GAZETTE: How high could rates go up and how soon before we see inflation slow significantly?
Stevenson: The Fed expects something between 3 and 4% [in its benchmark rate] and it is in this range that most economists think they are heading. Now it’s much higher than people expected even three months ago, and certainly higher than we thought a year ago. We therefore expect rates to rise towards 3 or 4%. [about twice what they are now] and likely to stay there until 2023. But if inflation doesn’t start to slow as expected, then rates could rise.
If you look at the projections from the Federal Open Market Committee meeting, you see a wider range of projections for 2024 than for 2022. This wider range of projections reflects the fact that some people are concerned that it will take longer to get inflation. under control.
I have no reason to be outside the range of projections that the FOMC has already released. But I think it’s reasonable to ask whether the range of projections should be even wider, given the huge uncertainty we face in the global economy right now. The reason I didn’t expect inflation to get this high is that I didn’t expect Putin to invade Ukraine and world energy prices to rise sharply. And I also expected supply chain issues like chip shortages to be resolved much faster. Because I expected a quicker resolution to our supply chain issues, I expected that we would see more of the kind of merchandise glut that we are starting to see retailers telling us they have. I expected this type of excess inventory accumulation to be more prevalent and in this situation there would be downward pressure on prices. I think there is always the possibility that we could see supply chains debottleneck quite quickly, which would put downward pressure on prices. In this case, inflation will subside more quickly. However, it is also possible that we will continue to see lockdowns like what we have recently seen in China over the next two years and we may continue to see war in oil producing countries. These global challenges limit supply and make it more difficult to control prices.
GAZETTE: In explaining this latest rate hike, Fed Chairman Jerome Powell said the Fed “understands the difficulties that inflation is causing.” But rising interest rates are also causing hardship for consumers in the form of higher interest rates for credit cards, car and student loans, and indirectly, mortgages, which are close to 6%. now have doubled compared to last year. Does the effort to slow inflation have the potential to cause more harm than good?
Stevenson: I’ve had a lot more patience for higher inflation in 2021 and even early 2022 precisely because the push to slow inflation – higher interest rates and slower economic growth – is also hurting people. The price increases we saw early on were mostly driven by durable goods. The Fed’s interest rate hike was not going to be able to have a direct impact on the durable goods supply challenges, and so, we just had to be patient. Supply chain problems would resolve themselves and inflation would start to get under control.
What happened is that a series of shocks allowed inflation not only to continue but also to spread throughout the economy in the services sector, in fact in all sectors. I think the most worrying thing for the Fed is that people are starting to expect inflation to stay high for a while. And as you form expectations around higher inflation, it becomes a self-fulfilling prophecy. Because if you expect higher inflation, you behave as if there is going to be higher inflation and that means trying to negotiate wage increases that reflect rising prices. If you’re a manager, you expect you to increase prices every quarter or every year, but you expect big price increases on a regular basis, and you start planning for that and integrating that and it becomes very difficult to undo.
What the Fed needs to do is make sure people continue to believe that we can get inflation down to 2%, that high inflation isn’t here for good, and that we don’t places a wage-price spiral, which means people look at the rising price of goods, then enter into negotiations with their boss and say, “If I don’t get at least an 8.3% raise, I won’t won’t even follow the price of the things I buy. So they negotiate very high increases that reflect inflation, but to pay that higher amount to all workers, employers end up having to raise their prices.
If you’re trying to borrow, those higher rates can be very, very expensive. And in fact, what the Fed wants you to do is think twice about borrowing. You tighten your belt; you buy fewer things. This is exactly how we realign supply and demand. But the only way it works is if someone feels the pinch and then reduces their request accordingly. The frustrating thing is that everyone wants to see prices go down, but no one wants to be the one feeling the pinch.
GAZETTE: Many people now believe that a recession is more likely than not within the next 12 to 18 months. Is a recession inevitable?
Stevenson: I’m optimistic by nature, but I’m not fooled, so I understand the risks of a recession. But it is not inevitable. The question is: how difficult will it be to achieve? We need to slow the growth in demand to bring the demand back to what we can sustainably produce, and we increase the supply, and then eventually the policy helps them meet in a nice happy place with stable prices and full employment. We don’t need to depress demand to meet supply exactly where it is today – and that is the fear of recession.
Can the Fed get away with it? Maybe. The challenge is that it’s not just about them. What will happen to oil prices? If we can get oil prices down, that will help them a lot to achieve that Goldilocks soft landing where there is no recession. If we could find a way to expand the supply of labor so that employers don’t feel like they’re competing so fiercely for workers that they’re pushing up wages on the rise. If there can be enough concern on the employer’s side that they can hold their ground when their employees come in and say, “I’m going to quit if you don’t give me that 10% raise now,” then we can slow inflationary pressures in the labor market. One of the quickest ways to do that would be to bring back some of the flow of immigrants that has really dried up over the last four to five years. I think there are things we can do. There are a lot of tools left.
My optimistic assessment is that many companies are still in fairly good financial health. These rate increases are not going to crush them. We’ve seen the savings rate decline recently, but household and corporate balance sheets are still quite bloated. We have a very low unemployment rate, a lot of people are working, so they have money coming in. So as these rate increases come in, they don’t hit weakened households or weakened businesses. They arrive in fairly strong households and fairly strong businesses. This is where I think the possibility of success lies.