The Fed Cuts Loose? : Planet Money : The Indicator from Planet Money An economic principle that has guided the Federal Reserve for decades is increasingly being questioned.

The Fed Cuts Loose?

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STACEY VANEK SMITH, HOST:

Next Wednesday, something is going to happen that is a really big deal but what you might not actually notice, unless, of course, you are the kind of person who spends all of your time, you know, arguing about nerdy economics.

CARDIFF GARCIA, HOST:

Like us.

VANEK SMITH: It's a big deal around here.

GARCIA: Invite us to your parties, folks. We're great by the punch bowl.

VANEK SMITH: It's our Everest.

GARCIA: So here is what's happening. The U.S. economy has been growing for more than a decade straight. And every month, it is still creating lots of jobs. And yet, on Wednesday, the Federal Reserve, in all likelihood, is going to give the economy an extra boost. And it's going to do that by lowering interest rates for the first time since 2008, back when the economy was collapsing.

I'm Cardiff Garcia.

VANEK SMITH: And I'm Stacey Vanek Smith. Today on THE INDICATOR FROM PLANET MONEY, we look at a big, controversial upcoming change in monetary policy, which is what the Fed does. Monetary policy does not always get a lot of attention, but it is a really big deal because it affects the labor market, our jobs, our wages, so it's really important to understand how it works.

GARCIA: So we are going to answer the question today, why is the Fed thinking about giving the economy that extra push next week when it's not clear that the economy needs it?

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GARCIA: There is an idea that the Federal Reserve has believed for decades but which it is now questioning at least a little. We've covered this idea on the show before, and it's that there is a relationship between the unemployment rate and inflation.

VANEK SMITH: And here's how this idea goes. So let's say the economy is really strong and almost everyone who wants a job has a job. So the unemployment rate is really low, so that means that companies are going to really struggle to find enough workers to hire. So to hire workers, the companies will lure them in by, you know, raising wages to attract them.

GARCIA: And if companies have to start raising wages by enough - by a lot, then those companies might also raise the prices of the goods and services that they sell just to offset the cost of paying those higher wages.

VANEK SMITH: And this is intuitive, right? If you run a company that makes televisions and suddenly have to start paying your workers more, you will be tempted to raise the price of the televisions you sell so that you can afford to pay the higher wages to your workers.

GARCIA: And when companies start raising the prices of the stuff they sell, that's called inflation. And a little bit of inflation from year to year is no big deal, but too much inflation - runaway inflation - that is terrible because it starts to frighten people that they won't be able to afford stuff in the future. It undermines confidence in the economy because prices are just going up and up and up.

So here's what you have to know. Here's the bottom line. When the unemployment rate gets to a low enough point, you would expect to get rising inflation, accelerating inflation. That's the relationship that the Fed has believed - unemployment low enough, inflation goes up.

VANEK SMITH: But what is low enough? I mean, what is the point where the unemployment rate starts to cause inflation to accelerate? There's no way to know this for sure, so the Fed kind of tries to estimate it. And six years ago, the Fed thought it was 5.6% - an unemployment rate of 5.6%. In other words, if the unemployment rate fell below 5.6%, then inflation would start to take off.

GARCIA: But guess what. A few years ago, the unemployment rate actually did plunge below 5.6%, and it kept going down. And yet, the runaway inflation never appeared.

VANEK SMITH: And now the unemployment rate is all the way down to 3.7%, which is almost the lowest it's been in 50 years. And yet, inflation is still really low. Prices have not really been going up. So what is going on? Why is inflation not increasing more even though unemployment is so low? Well, there are two possible explanations.

GARCIA: First, the Fed has simply been getting wrong its estimate for how low the unemployment rate can be before inflation starts to take off. This is actually pretty obvious now. Federal Reserve Chair Jerome Powell actually admitted this recently when asked about it by Representative Alexandria Ocasio-Cortez during his testimony before Congress.

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ALEXANDRIA OCASIO-CORTEZ: Given these facts, do you think it's possible that the Fed's estimate of the lowest sustainable unemployment rate may have been too high?

JEROME POWELL: Absolutely. You can't identify - this is something you can't identify directly. I think we've learned that it's lower than we thought - substantially lower than we thought.

VANEK SMITH: It's so weird for someone from the Fed to say a word like absolutely.

GARCIA: Yeah, so concretely, right.

VANEK SMITH: Sort of rattles me.

A second explanation for why inflation has not gone way up even though unemployment is low is that maybe the connection between unemployment and inflation just isn't the same as it used to be. That is what Jay Powell also said recently during his testimony.

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POWELL: The connection between slack in the economy where the level of unemployment and inflation was very strong if you go back 50 years, and it's gotten weaker and weaker and weaker to the point where it's a faint heartbeat that you can hear now. It's still there. You can see it at the state-level data and things like that. But I think we really have learned, though, that the economy can sustain much lower unemployment than we thought without troubling levels of inflation.

GARCIA: And why would this be? Things are getting exciting now, by the way, as you could tell.

VANEK SMITH: (Laughter) Well, you know, this is an emotional topic for us.

GARCIA: So why is it that the connection might have broken down between unemployment and inflation? Well, Jerome Powell thinks that it's precisely because inflation has been low for so long that people and companies just don't expect high inflation to be a problem anymore, and this expectation is itself what might be keeping inflation down.

VANEK SMITH: So to see why this relationship may have broken down, let's again use the simple example of a company that makes televisions. So if you run this company, you would love to raise the price of your televisions because that means more money that you're going to make in profits for each television you sell.

But let's say that you think inflation is going to stay low in the future. That means your rivals, the other television-makers, will probably not be raising their prices very much because that is the definition of low inflation. Prices only go up by a little. So you don't want to end up with your television company being the only one to raise its prices because then all of your customers will just switch over to buying the cheaper television sold by your competitors. So you also choose to raise your prices by only a little. In other words, inflation stayed low.

GARCIA: So that's just one example. But the theory is that because expected inflation is so low, actual inflation also ends up staying low, even when the economy is strong and there is not much unemployment. Again, that's the theory. But we got to say it is something that economists are still debating.

VANEK SMITH: So whether that theory is right or not, what we do know is that the Fed, at the very least, believes that the economy can be improved by a bit of stimulus from lower interest rates without high inflation becoming a problem. So it has signaled that it will do exactly that - lower interest rates.

GARCIA: But there is, of course, one other question that we have to answer about the Fed's decision. Even if the Fed thinks it's safe to lower interest rates now, why does the Fed think that the economy needs the boost in the first place?

VANEK SMITH: Yeah, why the fifth cup of coffee, Fed?

GARCIA: That's what we're saying here. Like, the economy's still creating jobs every month, and it has been growing for 10 years straight. Last year, the Fed was actually raising interest rates because the economy was growing so fast. Why has the Fed just recently changed its mind and decided that it needs to lower interest rates? Well, actually, Jerome Powell kind of gave an answer in a roundabout way in his congressional testimony.

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POWELL: However, uncertainties about the outlook have increased in recent months. In particular, economic momentum appears to have slowed in some major foreign economies, and that weakness could affect the U.S. economy. Moreover, a number of government policy issues have yet to be resolved, including trade developments, the federal debt ceiling and Brexit.

VANEK SMITH: No one says moreover in conversation unless they are a Fed chair.

GARCIA: True.

VANEK SMITH: Right?

GARCIA: Fact check true.

VANEK SMITH: Fact check true.

Here, though, Powell is saying that there are big pressures that are threatening to hold back the U.S. economy this year. Trade wars and weakening economic growth in other countries are two of the big ones.

GARCIA: So to get ahead of those pressures, the Fed is planning to lower or to cut interest rates, like we've said. Some people are referring to this cut as an insurance cut because it's there to bolster the economy as insurance in case those economic pressures do lead to weaker economic growth in the United States.

VANEK SMITH: So that is what we think the Fed is thinking right now. It's safe to boost the economy more without risking too much inflation, so you might as well do it, just in case the economy starts to get weaker later this year.

GARCIA: But is this a good idea? Well, this is actually one of those arguments where there really are two legitimate sides. Next week, on Tuesday, the day before the Fed is expected to cut interest rates, Stacey and I will each choose a side, then we're going to argue it out, have us a good, old-fashioned INDICATOR throwdown.

VANEK SMITH: Can you call it a throwdown if one of the people is so much stronger than the other one?

GARCIA: Listen; people will get to write in and vote, and they'll vote on who is right and who is Stacey. OK, there you go.

VANEK SMITH: This studio ain't big enough for the both of us, Cardiff Garcia.

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GARCIA: This podcast was produced by Constanza Gallardo, edited by Paddy Hirsch and fact-checked by Emily Lang. THE INDICATOR is a production of NPR.

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