The dismal inflation data just released raises a key question: Can all the good things we’ve seen in the economy—from confident big-spending consumers to a roaring stock market to an explosion in artificial intelligence capital spending—keep going going forward. It was the surge in prices that triggered a sharp rise in bond yields. real Is this a temporary trend caused primarily by the oil shock of the Iran war and lingering pressure from Trump’s tariffs?
This is the relatively optimistic stance that recent Fed Chairman Jerome Powell has taken. But one top monetary economist believes Powell has completely misread the signals, and if the central bank doesn’t act quickly, we could see a near repeat of the inflationary disaster of 2021 and 2022. “Powell keeps saying the same thing,” said William Luther, an associate professor at Florida Atlantic University. “He’s again blaming everything on ‘transitory’ forces, but not using that word, just like he was blaming supply chain disruptions for inflation back then. They weren’t the main problem then, and tariffs and higher oil prices aren’t the culprits now. Even if those problems subside and nothing else changes, we won’t solve the inflation problem. The Fed needs to address the root cause. That’s huge excess spending in the overall economy.”
In fact, recent data show a sharp shift from modest progress to regression into danger territory. The Labor Department’s Consumer Price Index report released on May 12 showed that inflation rose sharply by 0.6% in April, continuing the sharp upward trend of 0.9% in March. Those figures are two to three times the 2.7% average growth rate from December to February. The index has gained 3.8% over the past 12 months, nearly double the Fed’s 2.0% target. The next day, producer price index releases foreshadowed worse to come: the amount companies paid for raw materials and inputs surged 1.4% in April, three times forecast and seven times the December reading.
To Rudd, the real driver behind the recent surge couldn’t be simpler: The total dollar amount spent in the United States on goods and services is growing much faster than the number of cars, appliances, or hotel rooms we produce and supply. “The debate about tariffs and oil prices has some merit,” he said. “But these price increases are mainly money spent on other things and will not have a significant impact on overall inflation. The fundamental problem is more money chasing the same quantity of goods. We have an aggregate demand problem, not a supply disruption problem.”
Rudd explains that “aggregate demand” or “aggregate spending” includes all domestic spending by consumers, governments and businesses, from factories to inventories. So where does all this extra money come from? One major source is rising government spending: The Congressional Budget Office predicts a sharp 6% increase in federal spending in fiscal 2026, which ends in September. Powell also cited an obvious contributor: King’s massive ransom for AI data centers, which is expected to reach nearly $1 trillion this year, a multiple of the figure three years ago. First, consumers—especially the affluent—continue to spend significant time on everything from dining out to health and wellness. The “wealth effect” of stock markets, led by the S&P, which has risen 28% in the past year, may also encourage people to shell out more money.
The data confirms Luther’s position. In the four quarters ending in March, GDP grew at an annualized rate of 2.66%. As a reminder, the national income indicator measures the physical quantity of goods and services produced. But what about the flow of money used to buy goods sold in supermarkets and car parks? Total spending or total demand increased by 6%. This is 3.34 percentage points faster than output and translates into inflation, nearly matching the Consumer Price Index (CPI) figure. Data just released suggests that the tide of excess funds is growing rapidly and, unless contained, will put even more upward pressure on these tabs at the till.
Rudd accuses Fed of being passive loose Monetary policy, which requires developing strategies to control aggregate spending
Rudd points out a perverse consequence of Powell’s view that it is disruptions in delivery that are causing surges in the post-COVID world. From October to December last year, the Federal Reserve lowered its benchmark interest rate by half a basis point, from 4.00% to 4.25% to 3.50% to 3.75%. It hasn’t changed since then. But since early January, CPI has risen from 2.6% to 3.8%, and the expected annual inflation rate for the 5-year Treasury bond has increased by 0.42%. Inflation explains all of the increase in the five-year payment. So-called “real interest rates” have actually fallen. “What affects economic decisions is the real interest rate,” Rudd said. Rudd said lower real interest rates would encourage consumers and businesses to spend more, pushing up prices. The result is that “the Fed is actually easing policy in the face of higher inflation. Just by math, when the federal funds rate remains unchanged and inflation expectations rise by nearly 50 basis points, real interest rates fall by 50 basis points, effectively creating a looser monetary regime.”
“This is the failure of monetary policy since 2021,” Luther declared. “In the past few meetings, Powell has said that these temporary supply shocks will resolve themselves. He has not commented on the actual main source, which is the surge in overall spending.” Luther said that the Fed’s main responsibility is to keep “aggregate demand” stable, but the central bank has allowed it to run rampant. Luther argued that the factors the Fed claims cause inflation would not push up the consumer price index if the Fed used its power over aggregate demand to combat those factors. “The Fed can see an increase in federal spending a mile away,” he said. “The same is true for trends in consumer spending. The Fed should anticipate what Congress and households are going to do and set policy accordingly, focusing on making necessary adjustments to overall spending to offset where spending will increase.”
Rudd does not advocate a sudden increase in the federal funds rate. He believes that the shift to a robust strategy starts with communication, specifically explaining potential future threats and what steps the Fed will take to overcome them if they persist. “Powell should have said that we are seeing a significant increase in total spending and we are watching that and will respond,” Rudd acknowledged. “This communication must be contrary to the ‘no view on spending’ stance that we have seen.” Suggesting that inflation will subside when the war is over and oil starts flowing freely again fuels expectations that monetary policy will remain accommodative and fails to address the spending problem, he said.
Therefore, the first step in Luther’s toolbox is to correctly identify and interpret the real problem. “The Fed is hesitant to respond to supply shocks,” he said. “The Fed first needs to acknowledge the problem before it can develop a good response. Once it recognizes there is a spending problem, it needs to take action.” What action should the central bank take? The Fed should move from passive easing to effective tightening through its statement on future policy. Rudd said: “The Fed should change its stated outlook and shift to a tightening path.” In his view, the Fed must explain that even if the war ends soon or tariffs are not raised further, it will not hesitate to tighten monetary policy if it sees factors such as an explosion in capital spending and excess consumer spending persisting.
Rudd explained that, as always, the Fed has a number of options to address the overall big spending problem. It could raise the federal funds rate, raising borrowing costs and curbing lending that fuels spending ranging from car purchases to new factory construction. Raising interest rates on bank deposits with the Fed would entice lenders to move dollars from checking and savings accounts to the central bank, curbing the lending mix that fuels spending across the economy. Alternatively, the Fed could engage in quantitative tightening, selling mortgages and Treasuries off its balance sheet, absorbing money that would otherwise be spent.
On the bright side, Rudd is cautiously optimistic that Kevin Warsh, who succeeds Powell as Fed chairman on May 15, will take a better course than his predecessor – in part by making keeping aggregate demand stable as a top priority. “He’s a great choice,” Rudd said. “He has a wealth of knowledge about financial markets, and it’s hard to imagine inflation being as high under him as it was under Powell.” Rudd noted that Warsh has advocated shrinking the Fed’s massive balance sheet, a move that would keep money flowing in the right direction, away from consumption and toward investment — although he added that the new chairman didn’t specify how big the purchases would be, or how fast they would be made.
One potential spoiler, he added, is Powell continuing to serve on the Fed’s board of governors. “He said he would keep a low profile,” Rudd warned, “but respect for Powell will not disappear. There is reason to think he will have a greater than average say in the FOMC setting policy.”
What should worry all consumers and investors is that so far the Fed has responded to the return of big inflation the same way it did in early 2021. As Rudd said, the Fed needs to adopt a very different strategy this time. Kevin Warsh has all the right credentials to prove that the change agent’s time has come.
This story originally appeared on Fortune.com
