Last month I gave a speech entitled “Something has to give.”1 This message was sparked by the fact that we saw strong economic growth and strong employment data in the third quarter, while at the same time seeing a significant slowdown in core personal consumption spending (PCE inflation. While this was good news for employment growth, the pace of real economic activity appeared inconsistent with continued progress toward the Federal Open Market Committee’s (FOMC) goal of 2 percent inflation. It seemed clear to me at the time that something had to give – for inflation to fall further to our 2 percent target, the economy would have to slow from its high pace in the third quarter. Unless there was a slowdown, inflation progress was likely to come to a halt came to a standstill or even reversed, so it remained to be seen whether the economy would cool down or inflation would rise.
What we have learned in the last few weeks encourages me: Something seems to be giving way, and that is the pace of the economy. October data suggests a slowdown in economic activity, and fourth-quarter forecasts show a slowdown more consistent with progress in reducing inflation. Additionally, recent data showed inflation moving in the right direction in October, albeit gradually, after core PCE inflation rose from its summer lows in September.
Although I am encouraged by the first signs of a slowdown in economic activity in the fourth quarter, given the available data, inflation is still too high and it is too early to say whether the slowdown we are seeing will be sustained. But I am increasingly confident that policymakers are currently well positioned to slow the economy and bring inflation back to 2 percent. However, there is still significant uncertainty about the pace of future activity and therefore I cannot say with certainty whether the FOMC has done enough to achieve price stability. Hopefully the data we receive in the next few months will help answer this question.
Let’s start by updating the picture of economic activity. The first estimate assumed that real gross domestic product (GDP) grew strongly by 4.9 percent in the third quarter. We’ll find out tomorrow whether that estimate is accurate, but growth this quarter accelerated significantly compared to the first half of 2023, when real GDP grew just over 2 percent. Growth in consumer spending, which accounts for most of GDP, was strong in the third quarter.
October economic activity data suggests consumer spending is slowing compared to the third quarter. Retail sales fell 0.1 percent, the first decline since March. Spending on automobiles, a rate-sensitive sector, fell, which could be evidence that the FOMC’s monetary tightening is having some effect. Spending also fell at gas stations, largely due to a significant drop in gasoline prices, which is often a larger factor than shifts in demand for this retail segment. But even excluding motor vehicles and gas station sales, retail sales barely rose in October, which could reflect a general slowdown in demand.
Beyond consumer spending, there are signs that business activity in both manufacturing and non-manufacturing sectors slowed in October. If we exclude a sharp decline in automobile and parts production due to the United Auto Workers strike that ended Oct. 30, manufacturing output rose only slightly, by 0.1 percent, last month.2 Institute for Supply surveys Management among purchasing managers revealed that both manufacturing and non-manufacturing activity slowed in October.
Nowcasting models, which forecast GDP based on available data, predict a significant slowdown in economic activity in the fourth quarter. According to the retail sales report for October, the Atlanta Fed’s GDPNow model forecasts an increase of 2.1 percent for these three months, which is almost identical to the actual growth rate for the first half of the year. Something that boosted GDP significantly in the third quarter was the buildup of inventories, which are quite volatile from quarter to quarter. This volatility reflects how companies manage their inventories, building them up and depleting them at other times to manage cash flow and anticipate fluctuations in demand. Private inventory investment contributed 1.3 percentage points to GDP in the third quarter and this figure is unlikely to last. Inventory fluctuations could even have a negative impact on GDP in the coming quarters.
It should be noted that the GDPNow estimate does not take into account the impact of the autoworker strike. A number of estimates suggest that the strike will reduce the GDP growth rate by about half a percentage point in the fourth quarter and then increase GDP by about the same amount in the next quarter. Therefore, when considering the impact of the strike, I will rather consider the strength of economic activity. Overall, output growth appears to be moderating as hoped, supporting further progress on inflation.
The job market is also cooling down. Job creation has fallen this year from the high rates of 2022, and the unemployment rate rose from a more than 50-year low of 3.4 percent in April to 3.9 percent in October. The ratio of job vacancies to job seekers has fallen, as has the number of people leaving their jobs voluntarily. The average hourly wage, which grew by more than 5 percent annually last year, has declined more or less steadily in 2023 to 4.1 percent in October.
These are all signs of an easing labor market. But despite all the measures I’ve mentioned, they’re still at levels that would historically be associated with a fairly tight labor market. We have 10 months of data on job creation in 2023, and for the five months ending in May, the monthly average was 287,000. Despite the strong month of September, the average for the last five months was 190,000, which is close to the 10-year average from 2010 to 2019.3 That’s a significant slowdown, but job creation is still occurring at a higher rate than what would be necessary to accommodate new entrants into the labor market, taking into account changes in labor force participation. And although the unemployment rate, at 3.9 percent, is higher than its April low, it is still essentially as low as unemployment was during the booming labor market in the late 1990s. Members of the National Federation of Independent Businesses (NFIB) report that the number of job openings has declined significantly compared to 2022, but is still at levels higher than in the late 1990s or at any other time in the 36 years of the NFIB survey.4 The bottom line here is that the labor market is still quite tight, and I will be watching closely to see if it continues to weaken in a way that keeps inflation toward 2 percent.
So let’s talk about progress on inflation. Consumer Price Index (CPI) inflation for October was exactly what I want to see. There was no inflation this month, prices remained virtually unchanged, and unlike previous periods when improvements were concentrated in a few goods and services, the weakening of inflation was broadly distributed. Over the past 12 months, CPI inflation was 3.2 percent, a dramatic improvement from 2022 when CPI inflation was above 8 percent for most of the year. In October alone, a decline in energy prices offset increases in other categories, but the rise in core inflation excluding food and energy was still a modest 0.2 percent that month. Core CPI inflation was at 4 percent over the last 12 months, but a better sense of the recent trend comes from the annualized rate of three-month inflation, which was 3.4 percent for core inflation in October.
As you may know, the FOMC uses a different measure of inflation, personal consumption expenditures, for its 2 percent target, and this is consistently slightly below CPI inflation. We will get the PCE inflation for October on November 30, but a rough estimate based on differences with the consumer price index and the producer price index shows that overall PCE inflation over three months was 3 percent and over six months was 2, was 5 percent.
The question is whether inflation can continue to progress toward 2 percent. There are a few factors that favor this outcome, so let me go through them.
First, housing services inflation, which is heavily dependent on rents, has slowed since its peak last year, and the lagged effect of rent moderation last year should keep this sizeable portion of inflation at moderate levels.5 Goods prices have Inflation has contributed greatly to the decline recently and has moderated to the point where it is unlikely to contribute much. But non-housing services, which account for about half of PCE inflation, have not weakened as much as other categories, and there needs to be some improvement there for headline inflation to reach 2 percent.
Labor costs account for a significant portion of these service price increases, and the aforementioned slowdown in wage growth should help reduce this segment of inflation. Average hourly wage growth has slowed to an annual rate of 3.2 percent over the past three months, below the 12-month rate of 4.1 percent, a sign of continued improvement. This is also evident from the Atlanta Fed’s Wage Growth Tracker, which uses household survey data to estimate annual wage increases. In March it was 6.4 percent and fell to 5.2 percent in October. A broader measure of compensation, the quarterly employment cost index, has improved less dramatically this year. A services-focused measure of wage increases compiled by the St. Louis Fed also showed a slowdown. This research, based on data from payroll company Homebase, shows that wage pressures continue to ease, similar to broader measures of wage growth.6
This is encouraging, but it is not enough to be sure that this will continue. Just a few months ago, inflation and economic activity were recovering and the future looked less certain. And while it is encouraging that the FOMC’s preferred inflation rate has fallen below 3 percent over the last three or six months, our target is 2 percent and policymakers need to set a level that brings inflation to 2 percent over the medium term. I will be closely monitoring pressures on the prices of various categories of goods and services in the coming weeks to decide whether inflation continues its downward trend.
Let me now turn to the implications of all this for monetary policy. I would like to start with the point I made at the beginning: monetary policy is restrictive and is clearly contributing to the rapid improvement in inflation over the last year. The FOMC raised the federal funds rate from near zero to over 5 percent, the largest increase in more than 40 years, and, as some people have noted, we have seen the fastest decline in inflation on record. The increased inflation was partly the result of supply-side issues related to the pandemic, and some of the observed improvement in inflation was due to the mitigation of these issues. However, most data indicators and anecdotal evidence suggest that supply-side issues are largely behind us and will therefore do little to bring inflation back to our 2 percent target in the future. From now on, monetary policy must ensure that inflation falls back to 2 percent.
There has been talk that robust economic growth and falling inflation could be the result of higher labor productivity growth. In fact, productivity growth has averaged over 4 percent over the last two quarters, more than double the long-term rate. However, measures of labor productivity are very inconsistent, and in the 15 quarters since the pandemic began, productivity has increased at an annual rate of 1.4 percent, close to the 15-year average of 1.5 percent. Therefore, it seems premature to rely on productivity growth given the current monetary policy stance.
There has also been a lot of discussion this month about the general easing of financial conditions, which is reflected in market interest rates and the prices of other assets. To put this easing into perspective: from July to the end of October, the yield on ten-year government bonds rose by about one percentage point. Since the last FOMC meeting, which ended November 1, the 10-year bond interest rate has fallen by six-tenths of a percentage point. Long-term interest rates are still higher than before mid-year and overall financial conditions are tighter, which is likely to put downward pressure on household and corporate spending. But the recent easing of financial conditions is a reminder that many factors can influence these conditions and that policymakers need to be careful when relying on such tightening to carry out their duties.
The October economic activity and inflation data I cited is consistent with weakening demand and easing price pressures helping to bring inflation back to 2 percent, and I expect this to be confirmed in upcoming data releases. Before the next FOMC meeting, we will receive PCE inflation and job vacancy data, as well as a November jobs report and supplier manager survey. CPI inflation will be announced on December 12th, the first day of the FOMC meeting. All of this data will tell us whether inflation and aggregate demand continue to move in the right direction and whether inflation is on track towards our 2 percent target.
1. See Christopher J. Waller (2023), “Something’s Got to Give,” speech delivered at the Distinguished Speaker Seminar, European Economics and Financial Centre, London, October 18. The views expressed here are my own and not necessarily those of my colleagues on the Federal Open Market Committee. Back to text
2. See Board of Governors of the Federal Reserve System (2023), Statistical Release G.17, “Industrial Production and Capacity Utilization” (November 16). Back to text
3. After initially creating 336,000 new jobs in September, the number was later revised downwards to 297,000. Back to text
4. The survey is available on the NFIB website at https://www.nfib.com/surveys/small-business-economic-trends/. Back to text
5. The pace of growth in asking rents and rents for new leases – reflecting current rental market conditions – has slowed since the beginning of 2022. This slowdown has put downward pressure on accommodation inflation this year, which is likely to continue into the future. Back to text
6. See Maximiliano A. Dvorkin and Maggie Isaacson (2022), “Recent Trends in Individual Wage Growth,” On the Economy Blog, December 22. Back to text