The Fed can't save the economy

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The Fed can't save the economy

Matthew Yglesias

11 - 14 minutes

The Federal Reserve raised interest rates last week by 0.5 percentage points, a rapid shift compared to the Fed’s traditional 0.25 percentage point increments but a slowdown from the .75 percentage point increases following the past few meetings.

This seems like an appropriate decision, but I think going forward the Fed should probably slow back down to the normal quarter-point pace. We’ve had a couple months of good CPI data, the energy situation seems to have calmed down, and there’s reason to think that housing inflation has actually peaked. So while it would be inappropriate for the Fed to declare victory on inflation, it is time to start taking a more measured approach and see how the data evolves.

But whatever the Fed does (and a lot of people with more degrees and more detailed monetary policy knowledge are having a lot of arguments about what exactly that should be), I think the more important point is that the details of Fed policy won’t be the decisive factor in American prosperity.

For a long time, starting with the house price crash of 2007, Federal Reserve decision making really was the central engine of the economy. But although the Fed certainly could screw things up by driving the economy into a deep recession, it can’t actually deliver robust growth right now. Even inflation doves are talking about ending the interest rate increases — nobody is out there arguing that it’s an appropriate time for a new round of stimulus because it clearly isn’t.

But that means we can’t have the kind of demand-led growth that was so prominent during the Obama and Trump administrations when the driving issue was how much juice Congress and the Fed were willing to put into the economy. Today, even if you optimistically think the worst of inflation is behind us — and that is what I think — growth still needs to come from elsewhere.

For the second month in a row, the Consumer Price Index report showed inflation advancing at a reasonably low rate. Now to be clear, looking at price increases year-on-year, inflation is still running very high. Nobody should sweep that under the rug. But each month’s CPI report offers only one month of new data – the reason year-on-year inflation was high in the new report is that we had very high inflation over the prior eleven months. That’s relevant to most people’s lives, but the new information we have indicates that the pretty good inflation news from October was updated with outright good news from November.

On top of that, energy prices have been moving in a good direction for about six months. Food is unfortunately still a problem, but we hopefully won’t have the outbreak of a second war between major food producers.

The point is not that all is well with the world, but that the November data was at least consistent with all being well with the world, and the Fed should slow down their rate increases as we see what happens in future months.

Meanwhile, there is further good news from the important housing sector. I wrote back in June that looking at the price of new leases rather than the price of average rents showed housing inflation was running much hotter than the official data said. I also said that the good news was that as of June, new lease inflation was already slowing, albeit from a very high level.

Now, six months later, things have flipped and new leases are cheaper than average rents and also falling. The pace of spot rent increases peaked way back in November of 2021, so average rent inflation should start declining in the next CPI report or perhaps the one after that. Housing is a really large share of overall inflation, so this will probably move the statistical aggregates.

That said, I do have a cautionary note. We can’t just assume that declining inflation in a particular sector will lead to an overall decline in inflation. If gasoline gets cheaper, people may eat out more and push up the price of restaurant meals. If rent gets cheaper, people may buy more furniture and push up the price of durable goods. Inflation is a macroeconomic phenomenon, and a lot of people have been led astray assuming they could project more from a micro-level analysis than is actually possible.

The real significance of this, I think, is that different kinds of inflation impact people’s lives differently.

If gas and rent get cheaper but this leads people to dine out more and buy durable goods so inflation stays flat, that’s still a world in which most people are better off than they were before. Expensive energy is uniquely harmful to American economic welfare, and expensive grain1 and rent are nearly as bad. So the economic news here is genuinely very good, even if it doesn't mean the end of the road for the Fed.

The question is where future growth is going to come from.

Many people have questioned whether raising interest rates to control inflation will cause housing investment to collapse, exacerbating supply shortages and creating problems.

But the answer depends on which indicator you look at. New housing starts absolutely plummeted over the course of 2022, but completions of new houses did not, largely because housing completions didn’t experience the 2021 housing starts surge either.

An optimistic story we could tell about this would be that surging housing demand in 2021 led to a huge increase in efforts to build new homes, but supply chain problems and limited labor supply meant that the number of new homes actually getting built didn’t rise. Now, housing demand is cooling, but it’s still robust enough that we are adding new homes at basically the same rate we’ve been adding them all along — the fall in starts is a pretty meaningless blip.

A pessimistic story would be that completions just lag starts, and starts will continue their plummet next year, with completions following them down.

Looking more broadly at investment, you see a pandemic boom in residential investment that is turning into a bust. But even in bust form, it’s not at a terrible level. And nonresidential investment continues to barrel forward, even though interest rate increases have made it more expensive.

That’s so far so good, but rather than speculate about the future, the important thing to realize is that the future isn’t fully written yet. By raising interest rates, Jay Powell is bending time and making financiers less interested in long-term, highly-speculative ventures that may or may not generate some huge future payday. The question for policymakers is whether to give them positive expected value short-term payoffs for boring investments in tangible physical goods.

And that’s really up to us. There was an announcement last week of a plan to convert two big offices in D.C. into 501 apartments. If you know the city at all, you’ll realize that this particular location has to be close to the maximum possible ROI for an office-to-residential since it’s actually a very odd spot for an office that’s surrounded by mostly residential neighborhoods and already equipped with residential-serving amenities like grocery stores and an elementary school. Beyond that, it’s an expensive neighborhood, so even if the conversion costs a lot of money, units can be leased for very high prices. Most under-utilized offices aren’t as well-located, and spurring investment in conversions will require offering regulatory flexibility to do it on the cheap.

And that’s the general attitude we should have toward supply-side reforms at a time when the Fed is trying to reduce inflation.

Whether a given efficiency-promoting measure actually reduces aggregate inflation is bound to be a little bit ambiguous. I saw some people arguing about whether it makes sense to say that immigration reform could fight inflation by reducing labor shortages, with the con argument being that immigrants increase labor demand as well as labor supply. That’s true, but you could probably try to rig up a cyclically responsive immigration system that during boom times grants visas to sectors that are above average in their labor intensity while doing the reverse during a bust. Child care is an extremely labor-intensive sector, so using immigration here would likely help. But note that labor intensity doesn’t perfectly track skill level. You could switch from visas for dentists and doctors during times of labor scarcity to computer programmers during times of labor abundance.

The real issue with this is that it’s just the same as cheap gas. If the price of labor-intensive services falls, that probably helps reduce aggregate inflation, but it might not — people might go on vacation more or buy lots of couches. You need a macroeconomic policy to address a macroeconomic problem.

And this is true of regulatory reforms across the board. We’ll get more office-to-residential conversions if we allow a wider range of home plans. Converting a garage into an ADU in an expensive town is a high-payoff investment, even in an environment of higher rates and scarce labor, because it’s just not that expensive.2 Making that legal drives lots of investment and supply expansion. I saw some excitement from the administration about United's record order for new widebody airplanes, which is absolutely good news. But I hope they recognize that they actually have at their disposal tools to spur even more investment in planes by adopting European rules about pilot training rather than the more expensive American ones.

If the Fed causes a recession and a big spike in unemployment (which would be bad), then economic growth will come from putting jobless people back to work.

But everyone who isn’t working directly for the Fed needs to ask what happens if things go well and we don’t have a recession — where do we see economic growth coming from then? Paul Krugman made “depression economics” famous over the past 15 years, but we need to get used to non-depression economics. Growth has to come from innovation, more workers, better skills, more efficient deployment of resources, or growing and deepening our stock of capital goods. Some of this is out of our hands; we can’t directly control the pace of innovation. But a lot of it comes down to being rigorous and thoughtful about dozens and dozens of policy choices.

This includes the proposed Biden/Manchin permitting reforms.

Making it easier to get the permits to build energy infrastructure means more energy infrastructure and more growth. There’s a counterargument from the left that there’s nothing wrong with the NEPA process that couldn’t be fixed by hiring more staff to go through all the environmental review paperwork faster. But even if that’s true, is it a good use of our national stock of human capital? Take people away from other gainful employments in order to review environmental impact statements? In depression economics it doesn’t matter, because there are always more unemployed people you can hire. But in regular economics, cutting back on review timelines is a win on both sides because it frees up lots of resources.

This is a very traditional way of thinking about the economy, but it’s fallen out of fashion thanks to 10+ years of mostly bad labor markets and obsessive attention to demand-side policy. But just as the Fed is turning a corner on inflation, we need to turn this corner conceptually in terms of thinking about the roots of economic growth.