The Fed’s big swing at inflation

This is an audio transcript of the Behind the Money podcast episode: The Fed’s big swing at inflation

Michela Tindera
The US Federal Reserve is getting more aggressive in its fight against soaring inflation. Last week, the Federal Reserve decided to raise interest rates by 75 basis points. It’s the biggest interest rate increase in the US in decades.

Robert Armstrong
If I was to sum up the message of the Fed, it’s “we’re swinging the bat”.

Michela Tindera
That’s Rob Armstrong. He’s the FT’s US financial commentator.

Robert Armstrong
And you can swing a baseball bat and say, gosh, I hope no one gets hurt. But you’re swinging a baseball bat. Somebody is gonna get hurt. Less people are gonna be hired. More people are gonna be fired. There’s gonna be less investment. There’s gonna be less job creation. It’s gonna be a smaller economy.

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Michela Tindera
As recently as May, there had been talk of a soft landing for the economy, this idea that the Fed can raise interest rates enough to control inflation without causing a painful recession. But now, Rob says, hopes of that seem all but impossible. On today’s episode, we just hit a point where the Fed is getting tough. How did we get here and where are we headed next? I’m Michela Tindera from the Financial Times. And this is Behind The Money.

OK. So something really big happened at the Fed last week.

Robert Armstrong
Sure did.

Michela Tindera
Could you walk people through what brought the Fed to this point? When does the story of the inflation we’re seeing now start?

Robert Armstrong
We were in an extraordinary situation in the pandemic, and so we had a big shock to the economy, followed by an extraordinary set of fiscal stimulus plans from the government and monetary stimulus from the Fed. The pandemic dug a hole in the economy, and the federal government filled it twice. (Laughter) So and then there was that, they did too much stimulus. And then the Fed’s mistake was maybe not taking the inflation threat more seriously earlier. And we were all very unlucky when Vladimir Putin decided to launch an unprovoked and aggressive war against Ukraine, because that is a war between one of the world’s largest oil producers and one of the world’s largest wheat producers. And if you were already heading into inflation, that is the most extraordinary piece of bad luck you can possibly imagine. Right? It was like not only did we get a war, we got a massively inflationary flavour of war. So, although our suffering as Western consumers is a (inaudible) just a shadow compared to what the people of Ukraine have to go through, man, it was bad luck for us.

Michela Tindera
Rob explains that over the last six or even eight months, it became increasingly clear that inflation wasn’t slowing down. And not only that, but it was spreading.

Robert Armstrong
So the thing that I think scared the market, the world, the Fed, the president, everybody else, is that suddenly services inflation, not any good that has to go on some ship that can’t get there or there’s some delivery problem or some supply chain problem. Services inflation, haircuts start getting expensive. So now people are worried. Wages start to heat up. But then before this particular meeting, two things happened. One, the Friday before the meeting, we got a CPI reading that was terrible.

Michela Tindera
CPI stands for the Consumer Price Index. It measures the change in the price of goods and services in the US.

Robert Armstrong
People had thought because of the April CPI reading, maybe we’d seen the top in inflation. It was like a line that was going up and there was this little button hook at the top and people said, “Phew, maybe we finally made it”.

Michela Tindera
But then Rob says that the May number comes in and that changes things again.

Robert Armstrong
And it was like we’d had seen a little light at the end of the tunnel, and it turns out to have been an oncoming train. The long-term inflation expectation went from 3 per cent to 3.3 per cent, which doesn’t sound like a lot, but it was enough to really get the Fed to sit up and take notice. Because if we believe there’s going to be inflation, there is going to be inflation, we’ll make it happen with our expectations. So the Fed really can’t tolerate rising inflation expectations and they have to stomp them down. They have to scare everybody.

Michela Tindera
So by raising interest rates by 75 basis points . . .

Robert Armstrong
Yeah.

Michela Tindera
So could you kind of describe what that means?

Robert Armstrong
Probably the most important to the consumer economy is that as the Fed forces interest rates higher, mortgages get more expensive. And this has been the most, the most direct and astonishing change caused by the Fed. If you’re shopping for a house right now versus two years ago, you’re either looking at paying a lot more or living in a smaller house. And the important thing for the economy, actually in things like GDP, a consumer buying a house, that transaction doesn’t go into GDP because it’s an investment rather than consumption. It’s a, it’s a fixed capital good. But when people buy houses, there is a lot of economic activity that goes along with that. You pay the mover, you paint, you remodel, you get a new couch. I mean, anybody who’s moved knows that when you move, money just flies out the door and that money flies into the economy. And so less house transactions means a lower consumption in the economy. And we’re all gonna feel that.

Michela Tindera
And what about for investors, businesses?

Robert Armstrong
Well, one thing is that asset prices have been coming down because everyone knows. So the stock market has come down. Bond prices are coming down. And there are some, you know, some mildly complicated math behind that. But as the cost of money goes up, the price of financial assets comes down. There’s a lot of sort of addenda I could make to that point, but that’s the simple mathematics of it. And so for businesses, I’m running a publicly traded business, let’s say, and I had a big expansion plan in mind. But all of a sudden my stock price is down by 25 per cent from where it was a year ago. And, you know, the chairman of my board is gonna call me up and she’s gonna say, is this really the time to expand right now? You know, the stock price is down 20 per cent. We’re gonna have investors banging on our doors. Maybe we should be a little more careful here. Right? So the, the asset prices not only make people feel poorer in themselves, like your retirement account is smaller, your kid’s college savings plan is smaller. But it creates an environment among the people who manage companies of caution and that ripples through to the economy as well.

Michela Tindera
Could you talk a little bit about then just what the Fed’s messaging was around raising interest rates prior to . . . 

Robert Armstrong
OK. There’s been an evolution, right?

Michela Tindera
 . . . the week they announced it?

Robert Armstrong
A year ago or eight months ago, the Fed’s message was still “we think a lot of inflation has to do with temporary supply constraints. We think these factors are transitory and we think we’ll work through them.” That has clearly changed. They turned out to be wrong about that. Inflation has persisted. It has grown faster. And importantly, it’s starting to spread to areas that don’t have to do with the supply constraints. So the Fed’s tone has changed. They dropped “transitory”, and, especially in this meeting, they dropped a lot of the “soft landing” rhetoric in favour of more “we will do what we have to do” rhetoric. We recognise, you know, we regret if this is gonna cost anyone their job, but we’ve got to do what we’ve got to do.

Michela Tindera
So, do you think that this change in messaging has impacted the credibility of the Fed chair, Jerome Powell?

Robert Armstrong
I think we’re in an emergency here, and the absolute foundation of credibility is actually the Fed making the right policy. So I find the talk about credibility a little crazy because what it boils down to sometimes is saying the Fed should do a worse policy because that’s the policy they said they were gonna do before. Right? Actually, you want to make the right policy given the data you have at a given moment and you want to be as clear about how you do your work as possible. You want to be as clear about what data you’re looking at as possible. But when the facts change, the Fed has to change its path. And right now the facts are changing fast. And so they felt they needed to kick it up a notch from 50 to 75. Had they been generally messaging 50 before? Yeah, but the world changed. What would really destroy the Fed’s credibility is if the world came to the conclusion that it was run by a bunch of nitwits. We do not want them thinking the Fed is like, “well, we said 50, even though we needed 75, we did 50”. That’s no good.

Michela Tindera
So you talked about the consumer price index, but what are just some other pieces of data that the Fed is looking at?

Robert Armstrong
They’re gonna be very attentive to all measures of wages. Probably the deepest underlying worry is about a spiral between prices and wages. Wages, wage growth has slowed down a little bit. And they hope that it will slow down a bit more. So they’ll be watching that one closely and they will be watching other, any indicator of job market tightness. How many job openings are there? How do the weekly jobless claims, which, by the way, have been coming up a little bit, a few more people have been claiming unemployment in recent weeks. They’re gonna be watching any signal that softness or slack in the job market is increasing slowly. Of course, even though they can’t control it, they have to look at the oil price. It’s te . . . They can’t make the oil price come down. Interest rates, US interest rates can’t make gas cheaper. All US interest rates can do is reduce US demand by making the country poorer so it uses less gas. (Laughter) That’s, that’s the unpleasant situation that we’re in.

Michela Tindera
How do you think that this June meeting will be looked at in the future?

Robert Armstrong
I would say that last week’s meeting was an important crossroads for the Fed in a certain sense. Before this meeting, in, at least in their statements, in earlier meetings, they were still holding out the hope that inflation could be controlled with really minimal economic pain, minimal increase in unemployment, no recession. And this was the meeting when they made it abundantly clear that this is gonna hurt. They didn’t use those words. But it’s a little bit like when your doctor says to you, you’re gonna feel a little pressure here. This is a culmination of a long journey away from a very dovish Fed to a now a very hawkish one, meaning one that’s gonna be very aggressive. But I think this will be seen as the culmination of that journey, the journey from believing inflation and hoping inflation will be transitory, to realising that it can only be stopped with restrictive demand-destroying policies. The journey from soft landing to whatever it takes.

Michela Tindera
So the next Fed meeting is scheduled for late July. So what do you think will happen there or what are people expecting?

Robert Armstrong
I think the most important thing is that, that everyone needs to acknowledge and kind of forgive the Fed for, if you will, is that in an emergency scenario, they can’t both do optimal policy and tell us what policy is going to be very far in advance. We’re going into a period of greater uncertainty, so the next couple of Fed meetings are not going to be boring. And I’m sure the Fed hates that. They like to be boring. Central bankers live to be boring. But we do not live in boring times. And I think they have to send the message and they are sending the message or trying to send the message that they’re watching the data and responding accordingly. And that is a very hard message for markets to accept. Markets hate that, but that’s the world we live in now.

Michela Tindera
So what would it mean if in July they did another interest rate increase, but it was by something like 50 basis points instead of 75.

Robert Armstrong
That signals that we’ve seen peak inflation. The data is going the direction that we want. And the chairman has been very clear about this. He’s said “to change our plan, we need to see the data get better”.

Michela Tindera
So how can consumers, investors, businesses navigate this?

Robert Armstrong
Hmm, that’s a hard question. I think it is important for investors to keep in mind that as asset prices fall, your instinct is to like them less, but you ought to like them more. As prices today fall, future returns go up. So the right way for a person, especially a young person to look at the stock market right now is: It’s getting cheaper for me to get involved. I mean, this is tough to someone who is at or near retirement and needs to spend that money soon. But if you have a long runway in front of you, you should feel some excitement. I’m not saying that you need to put it in and indeed would be against people rushing to put money into the market. But I would encourage young people to think, man, an opportunity might be opening up for me here. Maybe I had a start a little bit at a time, putting whatever savings I have to work, and it’s a good time to start getting in that habit because the, a lifetime investor who is successful does not panic. And this is a time designed to make you panic. So practise not panicking. That is a skill that will serve you as an investor for the rest of your life.

Michela Tindera
Yeah, that’s encouraging given like, how difficult the housing market has been, and . . .

Robert Armstrong
Yes.

Michela Tindera
 . . . that’s like another place that young people want to invest, you know, so?

Robert Armstrong
I mean, this is something, we’ve had low interest rates for a long time. And one effect of that and other factors — demographic factors play into this as well — is that house prices and stock and bond prices have really gone up. And if you’re old, that’s great because you have those things already. But it has turned our country into something of an economic gerontocracy. And that’s not good for the future of the country that is destabilising over the long run. So you don’t want a traumatic asset crash. At the same time, if we were to reset asset prices in a non-horrific way such that the distribution of wealth, such that young people had a shot at watching assets they buy go up in value over their life, man, that would be nice. (Laughter)

Michela Tindera
Yeah. So kind of overall, you know, should people be freaking out?

Robert Armstrong
So let’s assume, and I think it’s an increasingly safe assumption that we’re going to have a hard landing, which means unemployment is gonna go up and the economy is going to slow probably sometime next year. That is not overall something to be happy about or to look forward to. That said, there is a big difference between shallow recessions and deep recessions. There’s a lot of different ways that can play out. None of this is black and white. We can still hope that the Fed brings demand down enough to tamp inflation, world events co-operate enough so that a little bit more supply comes on, maybe oil prices fall, etcetera, so that the slowdown we have is a shallow one. That’s a possibility. You know, I think we have to see unemployment come up a little bit, but hopefully not tons. So, should we freak out? Mildly. But it doesn’t have to be, you know, cats and dogs living together, the four horsemen of the apocalypse, etcetera, etcetera, (laughter) you know?

Michela Tindera
Yeah. OK. Well, thank you so much for coming on the show today.

Robert Armstrong
This was great fun. Let’s do it again soon.

Michela Tindera
Sounds good.

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Behind The Money is hosted by me, Michela Tindera. Stephanie Horton is our contributing producer. Topher Forhecz is our executive producer. Sound design and mixing by Sam Giovinco and Breen Turner. Cheryl Brumley is the global head of audio. Thanks for listening. See you next week.

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