Article originally published on: https://www.bu.edu/
Questrom’s Jay Zagorsky and CAS’ Laurence Kotlikoff on what’s likely to be next for the roller coaster we’re on
Interest rates are running in inverse direction to stock markets, with the former up and the latter sagging. Which direction is the economy headed? Americans are wondering after last week’s largest-in-three-decades interest rate hike—three quarters of one percent—by the Federal Reserve and Wall Street’s ongoing swoon into bear-market territory.
By making borrowing more expensive with its rate hike, the Fed hopes to temper spending and bring prices down without inducing a recession, Fed chair Jerome Powell said. He forecast another hike next month to counter inflation that was up 8.6 percent in May from a year earlier, the sharpest increase in 40 years. Stock markets, however, are spooked by the potential hit to growth and profits from slower spending.
So whither the economy? We asked two BU experts: Jay Zagorsky (GRS’87,’92), a Questrom School of Business senior lecturer in markets, public policy, and law, and Laurence Kotlikoff, a William Fairfield Warren Professor and a College of Arts & Sciences professor of economics.
BU Today: The Fed says last week’s large interest rate hike is aimed at curbing inflation without inducing a recession. Do you think it will achieve both goals, either, or neither?
Zagorsky: I think the Fed will tame inflation. However, I doubt they will do this without causing a recession.
When humans are faced with a difficult task, they prepare by practicing many times. This is why athletes train for years, professors write out and then revise lectures, or politicians try out new ideas on small, friendly audiences before taking the ideas to a bigger stage. The Federal Reserve is faced with the incredibly difficult task of bringing down inflation without driving the economy into recession. It gets to do this without practicing and without the ability to try things out on a small test group. Without practice or test cases, I think it is extremely unlikely for the Fed to achieve the twin goals of curbing inflation and keeping the economy humming.
Kotlikoff: The Fed’s rate hikes have been trivial. When the inflation rate is running at 8.60 percent and the Fed sets a short-term nominal interest rate at 1.25 percent, it’s leaving the real, inflation-adjusted, short-term borrowing rate at negative 7.35 percent! In 1979, Fed chair Paul Volcker let short nominal rates rise to 20 percent. So the Fed is accommodating, not fighting, inflation. This may be the smartest policy move. The cost of recession is far higher than of inflation, especially if we adjust the tax system to help us live with what is likely temporarily high inflation.
What will the Fed’s actions mean for those seeking mortgages, student loans, and credit cards?
Zagorsky: People who have debt that adjusts with interest rates are going to pay a lot more. People who want to take out loans to buy homes and cars are going to pay a lot more. Together, this will slow economic growth by inflicting economic pain on borrowers.
Kotlikoff: The Fed, as I just described, is engaged in cosmetic moves. It’s not trying to put the economy in recession. Yet that may arise if enough people decide that’s where the economy’s heading. Our economy is subject to multiple equilibria, which in lay terms means the economy can talk itself into recession. As I’ve explained elsewhere, collective panic is the only reasonable explanation for the Great Recession. The facts don’t convict any of the alleged culprits. If you read the press today, you’ll see copious references to the coming recession. The press likes to stress the awful. It grabs eyeballs. So does the party out of power. And calamity gives talking heads something to discuss. And then we have tycoons who may be talking down the economy, and by extension, the market, based on their investment positions.
Is the ultimate solution to the problem something that’s beyond the control of the United States or any government—that is, fixing pandemic-snarled supply chains and ending the war in Ukraine?
Zagorsky: I think much of the cause of this inflation was brought on by government actions. The Federal Reserve has maintained very low interest rates and loose monetary policy since the Great Recession of 2008. Congress provided large amounts of money to both individuals and businesses during COVID. Both of these policies supercharged the economy. Policies, like artificially keeping interest rates close to zero, distorted the economy, and the only long-term solution is to remove these distortions. Unfortunately, removing these distortions is going to be painful.
Kotlikoff: No, supply will come back. Take grain. Ukraine is not the largest wheat producer. Nor is it the second largest. It’s the eighth largest. China is the largest. The United States is second. No doubt the seven larger producers are planting wheat like crazy right now. Yes, the extra supply will take six months to hit the market, but prices of wheat and other foodstuffs will come down. This is not just my view. In general, the market is predicting a dramatic if gradual decline in inflation. This can be read off of the difference in market interest rates on nominal and inflation-indexed Treasury bills and bonds.
Progressive Democrats are blaming corporate greed and price-gouging for part of the inflation. Is that warranted, or is it political cover?
Zagorsky: Corporate and individual greed has always been part of our society. I have not noticed an increase in corporate or individual greed, so I don’t think this is the reason for inflation. I have been teaching business school students at BU since 1999. If I have noticed anything, it is that over time, BU students have become less focused on money and less greedy. I don’t know if this is a nationwide trend, but if it is a trend, this makes changes in greed less likely to explain inflation.
Kotlikoff: Political cover. Prices are being set by 32.5 million individual businesses, not by a few greedy corporations.
Senator Joe Manchin (D-W. Va) has been calling for reducing the deficit. Would that temper inflation?
Zagorsky: Reducing the deficit and the total US government debt is very important. The total debt is $30 trillion, of which almost $24 trillion is held by the public. When the Fed increases interest rates, this boosts how much individuals owe, but also boosts what the government owes on its debt. Rising interest rates will soon cause the US government to owe billions more in interest payments, which will force some hard budget choices.
Kotlikoff: Our government has a massive, long-term insolvency problem. And we have been making money to make money. The money supply rose by about 40 percent in 2020 and 2021 as the Treasury and Fed joined forces to print money to pay for COVID relief. So, yes, some of the inflation we are seeing is likely due to continuing to signal the ongoing use of the printing press to pay our nation’s bills.
Is the stock market’s recent swoon likely to continue, and what does that portend for the economy broadly?
Zagorsky: I think the stock market swoon will continue until the Fed stops raising interest rates. However, if I knew exactly what the stock market would be doing, I would not be teaching at the Questrom School of Business, but instead would be running my own hedge fund.
Kotlikoff: The market is in panic mode. It’s a good time to buy stocks. The market has always been highly volatile. But, on average, it does extremely well. So it’s a great casino. Just don’t spend your winnings until you leave it.