Are higher prices on consumer goods here to stay? Will home values dip in the months or years ahead? And is there a danger of overcorrection in the Federal Reserve Bank’s battle against inflation?
On September 21, the Fed announced a third consecutive 75-basis-point hike in the interest rate, in an attempt to bring inflation to heel. The Fed hopes to project the message that it is committed to stopping inflation, even if there are some costs, says Daniel K. Tarullo, Nomura Professor of International Financial Regulatory Practice at Harvard Law School. But Tarullo, who is also a former member of the Federal Reserve Board and the Federal Open Market Committee, adds that while a recession is “certainly not the Fed’s goal,” there are some signs that it should proceed cautiously.
In an interview by email, Tarullo tells Harvard Law Today about the impact of the recent rate hike, the danger of raising rates too fast — and where we might go from here.
Harvard Law Today: When you last spoke with us, you said there was a view among some experts in monetary policy that the Fed had “fallen behind the curve” by not raising rates earlier. The Fed has now raised rates several times this year and has just approved another big hike. Has the Fed now caught up?
Daniel Tarullo: Given the aggressiveness of the rate hikes over the last three meetings, the expectations for further rate increases expressed in the Federal Open Market Committee’s economic projections, and the emphasis of recent public remarks by members of the committee, it would be hard to argue that the Fed is behind the curve in the sense of underappreciating inflation risks. Beginning with his brief but pointed speech at the Fed’s annual conference in Jackson Hole last month, Chair Jerome Powell has had essentially one talking point: “We will do what it takes to bring inflation back to our two percent target.” He and other members of the committee are intent on convincing markets and the public that they will continue to tighten monetary policy even when high rates lead to rising unemployment and declining output.
HLT: Does this mean the Fed is trying to induce a recession?
Tarullo: A recession is certainly not the Fed’s goal but, in his press conference last Thursday, Chair Powell came pretty close to acknowledging that the path of rate increases may indeed lead to a recession. While he held out some hope that a so-called “soft landing” could be achieved (i.e, reduced inflation with only modest effects on employment and output), he had noticeably modified his comments from earlier this year, when he seemed to be suggesting that a soft landing was a good possibility. It appears that he, and a fair number of his colleagues on the committee, have accepted the argument of some economists that substantial progress in reducing inflation is unlikely without significant increases in unemployment.
HLT: Is there any danger of overcorrection? What could happen if there are too many rate hikes, or if they happen too fast?
Tarullo: I think there is such a danger, for two reasons. First, as I mentioned earlier, the Fed’s current communication strategy is wholly directed toward convincing markets and the public that it will not blink on inflation if unemployment starts to increase. The Fed likely adopted this single-minded approach precisely because of the credibility it lost during 2021, when it was clearly slow in recognizing that elevated inflation levels would not be transitory. So, it’s possible that a majority of the committee will now feel that they need to keep tightening even when the case for doing so is considerably less clear-cut than it has been thus far.
Second, like the rest of us, the Fed doesn’t really have a working theory of inflation that is useful for making monetary policy decisions in real time. The days are long gone when central banks believed that they knew how high unemployment would need to rise before inflation abated. As a consequence, the Fed is relying heavily on actual incoming data — inflation rates and various labor market indicators — to decide whether and by how much to keep increasing rates. But, because some of the effects of monetary policy operate on the real economy only with a lag, there’s a danger that the Fed will keep raising rates even as the effect of prior increases have not yet fully impacted the economy. It may be that the economy will already have slowed, and inflation begun to significantly abate, by the time later increases have an additional contractionary effect.
HLT: The Consumer Price Index shows inflation has had an impact on many products. Are the new high prices likely to stick? That is, could higher prices on some goods be permanent?
Tarullo: Prices are unlikely to decline across the board from current levels, though the prices of specific products or services could certainly go down, especially if we have a recession. But the Fed is not trying to achieve price roll-backs. Price stabilization efforts are forward-looking. Their goal is that additional increases not exceed their two percent annual target. Remember, if today’s elevated prices remained the same until next September, the inflation rate would be zero.
HLT: While the housing market has apparently cooled off from pandemic-era buying, home prices remain high, along with rental prices. However, this week, Federal Reserve Chair Jerome Powell indicated that the housing market may undergo a “correction.” What do you think this could mean?
Tarullo: I think his comment was in line with what I mentioned earlier — his acknowledgement that the Fed’s inflation-fighting policies may lead to a recession. It’s worth remembering that softness in the housing market is highly correlated with recessions, either as a byproduct or as a contributing factor. Residential housing is one of the most interest-rate sensitive sectors of the economy, and rates on a 30-year fixed mortgage have already climbed above six percent, after hovering at around three percent during 2021 and fluctuating around four percent in the years immediately preceding the pandemic. That’s a big increase in monthly payments for homeowners with a traditional 20 percent down payment. While limited availability of homes continues to support prices, I suspect the Fed expects that eventually more homes are going to start coming back on the market and that the clearing price for those homes will be lower than in in the last couple of years (though that will doubtless vary across regional markets).
HLT: What other tools does the government have to fight inflation, besides interest rate hikes?
Tarullo: In the short term, not many. Over the longer term, policies such as increased infrastructure investment that will enhance productivity and more vigorous antitrust enforcement can help.
HLT: In August, President Biden signed into law the Inflation Reduction Act. Despite the bill’s name, its main targets are climate and energy initiatives. What impact, if any, do you think the law could have on inflation?
Tarullo: Again, not much in the short to medium term. As you say, the principal aim of that law is to facilitate the transition to non-greenhouse gas sources of energy over the longer term. To the degree that aim is realized, the law could end up being a modest anti-inflationary measure. Actually, I’ve been asked by journalists whether the law might be inflationary in the short term, because of the contemplated spending. Unlike the big stimulus packages of 2020 and 2021, the amount of near-term spending under this law is not too significant in macroeconomic terms, so I don’t expect much impact on inflation one way or another.
HLT: Coming out of this week’s meetings, the projection of the federal funds rate seems to show that the Fed expects rates to remain relatively high for a while. What could this signal for actions it may take moving into 2023?
Tarullo: That’s right. This is another indication of the Fed’s objective of convincing everyone that it will stay the course on inflation fighting. Chair Powell, and other members of the committee, have emphasized that rates will stay up even after there is some evidence of inflation slowing. We’re almost certain to see increases of 50 or 75 basis points in the remaining two meetings this year. After that, it’s much harder to say. Up to now, it’s been easy to garner a consensus for these significant rate hikes. But once there’s some pain being felt from rising unemployment, you could see that consensus start to fracture a bit. It’s just that possibility that Chair Powell is trying to dispel from the minds of markets.