Work & Economy
Fed delivers good news overall on economy

Federal Reserve Board Chair Jerome Powell at Wednesday’s press conference.

Alex Brandon/AP Photo

Christina Pazzanese

Harvard Staff Writer

February 1, 2024 9 min read

Economist Jeffrey Frankel says the central bank held off on easing interest rates, but signs point to soft landing

The Federal Reserve did not cut interest rates, but chair Jerome Powell said things appear on a positive path and suggested the central bank may ease borrowing costs later this year. “This is a good economy,” he said following Wednesday’s meeting of the Federal Open Market Committee (FOMC), which sets Fed policy.

The committee voted unanimously to hold interest rates at 5.25-5.55 percent until there’s more data showing that inflation’s downward trend over the last six months is solid and enduring. One inflation measure, the Consumer Price Index, is now 3.4 percent, still above the Fed’s 2 percent target, but well below the pandemic-driven high of 9.1 percent in June 2022.

The Gazette spoke with economist Jeffrey A. Frankel, James W. Harpel Professor of Capital Formation and Growth at Harvard Kennedy School, about the Fed’s strategy and where the U.S. economy currently stands. Interview has been edited for clarity and length.

Powell said he thought Fed rate hikes were at their peak for this cycle, but the central bankers were still in “risk management mode.” What did he mean by that?

They’re always balancing competing risks of inflation going up versus unemployment going up. But he and his colleagues are continuing to talk a tough line — “We want to be really sure that inflation is dead before we start cutting rates.” The financial markets and various commentators have, I think, been premature in predicting that the Fed would cut rates.

The language they had in their statement, that Powell had at the press conference, and that they’ve had in the recent past, is that they are really happy to see the progress that has been made.It’s good news that inflation is coming down and especially good news that it has been accompanied by strong economic growth. But they want to see more evidence that inflation is coming down sustainably all the way to 2 percent before they start easing monetary policy.

It was no surprise that they decided they weren’t going to cut the interest rate in their January meeting, but there have been a lot of people saying they’ll cut in the next one or two meetings, March or May. That may be premature. They really want to make sure that inflation is defeated before they cut rates.

What kind of timeframe or benchmarks are they looking for and what data points will give them confidence that the downward trend is solid?

I don’t think they have a specific benchmark or threshold or magic number in mind. They’re looking for continuation of the path we seem to be on. It’s only six months ago that they were still raising rates, and they don’t want to turn around on a dime and start cutting them if it might be too soon. They want to see some more months or quarters of the trend we’ve been having over the last year.

When they talk about greater confidence that inflation is coming down, the measure they look at most closely is not the CPI, which is the measure most often discussed by the public. They prefer something called the PCE deflator, Personal Consumption Expenditure deflator. They want to see that measure of inflation come down.

To be sure, more variables enter into their decisions than just the inflation outlook. For example, the growth of the economy. And the unemployment rate. So hypothetically, say we went into a recession, which so many commentators thought we were going to do or even that we had done so in ’22 and ’23. And those commentators were proven resoundingly wrong. But if that were to happen at some point in the coming year, even with no change in the inflation numbers per se, that would move them toward easing sooner.

“It’s only six months ago that they were still raising rates, and they don’t want to turn around on a dime and start cutting them if it might be too soon.”

Jeffrey Frankel

A rate cut in March looks unlikely now, which has to disappoint some investors given that the markets roared to record highs in December fueled in part by the expectation we’d see at least three cuts starting in the spring.

Yes. The markets need to adjust to the fact that rates are going to be a little higher for a little longer than they thought. At the same time, the Fed has adjusted in the opposite direction. It wasn’t that long ago that they were saying that interest rates were going to be high all the way through this year. But the December statement, which still stands, said that almost all of them expect some cuts before the end of this year.

If we continue with growth this strong and inflation stops coming down or even goes back up again, they could certainly raise rates more. But I think that’s fairly unlikely, and they think it’s fairly unlikely. Probably the worst that would happen is that they could leave interest rates where they are for longer than people expect. As Jay Powell said, this is a restrictive stance. Just leaving it where it is is restrictive already.

Powell also said it’s still too early to say we made a soft landing. Do you agree?

That depends on your definition of soft landing, of course. One might say, we have achieved a soft landing already. A soft landing doesn’t mean that forever you have no recession. We’ve had better economic news in the last year or two than anyone could possibly have forecast. So, I am inclined to think we already have had a soft landing. But there’s no precise definition. If we had a recession tomorrow, or inflation went back up, people would say it wasn’t a soft landing after all.

Why has the U.S. economy been so resilient, especially compared to Europe, given that interest rates in the U.S. are still at a two-decade high; inflation remains above where the Fed wants it; hiring has slowed; and housing prices haven’t fallen much?

The preponderance of the evidence is that we had a large, adverse supply shock when the pandemic hit in February 2020. Not just the recession period when everyone had to stay home, but all the tangled supply chains and the rest of the impediments that we had to deal with in the early stages of the recovery. That showed up in higher inflation for a while.

Then, we got the kinks out. The long backups at the ports were cleared; the match between employers and workers improved; and the delivery lags shortened. It took a little longer than one might have expected. But that was a favorable supply shock. It has brought inflation down over the last two years without a recession. And, by the way, although job growth has slowed, it is still higher than its post-2000 average.

Now, you raise a good point: Why would that work so well in the U.S. and work less well in Europe, where they haven’t had such good news over the last few years? We’ll continue to research that and try to figure it out. Part of it is Europe is dependent on energy imports, and they were hit by the increase in energy prices, particularly when Russia invaded Ukraine. I think that’s part of the explanation.

I would also mention immigration, which is such a big issue in this U.S. election year. It’s evidently hurting President Biden politically that we have so much immigration. But actually, that’s been a plus for the economy. Not the chaos at the border, but the overall boost to the labor force.

Before mid-2021, the labor force was hardly growing, due to demographics and aging — people retiring. We have had this excess demand for labor, which has given us this very low unemployment rate and high job vacancy rate in the last few years. Immigration is alleviating that pressure to some extent. Immigration allows continued growth accompanied by lower inflation than there otherwise would be.

Big picture, how does the economy look at this juncture?

The 10-mile-high bird’s-eye view is that it’s been amazingly good. All the numbers: unemployment, job growth, real growth, inflation, over the last year, it’s been amazingly good. People have been very skeptical of that and haven’t believed the numbers when they hear them.

But I think that’s beginning to change. People are beginning to be convinced. That good news doesn’t really change the Fed’s decision as much as you would think. If we had had just the rapid growth without the decline in inflation, they’d be tightening monetary policy further. If we’d had just the decline in inflation without the rapid growth, they’d be easing monetary policy. Given that good news has happened on both fronts, unexpectedly rapid growth and unexpected rapidly declining inflation, they’re left in the same general position they were a year ago: trading off the pros and cons.

Coming down to the seven-mile-high view, we had an unfavorable supply shock when the pandemic happened, and we’ve had a favorable supply shock since the kinks have been untangled in the supply side.

Coming down to the five-mile-high view, the Fed has basically done it right but was a little slow to see the inflation danger and to raise interest rates two years ago. Some people might think that they’re always lagging a bit behind, a bit too slow. But basically, I think they’ve done it right.