https://www.bloomberg.com/news/articles/2024-06-12/wall-street-s-rate-cut-dreams-have-to-wait-as-fed-stays-on-hold?srnd=all

13 June 2024 at 10:12 GMT+12

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Big Take

The Fed’s Great Rate Debate

17:03
For over a decade, America’s central bank has had an inflation target of 2%. On Wednesday, the Federal Reserve announced that it would keep its main interest rate unchanged in order to try and get inflation to that magic number. But what if the Fed is thinking about inflation all wrong?

On today’s episode, host David Gura talks to Bloomberg’s Managing Editor for US economic policy Kate Davidson about the reasons the Fed introduced an inflation target in the first place, and Bloomberg Opinion columnist Mohamed El-Erian about the risks if the Fed is wrong about this – and who could be hurt the most.


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Here is a lightly edited transcript of the conversation:

David Gura: I’m David Gura, joined in the studio by my co-host, Sarah Holder.

Sarah Holder: Hi David!

Gura: Hey Sarah!

Holder: I just had to join you because here at the Big Take, this day is just too big for one host

Gura: Indeed, it is. It’s like our Super Bowl…if the Super Bowl happened eight times a year.

Holder: Exactly like the super bowl…Today, the Federal Reserve concluded its two-day policy meeting.

Gura: And no surprise, it did not change its target interest rate. Here’s Fed Chair Jerome Powell:

Jerome Powell: Today, the FOMC decided to leave our policy interest rate unchanged…

Holder: That rate is around 5.3% at the moment. Which means the cost of borrowing – from mortgages to car loans – is likely to stay high for a bit longer

Gura: The Fed is doing this, of course, to try and tame inflation: to make sure that the kind of price spikes we saw during the pandemic don’t come back.

Holder: Now, no one likes rising prices, and I for one am tired of spending a small fortune on a carton of eggs.

Gura: You and me both. But, as annoying as it is to pay more for gas and rent and dinners out and those eggs some inflation is seen as a good thing.

Holder: But increasingly, David, there’s been a big debate about just what number America’s central bank should be aiming for how much we should expect prices to rise in the future.

Gura: So, for over a decade, that Goldilocks number: not too hot, and not too cold, has been two percent.

It’s something that Chair Powell hammered home again … and again … during the post-meeting press conference.

Powell: We are strongly committed to returning inflation to our 2% goal

Powell: We'll need to see more good data to bolster our confidence that inflation is moving sustainably toward 2%.

Powell: We remain committed to bringing inflation back down to our 2% goal

Holder: But David, you spoke to economist and Bloomberg Opinion columnist Mohamed El-Erian who has been making the case that so much has changed recently … that the Fed’s inflation goal needs to change too.

Mohamed El-Erian: This two percent target may be inappropriate for the world we’re living in today.

Holder: This is The Big Take, from Bloomberg News. I’m Sarah Holder.

Gura: And I’m David Gura. Today on the show: Mohamed El-Erian, who believes the Fed’s two percent inflation target is wrong, and what it could mean, if it is, for everyone hoping to buy a home or pay down student loans, or preparing to retire.

Gura: Now, before we get into why the Federal Reserve’s goldilocks inflation number could be wrong, we need to understand how policymakers settled on that two percent target in the first place. Well, it all started … in the wake of the global financial crisis, says Kate Davidson. She’s Bloomberg’s managing editor for U-S economic policy.

Kate Davidson: The recovery from that crisis, even though the Fed threw everything they had at it, it was just very slow, very tepid. Inflation was very low.

Gura: This may be hard to imagine now, given how high inflation has been in recent years. But back then, this was a big issue. Low inflation. Prices were rising too slowly, or not at all. And this is a problem, because it can cause people to put off big purchases. Why would you buy now if the price isn't going to move? Well, that made it difficult for the Fed to use its main tool,cutting interest rates, to help the U-S economy grow after the crisis. That’s because back then, rates were already at zero, and the economy still was not growing.

Davidson: And that means that the Fed just didn't have any more room to cut rates further. And so this is a position they didn't want to be in. They actually wanted to get inflation back up again.

Gura: So, the Fed started looking for another lever to pull. Policymakers commissioned studies, and they looked at what other central banks were doing... and that’s when they found something that seemed promising on the other side of the globe, in New Zealand.

In 1990, that country was grappling with high inflation. So the Reserve Bank of New Zealand tried something novel: it introduced an inflation target of two percent. In other words it told the public what it thought inflation should be. And it worked! And eventually, several other big central banks followed New Zealand’s example

Davidson: The idea here was that, by setting this target, they would just be very transparent and clear and like, look, this is what we're going for. And that that would help the public's understanding and nudge that number up to the, around the place where they wanted it to be.

Gura: It seemed promising and it also appealed to then-Fed Chair Ben Bernanke, who’d been working to make the Fed more transparent with the public, and investors, and lawmakers. As an economics professor at Princeton, Bernanke co-authored an influential paper on inflation targeting. So, in 2012, after years of debate and deliberation, the Fed decided to adopt its own inflation target of two percent.Bernanke introduced it at a news conference in January of that year.

Ben Bernanke: Clearly communicating to the public this 2% goal for inflation over the longer run should help foster price stability and moderate long-term interest rates and will enhance the Committee’s ability to promote maximum employment in the face of significant economic disturbances.

Gura: Buried in all that Fed-speak is a reference to what’s known as the central bank’s "dual mandate." Kate explains the Fed has two big objectives.

Davidson: One is to achieve maximum employment and the other is to keep prices stable.

Gura: This is pretty rare among central banks and it can sometimes pose a challenge for the Fed’s policymakers. Because a growing economy that’s creating jobs can also sometimes overheat, as people spend more, causing prices to rise.

And of course, taming prices can sometimes slow economic activity and lead to job losses.

But for a while this inherent tension wasn’t really a problem even after the Fed introduced this target.

Davidson: I remember just month after month after month going and covering these inflation reports. And every month it was the same story: The Fed has undershot its inflation target again and again and again. And they were just having a very difficult time bringing inflation up to where they wanted it to be. Which, you know, given where we are today, just seems like really another world, right?

Gura: Well, about a decade later, prices spiked during the pandemic, as supply chain bottlenecks made everything more expensive. For a while, the Fed misjudged why inflation surged, and that damaged its reputation, according to Mohamed El-Erian. He’s the chief economic adviser at the financial services firm Allianz, and the president of Queens’ College Cambridge. And, as we mentioned, he’s also a columnist for Bloomberg Opinion.

El-Erian: The inflation credibility of the Fed was hit very hard by the massive mistake they made in 2021. People remember in 2021, when inflation started going up, the Fed rushed to call it "transitory."

Powell: Current high inflation readings are likely to prove transitory

Powell: So, I think the word "transitory" has different meanings to different people.

Powell: The concept of transitory is really this, it is that the increases will happen. We’re not saying they’ll reverse, that’s not what transitory means.

El-Erian: And David, "transitory" is a very dangerous word in economics because it implies a phenomenon is temporary. It's reversible. Therefore, you should look through it, and not do anything about it. By the time the Fed realized at the end of November, that they had made that basic analytical mistake, they then didn't move fast enough. So we had the ridiculous situation that, in the following March, when inflation hit seven percent the Fed was still injecting liquidity into the economy, and interest rates were still at zero.

Gura: Now, El-Erian says the Fed has done a remarkable job bringing down high inflation without causing massive job losses, or a huge hit to the economy.

But it is so wary that inflation could spike again that it’s keeping interest rates high in the hopes of hitting that magic 2% target.

El-Erian: The Fed is understandably seeking to, to hit that target because it has missed it for such a long time. And if it changes the target now, it will significantly erode its credibility, which is already being tested.

Gura: But that reticence is a mistake, El-Erian argues. Because, he says, that inflation target, which the Fed introduced more than ten years ago, is no longer fit for purpose.

El-Erian: We have to remember, David, there's nothing special about this 2%. It emerged in New Zealand back in the early nineties. It was an experiment for inflation targeting. It seems to work there. And suddenly the 2 percent became the target for central banks that vary in circumstances. Now it didn't matter because we were in a disinflationary world. So the 2 percent wasn't binding for decades. And now we live in an inflationary world where we have to ask the question, is 2 percent still the right target?

Gura: Coming up after the break: the huge risk to the economy if the Fed’s inflation target is wrong, the people who argue not so fast, and who would be hit the hardest.

Gura: Sarah, we’ve been talking about something so big, so exciting it required two hosts.

Holder: That’s right David – we’re talking about June’s Fed meeting and the central bank’s decision to keep interest rates at their current level.

Gura: But something else happened on Wednesday that got economic policy wonks like the two us fired up

Holder: Yes, it was a real embarrassment of riches for the econ-heads – just before policy makers sat down for the second day of their meeting, the Bureau of Labor statistics released the monthly consumer price index for May. That’s a key measure of inflation.

Gura: it is - and it surprised a lot of people by showing that price increases cooled last month. Overall, prices rose by 3.3% compared to last year. And if you compared May prices just to April, they didn’t climb at all.

Holder: ok So David, we know the Fed prefers another inflation gauge – the PCE deflator. But does the CPI news help or hurt Mohamed El-Erian’s case?

Gura: Well, his argument isn’t just related to these statistics, but to what he sees as a broader shift in the global economy and what that means for prices.

El-Erian: We no longer live in a world of deregulation, liberalization, and fiscal prudence. We live in a world of protectionism, of regulation, industrial policy, and unfortunately, fiscal irresponsibility. And globally, we're no longer in a world of disinflationary globalization. We are in a world of fragmentation, which is inflationary.

Gura: To unpack that, trade wars, geopolitics, and those supply chain shocks are changing the way goods are priced. In a world with less globalization, prices get stickier, and they can stay higher.

In other words, he believes the downside – of keeping rates high just to hit the Fed’s target – isn’t worth it. It’s too dangerous.

Gura: What are the potential consequences of the Fed getting this wrong? What are the risks to the economy?

El-Erian: At the minimum, it is foregone output. There is also the possibility of destabilizing the financial system. But what I’m really worried about, David, is the unnecessary burden that will be carried especially by low-income people.

Gura: El-Erian is now perhaps the loudest voice in a small chorus of experts who want the Fed to retire its two percent target, and they are trying to win converts.

It has been a tough sell. The Fed spent years arguing internally, and speaking with stakeholders, before it introduced that two percent target over a decade ago.

And there’s a big argument for saying that changing it now, in the middle of this fight against high inflation, could erode credibility.

Gura: Do you think that more people are coming around to the argument that you’ve been making, that now is the time to revisit this number?

El-Erian: I definitely think more people are coming around to this view.

Gura: Nobel Prize-winning economist Paul Krugman has written about revisiting the two percent target, and so has Olivier Blanchard, the former chief economist of the International Monetary Fund. And some U.S.lawmakers have started to question why the Fed is so steadfast when it comes to its two percent inflation target, including Democratic Senator Catherine Cortez Masto, of Nevada.

She brought it up, when the Fed chair testified before the Senate Banking Committee last year:

Catherine Cortez Masto: For the general public, for those working families and people, why 2%? Why is getting it to 2% so important?

Powell: "So, that has become the globally agreed... Essentially all major central banks target two percent inflation in one form or another."

Cortez Masto: How does that help my Nevada families? How does that help people in Nevada?

Powell: I will tell you how it does…I guess it is not obvious how that is. But 2 percent inflation, to have people believe that inflation is going to go back to 2 percent really anchors inflation there because the evidence is and the modern belief is that people’s expectations about inflation actually have an effect on inflation. If you expect inflation to go up 5 percent, then it will

Gura: Cortez Masto was getting at a tension that’s emerged recently, between strong economic data, and how Americans feel about the economy.

Now, sentiment may be a little squishy, but Bloomberg’s Kate Davidson says it’s still significant. Policymakers and politicians pay attention to it.

Gura: Can we talk about vibes a little bit?

Davidson: Sure.

Gura: It strikes me that in this debate, vibes matter. People, I think, are getting frustrated with how long this fight has been going on, and what it's meant for them and their pocketbooks.

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Davidson: Absolutely. I mean, it's, you see it every day, almost every day in the polling and the consumer sentiment surveys and the way that people talk about this economy. They go to the grocery store, they go to buy something, they can see prices are higher than they were several years ago. Um, but I think that they, they also feel like they're, you know, it's getting more expensive to carry debt. It's getting more expensive to take out loans, to borrow. And so it's this combination of factors where they feel like, well, things are maybe not that great.

Gura: What makes the Fed chair and other Fed officials so reluctant to revisit the Fed’s two percent target is this fear it could affect consumer expectations – and consumer behavior.

On top of that, the Fed is in a tough spot in an election year. It’s a fiercely independent institution, and policymakers, including Powell, don’t want to do anything that could be construed as political.

But El-Erian argues the Fed has to be more pragmatic.

Gura: You said that keeping this low 2 percent target could hurt low- income people, but aren't they already being hurt by high inflation as well? In addition to these higher interest rates?

El-Erian: I mean, that's a tragedy. You first hit them with an unanticipated inflation shock, and let's not forget that inflation was higher than average for the goods consumed by less-privileged segments of the household, those who capture a much bigger part of their budget. So they got hit hard. That's why inflation coming down is important.

But if the difference between being at 2 percent or being nearer to 3 percent is losing your job, is income insecurity, that is simply adding insult to injury. And that is what I'm worried about. The difference between a 2 percent inflation and nearer to 3 percent is very small if the consequences of being at one or the other is your job.

Gura: But for now, the Fed remains committed to its two-percent target. And as Powell said, at the end of Wednesday’s news conference, he still believes having it will benefit all Americans, including those with lower incomes.

Powell: We had a period of high inflation, inflation has come down really significantly, and we're doing everything we can to bring that inflationary episode fully to a halt and fully restore price stability. We're confident that we'll get there. And in the meantime, you know, it's going to be painful for people, but the ultimate pain would be a period of long, a long period of high inflation.

This episode was produced by: Alex Sugiura; Senior Producers: Naomi Shavin and Kim Gittleson; Editors: Stacey Vanek Smith; Senior Editor: Elisabeth Ponsot. Executive Producer: Nicole Beemsterboer; Sound Design/Engineer: Alex Sugiura; Fact-checker: David Fox.