Preet Bharara:

From CAFE and the Vox Media Podcast Network, this is Stay Tuned in Brief. I’m your host, Preet Bharara. On Tuesday the Federal Reserve Board will gather for its next meeting, where it is expected to once again, raise interest rates in an attempt to fight inflation. Fed chair, Jerome Powell, has indicated that he will continue to raise rates until the job is done. That approach has been quite controversial. Senator Elizabeth Warren has said that it could tip the economy into recession. So a lot is at stake. But the reality is that many of us don’t quite understand what the Fed is or what it does and why. So ahead of this week’s meeting, I wanted to bring on Greg Ip, the Chief Economics Commentator for the Wall Street Journal. For decades, Greg has covered the Fed and its leadership. Greg, thanks for joining us.

Greg Ip:

Thanks for having me, Preet.

Preet Bharara:

All right. So can we start from the beginning? What is the Federal Reserve and why do we care?

Greg Ip:

The Federal Reserve is our central bank. And as our central bank, they’re basically in charge of making sure that the purchasing power of our money is not eroded by inflation over time. As a matter of statute, they’re in charge of full employment and stable prices. But over time, it’s been clear that their primary goal is to make sure inflation stays under control. And the way they’ve interpreted that goal is they want inflation to be around 2% over time. The problem they’re having right now of course, is that depending on how you measure it, inflation is 6 to 8%. So they have a lot of work to do to get us back to where they want to be.

Preet Bharara:

Why 2%? Why is that the goal? Why not 0% inflation?

Greg Ip:

Well, there’s a few reasons why over time we’ve concluded that 2% is a better number than 0% as a long range goal. There’s measurement issues. It may be the case that some prices aren’t actually rising as much as we think, because their quality’s improving. So those mismeasurement issues mean you want to have a number that’s slightly above zero. And the other reason is that the way the Fed actually affects growth is by what we call the real interest rate, which is to say the interest rate minus the inflation rate.

With an inflation rate of 2%, they can actually lower the interest rate to zero and have a real interest rate of -2% if the economy really needs a lot of help. If the inflation rate was zero, they couldn’t do that. You couldn’t have negative real rates. So over time, they figure that a 2% inflation rate gives them just enough cushion to keep the economy on a nice, stable path without having inflation be so high that it really disrupts behavior and changes people’s attitudes.

Preet Bharara:

So explain for lay people, including myself, why it is that raising an interest rate can have an effect on lowering inflation.

Greg Ip:

So inflation fundamentally results from the demand for goods and services growing faster than the supply of goods and services that our economy is capable of given how good our technology is, how many factories we have and how many people are working. So how do you control demand if it’s growing too fast? Well, you make people less willing to spend. And one way you do that is you raise interest rates. When interest rates go up, people aren’t so likely to buy a house or buy a car. So the demand for those interest-sensitive products goes down. And then those hits to things like cars and houses have knock-on effects. For example, car companies might have to lay off workers. They have less income to spend, that also hurts demand.

And then we also see that higher interest rates affect other parts of the market. So when interest rates go up, as we have seen in the last few weeks, the stock market goes down, people feel less wealthy, and so they spend less. And so through a variety of ways raising interest rates weakens demand and helps bring it back into line with supply, and over time, stabilizes inflation.

Preet Bharara:

So I’m confused about something, because as I understood how supply and demand works in capitalism, that should necessarily take care of itself. So there’s a lot of demand for a product. The price of the product goes up. But then as the price of the product goes up, it balances out by demand going down. Why is not that simple ecosystem of supply and demand sufficient to keep inflation at bay?

Greg Ip:

Well, you’re absolutely right, Preet. At a microeconomic level, higher prices do exactly what you’re saying. They bring in more supply. That’s why the old saying in economics is that the solution to high prices is high prices. It tends to cause people to consume less of something and the industry to produce more of it. And we can actually see that happening right now in the energy market, for example. Because oil prices are high, more companies are drilling for oil, for example, in the US shale sector. And because the price of gasoline is high, people are actually driving less. So supply and demand are starting to come into line. And that is one of the reasons we have seen the price of gasoline decline.

Now, the problem is though, that what works at the microeconomic level may not be true at the macroeconomic level. And inflation is not just what one or two prices are doing. It’s what all prices are doing on average. And the problem you have is that even if the demand for one product, in this case, let’s say gasoline is going down, if incomes are growing so fast, because people have so many opportunities to work and they’re being paid so well, overall demand will continue to grow. And if you have that happen, then even if demand for some things, like in this case, gasoline goes down, demand for everything else will continue to go up and we’ll still continue to have an inflation problem. So solving inflation is about getting aggregate demand in line with aggregate supply, not just in individual markets.

Preet Bharara:

So I have some questions about how the Federal Reserve makes these decisions. It seems like it’s very formulaic. Inflation rises by some metric. And the Federal Reserve decides to increase or not increase interest rates by a certain amount. Why can’t that be done by a computer? In other words, how much discretion does the Federal Reserve have and why do they need it?

Greg Ip:

Well, there are a lot of people who sort of feel the same way. It’s even been said, “Why not replace with a ham sandwich?” So why go as fancy —

Preet Bharara:

No, because that’s the grand jury. That’s a grand jury.

Greg Ip:

Oh, sorry.

Preet Bharara:

They ate the ham sandwiches.

Greg Ip:

There’s a few reasons why you just can’t hand this job over to a computer or a ham sandwich. First of all, inflation’s a really noisy number. So we were just talking a minute ago about gasoline. Let’s say that there’s a hurricane that knocks out some refineries and the price of gasoline goes up. We know that that’s going to raise the inflation rate for a few months. But we also know that it won’t last. And so it would be foolish to raise interest rates to deal with an inflation problem that we know is going to disappear in just a month or two. So that’s why discretion has to come into it, is that the economy is a complicated beast. And that simply because inflation moved up or down one particular month, doesn’t necessarily tell you where it will be a year or two from now.

The other thing is that the Fed also has this complicated job where Congress has said that they’re responsible not just for inflation, but for full employment. And so even if they wanted to say, “Well, we don’t care what unemployment is. We’re just going to stick with high interest rates come hell or high water till inflation goes down,” Congress has said, “No, you also have to balance that against your goal of full employment.” And so there have been situations in the past where the Fed has decided not to push harder on the inflation goal, because it didn’t want to do too much damage to the full employment goal. And so that’s another reason why discretion comes into it. Every month they make their decision. They say, “Are we getting the trade off right between employment and inflation?”

Preet Bharara:

The Fed chair is appointed by the President, correct?

Greg Ip:

The Fed chair, yes. He or she is nominated by the President and confirmed by the Senate.

Preet Bharara:

How independent is the Fed chair after being confirmed?

Greg Ip:

Well, the Fed chair has a lot of independence, but it’s not absolute. So first of all, monetary policy at the Federal Reserve is actually produced by a committee. Committees do tend to get a bad reputation. But in this case, what it means is that the decision of what the interest rate should be is not solely up to one individual, albeit a very influential individual. It’s decided by something called the Federal Open Market Committee, which consists of seven members of the Federal Reserves board of governors in Washington, all of whom are nominated by the President and confirmed by the Senate. And then five presidents of 12 banks located throughout the country, which are appointed by their individual boards of directors.

And so this unusual public-private setup, which we basically inherited from a century ago when there was a lot of suspicion about centralized power, means that it’s not enough for the chairman of the Fed, in this case, Jerome Powell, to say, “I want to raise interest rates,” or, “I want a low interest rates.” He or she has to convince 11 other individuals that’s the right course of action. There are other factors also that constrain what the Fed chairman can do. The chairman is appointed to four-year terms. And if he or she wants to be re-appointed to a second term, he will have to show to Congress that he is deserving of it, that he did a good job of balancing those employment and inflation tasks. And he has to also show that every decision he made, albeit independently, reflected the mandate that Congress gave him, which is to say, give us full employment and give us low inflation.

Preet Bharara:

Can the President fire the Fed chair at will?

Greg Ip:

Well, that question has never been really tested. The view of most legal scholars is, no. The Federal Reserve Act says you can remove a governor or a chairman for cause, which has been interpreted to mean things like malfeasance or neglect of duty, but not just because you disagree with the policies of the Fed chairman. But this has never been tested in court. What I will say, Preet, is that I hope we never come to that point. And for now, most presidents, even those who are very unhappy with the job that the Fed is doing, have concluded that the market mayhem that would likely result from firing the Fed chair is simply not worth it.

Preet Bharara:

Does that answer the question that I was going to ask next, which is why not just have that power and authority at the President’s Economic Council? Some staffer for the White House does the same calculations, asserts the same discretion and makes that decision. And you put it not in an independent body, but in the White House, like many, many other powers, including the power to wage war.

Greg Ip:

To answer this question, you actually have to go deep back into American history. Now, for a very long time, the United States did not have a central bank. For a long time the dollar, the dollar that you hold in your hand, was not issued by a central federal authority. It was issued by actual individual private state chartered banks. It was only in the 1860s that we first got a national currency. And it was only in 1913 that we actually got a central bank that decided how much of that currency would circulate. So the very idea that the money supply should be controlled by a government institution is, in the long span of history, a relatively novel theory. Congress decided a century ago that the private system wasn’t working very well, because we kept having panics that would cause banks to collapse and the supply of money to contract and a depression would then follow.

That’s why they decided that there had to be a government-based institution, a central bank, to do the job. But even at the time, there was a deep suspicion of all that power being in the hands of a few individuals. And so that’s why they came up with a structure that spread the power between presidential appointees and these private individuals. And even today, notwithstanding that we have gotten used to a much larger role for the government in our lives, I think there’s a broad recognition that you really want the power to spend money, which is in Congress, separate from the power to print money, which is at the Federal Reserve. Because left to its own political imperatives, the temptation for our Congress and the President would be that they would always want easier monetary policy. They would always choose the short-term benefit of lower interest rates and more employment over the long-term benefit of keeping inflation low.

Preet Bharara:

So last question for you, Greg, what’s going to happen this week with respect to interest rates? And is a recession inevitable? Or, as you’ve written recently, are we in for a soft landing?

Greg Ip:

So I will make the following brave prediction, Preet, that’s the Federal Reserve at its meeting this week will raise interest rates. Now, of course, what people listening to this podcast probably most want to know is, well, by how much they will raise interest rates. I think the betting is that they will raise rates by a three-quarters of a percentage point. There is some speculation they could raise it as much as a full percentage point. That’s not my base case, but it could happen. Now, three-quarters of a percentage point is quite a lot. It’s especially a lot because they’ve already done that twice. So this would be the third interest rate increase of that very large size in a row. Why are they raising it so much? Because, as we mentioned at the outset, inflation is too high. It’s 6 to 8%. And the interest rate, even after this week, will probably still be in the 3 to 4% range, which is frankly, too low for an inflation problem this serious.

The next question is, well, where does this go? How does this end? Does the Fed keep raising interest rates until we have a recession? Let’s look at history. There has never been a time when we got inflation from as high as it is to as low as the Fed wants, which is 2%, without a recession. So unfortunately, if I’m just going by the historical record, I would have to say, yes, it’s probably the case that we will have to have a recession for the Fed to finish this job. And that’s one of the reasons why you see the stock market falling out of bed lately. It too, is starting to come to grips with that possibility. But it’s not a sure thing. We might get away with what we call a soft landing, which means a slowing in growth that doesn’t actually cause the unemployment rate to go up very much and therefore cause a recession.

Why might that happen? Well, in contrast to periods like the ’70s and ’80s, we don’t see inflation psychology entrenched in people’s behavior. In other words, if you look at surveys and various market indicators, people still seem to think inflation’s going to go back to 2% in a few years’ time. So hopefully, we don’t need a serious recession to get them to adjust their wage and price setting behavior to be consistent with that 2% target.

The other thing is that we’re dealing with a lot of disruptions in the economy that are a consequence of the pandemic and the lockdowns. There are severe shortages of semiconductors, which are restricting the supply of cars and therefore holding up the price of automobiles. It’s possible that as some of those supply shortages, which are also, by the way, affecting the labor market, resolves themselves, we could see inflation start to recede of its own accord without the Fed having to pound really hard on demand. So those are a couple reasons why we might defy the lessons of history and get away with a soft landing this time.

Preet Bharara:

Greg Ip, you’ve packed a lot of information into a few minutes. Thank you for joining us.

Greg Ip:

Oh, thanks very much for having me.

Preet Bharara:

If you like what we do, rate and review the show on Apple Podcasts or wherever you listen. Every positive review helps new listeners find the show. Send me your questions about news, politics and justice. Tweet them to me at Preet Bharara with the #AskPreet. Or you can call and leave me a message at (669) 247-7338. That’s (669) 24PREET. Or you can send an email to letters@CAFE.com. Stay Tuned is presented by CAFE and the Vox Media Podcast Network. The Executive Producer is Tamara Sepper. The Technical Director is David Tatasciore. The Senior Producer is Adam Waller. The Editorial Producers are Sam Ozer-Staton and Noa Azulai. The Audio Producer is Nat Wiener. And the CAFE team is Matthew Billy, David Kurlander, Jake Kaplan, Namrata Shah and Claudia Hernandez. Our music is by Andrew Dost. I’m your host, Preet Bharara. Stay tuned.