The Federal Reserve has declared victory in the fight against inflation. At its meeting today, the central bank announced that after two years of raising interest rates to contain prices, it is finally starting to lower interest rates again.
The Fed cut interest rates by 0.50 percent (or 50 basis points) and indicated that future cuts will be of a similar magnitude. That’s more aggressive than some observers had expected, but even at that pace, the super-low rates of pre-pandemic America are still years away. The immediate financial impact will therefore be small. More important, in all likelihood, is the message this announcement sends: Inflation is no longer a major problem, and the Fed is now focused on keeping the economy, especially employment, strong.
No one really knows how interest rates and consumer prices interact. The common theory is that higher interest rates, by increasing the cost of borrowing, force consumers to cut spending and businesses to lay off workers. This sets off a vicious cycle that stalls the economy and puts prices under control.
But that did not happen this time. The Fed raised interest rates and inflation subsided without causing any economic problems in between. Consumer spending and the labor market remained strong. If higher interest rates caused Although inflation is cooling, the exact mechanism remains a mystery. In fact, the theme of this year’s Jackson Hole Economic Symposium – you could compare it to Davos for central bankers – was “Reassessing the Effectiveness and Transmission of Monetary Policy.” That’s Fed jargon for “Interest Rates: How Do They Work?”
To complicate matters, setting interest rates is about more than the literal interest rate. The central bank also uses interest rate policy to influence people’s expectations of the future and, in turn, their behavior. Two years ago, when inflation soared, the Fed responded quickly and decisively, raising rates. “We will continue until we are confident the job is done,” Fed Chair Jerome Powell said in August 2022, making it clear that the Fed will do whatever it takes to get prices under control. Some experts believe this is why inflation has fallen so painlessly over the past year. Convinced that the problem was under control and a significant slowdown was imminent, consumers spent less money and employers curtailed their hiring spree just enough to help the economy return to normal.
That theory has its own problems. Most people have little idea what the Fed does and may have only a vague idea of what’s going on in the wider economy. In poll after poll, a majority of Americans continue to say inflation is a big problem, undermining the notion that the Fed’s steady hand has calmed the nation’s nerves.
Today’s rate cut, however, could be a rare and important case where the Fed’s message gets across clearly. The long-awaited policy change will generate enormous media attention. Most Americans may not be able to explain what the federal funds rate is or why it matters, but they will hear the nation’s economic experts declare that inflation is defeated and better days are ahead. This could become a self-fulfilling prophecy: If the Fed succeeds in improving economic sentiment in the country, companies may continue to hire and raise wages, consumers will continue to spend, investors will finance new projects, and the economy will remain strong.
The Fed’s announcement, just seven weeks before the presidential election, could also have political implications. Voters believe inflation is The The country’s central problem, and they blame the Biden administration for it – including Vice President Kamala Harris, some polls show. That view has persisted despite a long period of very low inflation. A major “inflation is over” news cycle could finally convince at least some voters that the problem is actually solved, which will benefit Harris.
The risk remains that the Fed has waited too long to act. Inflation has been near the central bank’s target for nearly a year, and the economy, while still far from a recession, is showing clear signs of slowing. Job openings have fallen, unemployment has risen, and more people are behind on their credit card bills and car payments. None of this would be particularly concerning if the Fed could just push a button and give the economy an instant boost, but it can’t. In fact, economists generally believe that interest rate changes take a while to feed through to the economy. How long, exactly? Nobody knows. As monetary policy experts Christina Romer and David Romer wrote in early 2023, “If policymakers continue to tighten until inflation falls as far as they want, they will likely have gone too far — because the effects of tightening policy will linger for many months after the rate hikes end.”
Many other prominent economists have issued similar warnings. If they are right, the recession that America miraculously avoided may turn out to be only delayed. On the other hand, experts have made many dire predictions about the economy over the past three years that have turned out to be wrong. Hopefully, one of them is still in the works.
