Is America Getting Interest Rates Wrong?

Update: In a unanimous vote on Wednesday, the Federal Reserve left interest rates unchanged.

Peter Coy: Hi, Paul. The Fed meets Tuesday and Wednesday to talk about interest rates, which many voters are really frustrated about. In the past few Times Opinion focus groups, we’ve had voters across the ideological spectrum express high concern about rates. You can also see it in the latest University of Michigan surveys of consumers. Inflation haunted many Americans, and now interest rates bedevil them in a different way. People are saying high rates make it hard to buy a home or car or deal with debts. They’re worried about how high rates may affect their children. Some say they were promised that rates would go down, and they’re losing patience. Some are blaming President Biden and saying things were better under Donald Trump. Polls show voters trust Trump over Biden on the economy.

I get some of this but not all of it. What do you think?

Paul Krugman: Hi, Peter. We eventually need to get into the underlying economics — why are interest rates high, and will they stay there? But first, on how interest rates influence people’s views, we need to deal with an odd aspect of the situation.

High interest rates are, indeed, a burden on some Americans, especially first-time home buyers. And that could explain why some people feel bad about their financial situation, despite low unemployment and rising real wages.

But here’s the odd problem: Generally speaking, people don’t feel bad about their financial situation. Survey after survey, including the just-released annual Federal Reserve survey of economic well-being, finds most Americans say that they are doing OK. Many are positive about their local economies — that is, what they can see personally. Yet they insist that the national economy is a disaster.

There are various stories we can tell about this disconnect, none of them completely satisfying. But let me at least advance one story about interest rates: Given that many Americans, for some reason, are determined to be negative about the economy and inflation has subsided, interest rates give them an alternative peg for their discontent.

In other words, interest rates are a real issue, but what people say about them may be rationalization rather than reality.

Coy: I think you’re right about interest rates being an alternative peg for people’s discontent. I just shy away from calling it a rationalization. That makes it sound willfully incorrect. That may be the case for some partisans, but I think a lot of nonpolitical people really do feel something’s wrong, even if they can’t pinpoint what the problem is.

Krugman: What I mean by “rationalization” is exactly that: Americans are feeling uneasy for reasons that are hard to pin down, and interest rates give one reason for their unease, even if it’s not really the main driver.

Coy: Paul, I want to stay with your point about voters’ sense of well-being. The peak year for economic well-being in that Fed survey was 2021, when the pandemic financial assistance was still flowing. As you say, well-being was still pretty good in the latest survey, which was fielded last October, but not as good as in 2021. Maybe that decline is where some of the free-floating anxiety is coming from.

As for high interest rates, a lot of Americans don’t buy the logic that rates need to be high to bring down inflation. I’m getting that from a new study by Stefanie Stantcheva of Harvard and two co-authors. According to their paper, people often think higher interest rates cause inflation, which is the opposite of textbook economics. The textbooks say that raising interest rates depresses the demand for loans by businesses and consumers, which cools off the economy, so there’s less pressure on prices. But a lot of voters say, “Heck, I’m paying more to borrow. Looks like inflation to me.”

You can see why so many people are upset about high interest rates if they think they’re unnecessary to fight inflation and actually make inflation worse. (I don’t buy that entirely, but if you think of interest payments as part of the cost of living, there’s something to the idea.)

Krugman: Several points about interest rates and inflation. The first is that the view that raising rates makes inflation worse is less obviously misguided than usual, even putting aside whether you count interest as part of the cost of living. Recent excess inflation — inflation above the Fed’s target — is largely about housing, and high rates discourage construction, hence reducing housing supply. I don’t think this means lower rates would reduce inflation, because there are lags: Cutting rates would probably pump up other prices faster than it would cut housing costs. But it’s not as open-and-shut as usual.

Second, public views about inflation are, in general, very different from standard economics. A majority of Americans blame corporate greed — which, again, isn’t necessarily off base, except that corporations were always greedy and it’s not clear why they should have become much worse.

Coy: Housing is a fascinating case. People who have cheap mortgages don’t want to sell because they’d have to pay a higher rate on a new place. So there aren’t many existing homes for sale. People are turning to newly built homes, but there aren’t enough of them, especially starter homes. No wonder affordability is so poor.

On your point about greed: Exactly — nothing new about companies wanting to make as much money as possible.

Krugman: What’s funny is that if Biden were to base economic policy on public perceptions but couldn’t do anything about interest rates, he’d basically do a Richard Nixon: pressure the Fed to print money while imposing price controls to rein in those greedy corporations. Nixonomics ended up working out badly in the long run, but only after he won the 1972 election in a landslide.

Biden won’t do that, but it’s quite possible that if he wins, Trump — who doesn’t worry about things like central bank independence — will do just that.

Coy: Except, of course, that successfully pressuring the Fed would backfire on Trump and the whole economy. Investors would send long-term interest rates to the moon — by demanding higher yields on bonds — if they thought that the Fed had become politicized and could no longer be counted on to fight inflation.

Krugman: Inflationary policies might well backfire on Trump, but good luck convincing him or his advisers of that. What’s a bit more puzzling is why billionaires who have been moving into the Trump camp aren’t paying more attention to his monetary irresponsibility. Maybe they think they can control him — which would make them some of the most naïve people in America.

But, of course, there aren’t many billionaires. What’s more important is how interest rates affect ordinary families.

Coy: I’d like to get into how high interest rates hurt the poor more than the rich. Most upper-income people own houses. Either they own them free and clear or they refinanced their mortgages at 4 percent or less. Lower-income people who are trying to buy for the first time are looking at 7 percent loans. Credit card rates were up to over 21 percent as of February. That hits people who can’t afford to pay off their cards every month. Four-year auto loans were up to 8.5 percent from under 5 percent two years ago. Etc.

Theory says higher interest rates should hurt stock prices, but that clearly hasn’t been happening. Stocks are ripping. So the people who own stocks are feeling rich and spending freely. That’s keeping the economy strong and keeping inflation above the Fed’s 2 percent target.

The Fed says: Well, inflation is too high, so we’d better keep rates high. But then that hurts borrowers. The blunt tool of high rates is coming down on the heads of the working class.

Krugman: I see your point about high interest rates hurting lower-income Americans especially hard, which is almost surely true. The question is one of magnitudes.

This is actually part of a broader discussion about the distributional effects of recent inflation. Many people, including many of my readers, are sure that recent economic growth has benefited only the affluent, without trickling down to lower-paid workers. But the data says just the opposite: much bigger wage gains for low-wage workers than those farther up the scale.

The counter, when I point this out, is that inflation has been higher at the bottom, where people spend a higher percentage of their income on food and energy, which is surely true. But we have some careful estimates of that effect, both from the Bureau of Labor Statistics and from the Congressional Budget Office — and what they say is that prices have, indeed, gone up more at the bottom but not by nearly enough to offset low-end wage gains.

My guess is that high interest rates will tilt this a bit further but still not enough to reverse the result that inequality has been falling, not rising.

All that said, many people will feel better if interest rates come down. So maybe we should talk about whether the Fed can and should be cutting rates. I can see strong arguments in both directions. Inflation looks pretty tame at this point, although still somewhat above the Fed’s target, but the economy also continues to chug along.

Coy: I’m in the yes camp on cuts. I don’t deny that inflation is higher than the Fed wants, but I think the economy is weaker than a lot of people perceive. Lower rates would help with that.

I have to say the May increase in payrolls from the establishment survey, 272,000, was surprisingly strong. A few other statistics, though: Employment as measured by the household survey fell in May from April. First-quarter growth in gross domestic product was just 1.3 percent annualized. Business bankruptcy filings are the highest since the third quarter of 2020. Sales of new homes are down almost 8 percent from a year ago. The Conference Board’s leading index of the economy fell again in April, indicating softer economic conditions ahead.

Paul, I take your point about low-end wage gains, but we also have a lot of evidence that low-to-middle-income people are feeling pinched. Businesses that cater to them are feeling it. The chief executive of McDonald’s talked about consumers being “even more discriminating with every dollar that they spend.” For a while, people were coasting on the money they saved from pandemic stimulus. But the San Francisco Fed recently said it appears that “American households fully spent their pandemic-era savings as of March 2024.”

I’m worried that the Fed is behind the curve, because there’s a lag between when it cuts rates and when the economy perks up. Could it already be too late to prevent the damage?

Krugman: Even though recent inflation data has diminished my worries on that front and I would support rate cuts, I’m kind of surprised to be not all that dovish. If you had argued against cuts, though, I probably would have pressed the case for them, just to keep things interesting.

But let me talk about the short run, then the long run.

In the short run, that G.D.P. slowdown in the first quarter appears to have been just a temporary inventory effect; final demand was still growing fast, and many trackers are projecting second-quarter growth nearing 3 percent, which is still quite hot. Right now we seem to be in a place where you can choose numbers to rationalize whatever you want to believe: The economy may still be chugging along or at the start of a slowdown, and people I normally trust are on all sides of the issue.

One thing I’m fairly sure about is that the acceleration in inflation we’ve all been talking about was mainly statistical noise. So that’s a case for cuts.

In the longer run, our current era of low unemployment, relatively high mortgage interest rates and high stock prices reminds me of the late 1990s. And you can make a case that the current economy bears some resemblance to that era. We have a big tech boom and a lot of investment in green energy. Productivity may — may — be picking up. I used to believe that interest rates would stay low because of a stagnant working-age population, but a sudden jump in immigration has changed that picture, at least for a little while.

All that said, my guess is that interest rates will come down substantially once everyone is convinced that the inflation episode is over. But maybe not back to where they were prepandemic.

Coy: Right now, investors, on average, are expecting the Fed to wait until September, at the earliest, to start lowering its target for the federal funds rate, which is the overnight lending rate it controls. That would be its last meeting before the election in November. A quarter-point cut in September would do basically nothing to stimulate the economy before voters go to the polls.

Investors expect the funds rate a year from now to be only half a percentage point to one percentage point lower than today. I happen to think the Fed may cut more and faster than that. But if it does, that won’t be cause for celebration. It’ll probably be because the economy needed emergency assistance.

Jerome Powell, the chair of the Fed, is in a tricky place. I think he and a lot of other Fed voters realize that the economy is softening and rate cuts may be needed sooner than investors are expecting. But they can’t say that because as soon as they sound the least bit dovish, investors will react as if a starting gun had gone off. They’ll overreact and bid up stock and bond prices. That will make financial conditions too easy, and it’ll bring back the inflation that the Fed has tried so hard to expunge. And as we’ve found out, people really, really hate inflation.

Krugman: So I’m weighing in just after the employment report for May, which has left the situation clear as mud. There are many data points out there suggesting that the Fed should cut rates: The inflation scare from early 2024 looks like a false alarm, cracks are appearing in commercial real estate, and there are hints of an employment slowdown in multiple surveys. But the single most prominent number — growth in payrolls — just came in hot.

So much for any chance of a rate cut in June, and it would take some really soft numbers to get any rate cuts this summer.

I still think it’s likely that we’ll get enough bad news on jobs and good news on inflation for the Fed to cut at least once before the election. But to be honest, I’ve spent around a year expecting a compelling case for rate cuts any day now.

Suppose the data finally breaks in a way that lets the Fed cut in July or, more likely, September. How will that matter?

In terms of effects on the real economy, zilch in the short run. Think about what it takes for a rate cut to filter through to gross domestic product. Interest rates mostly work through capital formation — construction, purchases of equipment and so on. This stuff takes time — time to decide on an investment project, time to line up contractors and workers, etc. So rate cuts wouldn’t show up in the real economy until some time next year.

But they may show up in financial markets right away: If the Fed starts cutting, that could be viewed as sounding the all-clear, so bond and stock prices may well surge.

What about the political implications? Well, what do I know? But if I had to make a guess, if the Fed finally starts cutting rates before the election, it will help Biden. This won’t mostly be because it will immediately reduce the burden of high rates on consumers, because that effect will be small. But stock prices would probably jump, which would feed optimism.

And a Fed rate cut would, in effect, put an official imprimatur on the notion that we’ve achieved a soft landing (which I believe we have). It would, in particular, be a statement that inflation is yesterday’s problem. This would, I believe, change the narrative in Biden’s favor. Even though most voters have very little idea what the Fed is or what it does, I believe that a Fed rate cut would spread via a kind of osmosis into how the media and influential figures, in general, talk about the economy.

But that’s all for the possible future. I’ll be shocked if we get any movement in interest rates before September.

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