The Journal. - Will the Fed Stop Raising Interest Rates?

Episode Date: July 25, 2023

The Federal Reserve is expected to raise interest rates again on Wednesday. The question is: Will this be enough to finally tame inflation? WSJ’s Nick Timiraos tells us about the fight between two camps of economists who are at odds about what will help – or hurt – the economy.   Further Reading: -Why the Fed Isn’t Ready to Declare Victory on Inflation  -The Real Fed Debate This Month: What Would Prompt a Rate Hike This Fall  -Last Mile of the Inflation Fight Will Be the Hardest  Further listening:  -Why Some Companies Keep Getting Away With Higher Prices  -Why the Fed Raised Interest Rates Amidst a Banking Crisis  Learn more about your ad choices. Visit megaphone.fm/adchoices

Most people don't really pay attention to what the Fed is doing, but these days it feels like it's getting a lot of attention. Do you feel like it's like you're covering a sports team? Yeah, yeah, you're covering a winning sports team, not in the sense that the Fed is winning, but that, you know, when there's action, when the team is doing well, when somebody's getting hot, then everybody's paying attention. That's our colleague Nick Timoros. He covers the Federal Reserve, so he's always paying

attention to what goes on at the Fed. And for Nick, tomorrow is like game day, because the Fed is expected to raise interest rates again. Another attempt to beat inflation. The increase Wednesday has been so widely telegraphed that it would be shocking if the Fed didn't raise interest rates. So the question here is, has the Fed done enough? Is this interest rate increase enough? Well, does it tighten financial conditions enough where the Fed has confidence that the economy is going to continue

to slow down and not reaccelerate? The Fed's goal is to get inflation down to 2%. We've made a lot of progress in the last year, but we're sitting at around 4%. And it's that last yard that economists are fighting over. Does the Fed continue to act aggressively because inflation is still a big problem? Or has it done enough and inflation is on its way down?

problem? Or has it done enough and inflation is on its way down? This has been sort of the central fight in economics for the past two years. So you could compare it to two different football teams. And whenever one inflation report comes out and it says, oh boy, inflation looks really bad, you know, one side is going to do an end zone dance, spike the football. Okay. I like the picture of the end zone dances. Welcome to The Journal, our show about money, business, and power. I'm Jessica Mendoza. It's Tuesday, July 25th. Coming up on the show, the Fed is expected to raise interest rates tomorrow. Will this be the last time?

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Other conditions apply. How many times has the Fed raised rates in the last few years? The Fed has raised interest rates 10 times since March of 22. They've raised interest rates faster than at any time since the 1980s. 10 consecutive rate increases over 15 months. If you had said in March of 22, hey, the Fed is going to raise interest rates by 5 percentage points over the next 14 or 15 months, not very many people would have believed you. And a lot of people would have said, there's no way financial markets will manage that. There'll be a complete meltdown in stock prices.

The bond market will go haywire. And so this is very unusual, you would say. It's quite unusual for the Fed to raise interest rates that rapidly. So far, those rate hikes seem to have helped. Inflation has dropped from its peak of 9% to about 4%, depending on what inflation measurement you use. Energy prices have come down. Goods prices are coming down. Housing rents are coming down. That's a lot of success. But getting inflation all the way down to where the Fed wants it to be, that's where economists are getting stuck and disagreeing. Nick breaks them up into two camps. The first group says inflation is transitory, temporary, just due to these weird last few years.

And it's not deeply ingrained in our economy. One group, Team Transitory, they're taking a bottom-up look at inflation. They're saying, look, at the ground level, whether it's car prices or rents, you can see when they went up, you can see they're coming down. So just chill out here. We see that they're coming down. You don't have to weaken the economy more. This group can go by another name, the optimists. The opposing group is more pessimistic.

They say inflation is likely to stay high without more action from the Fed. I would call them team persistent. They are worried that inflation will persist at a higher level. Maybe it won't be 6% or 7% that we saw a year ago, but still 3% or 4% would be uncomfortable. we saw a year ago, but still three or four percent would be uncomfortable. And they're saying, well, wait a minute. There are deeper underlying forces at work. And if you look at the big picture, you can see that there are people are making more money. They're spending more. They feel wealthier. They have money to spend, even if it's not keeping up with inflation. And as long as people continue to spend, you're not going to put the downward pressure that you need to get inflation to go down.

Team Persistent has been more pessimistic. They're saying there's going to be more pain. You're going to have greater sacrifice required, which means more people are going to have to lose their jobs to get inflation to come down. So back to Team Transitory, the optimists, the ones who are saying, relax, inflation is coming down. It just needs time. The general theory of their case is price increases went up because of things outside of the Fed's control. They went up because of the pandemic. They went up because supply chains were really messed up.

They went up because energy prices went up a lot. Those things have now fixed. The pandemic's over. They're now coming down. And even if you look at the services that are still elevated, they're reflecting sort of pandemic-related distortions. Airlines that couldn't meet supply and demand a year ago, your car insurer lost a lot of money because car prices went up, so they had to jack up premiums. But those things should also run their course. And so they would say, hey, Fed, stop it with interest rate increases.

You've done enough. It's going to fix itself. It was always going to fix itself on its own. In part, you've slowed down demand enough. That would be sort of the optimistic story here is that this all can come back down on its own, and hopefully the Fed hasn't done overkill, and we will have a soft landing. Lots of people, including the Fed, have said that the best outcome would be a soft landing,

meaning we can get inflation back down a target without risking a recession and many people's jobs. That's always the goal. It's very difficult to do. There's a very thin list of examples of soft landings. So I don't think the Fed has been banking on a soft landing, but this cycle has been different. The pandemic created a lot of unusual disruptions in the economy. And so there are reasons to think that this time could be different. Of course, every time I hear myself saying this time could be different, I sort of want to slap myself because that's what people say in every cycle, and it's usually not different.

The optimists think that if the Fed keeps raising interest rates, that could hurt the chance of a soft landing, and it could tip us into an unnecessary recession. They want to give the economy time to metabolize all the changes of the last couple of years. There is one data point that isn't as strong for the optimists' case. Labor costs. Even though energy, housing, and other consumer goods are coming down, services and the labor that goes along with them is more stubborn. Average wages are still high. Think about all the things that you consume that are services, you know, going to the doctor, getting your hair cut,

taking your pet for lodging if you go on a trip. And those are things that tend to be more labor intensive. You're paying for, you know, when you get a restaurant meal, you're paying for somebody to cook the meal for you and bring it to your table. So the labor bill is a big part of that. And the question now is, how much of a slowdown in the labor market, if any, do you need to get that last bucket of inflation to behave more like it did before the pandemic? This is exactly what Team Persistent, the pessimists, takes issue with. For the optimists, the labor market is one data point out of many.

For Team Persistent, it is the data point. Basically, they say that to make an anti-inflation omelet, you're going to have to break a few eggs. That's coming up. Summer is like a cocktail. It has to be mixed just right. Start with a handful of great friends. Now add your favorite music. And then, finally, add Bacardi Rum. Shake it together. And there you have it. The perfect summer mix.

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but what are you going to do if it settles out at 3.5% or something closer to 4%? And you've been saying that 2% is your target, what are you going to do then? These pessimists argue that inflation has to come all the way down to the Fed's target of 2%. Getting close isn't close enough. I would say the pessimists aren't necessarily saying the Fed has to raise interest rates a lot more. We're really arguing here about whether

after Wednesday's anticipated increase, you're going to have to raise rates maybe one more time. I think the bigger issue behind that is just how easy is this going to be to get inflation to come down? If the Fed has to hold interest rates at higher levels for longer, then you could begin to see more weakness in the economy over time. Could you walk us through the logic behind what this camp is saying to get inflation that last mile down to 2%? What do you need to do? Well, this camp is saying that to get inflation down that last mile, you really need to get

wage growth to slow. Wages reveal what employers think they can recover via prices or productivity and what workers expect given their own cost of living. So the more pessimistic Kampf will say, until you get wage growth to slow down, you can't really be confident that you're going to get inflation back to where you need it to go. And the only way that wages slow down, big picture, is for people to lose their jobs and unemployment to go up. Typically, you don't cover that last mile without a downturn because workers and businesses don't just, you know, voluntarily lower their prices or accept lower wages on their own. Think about your own situation at work. For the last two years, for most people, inflation went up more than your pay did. And so

when you're bargaining with your employer this year for what wage you should get next year, are you really going to accept 0% inflation-adjusted pay gains? Probably not. So now people are going to demand more pay and businesses are going to have to think about, you know, am I going to accept less margin, let my profit get squeezed? Am I going to try to pass that increase along to customers? That's what's going to determine how easy it is to get inflation down. So I think if I'm understanding you correctly, like wages are still going up, which sounds like it's good for workers, for the average worker. Like how could that be bad for the economy? It is good for the worker. I mean, the best news is that in the last couple of months, wages are now going up more than inflation. So you are

getting an inflation-adjusted bump. The money you're making now can actually cover your costs. That's great. The concern for anybody who wanted to see the economy slow down, i.e. the Fed, would be, well, if people are making more money, that's going to allow them to spend more. And if there isn't more supply, then prices will go back up again. And so Team Persistent argues that the Fed will need to raise interest rates to help control wages. But is there a scenario in which a resilient labor market might be good because it might bring about or help bring about a soft landing? Absolutely. Yeah, absolutely. I mean, the fact that interest rates have gone up so much in the last year and the unemployment rate has basically barely budged, it was at 3.6% in June.

in June, that's a sign of resilience that the economy has been able to withstand higher rates so far. And so maybe it has allowed the Fed to fight inflation or at least manage against the risks that inflation would have gone even higher if they hadn't raised rates without having to do serious damage to the labor market. Okay. It feels sort of weirdly paradoxical. It is. I mean, everything about the economy over the past three years has been weird, right? I mean, we shut everything down for a few months, turned it back on, and what we learned was it just, you know, it's a very complex thing, and you can't flip the switch. Why is it so important to get inflation down to 2%?

That's a really good question, because you're going to be hearing a lot of people say, maybe it's not so important to get it to 2%. If you got it from 9 to 3, take the win, and don't focus so myopically on 2%. Now, for the Fed, it's important because they said 2% was their target. And their whole strategy of targeting inflation, i.e. having a target, means you have to hit your target. The Fed believes that they have to follow through on what they said they were going to do to be credible. And if you just declare victory at 3%, then you won't be credible the next time inflation goes to 4%. Maybe people will say, well, they said 2% last time and they settled at 3%.

Maybe 4% will be good enough. And that's how you lose control of these kind of amorphous, mystical inflation expectations. Got it, right? Like, so one camp is almost asking, is it worth risking a recession to maintain credibility? And the other camp is saying, kind of, yeah. Yeah, that's exactly it. This is all about doing what you said you were going to do.

And that makes it easier to actually get inflation down next time because people will believe, you know, these things can influence sort of the vibes of the economy to an extent. No matter which camp is right about inflation, the average consumer shouldn't expect prices to drop. 2% inflation or 3% inflation means prices will still be more a year from now than they were today. It just means they won't be going up quite so fast. And I think a lot of people, you know, if you're paying like $4 or $5 for a cup of coffee, you're saying, when is it going to go back to the $3 or the $2 I was paying before? Spoiler alert, it's not going to go back. Once the price level goes up,

it usually doesn't go back down. What we're talking about with 2% inflation is it just doesn't go up quite as much as it was going up. Are you a betting man, Nick? No, I'm not. I had a feeling you would say that. I wouldn't have gone into journalism if I were a betting man. I had a feeling you would say that. I wouldn't have gone into journalism if I were a betting man. But like, I guess I'm going to push a little bit and ask anyway, what side would you bet on whether the Fed is going to raise rates again after this round? Whether the Fed is going to raise rates again, it really depends on what happens with inflation in the next few months. You know, the current outlook is that inflation is going to continue to come down. And it's hard to see the case for another interest rate increase after this one this week

if inflation continues to come down. There will be some people who say you need to do it because the economy is still too strong. But there's a good argument to make that this will be the last interest rate increase so long as inflation is better behaved. You know, the reason forecasters have been so wrong over the last year is that inflation hasn't been better behaved. Okay, spoken like somebody who likes to hedge his bets. Thanks. That's all for today, Tuesday, July 25th.

Before we go, if you're listening on Spotify, take our poll. Are you on the optimist team or the pessimist team? The Journal is a co-production of Gimlet and The Wall Street Journal. Thanks for listening. See you tomorrow.