The most important question for the US economy in 2024 is whether and when the Federal Reserve will cut interest rates. With inflation still slightly above the Fed's 2% target, the central bank faces a dilemma: cutting interest rates too quickly could send inflation rising again, while keeping them too high could cause people to suffer unnecessarily. This decision could also affect the outcome of the presidential election. Wall Street and the White House are anxiously awaiting the Fed's next move.
Given all this, one would reasonably expect that the relationship between interest rates and inflation would be thoroughly understood by the economic establishment. But that is not the case. Over the past two years, reality has been quite different from the theory laid out in economics textbooks. The inconvenient truth is that no one actually knows how interest rates work, or even if they work at all – not the experts who study them, not the investors who track them, and not the officials who set them.
The belief that raising interest rates is the cure for inflation has long been an article of faith. In the early 1980s, when inflation was nearing 15%, then-Fed Chairman Paul Volcker famously raised interest rates to record levels, sparking a major recession. Unemployment reached nearly 11% in 1982 and remained high for years afterward. But inflation stabilized, and Volcker went down in history as the hero who saved the economy by crashing it.
How exactly did Volcker get his job done? The conventional view is that raising interest rates creates a chain reaction throughout the economy. First, the Fed raises an interest rate called the federal funds rate (the interest rate that banks must pay to borrow money from each other), which in turn forces banks to raise interest rates on consumer loans. Higher interest rates ripple through the economy, making it more expensive to buy a home or a car, for businesses to invest, and for developers to finance new construction.
Gradually, everyone starts spending less. And, faced with less consumer demand and less access to capital, businesses start laying off employees. At this point, a vicious cycle is created. Laid-off employees spend even less, which means more layoffs, which results in even less spending, until the economy falls into a recession. With less money buying the same amount of goods, prices are eventually brought under control. The dreaded demon, inflation, is defeated.
This is the classic story of what happened in the 1980s. So when inflation hit three years ago and the Fed reached for its only tool, nearly every expert predicted an 80s-like economic collapse. The Bloomberg Economics model predicted a 100% probability of recession by October 2023, and the Fed itself predicted hundreds of thousands of job losses. The experts were wrong. Throughout 2023, the economy boomed, unemployment remained historically low, and consumers continued to spend. Despite this, inflation fell from a peak of 9% in June 2022 to around 3% by the end of 2023.
We're left with a bit of a mystery: the Fed raised interest rates, inflation fell, but the other stages of the chain reaction didn't occur. Did rising interest rates cause the inflation fall, or was it a coincidence? Multiple studies have concluded that the inflation spike was primarily due to the ripple effects of pandemic shutdowns. The subsequent fall may have been a natural consequence of things returning to normal.
Some experts believe that orthodoxy holds: “You have to ask, 'What is the counterfactual?'” Lawrence Summers, a former Treasury secretary and unofficial voice of mainstream American economics, told me. In Summers' view, without the Fed's actions, unemployment would be lower, wages would have soared even faster, spending would have risen even higher, and inflation would have risen even higher.
Still, if interest rates were helping to keep inflation in check, we'd expect that effect to be felt somewhere. But even in the construction industry, which is typically hit first and hardest when interest rates rise, employment continues to grow. “You can tell a lot of stories about the role interest rates have played, but at this point, they're just stories,” Skanda Amarnath, executive director of Employ America, a think tank that focuses on monetary policy, told me. “The data isn't conclusive.”
I said there is a conventional view on how interest rates work, but that is not the whole story. There are actually two conventional views. One is the chain reaction theory. The other has to do with expectations.
According to Introduction to Economics, if workers expect prices to rise tomorrow, they will demand higher wages today. This results in higher costs for businesses, which they then pass on to consumers in the form of higher prices. Economists call this feedback loop the “wage-price spiral.” In the 1970s, prices rose so rapidly for such a long period that people eventually came to expect prices to continue to rise and adjusted their behavior accordingly. Inflation became a self-fulfilling prophecy.
Expectations theory offers an alternative explanation for how Volcker tamped down inflation in the 1980s: By raising interest rates to record levels, Volcker sent the message that the Fed was willing to do whatever it took to tame inflation. Only then did Americans finally accept that price increases would slow.
Some experts believe that inflation has declined painlessly in 2023 because the Fed didn't let expectations get out of control in the first place. The Fed started raising interest rates early on, making it clear that it would stop at nothing to lower prices. Convinced that a recession was looming, employers stopped raising wages and hiring too quickly, and consumers cut back on spending, allowing the economy to move more smoothly toward a more stable equilibrium.
This is the kind of economic theory that seems very plausible until you apply it to actual human behavior. How on earth does the latest Federal Funds rate figure penetrate the consciousness of the American consumer? The average person doesn't pay much attention to the minutes of Federal Reserve meetings. You might think that the overall mood of the Fed would be transmitted to the public through the media, through a protracted game of economic telephone, but the evidence shows that this is not the case. The average American has depressingly little understanding of what is going on in the country's economy. (A recent poll found that 56% of respondents said the economy is in a recession. It's not.) And even if people are aware of rising interest rates, they don't necessarily react the way textbooks predict. A recent survey conducted by three economists found that 57% of Americans believe that rising interest rates will actually cause higher inflation. This is not completely irrational (more on this later), but it is the exact opposite of how people react to rising interest rates as described in introductory economics.
Even proponents of expectations theory admit they can't explain how it works. “Do we really think that some individual in some town is really saying, 'Oh, the Fed puts the fed funds rate at 5.5, so I'm not going to demand a wage increase?'” Adam Posen, a former central banker who co-authored a book on the role of expectations in containing inflation, told me. “Economic theory says yes. Through some kind of magical perception, people behave that way. I've always been a little skeptical of that.”
If the benefits of higher interest rates are mysterious and uncertain, the costs are abundantly clear. Many low-income families who rely on debt to cover everyday expenses are struggling. Several large clean energy projects have been canceled, in part due to rising financing costs. Higher interest rates are expected to cost the U.S. government $870 billion this year in debt service payments, more than it pays for Medicaid or defense.
Most worryingly, today’s high interest rates may paradoxically perpetuate the inflation problem. Most of the gap between current inflation (just over 3%) and the Fed’s 2% target comes from one area: housing. In theory, higher interest rates should make mortgages more expensive, reducing demand and thus stabilizing home prices. But in reality, many homeowners are staying put to keep the low-interest mortgages they secured when interest rates were low. This “lock-in effect” limits housing supply, exacerbating a decades-long housing shortage and putting upward pressure on prices. Even more worrying in the long term, higher borrowing costs mean less investment in new homes. With regard to housing, Mark Zandi, chief economist at Moody’s Analytics, told me: “The Fed’s main tool for controlling inflation is actually doing the opposite.”
The Fed sees it differently. At its most recent meeting earlier this month, the central bank decided to keep interest rates at their current levels, citing three stronger-than-expected inflation reports so far this year that have created uncertainty about the trajectory of prices. “We remain very vigilant on inflation risks,” Fed Chairman Jerome Powell said at the press conference announcing the Fed's decision. (Notably, the latest inflation report, released the same day as the Fed's announcement, showed signs of dramatic improvement.)
Powell's concern is that inflation remains too high for reasons no one fully understands. If people like Lawrence Summers correctly argue that interest rates keep the economy from overheating, then lowering rates could send inflation spiraling out of control again. This would be the ultimate nightmare scenario for central bankers, who fear losing the credibility of the inflation-fighting measures that Paul Volcker worked so hard to build, at great cost to them.
In other words, interest rates are like chemotherapy for central banks. They may have nasty side effects, or they may not work. But it's a lot better than gambling on the cancer of inflation. “The lesson of the 1970s is that once inflation really gets going, it's very difficult and expensive to stop,” Summers told me. “So there's every reason for the Fed to be especially cautious.”
A wait-and-see approach seems reasonable, but no one knows how long it will take for rate hikes to permeate the economy. As two prominent monetary policy historians wrote last year, “If policymakers continue to tighten monetary policy until inflation has fallen as much as they would like, they will probably overdo it, because the effects of tight policy will linger for months after they stop raising rates.” In other words, delaying rate cuts for too long could put people out of work unnecessarily. It could even trigger a recession.
The orthodox view of interest rates has a utopian quality: that inflation, one of the greatest threats to social and economic order, can be controlled with the push of a button. The events of the past two years have called this idea into question. This time, we were lucky enough to avoid both an inflationary spiral and a recession. Next time, that may not be the case. Fortunately, there are plenty of other ideas for fighting inflation, including taxing the consumption of the wealthy to curb spending, increasing immigration to ease labor shortages, cracking down on price manipulation, and keeping strategic reserves of critical goods in case of supply shortages. These approaches are much more cumbersome and politically problematic than waiting for the Fed to work its magic behind closed doors. But they may be necessary the next time inflation hits.