What Investors Are Getting Wrong About the Fed and Inflation

On this episode of The Long View, Carl Tannenbaum, Northern Trust’s chief economist, breaks down the state of the financial system, where real estate stands today, and what we might expect from the Fed on inflation and interest rates.

Here are a few excerpts from Tannenbaum’s conversation with Morningstar’s Christine Benz and Dan Lefkovitz.

When Will the Fed Cut Interest Rates?

Dan Lefkovitz: Well, you referenced inflation and employment. We are recording this in the third quarter of 2024, and the Fed has yet to cut interest rates. You obviously have a unique perspective having worked for the Fed, but the market was expecting six interest-rate cuts coming into the year. What do you think economists underrated or missed?

Carl Tannenbaum: Well, this is a question that my senior leadership has been asking me all year. Frankly, I’ve been under some pressure as they’ve been under the impression that lower rates would be very helpful. And anytime we have any slippage in any of our portfolios, the economist is the one who gets the blame. So sadly, this may be my last opportunity of appearing with you on your podcast.

I will say that we were certainly not among the group that was expecting such an extensive and aggressive set of interest-rate cuts from the Fed. I think coming into the year, we had thought that they would wait until June and then move in a measured way after that. The market was certainly expecting a lot more. And what the market missed, I think, was first inflation did prove to be stickier than most of us thought. We had a nice decline in the rate of inflation in the second half of 2023. And I think people were expecting, some were expecting anyway, that it would continue. But we saw that there were areas of the price picture that were going to have what we’ve called the “last mile problem.” In other words, getting all the way down to a level consistent with 2% was going to be harder. And those are housing. We created a little bit of a housing boom, but with low rates during the pandemic era. And so house prices have gone up and so rents often follow suit. I mentioned earlier that we’ve had a lot of newcomers to the country who need places to live. That’s also kept upward pressure on rents. And so, the cost of shelter, which is the biggest part of the Consumer Price Index and other inflation indexes, continues to increase at a year-over-year pace of more than 5%.

The second area is basic services where shortages of labor, which I mentioned are getting better, but still there are shortages. Those prices have continued to escalate at nearly a 4% annual clip. And we’ll need to see additional progress on both of those for the Fed to feel comfortable, eventually lowering interest rates. As we visit today, the news through the spring and the summer has gotten quite a bit better. Fed officials are sounding a little bit more contented and confident. And so, the market is set up for the first Fed cut in September, and I would tend to agree that that is a likely outcome. The market, though, is expecting the Fed to be very aggressive after that.

I’m still a bit cautious. And the reason is, is that inflation is still on a core basis, the way that the Fed looks at it at about 3% year over year. And the target is 2%. I’ve been asked frequently whether the Fed would declare victory if they got close enough. And frankly, the answer is no. Having worked at the Fed, the seriousness with which the Federal Reserve takes its 2% inflation target is something that markets often understate. The Fed believes that that level is consistent with long-term investment performance, economic growth, job creation, and many other positive things. They also feel that they’ve made a commitment to get inflation to that level and abandoning it when they haven’t reached it would be a shock, frankly, to their credibility. So, for all of those who are wondering whether the Fed might change its inflation target or hedge a little bit, I just don’t see that to be the case.

What Investors May Misunderstand About the Fed

Christine Benz: You referenced a lot of important subtopics there that we want to go back to. But we want to reference your Fed experience. Having worked at the Fed, what do you think observers misunderstand about the organization and how it operates?

Tannenbaum: That’s a long list, to be very honest with you. And I’ll be candid that having followed the Fed and monetary policy for decades before joining them, there was a lot that surprised me when I got inside the walls.

Let me just give you a sampling. The Fed is a big organization and monetary policy is only one of its facets. Certainly, people are familiar with the fact that it does bank supervision. But while it oversees individual institutions, it also feels like it is the safeguard of the stability of the financial system more broadly. And so, some of the inquiries they make and the decisions they take are aimed not necessarily at ensuring that no banks will fail, but more broadly, that the financial system will continue to perform well. And having joined the Fed in the spring of 2008, and certainly some of my partners here at Northern Trust based on that timing field that I caused the financial crisis. But instead, I found myself right in the middle of it. And many of the decisions taken by the Fed at that time were really aimed at making sure the financial system continued to operate to support the American economy as controversial as some of those changes were.

The Fed is also still very engaged in the payment system. They facilitate payments, still clear checks, are at the forefront of technology that’s helping payments become more efficient and fast. The Fed does a huge amount of work in community affairs. They look at a series of economic topics and try and bring smart people together to form intelligent policy. Austan Goolsbee, the current Fed president here in Chicago, called together a conference on daycare, which you might not think is a top economic issue, but it’s a huge issue for labor force participation, upward mobility, standards of living for a lot of families. And so, the Fed wants to be a nexus of good conversation on topics like that.

And then going back to what I said earlier about monetary policy, there is some feeling that the Fed somehow has policies of convenience. But the dedication that the Fed has to their mission is something that gets into those that work there very, very deeply. And I was quite surprised at how quickly the goal of facilitating a financial system and a set of economic conditions that are conducive to long-term economic performance got into me personally. It was very, very powerful. The four years that I was there were among the highlights of my career.

Why the Fed Hasn’t Slowed the Economy and Brought Down Inflation

Lefkovitz: So, Carl, you referenced that “last mile problem” and the Fed’s seriousness with which it takes its goal of bringing inflation to 2%. Why do you think that the interest-rate hikes that we saw, the most dramatic in a generation, why do you think that they have not slowed the economy and brought down inflation to the extent that the economic textbooks maybe would have predicted?

Tannenbaum: There are several factors that explain an apparent delay in the effectiveness of monetary policy. The first fall into the category of borrowers locking in the rates on their debt. You may remember that thanks to the easing that was done in 2020 and 2021, you have a number of Americans who have home mortgage rates of less than 4%. Perhaps you’re one of them. And if you are, I suspect that your plans to move may be on a long-term hold. But the data are that while the mortgage rates in the marketplace have gone up, the mortgage payments made by households have not budged a lot. And so that has blunted to a certain degree the impact of higher rates on things like the housing industry.

Secondly, partly under the blanket of a Fed guarantee in 2020, a lot of corporations, even those with not the highest ratings, were able to issue long-term debt at very favorable interest rates. And those don’t really begin rolling over until the early part of next year. So, corporations have not had to face the high level of current market rates. And then finally, consumers also really were able to curtail their borrowing when they were receiving pandemic stimulus checks. And it’s only been in the last 12 months that we’ve seen, for example, credit card balances get back to levels that they held prior to the pandemic. So, you do gradually see households paying that higher interest rate, and that should have a bit more of a headwind effect on economic activity.

Finally, for those who don’t have debt, the higher interest rate has added to their incomes. Those who are invested in, let’s say, cash or variable-rate bank products are getting much more in interest, and that’s contributed to their spending. So, in some sense, there’s an element of demand stimulation that’s associated with monetary policy that is often overlooked. All of that said, as time goes on, I believe that the moves that the Fed has made will become more noticeable and potent. And they’re factoring that into their decision as they contemplate whether the time is right for a pairing back just a little bit.