Hey, Chairman Warsh: What’s the Rush?
It seems likely that the Federal Reserve will increase interest rates on Wednesday.
While raising rates by a quarter point or even a couple of times before the year’s end might not cause major issues for the economy, there isn’t a compelling reason to do it right now. The Fed could take a breath—and I think it probably should.
In some respects, the Fed might feel cornered. Several officials have promoted a new theory regarding inflation expectations that suggests repeated supply shocks could upset these expectations. The theory proposes that if people face multiple supply shocks pushing up inflation, they may start to believe this will be a regular occurrence, leading to higher inflation expectations and eventually actual inflation.
However, this perspective has a few flaws. For one, there is currently no evidence indicating this is unfolding outside of Fed discussions. Key measures of inflation expectations, like the 10-year breakevens, are right where they were back in February, before the conflict in Iran and the rise in gasoline prices. Although shorter-term consumer inflation expectations have risen since the war, longer-term ones have barely changed. Business inflation expectations, tracked by the Atlanta Fed, remain quite calm.
Moreover, the inflation spike during the Biden administration wasn’t primarily driven by supply shocks. While there were some supply chain disruptions and rising energy prices due to geopolitical issues, the most significant contributors to the 40-year high inflation can be attributed to the Biden administration’s excessive spending and the Fed’s decision to maintain low rates for too long. So, it’s not exactly a case of a series of supply shocks inflating prices.
Nonetheless, all this discussion has led markets and analysts to anticipate that the Fed will move forward with a hike. The fed funds futures market shows a 90 percent chance of a rate increase this week and a 50 percent likelihood of another before the year wraps up. About 85 percent of economists polled by Reuters are expecting a quarter-point rise. Wall Street seems convinced that more monetary restraint is necessary.
The Hawk in Jackson Hole
Chairman Kevin Warsh’s recent speech in Jackson Hole was perceived as quite hawkish at the time, and it has taken on an even more hawkish tone since then. Coupled with the unexpectedly high core consumer price index for August and a surprisingly strong labor market report, it’s a lot to digest.
If the Fed decides against a hike now, it could seriously unsettle financial markets. The risk is that the Fed might yield to market expectations for a hike just when the economy might not be ready to handle it.
An intriguing argument for taking it slow came from Mark Zandi, who leads Moody’s Analytics. He suggests that trying to reduce inflation too quickly would likely necessitate slowing growth below potential levels, which could lead to layoffs, rising unemployment, and an economic downturn. Of course, once that path is initiated, it could be tricky to navigate successfully. Economic momentum plays a significant role, and attempts to cool it down could unintentionally lead to a slump.
Another complication is that the current drivers of inflation are, in fact, quite contractionary. Rising energy costs are tightening household budgets and increasing expenses for businesses. Higher interest rates can’t reopen oil shipping routes or refine more petroleum; they primarily make borrowing costlier and dampen spending. This only tightens the squeeze on consumers. Essentially, the Fed could weaken the consumer resilience that has been crucial in supporting the economy without actually addressing the factors driving up oil prices.
In short, by forcing other prices to drop to balance out a supply shock, the Fed may end up causing lost jobs and output.
AI’s Pace May Be Slowing
Additionally, there’s another reason for the Fed to consider patience: the current AI investment surge might be entering a slower period.
It’s likely that many readers have noticed a growing concern regarding AI and its market impact. Leaders in major AI labs are suggesting a slowdown and advocating for more regulations. An analyst noted a shift in discussion surrounding artificial intelligence, where safety considerations and calls for oversight are starting to clash with ongoing expectations for rapid advancement and infrastructure investment. A greater focus on supervision could potentially alter funding strategies across the industry.
This slowdown in AI development could extend beyond just Silicon Valley. AI advancements have noticeably boosted demand for chips, power equipment, and construction services. These developments have been essential for the profitability of companies involved and the job creation tied to them.
Izabella Kaminska, a sharp observer of financial trends, presents a more skeptical yet compelling perspective on the shift towards more cautious AI development. She argues that the ongoing infrastructure race has, in part, been about overspending competitors into submission. More efficient models might disrupt that strategy, while safety issues offer a plausible justification for stepping back from hefty financial commitments. Plus, the race to outspend rivals was perhaps never meant to be sustainable; it was more about establishing a competitive edge and discouraging rivals from overspending.
Zandi cautions that tightening policies could either hinder the AI boom or intensify pressures in other economic areas. If the boom is already losing steam, raising rates could be detrimental to both.
Keeping rates steady would maintain the option to react if service inflation picks up or expectations shift negatively. This would also give decision-makers time to evaluate whether the landscape of significant economic investments is evolving.
The Fed has room to gather more information. It would be prudent to take advantage of this before placing an undue burden on American workers for an expedited approach to achieving two percent inflation.
Unfortunately, it seems the Fed is poised to move ahead with a rate increase. So, perhaps the best we can wish for is a gradually paced Federal Reserve showing more patience in future meetings.
