ADRIAN MA, HOST:

Big news today from the Federal Reserve's top economists. It comes from a group officially known as the Federal Open Market Committee. But you can basically think of them as the Jedi Council of Fed economists. They're the ones who, for the past 15 months, decided to raise interest rates to fight inflation and, in fact, voted to do that 10 times in a row. But today, that all changed because for the first time since March of last year, they decided to do nothing, to leave interest rates where they are.

DARIAN WOODS, HOST:

This is huge and not least because it makes a huge break from what you've been hearing on THE INDICATOR for the last year and a bit.

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MA: Jerome Powell, the chair of the Federal Reserve...

WOODS: The U.S. central bank...

MA: The U.S. central bank...

WOODS: ...Raised interest rates today.

MA: ...Announced the Fed was raising interest rates by three-quarters of a percentage point.

WOODS: Today, Fed Chair Jerome Powell announced the Fed raised interest rates by a quarter of a percentage point.

MA: Three-quarters of a percentage point.

JEROME POWELL: Half a percentage point.

MA: A quarter of a percentage point rise in interest rates.

[CROSSTALK]

POWELL: Percentage, 75 basis points...

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WOODS: But no more. Well, at least for now. And on the one hand, this is encouraging news. It's a sign that inflation is continuing to cool down. But remember that inflation is still uncomfortably high. I mean, inflation is double the 2% target that the Fed wants. And it would be totally understandable to be - I don't know - a little impatient. Like, why is this taking so long?

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WOODS: This is THE INDICATOR FROM PLANET MONEY. I'm Darian Woods.

MA: And I'm Adrian Ma. Today on the show, we explain why it's taking so long. To understand that, it helps to think about the economy like a big, finicky shower. We'll explain what we mean by that after the break.

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WOODS: If you want to know what keeps the Fed economists up at night before a big interest rate decision, it helps to take a visit to your bathroom and turn on the shower.

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MA: We've all been in this situation, right? You turn on the shower. You want to get the water at just the right temperature. But the water is cold. So you stand there with your hand under the spray, waiting and waiting and waiting for the water to heat up.

WOODS: I've been in this position. I don't know. It seems like a complete waste of time. But in any case, this slow shower is our economy. Just like there's a lag between when you turn the shower knob and the temperature moving, there's also a lag when it comes to the government's monetary policy. Those are the actions that a central bank takes to try to heat up or cool down an economy.

MA: Yeah. And two economists who are credited with popularizing this idea are Milton Friedman and Anna Schwartz. So starting in the 1940s, they began studying how long it took for the government's monetary policy decisions to filter into the broader economy, to affect things like employment, GDP and consumption. And what they found was that this process took a while, like, often between half a year or even as long as 2 1/2 years. And even though today's era of instant communication has probably shaved off some of that time, it still takes a while for an interest rate change to ripple through the economy.

WOODS: In other words, what happens after the central bank's move is what they call a long and variable lag - long as in there's a delay, and variable meaning that the length of that delay changes depending on which part of the economy you're looking at or quirks of the economy at the time. Speaking of which, our NPR's shower correspondent, Adrian Ma, how is the temperature of that shower doing?

MA: (Laughter) Let me see. Let me stick my arm in here. Ooh, yeah. Still cold.

WOODS: OK. You might be in for an ice bath.

MA: OK. So we'll come back to that. In the meantime, what causes Fed policy to have this long and variable lag? Well, for one thing, this really complex chain of events has to happen in order for interest rates to affect inflation. The Fed has to raise the rates, and then, banks have to see that and raise their rates on everything from credit cards to home loans to business loans. And over time, the hope is that all of this slows down the economy and brings inflation under control.

WOODS: This lag is essentially what we saw over the past 15 months as the Fed raised interest rates to combat inflation. It started back in March 2022, but it wasn't until about six or seven months later that we started to see evidence that it could be working, that inflation stopped climbing and began trending down.

MA: And there's another way this lag makes policymakers' jobs more complicated. And that's the fact that different parts of the economy are more or less responsive to changes in the Fed's interest rates. This is the variability part we mentioned. So, for example, things like stocks, the lag time there is supershort, and you can see that every time the Fed makes an announcement about a rate hike or a rate cut; the stock prices are jumping up and down.

WOODS: Or even beforehand if the Fed has been signaling what they're going to do. For other kinds of things, the lag time is a lot longer. Think about situations where the price of something is set by a contract. If you just sign a one-year lease for an apartment, for example, the Fed can raise rates all at once. But that price, for the time being, is locked in. Same thing if you're a company that makes toys, for example. You might have a contract with a manufacturer to deliver toys several months from now during the holidays. That price, at least temporarily, is stuck in place.

MA: Darian, hold on.

WOODS: Yes.

MA: I...

WOODS: What's up, Adrian?

MA: I think the water is starting to heat up.

WOODS: OK, that's promising.

MA: Wait, sorry. Never mind. It's just - somebody flushed a toilet.

WOODS: OK.

MA: But it's OK 'cause this actually relates to our next point, which is, you know, between the short lags and the long lags, there are all kinds of things where it's really hard to predict how interest rates will affect them, right? In just the last year, we have seen consumer spending continue to surge. We've seen the job market continue to roar despite rising interest rates. And partly because of those rising interest rates, we've also seen a string of bank failures like Silicon Valley Bank.

And to complicate things further, you've got a messy world out there. I mean, the war in Ukraine, which affected prices for oil and food, is just one example. And when you put all this stuff together, it really messes with the Fed's macroeconomic math. To put it in shower terms, it's like you're still trying to dial in that temperature and somebody flushes that toilet.

WOODS: This long and variable lag is why we are still waiting for interest rates to bring down inflation to normal levels. And it would be fair to ask, OK, if we know that there is this built-in lag time for interest rates to have an effect on inflation, why doesn't the Fed just crank up the interest rates really high? Like, couldn't that just bring inflation down more quickly? Or in shower terms, if the water is scalding hot, just give that knob a quick, firm crank in the other direction. Enough of this drip, drip, nudge, nudge kind of business.

MA: Of course, the problem is when you crank the shower knob this way and that way, the temperature might change more quickly, but it can easily have you howling in pain when you get a blast of icy, cold water in your face.

WOODS: Yeah, the cure becomes worse than the disease itself. So similarly, if the Fed is overshooting with interest rates, you know, the result would be economic pain. Credit would become superexpensive. The economy would grind to a halt. Unemployment would spike way up.

MA: This is why Fed policymakers seem to prefer the slower, incremental approach, you know, to be patient with this long and variable lag that they have to deal with rather than, you know, cranking interest rates up to 11. On the upside, it is less risky. On the downside, it does take longer to see results.