Did the Fed Wait Too Long to Act?

The Federal Reserve has declared victory in the war on inflation. At its meeting today, the central bank announced that, after setting higher interest rates for two years in an effort to tame prices, it is finally beginning to bring them back down.

The Fed lowered interest rates by 0.50 percent (or 50 basis points), and has suggested that future cuts will be similarly sized. That’s more aggressive than some observers expected, but even at that pace, the super-low rates of pre-pandemic America are still years away. The immediate financial effects will therefore be modest. More important, in all likelihood, is the message that the announcement sends: Inflation is no longer a major concern, and the Fed is now focused on keeping the economy, particularly employment, running strong.

No one really knows how interest rates and consumer prices interact. The leading theory is that by raising borrowing costs, higher rates force consumers to cut back on spending and businesses to lay off workers, sparking a vicious cycle that brings prices under control by strangling the economy.

But that didn’t happen this time. The Fed raised rates and inflation abated without all the economic pain in between. Consumer spending and the labor market have remained strong. If higher interest rates caused inflation to cool off, the precise mechanism remains a mystery. In fact, the theme of this year’s Jackson Hole Economic Symposium—think Davos for central bankers—was “Reassessing the Effectiveness and Transmission of Monetary Policy.” That’s Fed-speak for “Interest Rates: How Do They Work?”

Making matters even more complicated, setting interest rates is about more than the literal rate of interest. The central bank also uses rate policy to influence people’s expectations of the future and, in turn, their behavior. Two years ago, when inflation was spiking, the Fed moved quickly and decisively to raise rates. “We will keep at it until we are confident the job is done,” Fed Chair Jerome Powell said in August 2022, making clear that the Fed would do whatever it took to bring prices under control. Some experts believe that is why inflation fell so painlessly last year. Convinced that the problem was under control and that a major slowdown was around the corner, consumers stopped spending as fast and employers curtailed their hiring sprees just enough to help the economy get back to normal.

[Rogé Karma: The Federal Reserve’s little secret]

This theory has problems of its own. Most people have very little idea what the Fed is doing and may have only a vague sense of what’s going on in the broader economy. In poll after poll, a majority of Americans continue to say that inflation is a major problem, which undermines 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 in which the Fed’s message clearly does get through. The long-awaited policy change will generate enormous media coverage. Most Americans might not be able to explain what the federal-funds rate is or why it matters, but they will hear that the country’s economic experts have declared that inflation has been defeated and that better days are ahead. This could become a self-fulfilling prophecy: If the Fed succeeds at brightening the economic mood of the country, then perhaps businesses will keep hiring and raising wages, consumers will keep spending, 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 a political impact. Voters think inflation is the central problem facing the country, and they blame the Biden administration for it—including Vice President Kamala Harris, according to some polls. This view has persisted despite a long stretch of very little inflation. A big “inflation is over” news cycle might finally convince at least some voters that the problem really has been solved, to Harris’s benefit.

The risk remains that the Fed waited too long to act. Inflation has been near the central bank’s target for almost a year, and the economy, while still far from recession territory, has begun to show clear signs of slowing. The number of job openings has fallen, the unemployment rate has risen, and more people are behind on their credit-card bills and car payments. None of this would be particularly worrying if the Fed could simply press a button and provide an immediate boost to the economy, but it can’t. In fact, economists generally believe that rate changes take a while to filter through the economy. How long, exactly? No one knows. As the monetary-policy experts Christina Romer and David Romer wrote at the beginning of 2023, “If policymakers keep tightening until inflation falls as much as they want, they will likely have gone too far—because the effects of tight policy will continue for many months after they stop raising rates.”

Many other prominent economists have made similar warnings. If they’re right, then the recession that America miraculously avoided may turn out to be merely delayed. Then again, experts made a lot of dire predictions about the economy over the past three years that have turned out to be wrong. Hopefully they have one more in them.