Today, Explained - Get used to higher interest rates

Episode Date: May 4, 2023

The Federal Reserve has once again raised interest rates, which means borrowing money for your mortgage or your business is once again more expensive. New York Times economics reporter Talmon Joseph Smith explains why this might keep happening. This episode was produced by Miles Bryan and Amanda Lewellyn, edited by Matt Collette, fact-checked by Serena Solin, engineered by Michael Raphael and Paul Robert Mounsey, and hosted by Noel King. Transcript at vox.com/todayexplained  Support Today, Explained by making a financial contribution to Vox! bit.ly/givepodcasts  Learn more about your ad choices. Visit podcastchoices.com/adchoices

Over the last 14 months, on nine separate occasions, Jerome Powell's Federal Reserve has ticked interest rates up, up, up. And then yesterday, a typically subdued Powell did it again. Today, the FOMC raised its policy interest rate by a quarter percentage point. Since early last year, we've raised interest rates by a total of five percentage points. Many words to say the Fed is making money more expensive. Your mortgage, your small business loan, it just costs more to borrow. A point that he typically amped Senator Elizabeth Warren has made. Chair Powell hasn't just raised interest rates, he has raised them on a curve unlike anything we've seen. Deepest in 40 years. Deepest in 40 years. In 14 months, he's gone up five points here.

And that's when things start to break. Today on Explained, are higher interest rates starting to break things? This NFL season, get in on all the hard-hitting action with FanDuel, North America's number one sportsbook. You can bet on anything from money lines to spreads and player props, or combine your bets in a same-game parlay for a shot at an even bigger payout. Plus, with super-simple live betting, lightning-fast bet settlement, and instant withdrawals, FanDuel makes betting on the NFL easier than ever before. So make the most of this football season and download FanDuel today. 19-plus and physically located in Ontario.

Gambling problem? Call 1-866-531-2600 or visit connectsontario.ca. Сегодня и что оно означает? This is Today Explained. Talman Joseph Smith, economics reporter at the New York Times and good friend of Today Explained. Start by telling me whether a 5.25 interest rate, which is where we're at today, is considered high. Yes and no. So to get to the yes first, it is absolutely a very high interest rate compared to, say, the 2010s when most of the decade interest rates were at or near zero, with exception of a year or two here or there. And it's important to also keep in mind,

however, the pace of this rate site high goal. So in February 2022, just over a year ago, the Fed still had baseline interest rates near zero. By summer, they were around 1%. And basically a year, they've hiked interest rates 10 times and essentially quadrupled that 1% rate from a year ago. In fact, a little bit more than that. However, in the grand scheme of things, interest rates across much of the 20th century and much of the early part of this century were at current levels or much higher. All right, so let's talk about the response to yesterday's rate hike. 5.25, you're putting it in context and you're saying, look, in context, it's not that high, but it's high for now. What's the response? There's this sort of

battle that's been going on really since 2021, the spring of 2021, when inflation first reared its head, there has been the doves and the hawks. Doves are generally folks that say the cost of borrowing could be lower in order to support the economy and the labor market in various ways. Rate increases make it more likely that companies will fire people and slash hours to shrink wage costs. Rate increases also make it more expensive for families to do things like borrow money for a house. And so far... On the other side, you have hawks who believe that wherever the Fed's stance is at a given time, the Fed's probably not doing enough. We have more work to do on inflation. Inflation, although we've had some welcome news,

is still too high. And we need to do what we can with our monetary policy tools to bring it down. For much of 2021, the Doves had somewhat of an upper hand as people looked at supply chains being messed up. They looked at the fact that China was still shut down even as we reopened with our vaccines. And they said much of this might be transitory, which is a fancy word for transient,

which is a fancy word for temporary, that we wouldn't have to live with these higher rates of price increases for very long. And so why not just practice patience and let this thing sort of resolve itself? And the hawks were saying, no, no, no, you don't understand. We have spent trillions and trillions of dollars. Those trillions and trillions of dollars in spending have not even fully hit the economy. For now, as long as we have constrained supply, those trillions of dollars are going to stimulate demand

in a way that will be unsustainable on a longer basis than you think. Now, nobody could have predicted, unless they had a crystal ball, the Ukraine war. But just as there was hope that inflation might settle on its own, the Ukraine war happens, supply chains get even more discombobulated, energy prices, commodity prices experience all sorts of volatility, and we get the sort of near double-digit inflation that we got last spring, last summer. And so the hawks ended up having the upper hand. As inflation has moderated over the past year, going from that peak of 9% down to 5%,

and actually 4.2% according to the Fed's preferred measure, Doves, once again, are sort of having the upper hand. In fact, there are some hawks who have converted to dovedom, saying that, okay, we were right in 2021 and in early 2022, but geez, I mean, we've hiked 10 times now. We've more than quadrupled the rate. How about we take a pause? Now, the Federal Reserve seems to be leaning towards taking a pause by their next meeting in June. There's this idea that this might be the last rate hike.

A decision on a pause was not made today. You will have noticed that in the statement from March, we had a sentence that said the committee anticipates that some additional policy firming may be appropriate. That sentence is not in the statement anymore. We took that out. That's a meaningful change that we're no longer saying. Part of the reason that they're thinking about taking a pause, presumably, is because of what higher interest rates do to the economy more broadly. Let's talk about what higher interest rates have been doing. And let's start with a place where I think almost every single one of us probably focuses our attention at one point or another, which is the housing market. What do higher interest rates mean for people buying houses and people selling houses? In the most direct way, it makes your

monthly mortgage payment much more expensive when the mortgage rate goes up. And we saw during the height of the housing boom in 2020, 2021, and even leaking a little bit into early 2022, there were plenty of folks, all of whom were able to get interest rates at four, three, and in some cases, nearly 2%. That allowed many people to lock in cheap fixed-term debt, even as interest rates have risen over the past year or so. They've been locked in, and so they've not been affected. However, if you're a new home buyer, you not only have to contend with higher prices that have come as a result of the housing boom that we've seen, but now you can't really get a mortgage for two or three or four percent. And in some cases, not even five percent. Often you're looking at seven percent. And if your

credit score is not that great, eight percent. And that's if you can even afford the down payment in the first place. My interest rate on my mortgage is three percent. And I will tell you something, in all honesty, if it had not been 3%, I wouldn't have bought a house. It was like everyone said to me, you need to do it now while rates are low. And I was like, okay, I'm of age. I'm going to do it. But if interest rates had been 6% or 7%, I would not have gotten that advice, and I would still be renting. What do high interest rates do to businesses?

So this is one of the main channels that the Fed operates its policy. It is the simple mechanism that when the baseline interest rates for the cost of borrowing money goes up, every single business has their cost of borrowing set against that. And it's usually going to be a little bit higher based on your credit worthiness. That has changed. Now, many businesses are going to, over the course of this year, and certainly over the course of next year, going to have to go back to the well and ask for more funding to get another credit line from the bank, or just at least refresh it. Many people may have sticker shock when they realize that the new cost of borrowing money,

just because the federal funds rate, that policy rate that we've been talking about, just because it's gone up by so much, their borrowing costs will have gone up by a lot as well. And that could lead to some of the things that you've talked about with other guests and that you've talked about with me, which is they may make pretty drastic cutbacks internally, including stopping new expansions of business, maybe not investing in new equipment, maybe not doing new hires, and in many cases or some cases, deciding to fire people to cut back on staffing. And that's where you get into the sort of things that people really worry about, which is the eventual impact that this could have on the labor market.

Okay. So we have housing, we have businesses. And then, Tal, a thing that we keep hearing the sort of things that people really worry about, which is the eventual impact that this could have on the labor market. Okay. So we have housing, we have businesses. And then, Tal, a thing that we keep hearing is that one of the reasons we have seen bank failures over the past couple of weeks is because of interest rates going up. Can you explain that? Can you make two and two equal four here? How does Silicon Valley Bank end up closing just because Jerome Powell is like, we're going to jack up interest rates a bit more? They had these assets on their books,

these treasury bonds on their books that paid out a lot less than newer bonds issued at higher rates could, which makes those old bonds less valuable. Now, that's not usually a big problem if you don't have depositors that are worried about their money. But as news about how a lot of these assets they had in their books were not as valuable now compared to 2020 and say 2021 got out, their depositors were so concentrated. They're part of a sort of Californian elite that often also had deposits that were above the government-protected limits in terms of deposit insurance. Put that all together, and you do have almost a worst-case scenario that isn't the case for much more diversified banks throughout the country. However, it's obviously spooked markets. It's spooked the Federal Reserve. Jerome Powell spoke about how banking stress, financial conditions being challenging factored into their sort of forward guidance.

We will continue to very carefully monitor what's going on in the banking system, and we'll factor that assessment into our decisions in an important way going forward. And so if we have banking getting hit, and we have homebuyers and home sellers getting hit, and we have businesses, and in particular, we pay attention to small businesses getting hit, when do things start to break? It's funny. You do all sorts of reporting that I do, and you're talking to asset managers that control trillions of dollars. I spoke with a CIO of fixed income at BlackRock yesterday. I could just smell how rich he was through the phone.

You listened to Jerome Powell yesterday. And he is arguably one of the most powerful figures in the entire globe. And they all keep saying the word uncertainty, uncertainty. You can just imagine, as a reporter and as a citizen, I think it's very understandable that people are uncomfortable and fearful. Because when sort of the smartest money in the room and, you know, most powerful people in the world are saying that they're not sure what's going to happen either in the coming months, that's a good reason to be cautious, if not fearful. In terms of how we'll go from here, there's this old phrase that monetary policy operates with long and variable lags. Basically, that you never really know exactly what interest rate hikes, especially when they happen this quickly, will do to the economy, besides the obvious things that it will do to interest rate sensitive sectors. And they happen with a lag regardless. So

we're not out of the woods yet. I can't tell if you're optimistic or pessimistic, Tal. It depends on the day. It depends on the day. All right, we're going to take a break. And when we come back, we're going to talk about the last time interest rates were really, really, really high. Tal, you're coming back with us? Yep. Support for Today Explained comes from Ramp. Thank you. They give finance teams unprecedented control and insight into company spend. With Ramp, you're able to issue cards to every employee with limits and restrictions and automate expense reporting so you can stop wasting time at the end of every month.

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Talman Joseph Smith of The New York Times. The federal funds rate, the interest rate, is now at 5.25%, which seems very high to us. But historically, it interest rate is now at 5.25 percent, which seems very high to us. But historically, it is not that bad at all. I was looking at some data the other day. In 1980, it was 20 percent. What was it like to be a consumer during that period? In the early 80s, the average boomer, who is now somewhere between 60 and 80 years old,

they were in their late 20s and in their 30s like most millennials are now. Interest rates were really high, and that's in part because inflation was really high and the Federal Reserve of that era was doing its own version of hiking the cost of capital in order to try to bring inflation down. Robin, there are those who claim Paul Volcker is the real father of this recession. In October, soon after he became Federal Reserve Chairman, the Fed intensified its efforts to stop inflation. Its basic strategy was to cut back the amount of money that would be available for borrowing.

They succeeded eventually, and you got a really nasty recession out of it. Mr. Volker, welcome. First, are you willing to accept parenthood for this recession? No, I'll claim no paternity. I don't even like the question being asked that way. But in the meantime, and even for a bit afterwards, interest rates were really high. And I was talking with your heroic producer before we started chatting, and he mentioned how Rocky Balboa in one of the Rocky

movies is like bragging about how he got a mortgage rate that was 9.5% or something along those lines. This is Miles, the producer. It wasn't Rocky, it was his wife, Adrian, and she wasn't bragging so much as just stating the fact. I regret the error. The bank said it will give us a $16,000 first mortgage at 9.5%. Well, hey, I told my dad, I said we'd will give us a $16,000 first mortgage at nine and a half percent. Well, hey, I don't mind. I say we get the house now. Yeah, but we can go upstairs. I don't mind. It's just details. I'm sure it's nice. And so I think that bit of pop culture is sort of telling about the sort of relative scale of what it was like to sort of operate as a consumer and as a person during that time. And I think in some ways it

serves as a cautionary tale as we debate as a country when and if we should pause our current rate hiking cycle. I was talking to my mom the other day and she was telling me that when my parents bought their house, their interest rate was 12%. It is inconceivable to me of the 3% interest rate that people might have been borrowing money on those terms. When did the interest rates start to come down? They came down from their high teens in the early part of the 80s, down, down, down through the 90s. And then comes the Great Recession. And you have the Fed's policy interest rate go all the way down to zero. The Federal Reserve has decided to keep interest rates at a record low. With the economy continuing to bleed jobs and credit still hard to come by, the central bank said it will employ a new tool

hoping to boost the economy out of the recession. There was talk about whether the entire global financial system would collapse. We actually had deflation for a period of time that lasted for quite some time, depending on the sector. I'm sure there's plenty of people that remember housing prices dropping by double digits continually for a period of time. And job loss, permanent job loss, especially, was very prominent. And it was a period of folks having their car taken by the repo man, of having their houses foreclosed on in a way that was incredibly widespread and common. It seemed like everybody knew somebody that was affected if they weren't affected themselves. And in terms of the overall economy, what economists call aggregate demand was very, very suppressed. There's a much more simple way to put it, which is if you're broke, you can't

spend that much. And a lot of people were broke. I'm sure you and I both vividly remember when the Obama administration had a big stimulus plan. The American Recovery and Reinvestment Act that I will sign today, a plan that meets the principles I laid out in January, is the most sweeping economic recovery package in our history. And it worked, but it didn't really get us out of a rut. But people were still very, very upset about that stimulus plan, and they thought it was irresponsible in some cases. It began last February with an offhand slap at President Obama's stimulus plan by a cable

commentator. We're thinking of having a Chicago tea party in July. All you capitalists that want to show up to Lake Michigan, I'm going to start organizing. So that sort of ended up leaving the Federal Reserve as the only game in town. And the Federal Reserve can't spend in the direct way that the government can, but it can lend. And so the 400 PhDs at the Federal Reserve and the Federal Open Market Committee, all the folks that run the Fed together, circle around this idea of like, okay, well, what if we just keep it really inexpensive for businesses to finance their operations? Hopefully that'll do something. So I'm not sure about the age range of our listeners

here, but I'm sure plenty of people have seen the meme of a stick man poking a blob saying, do something. And for much of the 2010s, that's what the Fed was doing. And they weren't getting a lot of results by some measures besides helping finance fledgling industries like tech, which ended up being a very big deal. And, you know, there's an uncertain but real share of, you know, apps that we have and delivery services and all sorts of things of that nature that we might not have if the cost of borrowing was harder for startups. Give me a few examples of the companies that you're talking about. Your Ubers of the world, Netflix, the sort of big tech companies that we've seen.

Why would you go after revenue? Because to make money? No. If you show revenue, people will ask how much and it will never be enough. The company that was the 100x or the 1000x or becomes the 2x dog. But if you have no revenue, you can say you're pre-revenue. You're a potential pure play. It's not about how much you earn. It's about what you're worth. And who's worth the most? Companies that lose money. A lot of that, some think, would not be as powerful of an industry in our economy. The sort of tech-based engine would not be as strong without this period. However, the apps that we scroll or the delivery services that we have don't necessarily raise living standards. And I guess that brings me very quickly to just

the counter argument here that, no, in the end, those low interest rates actually did help stimulate things. By the end of the slow jobs recovery that we got throughout the Obama era, the economy kept expanding because it was cheap for businesses to borrow, and inflation was still low. And so we all chugged along, and people were feeling pretty good about the economy, even though there was still an affordability crisis at that time. And even though, obviously, politically, the country was incredibly divided. And then, of course, we had COVID, which has been an incredible exogenous shock that has sort of changed everything, at least for now. So at the end of the day, Tal, what's more abnormal?

The moment we're in where we see interest rates ticking up and we're all getting very nervous or all of those years where interest rates were near zero, what kind of world do you think we're headed into? The one that we came out of or the one that we're in in early 2023, mid-2023? So I'll go back to that phrase I used before, at risk of being repetitive, uncertainty. There's a wide band of uncertainty. There's a lot of very credentialed, very proven smart people who respectfully disagree on this issue. But in terms of my own inkling, I think we'll probably end up somewhere in between, right? It seems inevitable to me and to many of other reporters that the Fed will eventually have to ease from

their current rate position. For example, a guy that I know at J.P. Morgan, that's very high up there and well-respected, he, as well as another investment firm called Bespoke, both think that inflation could be below 3% by early next year. And that even if we have a nasty temporary uptick in inflation in the next month or two, that the overall yearly rate could still be below four by sometime in summer. At which point, people might say, well, Fed, it looks like you're actually sort of winning your fight on inflation, especially since a lot of the data that we get on inflation lags behind us, right? Often we're talking about data that is a month or more behind the president. And so that would put a lot of pressure on the Fed

to cut rates, because if the point of a 5.25% interest rate is to get inflation down, and inflation is now seemingly coming down, heading back towards 2-ish percent, then maybe it could be time to ease, especially if the trade-off could be what some might say is unnecessary pain on small businesses and those employed by small businesses as well as large businesses. But the flip side of that is that the country does really seem to be scarred by recent inflation, right? And I think there'll be a hesitation to cut rates too much.

Certainly, I don't think there's a big coalition for going back to 0% or near 0% anytime soon. You know, the funny thing here is that, you know, there were clearly some excesses that did come from having a near zero rate, right? The animal spirits kind of got crazy. There was a lot of froth, right? I'm sure we all remember, you know, reading about, you know, scooter companies valued at billions of dollars based on no proven track record, right? Things got a little bit crazy. And so it does seem like there'll be somewhat of a hangover that makes it so that we end up somewhere in the middle ground. Talman Joseph Smith covers economics you can find more of his work at a lone newspaper

called the New York Times Miles Bryan and Amanda Llewellyn produced today's show, Matthew Collette edited Russ Hanneman advised Michael Raphael and Paul Robert Mouncey engineered I'm Noelle King. It's Today Explained. Thank you.