Plain English with Derek Thompson - Is the Federal Reserve Making a Huge Mistake?

Episode Date: September 27, 2022

Last week the Federal Reserve raised interest rates by 0.75 percentage points, continuing one of the fastest escalations of the benchmark rate in history. Jerome H. Powell, the Fed chair, warned that more pain was to come as the central bank fixes its eye on Sauron on our core inflation. But the theme of this episode is that U.S. interest rate policy does not stop at the U.S. border. Our monetary policy is a lever that moves the world. Soon after the Fed’s announcement last week, the British pound crashed, oil prices fell, currencies (crypto- and otherwise) fell, and the possibility of a global downturn came ever slightly into greater focus. Today’s guest is Jason Furman, the Harvard economist and former top economic adviser to President Barack Obama. We talk about the state of the U.S. economy, why the Fed is doing what it’s doing, the best arguments against rising interest rates, the global fallout of U.S. monetary policy, and the possibility that the world economy is headed for a dark, dark winter. If you have questions, observations, or ideas for future episodes, email us at [e-mail]. You can find us on TikTok at www.tiktok.com/@plainenglish_ Host: Derek Thompson Guest: Jason Furman Producer: Devon Manze Learn more about your ad choices. Visit podcastchoices.com/adchoices

I'm Yossi Salik, and I'm the host of Bansplain, a show where we explain cult bands and iconic artists by going deep into their histories and discographies. We're back with a brand new season at our brand new home, the Ringer podcast network, tackling a whole new batch of artists, from grunge gods to power pop pioneers to new metal legends and many, many more. Listen to new episodes every Thursday, only on Spotify. Today's episode is about the Federal Reserve and a potentially frightening moment. for the world economy. Let's begin the story in the U.S. last week the Federal Reserve raised interest rates by 0.75 percentage points.

Yet again, this continues one of the fastest escalations of the benchmark rate in history, and Jerome Powell, the Fed Chair, warned that more pain was to come as the central bank fixes its eye of Soron on our core inflation rate. Now, the theme of today's episode

is that U.S. interest rate policy does not stop at the U.S. border. Our monetary policy is a lever that moves the world. And soon after the Fed's announcement last week, you saw the British pound crash, oil prices fell, cryptocurrencies fell, other currencies fell, non-crypto. And the possibility of a global downturn, a global recession, is coming ever more slightly into focus. This is a part, I think, that's gone undercover in a lot of financial news today. the global effects of U.S. economics. Last week I read an essay by the economist Adam Too's called The South Asian Poly Crisis.

I read it before bed, which was not a very good idea, because this was the very opposite of a bedtime story. It freaked me the hell out. I don't know a whole lot about Southern Asia, but this piece was really revelatory. The economist Tooz offered a scary tour of Sri Lanka, where the public recently stormed the presidential palace, and Pakistan where devastating,

flooding inflation have produced a political crisis inside a nuclear power. Now, much of Southern Asia relies on other countries for their energy. They need valuable currencies to buy that energy. But in the last few weeks, their currencies have cratered against the dollar. And that means the energy they so desperately need is getting more and more expensive to import. That means it's like the Federal Reserve in raising interest rates is incidentally. pouring gasoline on the fire of an energy crisis in Asia. Right?

The domino effects sometimes aren't very obvious, but when you put them together, it doesn't look so good. Indeed, what does it look like to be headed into a world where interest rates are rising, currencies are falling, and the war in Ukraine continues to scramble energy markets? Well, today's guest is here to answer many of those questions.

His name is Jason Furman, return guest. turn guest. Jason's a Harvard economist and former top economic advisor to President Obama. We talk about the state of the U.S. economy, why the Fed is doing what it's doing, the best arguments against what it's doing, rising interest rates, the global fallout of U.S. monetary policy, and the possibility that the world economy is headed for a dark, dark winter. I'm Derek Thompson. This is plain English. Jason Furman, welcome back to the podcast. Great to be back. So give me your temperature check in the economy right now. Unemployment is very low. Jobless claims are quite low. Gas prices have fallen in the last few months. Shipping costs have come down. That is all good news.

But then there's the core inflation thing, which is bad. So what is your evaluation of the state of the economy at the moment? Relative to what one would have thought a few months ago, the near-term imminent where in a recession risk is much, much low. lower. The economy continues to add an extraordinary amount of jobs month after month. Yes, the unemployment rate went up last month, but it's still very low. And the reason it went up is because more people were looking for jobs, not because people were losing their jobs. Consumers continue to spend, just in general, you know, if you were worried a few months ago, we were about to go into a recession. That worry seems to have receded. On the other side of the ledger, though, inflation is more of

worry now than it was even a few months ago. A few months ago, you might be able to convince yourself that inflation was temporary due to the Russian invasion of Ukraine. The fact that the core inflation rate, when you strip out food and energy, was so high in the month of August, was, I think, the final nail in the coffin for that thesis, because it showed in a month, even when gas prices were coming down, that everything else, the prices of it were rising and rising quite strongly. So it's a season of dying narratives. The we're in a recession narrative seems to be dead, but the inflation is just transitory story isn't doing so hot either.

Last week, the Fed raised interest rates again, and I wonder why you think this is the right medicine for what ails the economy. When the Fed raises interest rates, it reduces economic activity. It does that because it's more expensive to borrow for a home, so you'll build fewer homes. It's more expensive for a business to borrow,

plant and equipment so they'll install less of it, more expensive for consumers to borrow money for, let's say, purchasing a car, so they'll want to buy less of them. All of these are about the same thing. It's cooling off the amount of demand in the economy. The goal isn't to slow job creation, but that is one impact of it. And by doing that, it also will slow nominal wage growth, which is a key driver of price growth. So this is a whole chain of things, but the brief version is reduce the forms of economic activity. The Fed can reduce and do that in a way

that reduces demand more than supply, so price growth and wage growth slows. And this especially happens in sectors that are really sensitive to interest rate increases. So interest rates go up, mortgage rates go up, there's less demand for houses. Theoretically, the whole construction industry begins to slow because there's less demand for houses. And that's a way in which the rising interest

rate could domino effect into less wage growth and construction, maybe a little bit of less job growth and construction, which cools off all the demand that comes from that sector. Is it fair to say, and a lot of people, I think, on the left are already saying, that the Fed is somewhat purposely putting people out of work, purposely slowing down the economy, purposely driving us closer to the brink of a recession in order to slash inflation? I mean, cooling demand is a very nice, anodyne phrase that we can use, but there are other less nice, less anodyne phrases that we can use to describe what the Federal Reserve is trying to accomplish in the real economy. Are those descriptions from the left, fair, do you think?

I think they're fair, and actually, Chair Powell at his press conference last week, basically didn't sugarcoat it. He said that would be the consequence. of what the Fed was doing. Now, from a policy perspective, if you think the trade-off is between a shallower slowdown now, or maybe a shallower recession, or a deeper recession, and even more jobs lost in the future, that to some degree is the way the Fed, I think, correctly is thinking about it. And in that world, more aggressive action today, yes, it does cost jobs, but it would cost even more jobs if we tried to reestablish and get inflation under control after expectations had gotten out of control for several years. But yes, absolutely. It's jobs.

Jason, what if the Fed just did nothing? Like, what if Jerome Powell got up there in front of the mics and the cameras and the journalists and said, you know what, I'm just not really into doing this anymore? Like raising rates, not for me. The Fed is quiet quitting. We're just going to stop doing anything. Sit around, hope everything works itself out. What's so bad about that? What would be so bad about doing nothing? I think it's likely that if the Fed stopped acting,

the stock market would be thrilled. It would go way up. Everyone would be wealthier. Businesses would expect more near-term demand, and so they'd increase their hiring. That scramble for workers would lead wage growth to be even faster than it was. that would lead price growth to be even faster than it was.

And so we would end next year with an inflation rate higher than we have now. We'd be even further from where we want to be. If the trade-off here is do you want a permanent 2% inflation rate or do you want a permanent 3% inflation rate? You know, that's, I think, you know, you could argue either side of that. In fact, I'd argue the 3% side of that. If, however, the choice is on one side, you have an inflation rate that. it keeps rising. And on the other side, the inflation rate is stable. I think it's pretty hard to defend a policy course under which inflation rate will actually be faster next year, faster the

year after, et cetera. And maybe just say one more thing on that, because there's a lot of listeners I have to imagine that are, say, under the age of 42, 43, which means that they've never been alive during a period like the mid-1970s when you really did have a way. wage price spiral, where inflation really did get out of control. Why is that kind of scenario so painful and horrible that it is worth this upfront pain that the Fed is delivering? Look, if you want to say that you're going to live with an inflation rate that's rising forever, then I think you can dispense with all of this. Once you rule that out, you're just going to need some way to keep inflation expectations to some degree anchored and long-term inflation

expectations have been. And you want a labor market where the state of supply and the state of demand are sort of balanced enough such that you don't have just continually rising nominal wages, which again, it's the main input into cost of businesses lead to continue prices. So a lot of what we learned in the 1970s and in early 1980s is that there can be this tradeoff not between inflation and unemployment, but between rising inflation and unemployment. And that's what the Fed is very correctly worried about. So given all the tradeoffs and all the uncertainties that we face, do you think the Fed is doing the right thing? Yeah. So first of all, I mean, I think the most important thing is that people operate on a reasonable outlook for the future and a reasonable menu of choices. And so if you're

constantly thinking the problem's just going to solve itself. And so it's a false choice. We're going to have inflation of, say, 2% and the unemployment rate not rise. I think that's certainly a possibility. It's not a probability. It's not the most likely scenario. There are all the things that you just pointed to for inflation coming down. But let's take, you know, one of them. I can't remember if you just mentioned it. But the Baltic Dry Index. This is a measure of freight shipping costs. It's went way up. It's now. come way down. Some people point to that and say inflation's going to go away. The problem is, if you look at the cost of goods in this country, only 1% of that cost is the cost of shipping.

And you look at goods, they're only, I think about a fifth of what our overall spending is. And so if 1% of a fifth of overall costs goes down, that just doesn't matter that much for inflation. So some of this is grasping its straws. In the housing sector, A lot of the measures people are looking at are for new leases. And all the existing leases that have not reset yet, which often happens if somebody moves, sometimes the landlord does it to you in midstream, those haven't reset to be as high as where the new leases are.

So even if new lease growth slows down, there could be a year or two of higher growth in rent underlying in terms of what people have. And then there are some shoes that could drop the other way. inflation and the Fed's preferred measure in the last couple months have been held down by the fact that the stock market fell, which means commissions on investment advice have fallen. And when the stock market stabilizes, those commissions will stop falling and the Fed's preferred inflation measure will rise as a result. So I think we don't want to sort of grasp at straws on transitory. We may luck out.

That may happen. but I think one's best guess is that the choice is, at very least, high inflation versus unemployment, more likely rising inflation versus unemployment. So perhaps we don't want inflation psychology to become sewn into the fabric of society. That's a good argument in defense of Fed policy so long as you limit your analysis to the U.S. But of course, Fed policy doesn't just stop at the border. It intersects with global economics. And last week, several other countries, Indonesia, Taiwan, the Philippines, South Africa,

Norway, all raised rates. Is there a risk of everyone going so fast at the same time? I am worried about that. I am a little bit more worried for other countries than I am for the United States. There's a much larger and more imminent recession risk in Europe over natural gas prices. A larger fraction of European inflation is truly out of their control than is the case for U.S. inflation. Emerging markets that raise interest rates, it can have real consequences in terms of their fiscal sustainability, which can often be more precarious than the United States. If the dollar strengthens against an emerging market, that means it's more expensive for them to repay the money they borrowed in dollars. So I think this creates complications for countries

around the world. So yes, I am nervous about all of that. I think ultimately the fact that, Fed needs to do what's best for the United States. And so it should take that into account insofar as it spills back to the United States. And for the United States, I'm more confident that this is the right course of action than I am that it is for sort of every other country that's out there. You mentioned foreign currencies, and this has been a piece of huge fascination for me in the last few weeks because one of the major themes of this year is that rising interest rates in the U.S. have strengthened the dollar. And another way to say that is that other currencies, foreign currencies, are weakening

relative to the dollar. So this year alone, the pound is down 20 percent, the euro is down 15 percent, the Canadian dollar is down 7 percent. Turkey and Argentina, their currencies are down nearly 30 percent. First, at just a 101 level, why is this happening? how does rising interest rates cash out in strengthening the U.S. dollar against these currencies? So there's two ways to think about this. One is purely financial market fundamentals. When interest rates go up more and faster in the United States than they do in other countries,

and that's what we're seeing. They are rising everywhere, but the United States was the first and the fastest to raise rates. Then investors want to move their money into the United States because they're now getting a higher rate. rate of return in the United States. When you do that, move your money to the United States. You're buying dollars. You're selling your own currency, and that strengthens the dollar. In addition to that more fundamental effect, there's something psychological going on. Whenever people get nervous about the global economy, they want to put their money wherever

it's safest. And what is the safest thing in the world? Pretty much always is the United States, United States, Treasury bills and bonds. And that's, for example, what you saw with the United Kingdom, even though their interest rates recently went up that in theory should have made the UK more attractive as an investment destination. But people were so nervous about the UK, so nervous about the economy there, that they said, you know what? We don't want to be in the UK. What's safe? Oh, yeah, we'll put it into dollars. And when people hear, oh, you know, the pound fell 20%, or, you know, Turkey's currency is his class by 30%,

I think a lot of people think to themselves, well, that sounds really bad. But like, wait, why is it bad? What is specifically catastrophic for a country when its currency is declining in this way? So it depends on circumstances. When your currency declines, it can help your exports, which can strengthen your economy. Sometimes that's a good thing if you're trying to get out of a recession. If you're trying to tamp down on a boom and bring down inflation, that's a problem. Another thing is a lot of things people in the UK buy are made elsewhere in the world.

They're now paying 20% more for every single thing they get from the rest of the world, which I think is about a third of what they buy in their country. So it's going to raise their prices and raise their inflation. And then finally, an issue which the UK doesn't have, but many emerging markets do, is they borrowed in dollars. And so if you're Turkey and your currency falls by 30%, you're going to need 30% more Turkish lira to pay back $1 of foreign dollar-denominated debt. So let me just try to put a couple things together here.

So South Asia and much of Europe relies on energy imports that are often priced in dollars. Russia's invasion of Ukraine and the Western sanctions that we passed to punish them for that messed up global oil and gas markets, prices surged, and then the Fed started raising interest rates to fight back against inflation. That causes the dollar to strengthen against these currencies of energy importing countries. Let's just take those in South Asia, for example. It makes it their currencies are weakening against the dollar. They still have to import all this energy, but the price of that energy just keeps going up and up and up. So like putting everything together here and connecting the dots, is it fair to say that U.S. monetary policy is at least

marginally contributing to the global energy crisis by increasing the cost of energy in these countries that are importing energy price and dollars? It's a good question. There's two effects. One is the one you just described, but also by reducing U.S. demand, the United States is a huge user. of oil and other forms of energy, and that can bring the global price of energy down as measured in dollars. So I don't know what the net of those two is. It's possible that somebody out there does.

But it is true that when the United States raises rates, in general, it's exporting some inflation. Because the dollar gets stronger. That means it's cheaper for Americans to buy stuff. It's more expensive for foreigners to buy stuff. and, you know, it makes life a little bit harder for other countries trying to manage their inflation, their macro economies, their debts. Well, let's talk about one of those countries that is severely struggling to manage its inflation

and manage its basically everything, and that is the UK. On Friday, last week, the new British government announced this sweeping series of tax cuts that, to my eye, got the worst critical and finance review of, like, any public. policy, I can remember. Britain's benchmark stock index fell 2%. The pound immediately dropped 3%. It's like one of these things where like, if economic policies were movies, this would have gotten like a rotten tomato score of zero or like, you know, maybe one if the prime

minister herself were given a vote. Why was the reaction to this move in the UK so horrible? And maybe just tie that into, I should have asked this as a prelude, tie that into the specific economic challenges that Britain faces right now. Yeah, I think you described it exactly right. And what makes it even more remarkable is that Liz Truss, who's now the prime minister, campaigned for the last two months on doing something like this. So this was not a complete out-of-the-blue surprise. Financial markets... And just say what she did, because I barely described it. Yeah, what is the actual plan that got the horrid reviews? So it basically is lots and lots of tax cuts without any statement about how to pay. for them. Some of them is for people's energy bills. Some of them are reducing the tax rate on,

the top tax rate in the UK, which I think is around $200,000 or something in that neighborhood there where it starts. Some of it is some other taxes and levies that were suspended. And they didn't say anything about how this would pay for. They didn't show any sort of budgetary analysis, economic analysis, distribution analysis, the things you'd normally do. There were rumors they were going to try to take away the independence of the Bank of England. She is upset that the Bank of England is raising interest rates, thinks that is hurting the economy, campaigned criticizing that. They reaffirmed the independence of the Bank of England, but they said that the head of the

Bank of England would have to meet with the Chancellor of the Exchequer, their Treasury Secretary equivalent, would have to meet twice a week. And so there's a little bit more of a gnawing fear now that the UK will slowly erode the independence of the Bank of England and make it just set interest rates in whatever way is most useful to the government in the short term. You answered it well, but I think it leaves a bit of a mystery, which is, you know, why would tax cuts for the rich cause the stock market to crash? Like, typically you would think at least in America, like I'm not even going to, I'm not going to

pretend that I understand this. of any market, but I at least half understand the psychology of American markets. I feel like historically in the U.S., if the federal government says, hey, all the fat cats out there get a big massive tax cut, congratulations, I would think the stock market would go up. But instead, the exact opposite happened in the U.K. So why? Yeah. So the biggest reason is that the market thought this would cause more inflation, and that would cause the Bank of England to raise rates more quickly. Or they thought even five or ten years down the road, not quite sure how the UK would deal with all of its debt. And so maybe it would have a big bout of inflation in five or

10 years to get rid of all its debt. Either way, the same thing happened, which is to hold UK debt, you demanded higher interest rates. And interest rates were the most notable thing. They rose the five-year interest rate, one of the benchmarks people look at for the UK, I think might have risen more than any other day, or certainly it was in the top two or three four, two or three in the past half century. Now, the stock market is very closely tied to interest rates. One simple way to think about it is when interest rates go up, well, you might as well put your money in bonds. They're now getting a good interest rate. You move them out of stocks and stocks go down. There's other equivalent ways to think about it, but I think that's the simplest one. So basically in the UK,

what they did, and this is something, you know, I teach in my class, which is when you borrow more money that drives interest rates up. In the UK, it turbocharged that because of the short-run fears about inflation, the long-run fears about solvency. And whenever interest rates go up, you tend to see the stock market go down, and that's what happened there. So it's not just the UK that is facing an inflationary crisis. It's all of continental Europe. I think one potential piece of curiosity for some listeners is that in the U.S., gas prices have been falling now for two months, maybe more than two months. In Europe, however, they're dealing with catastrophically increasing energy prices. What's the difference? Why is the European energy crisis headed in such a different

direction than the U.S.? Yeah. So Europe has a big inflation problem that the underlying inflation rate is a little bit better than the United States, but the energy inflation rate is much, much worse. And that's because they relied heavily on Russian natural gas. That natural gas has been shut off. Oil, we're very used to. It has roughly the same price everywhere in the world. There's some important caveats, but it's roughly the same.

And that's because it's really easy to transport oil. Natural gas is much harder to transport. You need to turn it into a liquid. You need to load it in special ports. you need to unload it in special ports. They need to be connected through special infrastructure to other parts of the energy system. And so the price of natural gas in Europe right now

is just much, much, much higher than it is in the United States. And that's the key way in which electricity is being made. At the same time, you see European countries like Belgium just took a nuclear plant responsible for 10% of their electricity offline. You can debate how important nuclear is over the medium and long term for climate change. I don't think there's any argument for taking it offline in the year 2022 in the middle of an energy crisis. And now we have something with Europe, where if you want to forecast the European economy over

the next six months, you have to forecast something that normally isn't a key economic variable, which is how cold the winter is. I've rarely thought about that when thinking about what's going to happen in the business cycle. But if Europe has a cold winter, it's going to run through the natural gas storage that it's built up. It can't get a whole lot of it very quickly. And so the price will skyrocket. Some industry could grind to a halt, and it could be a that much worse recession if winter is, say, 5 degrees colder than what you might otherwise have expected. No, it's almost profoundly medieval to have to factor in future temperatures into a

economic analysis. Like, the temperature is going to fall so much that people literally will not be able to work. Entire sectors might be shut down because they won't be able to supply those particular industries with sufficient energy. Putting all of this together, the fact that Europe is facing a potentially freezing winter with very limited energy resources, the fact that England is being, excuse me, the UK is being led by a really cockamamie economic policy on top of skyrocketing inflation. The fact that the appreciating dollar and weakening foreign currencies are exacerbating energy crises all over the world, it just really does seem to me like the global economy is in a lot of trouble. And my friend and Axios economic correspondent Neil Irwin was

tweeting quite gloomily late last week, where he said, quote, it feels like today, this was last Friday, might turn out to be a momentous day in economic financial history in ways that aren't known to the vast majority of people at the time, a wee bit like August 9th, 2007. And I asked him, what are you talking about? Why are you getting a little bit of a sort of global economic recession vibe out of the last week's news? And he said broadly, after 15 years of negative real rates and costless debt accumulation, the world financial system is adjusting to positive real rates and high debt overhang, and it's going to be a very, very bumpy ride.

to what extent do you think that this somewhat gloomy and maybe catastrophic or maybe very realistic analysis is in keeping with how you see the global economic picture? Yeah, I am more nervous about most every other country in the world than I am about the United States. And don't get me wrong, I'm nervous about the United States too. I'm just talking about relative magnitudes of nerves. And in part, it's because of the natural gas issues in Europe. We're talking about the emerging market, deadish. and a range of other factors. But, you know, the question, though, is how should one operationalize this nervousness?

And if part of the problem that we have is that, you know, markets were overpriced because they thought interest rates were going to be low forever, and inflation was getting out of control, because, by the way, the unemployment rate is at the bottom of the range it's been at for the last 20 years in most European countries right now, too. not just the United States. If all of this happened and you try not to address that underlying inflation problem, you know, maybe you have, you know, the problem might be even harder to deal with a year or two from now. I don't want to talk anyone out of their nervousness, though. I think I'd be really nervous if people weren't nervous if people weren't constantly monitoring and

revisiting this question. But, you know, fundamentally, I go back to where we began in our discussion. The unemployment rate is low in the United States. Job creation is high in the United States. That part of the Fed's mandate is satisfied. The inflation part of the Fed's mandate is not close to being satisfied. And so I think they really do have to do what they're doing. I like that you said, by the way, how should I operationalize this nervousness? We recently had a psychologist on the show talking about negative self-talk. And I feel like that's something that he might have said. How should we operationalize our own nervousness? So at least we're having a little bit of thematic consistency between our macroeconomic and psychology episodes. Very last question for you is, you know,

I'm not, I don't think I'm very good necessarily at seeing the way that these dominoes click into each other, especially what involves global economics. There's just so many things that you have to maintain awareness of to see exactly how different things affect each other. But I've mentioned a couple domino pieces that I'm nervous about. You know, I've mentioned the sort of South Asian energy crisis. I mentioned the top of the show in my open about how I'm particularly nervous about some countries like, you know, Pakistan and India, and how a combination of economic crises and political crises, maybe even climate crises could create really, really terrible situations there.

Is there a domino piece that you're particularly worried about that I haven't touched on? some way that what's happening in energy markets right now and what's happening with central bank rate raising behavior right now could really create a problem for the world that I haven't brought up in a question. I think you've brought up a lot of the different issues. I do think we want to differentiate the world. If you're a commodity exporter and commodity prices, food prices, for example, are very high right now. For commodity exporters, that's a good. good thing. For commodity importers, that's a bad thing. The way an emerging market, we tend to lump them all together, but the way you handle the policies coming from the United States have a big

impact on how they affect you. Turkey has handled them disastrously with disastrous consequences as other countries that have done a better job. So there really is quite a lot of variety out there. and maybe the thing I'm most nervous about, though, would be the political economic feedback effects. High inflation tends to destabilize governments. It can bring populace to power. Some of the remedies for high inflation themselves will cause more inflation and economic pain, for example, what we're seeing in the UK, Turkey,

and some other countries. And so you have this negative feedback loop between political stability, an economic stability, that could sort of spread those policies, which I think do matter quite a lot in terms of how you handle this, and spread the bad ones and constrain the good ones and make the problem worse. Thank you very much, Jason Furman. Really appreciate it. I always love talking to you, Derek. Thank you for listening. Plain English is produced by Devin Manzi. If you like the show, please go to Apple Podcast or Spotify, give us a five-star rating, leave a review. And don't forget to check out our TikTok at plain English underscore.

That's at plain English underscore on TikTok.