With Interest Rates Steady, What’s Next For the Economy? Interview with Yale Economist William English
In its March meeting, the Federal Reserve held interest rates steady after a series of cuts at the end of 2024. In recent remarks, Fed Chairman Jay Powell has said: “We do not need to be in a hurry to adjust our policy stance.” While the Fed noted that economic activity has continued to expand at a solid pace, and the unemployment rate has stabilized at a low level in recent months, it also cited slower progress on inflation and uncertainty about the effects of the policies of the new presidential administration.
In the interview below, Yale Professor and former Fed official William English talks through the recent moves by the Fed, as well as the uncertainty around tariffs and fiscal policy.
What do you make of the recent Fed decision, and what data or economic indicators do you think are most important in its consideration to keep the rate steady?
The Federal Open Market Committee (the monetary policy making body of the Federal Reserve) had cut rates by a full percentage point last fall, but with inflation still above target and no longer clearly falling, policymakers thought that further cuts were not appropriate.
Prior to the current administration, the Fed expected inflation would fall towards their target of two percent. This isn’t because there’s a lot of slack in the economy—Chairman Powell has talked about how it's operating near potential—But they think longer term inflation expectations are well anchored around two, which will help pull actual inflation, which is a bit higher than that, down. But there’s a risk that won’t be true, and inflation may remain higher—perhaps somewhere around 2.5 percent, so it’s a little bit of a wait and see sort of issue. They’ve basically indicated that they want to see more evidence that inflation is returning to target before cutting rates further.
They also noted that they want to see what policies are implemented by the new administration before responding. Broadly, they saw policy as being in a good place, with the economy performing well, and they were in no hurry to adjust policy.
How monetary policy plays out this year will depend on economic developments. If inflation moves lower, I expect the Fed will ease policy to keep the economy on track. The Fed will likely also ease if the economy slows—for example, because of the current elevated uncertainty about fiscal policy and tariffs. On the other hand, if the economy strengthens or inflation moves higher, the Fed would cut rates more gradually. In any event, I’m confident that the Fed will ultimately get inflation back to target. Policymakers realize that providing low and stable inflation over time helps support investment and growth, and so leads to the best outcomes for the American people.
How does uncertainty around current economic and political trends play a role in the Fed’s decision making?
One important thing to realize is that uncertainty is typically very high. The Fed publishes forecasts every quarter with tables that show typical margins of error at a one-year horizon for various indicators. Over the past twenty years, those margins have been in a range of plus or minus 1-1.5 percentage points, on average, so things are very uncertain on average. Right now, with the current Administration, there’s also a lot happening with fiscal policy, tariffs, and so on, so the outlook is even more uncertain than usual. If it weren’t for these political factors, I think the level of uncertainty would be typical for policymakers.
This heightened uncertainty is another reason, if you’re the Fed, that you may want to wait and see and get some resolution before you take further steps with monetary policy. From their recent announcements, it feels like they’re very much in wait and see mode. They still think inflation is likely to move gradually back to target, but it’s unclear how quickly this will happen. If inflation stays high, then policymakers will leave rates higher for longer. If the economy weakens, or if inflation falls faster than they expect, then they’ll be cutting rates sooner and faster. But there's a whole lot of uncertainty around that.
How important has Fed policy been to the changes in inflation we’ve seen in the past few years? What other important factors played a role?
The main thing that monetary policy did was cut off the overheating before it got out of hand—before the significant period of inflation got built into wage and price setting, which has historically led to larger and more challenging inflation problems.
There’s an important paper by Olivier Blanchard and Ben Bernanke that breaks down a lot of the recent arguments over inflation: "What Caused the US Pandemic-Era Inflation?" One of the main themes is that a lot of the recent inflation was temporary because of the pandemic: there were big disruptions to supply, and big commodity prices shocks, and so inflation went up a ton, but those things were transitory. They were transitory, but also more persistent than the Fed thought. Inflation rose further than expected and then came down more slowly than expected, and underneath that period of high inflation, the economy was overheating. The labor market was spectacularly tight, and the levels of vacancies relative to unemployment were really high. Quits were really low. There were many indicators pointing to a hot labor market, which pushed inflation higher. With some of that inflation being persistent, a big question has been: will the anchoring of longer run inflation expectations around the target of 2 percent be enough to pull inflation back down? And, as I noted, the prospect of additional tariff-induced inflation makes that question even more difficult to answer.
A related question is whether the Fed will need to aim for some slack in labor and goods markets to get inflation back down? Read literally, the paper says you’ll need some slack. But the Fed thinks not. They believe that if they keep the economy at potential and the labor markets more or less in balance, then inflation will fall, but there's a lot of uncertainty.
Something that has come across in headlines is that the Fed has been cutting rates, but mortgage rates haven’t followed suit. What’s the disconnect here?
It’s important to understand that longer-term interest rates are typically close to the expected average level of short-term rates over the life of the longer-term rate. So the ten-year Treasury yield is the market’s expectation of what the Fed’s policy rate will be on average over the next ten years. There’s also a risk premium: If you buy the ten-year Treasury, and then rates go up, you can lose money, so people need to be compensated for that risk.
What’s happened since last summer, is that markets have come to expect that the Fed will reduce its policy rate more gradually—so the average expected short-term rate is a little higher than before. Estimates of the risk premium have also gone up some, and that’s also pushed up long-term rates. Why is this? While many things are possible, there are concerns around what’s happening with fiscal policy. Will there be another round of tax cuts? Will there in fact be reductions in spending? Will we get on a more sustainable fiscal path? How will all this play out over the next four years?
With the economy a bit stronger, and inflation a bit higher, monetary policy won't ease as fast as we expected last year. Combined with uncertainty and worry about where fiscal policy is headed and whether we’ll get on a more sustainable path, this is all contributing to the upward push on long-term rates.
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