Chart 1

In case you’re wondering, in today’s primer I’m going to number the charts, because I’ll want to refer back to them a couple of times.

In 1979 Jimmy Carter appointed Paul Volcker as Fed chairman, and Volcker was determined to do whatever it took to get inflation down. The Fed had not yet adopted its modern practice of setting a specific target for the federal funds rate, the interest rate at which banks lend to each other. Nonetheless, Volcker’s tight-money policies sent the fed funds rate soaring — and sent the economy into a deep recession (officially two back-to-back recessions, but most economists think of them as a single episode), with unemployment peaking in double digits:

Chart 3. Source: FRED

Given this apparent tradeoff, and given the clear benefits of low unemployment, there was widespread discussion about whether it would be a good idea to “move up the Phillips curve” — to accept somewhat higher inflation in return for a lower unemployment rate. However, in 1967 and 1968 Edmund S. Phelps of Columbia University and Milton Friedman independently argued that such a strategy would fail.

Any sustained rise in inflation, they argued, would end up getting built into wage- and price-setting. So, for example, historical data might suggest that you could get unemployment down from 4 percent to 3 percent by accepting 3 percent inflation rather than 1 percent. But after a while, trying to keep unemployment at 3 percent would require accepting ever-higher inflation — say, 5 percent rather than 3, then once 5 percent got built into expectations, 7 percent and so on.

The Phelps-Friedman analysis predicted that an economy whose policymakers tried to move up the Phillips curve would instead find themselves going through “clockwise spirals.” That is, rather than getting a sustained fall in unemployment, they’d find themselves with high inflation and would have to go through a period of persistent inflation despite unusually high unemployment — stagflation — to get inflation back down.

And that’s exactly what happened over the next two decades, during which the economy went through several such spirals:

Chart 5 Source: FRED

What happened? The most popular explanation is that once inflation got low enough, expectations became “anchored,” with businesses and workers basically assuming that inflation would stay near 2 percent, and not revising that view even when inflation ran a bit hotter or colder for a while.

What does all this say about Fed policy? Low unemployment is good, and the Fed should try to achieve it. But trying to push unemployment too far down can lead to higher inflation, and runs the risk of unanchoring expectations and bringing back the stagflationary environment of the 1970s and early 1980s. So monetary policy often involves judgment calls, trading off the benefits of full employment against the risk of inflation.

Who makes that judgment? People. But people all too often engage in motivated reasoning.

Historically, nations have tried to limit the effects of motivated reasoning by putting technocrats rather than politicians in charge of central banks, and giving them considerable independence. That independence is what Trump is trying to destroy.

Even technocrats, however, make mistakes. So there’s a long history of efforts to remove the human factor entirely, to devise rules for monetary policy that don’t involve judgment calls. The Fed doesn’t follow any of these rules, but they do offer some useful guidance to the Trump-Fed dispute.

Monetary rules

Do people remember monetarism? In the 1960s and 1970s Milton Friedman aggressively pushed the idea that monetary policy could and should be put on autopilot. The Fed, he argued, should seek steady, slow growth of his preferred definition of the money supply, and if it did so the economy would take care of itself. The Fed briefly targeted the money supply rather than interest rates after 1979, which is why you see those wild interest rate fluctuations in Chart 2.

But monetarism failed. By saying this, I’m ensuring that I will receive a lot of hate mail; there are still many people who treat Friedman as an icon who must be revered, never questioned. But the fundamental premise of monetarism was that there was a stable relationship between the money supply and GDP, and that turned out not to be true.

Stanford’s John Taylor has had a more enduring influence. In 1993 he argued that the Fed should set interest rates using a formula involving only two considerations: the deviation of inflation from a target rate and how far the economy is from full employment. The inflation target, by the way, is 2 percent. How that became the magic number is a strange story — blame New Zealand! — but that would take us too far afield.

Since Taylor’s paper economists have proposed a number of variants on his original rule, but the principles are similar and the different rules generally give similar guidance.

The Fed has never formally adopted a Taylor rule. But much of the time its policy nonetheless looks as if it were following a Taylor rule. The main exceptions are when the economy faces huge disruptions, first the 2008 financial crisis and then Covid and its aftermath.

Why is this relevant? Because right now the most widely cited Taylor rules say that the current interest rate is … about right. The Atlanta Fed has a Taylor Rule Utility that calculates interest rate prescriptions for several popular versions of the Taylor rule and also lets you roll your own. Here’s what it looks like currently:

Chart 7

In case you’re wondering, this chart uses the Harmonized Index of Consumer Prices, a European measure also available for America, to make an apples-to-apples comparison. European inflation took off a bit later than U.S. inflation but also came down a bit later. But basically, inflation experience was the same on both sides of the Atlantic despite significant differences in monetary and fiscal policies, suggesting that global supply-chain issues were the dominant story. And those supply-chain issues have now been resolved.

This, however, creates a puzzle. The Fed raised interest rates to bring inflation down, and inflation is now down. So shouldn’t the rate hikes be reversed?

Well, that would be the natural argument if higher rates had led to a recession and high unemployment. But they haven’t! Nobody is quite sure why, but the best guess is that for a variety of reasons the interest rate consistent with full employment — “r-star” — is higher than it was a few years ago. So what does that tell us about interest rate policy?

What is Trump thinking?

Right now the state of the U.S. economy is, from the point of view of interest rate policy, more or less OK. Unemployment is a bit higher than it was at its low point last year, but remains historically low. Inflation over the past year has been somewhat above the Fed’s target, but only by around a half percentage point. So neither unemployment nor inflation data offer a compelling reason to change interest rates, and to the extent they’re giving signals, they point in opposite directions.

You could make the case for large interest rate cuts if you believed that the economy was on the edge of a major slump, perhaps caused by uncertainty over tariff policy. But while there have been warnings about the risk of a slowdown, it’s not obvious in the data, at least so far. And Trump himself keeps insisting that the economy is booming.

There is, on the other hand, very good reason to believe that inflation will rise substantially in the months ahead, as those tariffs are passed on to consumers. But this inflation bump will probably — probably — be transitory.

Is there a case for an interest rate cut? Yes, if you believe that a slump is coming and tariff hikes won’t raise long-term inflation. But it’s not an overwhelming case, and at most it’s a case for a modest cut, not what Trump is demanding — a cut of three percentage points, which is something that the Fed only does in the face of major economic crises.

So what is Trump thinking? He has argued that lower interest rates would reduce the budget deficit, by cutting the cost of servicing federal debt. But economists have a term for using monetary policy to help finance budget deficits rather than manage the economy: “fiscal dominance.” And anyone who knows economic history knows that fiscal dominance is how you get runaway inflation, Turkey or Venezuela style.

Also, as I said at the beginning, he seems to think of interest rate cuts as a sort of achievement award, something you get as a reward for running a great economy. If you say, “He can’t really believe that’s how it works,” you’re underestimating the role of sheer ignorance in human affairs. And a big interest rate cut might temporarily boost his remarkably low polling on economic policy.

The important thing for the rest of us to understand is that while there are legitimate arguments for (but also against) modest rate cuts later this year, there is no reasonable case for the mega cuts Trump is demanding.

Which does not, unfortunately, mean that he won’t eventually bully the Fed into giving him what he wants.