Interest rates are almost certainly coming down next week, but the reduction may be modest — at least for now, predicts Daniel Tarullo, the Nomura Professor of International Financial Regulatory Practice at Harvard Law School.
Tarullo, who is a former member of the Board of Governors of the Federal Reserve System says that the Fed is eyeing rate cuts now that overall inflation is running close to its target of 2%, despite an economy buoyed by relatively strong retail and labor markets.
He says the Fed will likely move with caution. “They probably want to avoid a situation in which an inflation reduction proves to be short-lived, and they have to raise rates soon after lowering them.”
Slashing interest rates could help Fed Chair Jerome Powell achieve a so-called “soft landing” for the economy — a relatively rare success story in which previously runaway inflation cools without triggering a recession. Such a positive outcome is not guaranteed, but is “very plausible,” Tarullo says.
On the other hand, Tarullo says that a rate cut isn’t likely to result in lower costs for groceries or housing, which have experienced some of the highest price spikes over the last several years.
And he warns that price slumps could be a bad thing: “If the decreases came about because of significantly reduced consumer demand, that would very likely mean we were in a recession.”
In an interview with Harvard Law Today, Tarullo shares his view on the current economy, why the Fed is planning to cut rates now, and what Powell and his colleagues will look for as they consider whether to drop rates even further.
Harvard Law Today: How would you describe the general state of the economy right now?
Daniel Tarullo: The economy has been a bit up and down this year, with a pronounced slowdown early in the year followed by a considerably stronger spring. Right now, the third quarter looks to be chugging along somewhere in between — around 2% on an annualized basis, perhaps a bit higher. But the important question is less where we are now than where the economy is headed over the next six months or so. To a considerable extent, the answer will depend on the trajectory of the labor market. So, for example, if job creation falls off materially, and unemployment rises, the encouraging retail sales figures of the past couple of months will almost surely deteriorate — because, obviously, people spend less when they are either out of work or worried that they might lose their jobs.
HLT: What were the key takeaways from Friday’s jobs report?
Tarullo: The only clear takeaway was that there were no clear takeaways. On the one hand, the number of new jobs created bounced back from some pretty soft levels over the summer, and the unemployment rate actually ticked down a tenth of a percentage point to 4.2%. Wage gains for the last year still look decent. On the other hand, the 142,000 new jobs created — while certainly better than the numbers earlier in the summer — came in modestly under consensus expectations. The three-month average is still well below the pace of job creation in the first half of the year and, more significantly, probably a bit below the level needed to absorb new entrants into the job market.
My guess is that most people, including the members of the FOMC [Federal Open Markets Committee], read the August jobs report through the lenses of their own predispositions. If you thought — as I did — that the trend of labor market cooling has been underway for some time now, and that there is a risk of this trend accelerating, the report probably reinforced that view. On the other hand, the report can also be read consistently with the view that the cooling of the labor market has been going just about as hoped, and that it was prudent to wait until now to begin lowering rates.
“The only clear takeaway [from the most recent jobs report] was that there were no clear takeaways.”
HLT: Some Fed officials, such as Atlanta Federal Reserve President Raphael Bostic, have said they are willing to begin lowering interest rates, even though inflation has not yet reached the target rate of 2%. Can you explain this line of reasoning?
Tarullo: Because it takes a while for the effects of interest rate changes to work their way through the economy, monetary policy needs to be made with an eye to the future. So when members of the Federal Open Market Committee indicate they’re ready to cut rates even though inflation is currently still modestly above the committee’s 2% target, they are saying that they expect inflation to continue to moderate and that they think they should make monetary policy less restrictive in order to stave off a recession in the future. This view is strengthened by the fact that the supply bottlenecks that caused a good bit of the jump in inflation in 2021 have now mostly faded. It’s worth noting, by the way, that even after the widely anticipated cut in rates next week, monetary policy will still be restrictive. That is, it will be above the so-called neutral rate of interest — the rate that the Fed believes will neither stimulate nor slow the economy.
HLT: What could happen if rates are cut before inflation is back down to the Fed’s 2% target?
Tarullo: As I just noted, monetary policy operates with a lag. If the Fed waited to lower rates until inflation was all the way down to its 2% target, it would take some time for that policy change to affect the economy. Meanwhile, the impact of past tightening would continue, potentially causing an unnecessary decline in growth, or even a recession. The key point is for the Fed to be reasonably convinced that inflation is heading back toward 2%. From Chair Powell’s speech at the Jackson Hole conference last month to statements by other FOMC members last week, it’s pretty clear they do have conviction on this point. It’s probably worth noting, though, that the FOMC might have been inclined over the last couple of months to err a little bit on the side of waiting to begin rate reductions. They probably want to avoid a situation in which an inflation reduction proves to be short-lived and they have to raise rates soon after lowering them. Given the widespread perception that the FOMC was slow to react to inflation back in 2021, I suspect this inclination has been a factor — though a modest one — in the Fed’s not lowering rates until next week.
HLT: The prices of food and housing remain much higher than before the COVID pandemic. Should we expect the cost of these things to ever go down? Or is price stability moving forward the most we can hope for?
Tarullo: The prices of some individual grocery products did go down as supply disruptions caused by the pandemic eased. And we’ll certainly see the usual ups and downs of specific product prices as supply and demand change. But it’s quite unlikely that overall grocery prices will decline significantly — and certainly not to pre-pandemic levels. Remember, median salaries and wages are considerably higher than they were four and a half years ago as well.
Housing presents a much more complicated, and persistent, challenge. Factors such as subsidies for mortgages and zoning restrictions pushed up prices long before the pandemic and recent bout of inflation. Without public policy changes, these factors will continue to have an effect. The tight monetary policy of the last few years has added an additional factor to these chronic problems. After years of very low interest — and thus mortgage — rates, the rapid increases engineered by the Fed quickly drove up the cost of financing a home purchase. That has caused the many households that benefitted from the very low-rate mortgages of the preceding fifteen years or so to delay a move they might otherwise make, because they don’t want to give up an affordable mortgage for a much more expensive one. That phenomenon, which should ease some as rates come down, has further exacerbated supply shortages in some housing markets.
HLT: Let’s say there was a situation in which housing and food prices decreased significantly. Would there be a downside?
Tarullo: It would depend on why those prices decreased. Roughly speaking, if the decreases came from supply side factors such as increased competition or greater production cost efficiencies, that would be a pretty unmitigated good. On the other hand, if the decreases came about because of significantly reduced consumer demand, that would very likely mean we were in a recession, which obviously is not a good outcome.
HLT: Fed Chair Jerome Powell’s goal for the last few years seems to have been a “soft landing.” Has the Fed achieved that, or are we still waiting to see?
Tarullo: That’s the question everyone is asking — one that won’t be answered for a while yet. A soft, or at least “softish,” landing is a very plausible outcome. But it’s not assured.
HLT: What is likely to happen during the Fed’s meeting on Sept. 17-18?
Tarullo: Well, Chair Powell and other FOMC members have been pretty explicit that they will reduce the federal funds rate target next week. The question is whether the reduction will be 25 basis points (a quarter of a percentage point) or 50 basis points (half a percentage point). If you forced me to make a prediction, I’d say it will be 25 basis points, but I don’t have great conviction in that prediction.
The choice the Fed makes will give us some insight into how they currently assess their chances of engineering a soft landing. If the committee lowers interest rates by 25 basis points, that will indicate greater confidence that it believes the economy has cooled, but not so much as to make a recession a significant risk. Thus, they can plan on proceeding gradually through a series of 25 basis point decreases, allowing them to get even greater conviction that inflation is headed toward their 2% target. If, instead, they lower rates by 50 basis points, that may be an indication that they’re worried they’ve waited too long to act and that the risks of a recession are a little higher than they would like.
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