongoing effort to achieve unrealistically high GDP targets. This worked to stimulate robust economic growth and boost local government finances and create an upward spiral in activity, real estate development and prices and household net worth. But the strategy relied on expectations that home values would keep rising. In this regard, the role of home price expectations in China’s real estate boom were strikingly similar to those in the U.S. during its debt-finance housing bubble in the early 2000s, and Japan’s asset price bubble of the late-1980s. Chinese citizens came around to realize the excesses beginning in 2021, and once home price expectations started to erode, they collapsed.

The government scheme unraveled, and left a huge negative gap in China’s household net worth, the largest portion of which was in real estate (estimates ran as high as 75%, more than triple the U.S.’s current 22%). Mirroring Japan in the 1990s and the U.S. following the collapse of its housing bubble, China’s households raised their rate of saving and cut spending to replenish their balance sheets. Many Chinese businesses similarly suffered, including those in land development activities and others that had relied on loans collateralized by real estate. This followed the same pattern as Japan in the 1990s and the U.S. through and following the Great Financial Crisis.

Unlike Japan, which denied it had a problem through much of the 1990s and allowed zombie banks (those that were effectively insolvent) to continue making loans to keep inefficient companies afloat, China quickly acknowledged its problem, but underestimated its severity, and addressed its economic malaise too tentatively. In addition, it tried to directly manage household behavior to try to lift the morbid housing market. For example, some local governments forced select government employees to buy homes while constraining any declines in home prices. Such non-market strategies have had only limited success, harmed credibility and have inhibited rather than facilitated the necessary adjustments that would stabilize real estate and lead to recovery.

One tell-tale indication that the economic recovery is tentative is the ongoing negative expectations of home values. Current data show that residential real estate prices continue to fall (Chart 2) and no leading cities are experiencing an increase in home values while 100% are showing prices that are flat or declining (see Chart 3). Until expectations of home values turn up, households’ propensity to spend will be constrained.

The healthiest way to generate a positive sustained improvement in home values is to stimulate aggregate demand in the economy that boosts consumption and increases jobs that results in rising demand for housing that will absorb excess inventories. This requires a significant increase in deficit spending. Both Japan and the U.S. incurred large increases in government debt and sustained periods of zero interest rates to stabilizing their real estate sectors.

Chinese leaders already face high debt (in various government levels and artificial entities such as Local Government Financing Vehicles) and are reticent to take on more. (Another way to reduce China’s housing excesses would be to destroy a massive number of vacant apartment buildings, but that would harm government credibility and be anti-growth…remember President Obama’s “cash-for-clunkers” which offered financial incentives to people who had their motor vehicles destroyed in an effort to stimulate energy-efficient cars?)

President Trump’s misguided tariffs come at a particularly bad time for China. In 2018, when Trump first imposed high tariffs on China, its economy was strong and its leaders confident. Now, China’s domestic economy is weak. It relies heavily on exports for sustaining growth in its high wage manufacturing sector. It can only sell overseas so many EVs. While China’s exports to non-U.S. trading partners have picked up, its exports to the U.S. have fallen sharply since 2023. Importantly, China relies heavily on its high value-added exports of high-tech materials and components to the U.S., including computer chips and smart phones.

Trump has placed a deadline of July 9 for imposing higher tariffs, but at this writing is indicating that deadline may adjust to August 1. Trump likes negotiating deals and likes to be popular. As I have emphasized, this is a terrible approach to conducting economic policy. But China’s domestic dilemmas make it open to negotiating with the U.S. to lower tariffs and trade barriers. The result—backing off from Trump’s threats and lowering the U.S.’s average effective tariff—would be a positive and is expected within a month.