When it comes to inflation, monetary policy might not be getting the job done

The Federal Reserve is trying to slow the economy down, but after eight interest rate hikes in a year, it doesn’t seem like the economy is taking the note.

The Fed’s inflation progress was top of mind this week as Federal Reserve Chair Jerome Powell took questions from both the Senate Banking Committee and the House Financial Services Committee. Powell reiterated the Fed’s commitment to tamping down inflation. “I think nothing about the data suggest to me that we’ve tightened too much,” Powell said before the Senate on Tuesday. “Indeed, it suggests that we still have work to do.”

Yet the economy hasn’t slowed down. In January, the unemployment rate was at 3.4%, a 50-year low, and the U.S. consumer is still spending.

“Marketplace” host Kai Ryssdal spoke with Neil Irwin, chief economic correspondent at Axios, about why the Fed’s toolbox seems ineffective. Ryssdal started by asking Irwin: What if monetary policy isn’t getting the job done now? An edited transcript of their conversation follows.

Neil Irwin: I think that’s definitely what’s happening. We have a 50-year low in the unemployment rate, 3.4%, at a time the Fed’s been doing everything they can for the last year to tighten the money supply. It’s clear there have been some shifts in the economy that just make their policies less effective than they used to be at adjusting how the economy works.

Kai Ryssdal: Lay that out for me. What are the changes?

Irwin: Well, less employment and less activities tied up in physical durable goods, right? So the things that you borrow money for — you know, a car or a house — are a smaller share of the economy relative to things that are services — you know, going to restaurants, going to stay in hotels. So that might mean that the interest rates are less effective. There’s some other things in the structure of the financial system and how it works. Maybe businesses are [using] lean inventories, they don’t need as much credit, so raising rates doesn’t affect how they behave. You know, wealth inequality might be a factor. When so much wealth is held by mega billionaires, maybe it’s a situation where their spending isn’t as sensitive to what happens to asset prices as more middle-class people. A lot of theories, but the end result is we definitely have an economy that’s still roaring ahead even as the Fed is trying to slow it.

Ryssdal: OK, so we’ve raised rates, the Fed has raised rates eight times in a year, give or take 4+ percentage points. Do you suppose it’s possible that given all the changes in the economy, monetary policy just doesn’t work anymore, and Jay Powell and the gang need to find new ways to do things?

Irwin: I think that’s going too far. For one thing, there are always lags. And we may see these effects — there’s some hints of that happening already — really start to bite as 2023 progresses. And also you have to think a little bit in counterfactuals, right? So what would have happened if they had kept rates at zero all of last year? We’d probably have an even hotter economy, even higher inflation. In all likelihood, their impact might not be what it used to be, but it’s still in the same direction, meaning higher rates translates into lower inflation.

Ryssdal: Can we talk about that lag for just one second? Of course, Milton Friedman, “long and variable,” 12 to 18 months or so. You point out in a different piece the other day: We’re at 17 months now of this hiking cycle, give or take. And also, the Fed is communicating now like it never has before, and we’re seeing effects a lot sooner.

Irwin: That’s right. So back in November 2021 — which, as you say, 17 months ago — that’s when they first started to signal, “Oh, we’re behind the curve on inflation, we’re going to start moving more aggressively.” And as soon as they started communicating that, longer-term interest rates adjusted accordingly. And so that tightened the supply of credit in the economy. There’s a real good argument that those long and variable lags, as you say, the famous phrase, are not quite as long as they used to be. The problem, and Jay Powell emphasized this in his congressional testimony just this week: We really don’t know. The uncertainty around those lags and how severe they are, it’s really a wide band of uncertainty. So you know, are we about to have a catch-up effect where the economy adjusts to these rate increases that were happening last summer? Maybe, but nobody’s quite sure.

Ryssdal: Maybe. That’s great. One last thing, and then I’ll let you go. You mentioned Chair Powell’s testimony. I do want to touch on some of the pushback he has gotten from progressive members of Congress about the costs of this policy and what it might do to the labor market. You hear the phrase from progressives, you know, 2 million people are going to lose their jobs as the Fed keeps on raising rates. And Powell said at one point in a rather barbed exchange with Sen. Elizabeth Warren from Massachusetts, she said, “2 million people, doesn’t that mean anything?” And he said, “Would they be better off if we just walked away?” So I guess the question is, what else is the Fed supposed to do but use the tool — blunt though it may be — that it has?

Irwin: Yeah, I think the way Jay Powell and the Federal Reserve view the world is they don’t want to cause unemployment, they don’t want to put people out of work, but the history shows that the cost to doing the things they need to do to bring demand down, to bring supply and demand in line, to ultimately bring inflation down, a side effect of those policies — traditionally, historically — has been to raise unemployment. And that’s the real jam we’re in. Now, could this time be different? Maybe, right? We’re in a weird economy, the post-pandemic economy has defied all the expectations in a lot of ways. Maybe there is a pathway to have inflation come down without unemployment rising that much. But I think it’s kind of a wait and see moment and do we see progress on inflation even as we retain this robust job market we have right now?