Thank you for the opportunity to participate in today’s panel discussion. My assigned topic is US monetary policy in the current global inflation episode. I will briefly review the U.S. outlook and then turn to three broader questions raised by the historical events of the pandemic era.
U.S. inflation has fallen over the past year but is still well above our 2 percent target (Figure 1).1 My colleagues and I are pleased with this progress, but expect the process to keep inflation up on a sustained basis Reducing 2 percent is still a long way to go. The labor market remains tight, although improving labor supply and a gradual weakening in demand continue to bring it into better balance.2 Gross domestic product growth was quite strong in the third quarter, but like most forecasters, we expect that to change Growth will weaken in the coming quarters. Of course, that remains to be seen and we are aware of the risk that stronger growth could undermine further progress in rebalancing the labor market and reducing inflation, which could justify a monetary policy response. The Federal Open Market Committee (FOMC) aims to achieve a sufficiently tight monetary policy stance to reduce inflation to 2 percent over time. We are not convinced that we have achieved such a stance. We know that further progress towards our 2 percent target is not assured: inflation has given us some misconceptions. Should it be appropriate to further tighten the policy, we will not hesitate to do so. However, we will continue to proceed cautiously to manage both the risk of being misled by a few good months of data and the risk of tightening too much. We make decisions on a meeting-by-meeting basis based on the totality of incoming data and their impact on the outlook for economic activity and inflation, as well as on the balance of risks, and determine the extent of additional policy tightening that might be appropriate to return inflation to 2 percent over time. We’ll stick with it until the job is done.
With that, I would like to address three questions that have arisen from the declining but still elevated inflation we are experiencing today. The first question is, looking back two and a half years, what we can say about the original causes and ongoing policy implications of current inflation.
After being below our 2 percent target in the first year of the pandemic, core PCE (personal consumption expenditures) inflation rose sharply in March 2021. Economic forecasters generally did not expect this, as the February 2021 survey of professional forecasters showed that core PCE inflation was at or below target in the following three years.3 The real-time questions for policymakers were what the high Inflation caused and how policymakers should respond. Initially, many forecasters and analysts, including FOMC participants, viewed the sudden rise in inflation primarily as a result of pandemic-related shifts in the composition of demand, a disruption in supply chains, and a sharp decline in labor supply. The resulting imbalances between supply and demand led to sharp price increases for a number of items most affected by the pandemic, particularly goods. From this perspective, our dynamic and flexible economy is likely to adapt relatively quickly as the pandemic subsides. Supply interruptions and shortages would decrease. Labor supply would recover, supported by vaccine rollouts and school reopenings. The increased demand for goods would shift back to services. Inflation would decline relatively quickly without requiring a significant policy response.4
Although monthly core PCE inflation spiked in March and April 2021, it declined for five consecutive months starting in May, providing some support for this view (Figure 2). But in the fourth quarter of 2021, the data changed significantly amid waves of new COVID-19 variants, there was only gradual progress in restoring global supply chains, and relatively few workers re-entered the workforce. This lack of progress, along with very strong household demand, contributed to a tight economy and a historically tight labor market, as well as persistently high inflation.
The committee signaled a change in our policy approach and financial conditions began to tighten. A new shock came in February 2022 when Russia invaded Ukraine, causing a sharp rise in energy and other commodity prices. When we launched in March, it was clear that reducing inflation would depend both on addressing the unprecedented pandemic-related demand and supply distortions and on our tightening of monetary policy, which would slow aggregate demand growth and allow supplies time to catch up. Today, these two processes work together to reduce inflation. The FOMC raised the federal funds rate target range by 5 1/4 percentage points and reduced our securities holdings by more than $1 trillion. Monetary policy is restrictive and puts downward pressure on demand and inflation.
Eliminating pandemic-related supply and demand distortions plays an important role in reducing inflation. For example, wage growth across most measures has declined steadily since mid-2022 despite continued robust employment gains (Figure 3), reflecting a resurgence in labor supply thanks to higher labor force participation and a return of immigration to pre-pandemic levels.
While the overall supply recovery continues, it is not clear how much more can be achieved through additional supply-side improvements. In the future, more of the progress in reducing inflation may have to come from tight monetary policy that slows aggregate demand growth.5
As to my second question, it has been widely assumed for many years that monetary policy should limit or “overlook” its response to supply shocks to the extent that they are temporary and idiosyncratic.6 Many also argue that in In In the future, supply disruptions are likely to occur more frequently or more persistently than in the decades immediately before the pandemic.7 A second question, then, is what we have learned about the standard “see through” approach.
The idea that the response to the inflationary effects of supply shocks should be mitigated arises in part from the trade-off that these shocks entail. Supply shocks tend to move prices and employment in opposite directions, while monetary policy pushes both in the same direction. Therefore, the monetary policy response to higher prices due to a negative supply shock should be moderated, otherwise it would exacerbate the undesirable decline in employment.8 Furthermore, supply shocks most often came from the volatile food and energy categories and passed quickly. While food and energy prices have a decisive influence on the budgets of households and companies, the policy instruments of central banks have a slower effect than the development of the raw material markets. An aggressive response to quick, temporary price increases could increase macroeconomic volatility without promoting price stability.
Our experience since 2020 shows some limits to this thinking. First, it can be difficult to separate supply shocks from demand shocks in real time and also to determine how long each will last, particularly under the extraordinary circumstances of the last three years. Supply shocks that have a lasting impact on potential output may require restrictive policies to better align aggregate demand with the suppressed level of aggregate supply. The sequence of shocks to global supply chains experienced from 2020 to 2022 depressed production over a longer period and may have permanently changed global supply dynamics. Such a sequence requires policymakers to limit inflationary effects through policy restraint.
In this case, political restraint is also good risk management. Supply shocks that push inflation high enough for long enough can affect the longer-term inflation expectations of households and businesses. Monetary policy must head-on any risks of possible easing of inflation expectations, as well-anchored expectations help bring inflation back to our target. The dramatic tightening of monetary policy in 2022 likely helped keep inflation expectations well anchored.
My third question is at what level will interest rates settle when the effects of the pandemic are truly behind us? By 2019, the general level of nominal interest rates had fallen steadily over several decades (Figure 4). When the pandemic broke out, inflation rates in many advanced economies were below target and policy interest rates were low or slightly negative, raising difficult questions about the effectiveness of interest rate policy when constrained by the effective lower bound (ELB). Over two decades, an extensive literature has identified numerous possible changes to the widely used inflation targeting regime, including negative policy interest rates, nominal income targeting, and various forms of compensation strategies in which persistent inflationary deficits are followed by a period of inflation moderately above 2 percent.9 Today, inflation and Key interest rates increased, and the ELB is currently not relevant to our policy decisions. However, it is still too early to say whether the ELB’s monetary policy challenges will ultimately be a thing of the past.
The continued proximity of interest rates to the ELB was the focus of the monetary policy review and changes we made to our framework in 2020. We will begin our next five-year review in the second half of 2024 and announce the results approximately a year later. Among the questions we will consider is the extent to which the structural features of the economy that led to low interest rates in the pre-pandemic period will persist. Over time, we will continue to learn from the experiences of recent years and what impact they may have on monetary policy.
These are just three of the many questions raised by these challenging times, and we are still far from fully understanding the answers. I appreciate the opportunity to discuss these issues with you today and look forward to our conversation.
1. Inflation as measured by our preferred measure, the 12-month change in the total personal consumption expenditures (PCE) price index, fell from 6.6 percent in September 2022 to 3.4 percent in September 2023. The 12-month change in the core PCE measure, which excludes volatile food and energy prices and therefore potentially provides a better signal of inflation developments, fell from 5.5 percent in September 2022 to 3.7 percent in September 2023. Back to text
2. The labor force participation rate has increased since the end of last year, particularly among people aged 25 to 54, where this rate has increased by almost 1 percentage point on a net basis since December. Private payrolls increased by an average of 191,000 per month in the 12 months ended October 2023, compared to a rate of 435,000 per month in the 12 months ended October 2022. Meanwhile, both the quit rate and the wage premium for job changers returned in their pre-pandemic values. And while they remain above levels consistent with 2 percent inflation over the longer term, broad indicators of 12-month wage growth continue to trend downward. Back to text
3. The average Q4-to-Q4 core PCE inflation forecasts from the February 2021 survey of professional forecasters were 1.8 percent, 1.9 percent and 2.0 percent for 2021, 2022 and 2023, respectively. Return to text
4. Both the June summary of economic forecasts and the August survey of professional forecasters showed a near-uniform view that the onset of inflation would pass quickly and that inflation for 2022 would be around 2 percent. Neither forecasters nor policymakers foresaw more than a moderate tightening of monetary policy. Back to text
5. See, for example, Ben Bernanke and Olivier Blanchard (2023), “What Caused the US Pandemic-Era Inflation?” Hutchins Center Working Paper 86 (Washington: Brookings Institution, Hutchins Center on Fiscal and Monetary Policy, June). Back to text
6. As I will explain later, this requires that inflation expectations are well anchored. Back to text
7. See, for example, Agustín Carstens (2022), “A Story of Tailwinds and Headwinds: Aggregate Supply and Macroeconomic Stabilization (PDF),” remarks at “Reassessing Constraints on the Economy and Policy,” a symposium sponsored by the federal government The Reserve Bank of Kansas City took place on August 26 in Jackson Hole, Wyoming. Back to text
8. For an example related to energy price shocks, see Martin Bodenstein, Christopher J. Erceg and Luca Guerrieri (2008), “Optimal Monetary Policy with Distinct Core and Headline Inflation Rates,” Journal of Monetary Economics, Supp., Vol. 55 ( October), pp. S18–33. Back to text
9. A number of these issues were discussed in the analytical work supporting the 2019-2020 scoping review; see Board of Governors of the Federal Reserve System (2020), “Review of Monetary Policy Strategy, Tools, and Communications,” website. For a discussion of the ELB’s implications for monetary policy strategy, see Fernando Duarte, Benjamin K. Johannsen, Leonardo Melosi, and Taisuke Nakata (2020), “Strengthening the FOMC’s Framework in View of the Effective Lower Bound and Some Considerations Related to.” Time- Inconsistent Strategies,” Finance and Economics Discussion Series 2020-067 (Washington: Board of Governors of the Federal Reserve System, August). For more information on the effectiveness and use of specific policy instruments in this environment, see Jonas Arias, Martin Bodenstein, Hess Chung, Thorsten Drautzburg and Andrea Raffo (2020), “Alternative Strategies: How Do They Work? How Might They Help?” Finance and Economics Discussion Series 2020-068 (Washington: Board of Governors of the Federal Reserve System, August); Jeffrey Campbell, Thomas B. King, Anna Orlik, and Rebecca Zarutskie (2020), “Issues Concerning the Use of the Policy Rate Tool”, Finance and Economics Discussion Series 2020-070 (Washington: Board of Governors of the Federal Reserve System, August); and Mark Carlson, Stefania D’Amico, Cristina Fuentes-Albero, Bernd Schlusche and Paul Wood (2020) , “Issues in the Use of the Balance Sheet Tool,” Finance and Economics Discussion Series 2020-071 (Washington: Board of Governors of the Federal Reserve System, August). Return to text