Inflation Forces the Fed’s Hand

0:07Ryan Knutson:Yesterday, our colleague Nick Timiraos walked into a place he knows well, the press briefing room at the Federal Reserve.

0:18So I walked into the room, my seat was in the back yesterday. They had instructed all of the reporters beforehand, you know, ask one question, no follow-ups. The questions were short. The answers were short.

0:37Ryan Knutson:Nick was there to hear from Kevin Warsh, who took over as Fed chair in May. Having a new Fed chairman, it's a little bit like we just started a new school year, right? It's a little bit like having a new teacher. Everybody's trying to figure out, well, what's this guy or gal like? How are they going to respond to this kind of question or that kind of question? And what's the headline? What happened yesterday at the Fed? The Fed raised rates for the first time in three years. Good day. In the meeting just concluded, the FOMC decided to raise the target range for the federal funds rate by a quarter of a percentage point.

1:21to 3.75 % to 4 % in support of the Federal Reserve's dual mandate. This is kind of a big deal. Raising interest rates is a big deal because it takes a certain amount of evidence and confidence to say we need to change direction. The plain fact is that inflation is too high and has been for too long. We had been cutting. We stopped cutting. That was a change. And now we're actually going to raise interest rates.

1:59It's especially a big deal doing it now, two months before the midterm elections, doing it when the White House has been saying inflation's under control. You know, these high prices are going to go back down really soon. The Fed's saying maybe not.

2:18Ryan Knutson:With the recent turmoil in the bond market and yesterday's interest rate increase, the cost of borrowing will go up throughout the economy. Mortgage rates, car loans, any balance you might have on your credit card, it'll all be more expensive. Nick, I thought we were supposed to be done raising rates, and it feels like we're now at yet another pivotal inflection point where the economy is not looking like it's moving in the right direction. Yeah. If you went back to the beginning of the year and you said the Fed's going to be raising interest rates just a few months after Donald Trump gets his new chairman, I'd have said no way.

2:55But if you had been following anything in the last couple months, it wasn't a big surprise at all.

3:06Ryan Knutson:Welcome to The Journal, our show about money, business, and power. I'm Ryan Knudson. It's Thursday, September 17th.

3:19Ryan Knutson:Coming up on the show, why the Fed chair who was supposed to lower rates just raised them.

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4:41Ryan Knutson:When President Trump selected Kevin Warsh to replace Jerome Powell as Fed chair in January, the Fed had been in a period of cutting interest rates. Inflation was coming down, and the economy was looking more stable. At that time, investors said, OK, we think we're going to get more interest rate cuts now. The idea was that once Powell's term ended in May and Kevin Warsh came in, it would open the door to a looser policy because that's what Trump wanted and that's what Kevin Warsh had signaled. But within weeks of Trump's decision to tap Warsh, the economy was hit with a massive shock. We have breaking news that we're following from overnight.

5:22The U.S. and Israel have launched a wide-scale assault on Iran. The Pentagon today announcing it's sending more troops and fighter jets to join the operation. When the U.S. bombing campaign began in Iran, not too many people realized at the time how that was going to change everything in 2026.

5:42Ryan Knutson:When Iran closed the Strait of Hormuz, oil prices spiked, raising costs for businesses and consumers across the economy. Inflation became a bigger problem. Other central banks began raising interest rates around the time Kevin Warsh became Fed chair in May. People are beginning to say, hey, wait a minute. But not only does it look like you might not be able to cut interest rates this year, you might actually have to raise interest rates. So Warsh had his first Fed meeting in June. You were there. Nick, what was that like? Well, again, new teacher. Nobody really knows what to expect. At his first meeting, he comes in at the press conference and delivers this flat vow.

6:25We have not gotten the job done on inflation. I am going to fix it. The commitment to deliver is strong, unanimous, and unambiguous. And that's, I think, an important message. We've missed for five years, and we're going to fix that. And everybody said, wow, that's a bold statement. So maybe we should be prepared for interest rates to go up now.

6:50Ryan Knutson:Raising and lowering interest rates is the Fed's main tool for fighting inflation. When the Fed raises interest rates, loans get more expensive, and therefore people have less money to spend. Demand falls, and prices usually slow down in response.

7:09Ryan Knutson:By the next Fed meeting, in July, the picture of the economy was still mixed. At that point, under Warsh, the Fed decided not to raise rates. But three Fed officials on the 12-person rate setting committee dissented. You'd say, well, 9 to 3 is still an overwhelming majority, But in kind of Fed, if you're sort of Fed-coded, you know that three descents is a lot when they're in one direction. That was a significant statement. And then at the press conference, Kevin Warsh really struggles or declines to offer any rationale for why they held interest rates, how that would be consistent with the pledge that he had been making up until that point to get inflation down.

7:54So there's a little bit of a credibility dilemma after that. Well, is he planning to just talk tough? Does he plan to follow through? What's going on here?

8:05Ryan Knutson:In other words, he said, my mission is to get inflation under control. But then the July meeting comes along, he doesn't take the action necessary to do that. He doesn't raise interest rates. It wasn't even that they didn't raise interest rates. It was declining to give any rationale for how that would be consistent with what you'd said. it. During that July press conference, markets reacted badly in real time. As Warsh spoke, long-term treasury yields rose, a sign that if Warsh was less inclined to raise rates to combat inflation, investors expected either a little more inflation, higher rates later, or some combination of both.

8:42And so then going into August, the big question was, well, what's the new chair all about. You heard the gamut of views. There were people saying he's very close to President Trump and Trump doesn't want him to raise rates, so he's not going to raise rates. There were other people who have worked with Kevin Warsh when he was in the private sector saying, you don't understand. He's very serious about getting inflation down and no one should underestimate his resolve and his commitment once he decides this needs to happen. So it was sort of one of these choose-your-own-narrative or choose-your-own-ending stories.

9:19Ryan Knutson:Can you help me understand a little bit better what happened in the economy this summer that's causing inflation to go back up again? One, Iran war. Energy prices, you know, when gas prices go up, maybe people can drive less. That destroys some demand for gas. When diesel prices go up, anything you buy at the supermarket, if it got put on the shelf via a freight truck that's powered with diesel, the store can't say, well, we don't want as much food on our shelves because diesel's high. So, you know, the Iran war and the pass through to some of these refined products, that's a big one. Number two, the AI buildout is straining demand for electricity, memory, the whole supply chain there, you're seeing prices go up.

10:09Third, you still have tariffs as an issue. It was thought that would be in the rearview mirror by now, and there's a lot of evidence that tariffs have completely passed through into prices. But there are still questions on that. And so the world looks a lot different than it did eight or nine months ago.

10:26Ryan Knutson:All these factors made a strong case for raising rates. But then came the final straw. Last week, a key monthly report on consumer prices showed inflation had jumped higher than expected. Prices rose by 3.4 % from a year ago. So, all indications were that the Fed needed to do the exact thing that President Trump has so long opposed. Here he is just days before the Fed's latest meeting. The United States is so strong, we should be paying the lowest interest rate in the world. Regardless of their formulas, I know more about formulas than anybody. And we're the best credit in the world. Despite his misgivings, Trump said he met with Warsh before yesterday's decision was announced.

11:15Ryan Knutson:Which, by the way, isn't something presidents normally do. And Trump said he gave Warsh his blessing to do what he thought was best. And I talked to Kevin, and I said, you might as well vote with the board because it's not going to matter. On Wednesday evening, when he was asked about it, he said, well, I actually talked to Kevin Warsh and I told him, go ahead and raise interest rates because clearly your board wants to do it. The board is very hostile. They're very political. They're doing the wrong thing. They're a bunch of politicians. Do whatever you need to do because, you know, he sort of implied this is a lost cause.

11:49Ryan Knutson:The thing is, when the Fed raises rates, it usually doesn't just do it once. It keeps making gradual increases over time. I think the real question is, how much longer does this sort of uneasy peace between the Fed and the White House last? If the Fed has to raise interest rates more than they're anticipating, if they really have to slow down the stock market, if that's what they think they need to do to get inflation under control, then it could get a lot more difficult. This was sort of the easy... The first one is maybe the easiest. So if this isn't a one-time rate hike, how much longer could it go on?

12:33Ryan Knutson:That's next.

12:49Ryan Knutson:All right, let's talk about the challenge that the Fed has in front of it. The Fed wants inflation to be around 2%. It's been above that target for the last five and a half years. How entrenched is inflation becoming in the economy at this point? Well, the risk is that it is becoming entrenched. I think, you know, people say, oh, look, inflation has been above the Fed's target for a long time, and that's true, but I would sort of separate out what's happened.

13:18For several years, inflation was coming down to the Fed's goal. So yes, it was above 2%, but it was coming down. That ended in the middle of 2025. And so the real worry isn't just that it's been above the target for a long time. It's that it's no longer making progress.

13:36Ryan Knutson:That progress stopped with President Trump's tariffs and later the Iran War. At first, some economists thought those shocks would be temporary. But tariff battles have persisted. The AI boom continues to strain demand. And the Iran war has no end in sight. If part of the inflation issue is fuel prices, how hard do you think it'll be for the Fed to get inflation under control under this set of circumstances? Well, they're sort of at the mercy of what happens to oil prices, commodity prices. They can't create more oil, right? They can't print hydrocarbons. In 2022 and 2023, when inflation was a big problem, to the extent it's being driven by demand, it's pretty easy.

14:24Turn off the housing market, right? Raise interest rates, turn off the housing market, slow demand.

14:29Ryan Knutson:Make it more expensive for people to get loans and therefore they will not spend as much. They will spend less. They will consume less. Price growth will slow. If the inflation is coming from this crazy investment boom where these AI companies are spending huge sums, 50 or 75 basis points of an increase in interest rates isn't going to stop any of that. It's not going to bring the Stratohormu's open. And so the challenge for the Fed could come if you get into a place where they're really having to slow the rest of the economy, which was not overheating, simply to manage these supply challenges that you don't want those supply bottlenecks to create more price pressure.

15:16So you're going to have to cool everything else down.

15:23Ryan Knutson:In other words, raising interest rates half a percentage point or three quarters of a percentage point, to translate what you mean by basis points, isn't going to bring down the cost of oil. Right, but it can bring down the cost of other things, right? You can slow down the housing market. You can cool down demand for discretionary spending. And that might take some of the pressure off, given that there are these other sectors that you're just sort of unable to do anything about it. How has the U.S. economy been absorbing this persistent inflation, especially in the most recent uptick this year?

16:00Well, it's a little bit too soon to say, but when inflation goes up and wages don't go up, we call that real wages. Inflation-adjusted wages have been flat this year. So for people who don't have assets, who aren't benefiting from being invested in the stock market, they may have to spend more out of their savings if their paychecks aren't keeping up with price increases. And if that continues, it could really crimp consumer spending.

16:33Ryan Knutson:So how are businesses dealing with this inflation that's lingering and getting worse again? You hear different things from businesses. Some businesses say we're passing through these cost increases that we're getting, the shipping cost increases, energy price increases. We're able to pass it through and we're not losing market share. And we're not, you know, we don't have to take a big hit to our margins. Other businesses are telling you there's resistance to higher prices. We can't pass it through. For the Fed, that's probably good news. It means that if people are pushing back against price increases, it's going to be harder to raise prices.

17:10I think the real question is, you know, if these cost increases continue, are businesses going to be able to pass them along?

17:20Ryan Knutson:After Fed meetings like this, Fed officials issue projections about where they think interest rates are headed. Yesterday, the majority said they anticipate needing to raise rates at least one more time before the end of the year.

17:36Ryan Knutson:So what do you think the story of Kevin Warsh's Fed chairmanship is going to be based on how the first few months have gone and what he's facing now? Well, so far it tells you he is going to be independent. Donald Trump didn't want him to raise interest rates, and he did. So, you know, that should quiet these concerns that some people have had. What more do you need to see? They raised interest rates. Actions speak louder than words. I think the challenge is still going to be there because, like I said before, this is an easy one. You know, this is the first one. What happens if inflation is a problem and the stock market's coming down or the unemployment rate's going up and you don't see evidence that inflation's getting better?

18:21That's when it gets harder. But right now, no one can call Kevin Warsh a sock puppet if he's raising interest rates and Donald Trump is saying, I didn't want you to do that.

18:34Ryan Knutson:Before we go, remember Red, White, and Who? Our politics miniseries from 2024. Well, we're bringing it back for this year's midterms. And we want to hear from you. I want to know how the economy is affecting how you're going to vote this year. Is it a major concern as you enter the polling booth? Can you tell us about a specific moment that's affecting your thinking? If you voted for Trump in 2024, is the economy going the way you expected? Send us a voice note to thejournal at wsj.com. That's thejournal at wsj.com. There's also a link to our email address in the show notes.