This week we talk about the Fed, interest rates, and inflation.

We also discuss cooling economies, the Federal Funds Rate, and the CPI.

Recommended Book: Dirty Laundry by Richard Pink and Roxanne Emery

Transcript

I’ve done a few episodes on this general topic over the past several years, so I won’t get super in-depth about many of the specifics, but the US Federal Reserve has a dual-mandate to keep prices stable and to maximize employment in the country—though that core responsibility has been expanded in recent years to also include regulatory control over banks, providing a variety of services to banks and other savings associations, and doing what it can to moderate long-term inflation rates.

A lot of these responsibilities are intertwined, in the sense that, for instance, if you increase interest rates, that can lead to less spending by corporations that might otherwise borrow and spend liberally, creating more jobs; so adjusting one lever often tweaks seemingly disconnected outcomes—which is part of why this agency’s activities often fly below the radar of non-regulation, non-monetary-world people and publications; they’re super-careful with their powers, because one wrong move can cause ripples of discomfort throughout the US and global economy.

When one of those metrics they’re meant to moderate goes haywire, on the other hand, they’re all over the news; their every action, even the seemingly unimportant ones, tracked in great details, and breathlessly reported-upon.

For a variety of reasons, including the large-scale shut-down of various aspects of society and the global economy, and the consequent disruption of global supply chains, inflation—as measured by CPI, or the Consumer Price Index—shot through the roof, pretty much everywhere on the planet, beginning in 2020.

Leading up to that moment, many wealthy countries had been doing pretty well in terms of moderated inflation levels, and the US was no different: year-over-year inflation growth was down to sub-1% levels in 2014 and 2015, and it was close to the Fed’s 2% target level from 2010, when the worst of the 2007-2008 economic crisis had receded, until 2020, when it was down to 1.4%.

That year, the Federal Funds Rate, which is the lever the Fed uses to adjust interest rate levels throughout the US government and economy, setting the interest rate banks charge to lend each other money short-term, basically, that number eventually influencing everything from savings account interest payments to mortgage rates to what you can expect to pay for a car loan—that Federal Funds Rate was down to .25% in 2020 and 2021, which is very low, which meant that debt was very cheap and easy to acquire, corporations happily borrowing as much money as they wanted, as it would cost them very little to do so, and that meant expansion across the economy, that expansion further aided by low interest paid on savings accounts and similar, safe-havens for money, which made investing in startups, stocks, and similar, risky investment vehicles more appealing—because the safe stuff didn’t pay much of anything.

All of which meant a spending bonanza—right up to the point that COVID-19 started rippling outward from China, and the world’s governments responded with lockdowns and similar, economy-stifling measures.

By the end of 2021, year-over-year inflation in the US was up to 7%, from 1.4% the previous year, and it was 6.5% the following year.

In 2022, the Fed bumped the Federal Funds Rate from that incredible low of .25% up to 4.5%—a huge jump, and a staggering blow for an economy that was experiencing a dramatic surge in prices; the goal being to slow things down, and consequently, hopefully, also slow that inflation rate.

Other factors likewise influenced inflation around the world during this period, including Russia’s invasion of Ukraine, which massively complicated the global energy market, alongside other disruptions, and the weirdening of politics, which have become increasingly tribal and extreme over the past decade or so in many governments around the world, have made it trickier to legislate, and have carried a wave of unserious and obstructive lawmakers into office.

That hiking of the Federal Funds Rate ended what’s been called the US’s ZIRP era: a period in which zero interest-rate policy, or so close to zero that it’s essentially zero interest rate policy, defined the shape of the economy, what professions everyone chose to pursue, which players became dominant in their industries, and what sorts of bets made financial and reputational sense.

The US, and much of the world, especially the wealthy world, was thus suddenly plunged into a very different financial and regulatory environment, changing its posture and the politics of money and spending, while also queueing things up for a potential future in which inflation might be tackled and the Fed might start adjusting the dial downward once more, tipping the economy back into something more spendy and risk-taking, after a handful of years in which the name of the game has been cutting costs, laying off as many people as possible, and recalibrating toward today’s profits over investing in tomorrow’s potential gamechanging outcomes.

What I’d like to talk about today is the Fed’s recent decision to do exactly that, adjust their interest rate dial, and how the way they did it is being received by those who are the most affected by this choice.

—

The mechanism of the Federal Funds Rate is fairly straightforward: make it more expensive to borrow money and you tend to cool the economy.

Do this at the wrong time—when the economy is already cool—and you hurt the businesses that make up the production side of things, but also consumers, as there likely won’t be enough jobs, and enough jobs paying enough for folks to earn a living, buy things, and keep those businesses operating at nominal capacity.

Don’t do it when you need to, though, and the economy can get out of hand, running too hot, expanding wildly, and possibly also pumping up inflation at a rate that makes everything pricier, which can lead to similar consequences: folks not able to afford as much because the price of things is going up, despite their pay being decent and the job market being on fire.

This rate has to be used like a scalpel, not a chainsaw, then, lest you tip things one way or the other, in either case resulting in some type of economic truncation and various types of suffering for the citizenry of the country in question.

In this context, a “soft landing” is a semi-mythical accomplishment involving the just-right application of the Federal Funds Rate so that you increase interest rates, maybe dramatically, to stifle high inflation, but then pull those interest rates back at just the right moment so that the economy is cooled, but not damaged, and you’re thus able to put things back on a nice growth trajectory, but with something like a 2% inflation rate, rather than something much higher, or just as bad in some ways, much lower than that.

It’s been speculated that a soft landing might be attainable by this Fed’s current leadership because they seemed to be acting prudently and objectively, despite the politics surrounding their efforts, and they also seemed willing to hold off on lowering the rate even when much of the business world and parts of the government were losing its mind over worry that they would keep it high for too long.

In late September 2024, the Fed announced that they’d decided to finally cut this rate, from a target range of 5.25-5.5%, down to a target range of 4.75-5%.

That’s a drop of .5%, which is unusual except in emergency circumstances, and while it wasn’t totally out of the blue—many analysts and betting markets had given a high probability to this potentiality, as opposed to the usual .25% cut—it was still quite a big event, as it makes pretty clear that the Fed sees their job as being mostly done, at least in the sense that they need to cut inflation quickly and dramatically.

That decision was made on the basis that US inflation rates, using the Fed’s preferred index, had dropped for the fifth consecutive month in August of this year, down to 2.2%, which marked the lowest level since February of 2021; that’s down from 2.9% in July, and is tantalizingly close to their target rate of 2%.

The implications of this double-the-usual drop in the Federal Funds Rate are many, and the specifics and claims vary depending on who you ask.

One perspective of why this did this how they did it is that the Fed sees that it’s work is done on this matter, and they’re keen to get interest rate levels back to something more moderated as quickly as possible so that the economy can keep its solid momentum going apace. They also recognize that there’s a delay on these sorts of decisions and their impact, so getting close to 2% and then pulling back is more likely to ultimately land them somewhere close to 2%, while waiting for reports that show 2% before pulling back would be likely to lead to an overshoot, which could be really bad for economic outcomes.

Another view is that the Fed accidentally held on a little too long and maybe should have cut rates by .25% at their previous meeting, and now, to make up for that, they doubled the cut; but  because of that accidental delay, the economy could suffer a bit, the Fed overshooting after all, which again, wouldn’t be ideal, but is a possibility because of that aforementioned delay in cause and effect.

Some prognosticators in this space, however, are seeing this as a panicky indication that we’re actually careening toward a recession, as some of the economic indicators folks watch to predict such things are flashing red, and while a successful soft landing could theoretically help the US avoid such a path, the current wave of relief and optimistic anticipation could also be an illusion that’s concealing structural weaknesses in the US economy that are about to rupture.

The most popular version of that more pessimistic prediction is that the US will experience a recession in 2025, maybe 2026 at the latest, and it will have to make it through that trough before it can start climbing up the peak, again—which would be bad news for investors and businesses, and would mean basically resetting to a standing start, in terms of growth, as opposed to perpetuating the momentum of the economy as it exists, today, which is doing pretty well by most metrics.

That could also be quite bad for burgeoning industries like those connected to AI systems, renewable energy, and microchips, as these are all investment-intensive corners of the economy, and a recession would almost certainly significantly truncate the amount of money sloshing around in investors’ bank accounts, waiting to be injected into businesses operating in such spaces.

All that said, at the individual level, while inflation has been moderated by many measures, prices dropping substantially from where they were even a few months ago, what’s been called the “vibecession” seems to still be hampering the everyday person’s sense of how things are going economically in the US—the numbers look pretty good, but the average person reports that they think things are going catastrophically.

It’s thought that this is at least partly the consequence of economic ignorance—folks only remembering the many negative headlines they see, and not realizing how historically low unemployment is, and how historically high the stock market has climbed, alongside other positive measures.

But the more potent ingredient, almost certainly, is that while inflation has moderated for many common goods and expenses, others, like food, are still quite high, and that’s an expense that we don’t just see periodically, like when we buy new shoes or a new car, but every week or even every day, which is a far more regular punch to the gut that hits not just our pocketbooks, but also our perception of how far our money goes, and how well off we feel as a consequence.

There’s already a great deal of speculation as to what the Fed will do at its next meeting in November, and bets on popular futures markets indicate there’s a 54% chance of another half-point cut, as opposed to a 46% chance of a quarter-point cut.

That latter potentiality would arguably support the assertion that the Fed is scrambling to make up for lost time, hoping to avoid an inflation reduction overshoot—or from a more positive perspective, maybe just wanting to get back to a more neutral interest rate stance sooner rather than later, to help keep the economy chugging along, without any periods of sluggishness, while the former potentiality, a quarter-point cut in November, would ostensibly seem to be a more confident stance from the Fed, but could also worry investors, as it might mean it’ll take a bit longer to fully return to that neutral stance.

Whatever speed the Fed ends up opting for in dropping interest rates, though, most analysts see the rate falling to something like the 3-3.25% range by the middle of 2025, which is at the top end of what’s generally see as a neutral rate for such things—a rate that won’t add fuel to a hot economy, but also won’t cool things artificially.

By that point, we’ll probably also know if the Fed has managed to nail a soft landing; it seems like they might have, but at this point there is still reason to suspect they didn’t, and that this is just the silence before the storm.

Show Notes

https://www.washingtonpost.com/opinions/interactive/2024/john-lanchester-consumer-price-index-who-is-government/

https://en.wikipedia.org/wiki/Consumer_price_index

https://en.wikipedia.org/wiki/Misery_index_(economics)

https://apnews.com/article/federal-reserve-barkin-interest-rates-inflation-bba49b528649cf866e391a783033c067

https://www.cnn.com/2024/09/23/economy/rate-cut-what-next/index.html

https://www.wsj.com/business/entrepreneurship/fed-interest-rate-cut-small-business-spending-abfed941

https://www.forbes.com/sites/georgecalhoun/2024/09/26/the-feds-rate-cut--a-soft-landing--or-fake-news/

https://www.reuters.com/markets/us/fed-is-aligned-rate-cuts-upcoming-data-will-shape-pace-2024-09-27/

https://apnews.com/article/interest-rates-inflation-prices-federal-reserve-economy-0283bc6f92e9f9920094b78d821df227

https://www.cbsnews.com/news/federal-reserve-rate-cut-credit-cards-mortgages-already-lowering-rates/

https://www.federalreserve.gov/newsevents/pressreleases/monetary20240918a.htm

https://www.investopedia.com/will-fed-rate-cuts-save-commercial-real-estate-cre-loans-banks-8719181

https://finance.yahoo.com/news/new-pce-reading-supports-case-for-smaller-fed-rate-cut-in-november-143349577.html?guccounter=1

https://www.bloomberg.com/news/articles/2024-09-28/powell-speech-and-jobs-data-to-help-clarify-fed-rate-path?embedded-checkout=true

https://www.reuters.com/markets/us/traders-bet-second-straight-50-bps-fed-rate-cut-november-2024-09-27/

https://en.wikipedia.org/wiki/Federal_funds_rate

https://en.wikipedia.org/wiki/Zero_interest-rate_policy

https://www.investopedia.com/terms/s/softlanding.asp

https://www.cbsnews.com/news/federal-reserve-rate-cut-credit-cards-mortgages-already-lowering-rates/

https://www.theguardian.com/business/2024/sep/27/stock-markets-hit-record-highs-after-news-of-a-fall-in-us-inflation

This is a public episode. If you'd like to discuss this with other subscribers or get access to bonus episodes, visit letsknowthings.substack.com/subscribe