Fed faces consumer trust crisis as inflation stays above 3%

Consumer confidence in the Fed's ability to control inflation is eroding as prices remain stubbornly above target.

The Federal Reserve faces a growing credibility gap with American consumers who blame the central bank and political leadership for inflation that has exceeded its 2% target for more than five years, according to new survey data.

"Consumers have been stressed for the last year and a half despite what economic data suggests," said Tsvetta Kaleynska, whose firm's data points to the Fed and current political setup as what consumers blame for inflation.

The distrust comes as the Fed convenes Tuesday and Wednesday for its July policy meeting, widely expected to hold the federal funds rate at 5.25% to 5.5%, where it has sat since July 2023 after 11 consecutive hikes. Core inflation has been stuck at around 3% or higher since 2023, and the resumption of the Iran war has pushed oil briefly past $100 a barrel and gasoline above a nationwide average of $4 a gallon. Only 29% of Wall Street traders predict a rate hike this week, though 76% foresee one in September, according to the CME FedWatch tool — up from 59% a month ago.

The disconnect between consumer sentiment and official data poses a challenge for Chair Kevin Warsh, who told Congress this month the Fed has "no tolerance" for elevated inflation. If households expect prices to keep rising, they may adjust behavior in ways that make inflation self-fulfilling — forcing the Fed to choose between a politically difficult rate hike or watching its credibility erode further.

The Credibility Gap Widens

The last time consumer inflation expectations diverged this sharply from official projections was in mid-2022, when the Fed was in the early stages of its tightening cycle and the S&P 500 fell 18% over six months. Today, the 10-year Treasury yield has already climbed to 4.7%, reflecting higher term premiums as bond investors price in the risk that the Fed will need to act. The yield on the 2-year note, more sensitive to rate expectations, has risen 15 basis points this month alone.

Fed officials have grown increasingly vocal about the need for action. "Sternly staring at inflation until it melts before our withering gaze is not an option," Christopher Waller, an influential member of the Fed's governing board, said in a July 13 speech. If core inflation keeps climbing, the rate-setting committee "will need to consider" hiking rates "in the near term," he said. Lorie Logan, president of the Federal Reserve Bank of Dallas, said "modestly higher interest rates would better balance the outlook."

What the Fed Can and Cannot Fix

The central bank's challenge is that the primary drivers of the current inflation — the Iran war's impact on energy supplies and tariffs imposed on foreign goods — are largely outside its control. Higher interest rates can slow demand and cool price pressures, but they cannot restore oil flows through the Strait of Hormuz, through which a fifth of the world's oil and natural gas pass, or unwind tariffs already in place.

"The Fed is looking at inflation well above goal, but mostly for reasons that it doesn't have any influence on," Vincent Reinhart, chief economist at Dreyfus-Mellon and a former top Fed economist, said.

Warsh has suggested the Fed's job is to prevent specific price increases from "broadening out" to other parts of the economy — a task that may require rate hikes if consumer inflation expectations become unanchored. The next opportunity to act comes Sept. 15-16, when the Fed's rate-setting committee meets again. If oil prices remain elevated and consumer sentiment continues to sour, the pressure on Warsh to move from tough talk to action will only intensify.

This article is for informational purposes only and does not constitute investment advice.