Hey, Chairman Warsh: What’s the Rush?
It’s almost a certainty that the Federal Reserve will raise interest rates on Wednesday.
While a single quarter-point rate hike or even a couple before the end of the year is unlikely to derail the economy, there’s no pressing need for higher interest rates right now. The Fed could afford to wait—and probably should.
In some ways, the Fed has backed itself into a corner. Several Fed officials have given support to a novel theory of inflation expectations in which serial supply shocks risk de-anchoring inflation expectations. The idea is that if the public gets hit with supply shocks that push up inflation enough times, it will eventually decide that this is just going to keep happening, pushing up inflation expectations and eventually actual inflation.
There are a few problems with this view. First of all, there’s no sign of it happening outside the notebooks of Fed officials and their advisers. The 10-year breakevens—a key measure of expectations—are exactly where they were back in February, prior to the war with Iran and the consequent increase in gasoline prices. While short-term consumer inflation expectations are higher than they were before the war, longer-term expectations have barely budged. Business inflation expectations, as measured by the Atlanta Fed, are benign.
Second, the inflation shock of the Biden years was hardly a supply shock at all. There were some supply chain issues, and Putin’s invasion of Ukraine pushed up energy prices globally, but the most significant causes of the worst inflation in 40 years was the Biden administration’s reckless “American Rescue” deficit spending and the Fed’s decision to accommodate it by holding rates too low for too long. So we’re not really dealing with the latest of a series of supply shocks pushing up inflation at all.
But all this talk has helped convince markets and analysts that the Fed is going to hike. The Fed funds futures market implies a 90 percent chance of a hike this week and a 50 percent chance of another hike by the end of the year. Eighty-five percent of economists surveyed by Reuters now expect a quarter-point increase. Wall Street has convinced itself that another dose of monetary restraint is necessary.
The Hawk in Jackson Hole
Fed Chairman Kevin Warsh’s speech in Jackson Hole last month was viewed as hawkish when it was delivered. In the weeks since then, it has come to be seen as even more hawkish. Add to that the hotter-than-expected core consumer price index reading for August and the much-better-than-expected labor market report.
Faced with all this, not hiking would be severely disruptive to financial markets. The danger is that the Fed obliges the market’s expectations for a hike just as the economy may be becoming less capable of absorbing it.
A compelling argument for patience came this week from Mark Zandi, chief economist at Moody’s Analytics. He argues that squeezing inflation down faster will require pushing growth below potential. That would almost certainly require raising rates enough to trigger layoffs, rising unemployment, and an economic slowdown. The trouble, of course, is that once you start on this path, it’s hard to get it exactly right. Momentum means a lot in the economy, and the intended cooling could become an unintended slump.
Part of the problem is that the underlying source of inflation right now is already contractionary. Higher energy prices squeeze household purchasing power while raising business costs. Higher interest rates cannot reopen an oil shipping route or refine more petroleum into gasoline. They work by making financing more expensive and suppressing spending. The squeeze on consumers gets even tighter. The Fed, in other words, could break the consumer resilience that has helped keep the economy afloat without doing anything to bring down oil prices that pushed the index higher.
In essence, what the Fed would be doing is forcing other prices to fall in order to compensate for a supply shock. The result would likely be lost output and jobs.
AI’s Pace May Be Slowing
And there is another reason for patience: the AI investment boom could be approaching a slower phase.
It probably has not escaped the notice of readers of Breitbart Business Digest that there is a renewed concern about AI hitting the markets. Leaders of the big AI labs are calling for a slowdown and more regulation. Bloomberg’s Joe Weisenthal, writing in Monday’s Odd Lots newsletter, identifies a change in the conversation around artificial intelligence. Safety concerns and demands for oversight are beginning to collide with expectations of ever-expanding capabilities and infrastructure spending. More resources devoted to supervision and a slower development schedule could alter investment plans throughout the industry.
A slowdown will not just be a Silicon Valley story. As we’ve been covering extensively, the AI buildout has been a major support for demand for chips, power equipment, and construction. It has been fueling the profits of the businesses supplying them and the hiring of the people who work for those businesses.
Izabella Kaminska, one of the sharpest analysts of the financial scene, has a more cynical and more persuasive idea of what’s behind the turn toward safety and “pacing” of AI development. The infrastructure race, she argues, has partly been about outspending competitors into submission. More efficient models could weaken that strategy, while safety concerns provide a respectable explanation for retreating from extravagant spending commitments. Perhaps more importantly, the race to outspend was never sustainable and was not meant to be. The point was to spend enough to dig an economic moat around the incumbent AI powers and to convince your competitors to spend themselves into an early grave.
Zandi warns that tightening could either restrain the AI boom or put greater pressure on the economy outside it. If the boom is already losing momentum, a hike risks doing both.
Holding rates steady would preserve the option to act if service inflation accelerates or expectations deteriorate. It would also allow policymakers to assess whether the economy’s biggest investment story is changing.
The Fed has time to learn more. It would be wise to use it before charging American workers for an accelerated delivery of two percent inflation.
Unfortunately, the Fed’s next step looks like it is all but set in stone. So perhaps the best that we can hope for is a Fed that paces itself, showing patience at future meetings.