Thank you to President Kasey Buckles and the Program Committee for giving me the opportunity to deliver the C. Woody Thompson Memorial Lecture. It’s a pleasure to be back in the Midwest. Before joining the Federal Reserve, I taught economics at Michigan State University, which I chose for its bird’s-eye view of the industrial Midwest. Big 10 rivalries aside, Ohio and Michigan have some things in common, including many of the same economic concerns and interests.
Today I would like to share my views on the trajectory of the US economy and its implications for the appropriate course of monetary policy.1
This is a particularly challenging time for an economic analyst or policy maker. Recent developments in the banking sector have increased existing uncertainties about the recovery from the pandemic shock and developments abroad. In this context, the economic and political outlook must balance data dependency with forward-looking analytics. Recent data shows greater momentum in inflation and economic activity, but recent developments in the banking sector may point to greater headwinds for financial conditions and the future economy.
The US Economy
Assessing the current economic situation requires a reconsideration of the pandemic and its economic impact. From the perspective of the NBER Business Cycle Dating Committee, the 2020 recession was unprecedented. Of the 35 recessions since 1858, only 8 months have stretched in the single digits from peak to trough. 2020’s was severe, but it lasted just two months from peak to trough and was the shortest recession on record.
However, the economic impact of the pandemic reverberated throughout 2021 and 2022. Inflation surged during the recovery amid pandemic-related supply disruptions, while demand for goods was boosted by a shift away from in-person services, and aggregate demand was bolstered by monetary and fiscal support. Russia’s invasion of Ukraine in February 2022 was another supply shock to the global economy, driving up energy and other commodity prices. Last June, US inflation peaked at 7 percent as measured by the 12-month change in the Personal Consumption Expenditure (PCE) index.
In response, the Federal Reserve has used its monetary policy tools to restore price stability by aligning demand with still-constrained supply. Over the past year, we have raised the federal funds rate by almost 5 percentage points and started to reduce the size of our balance sheet.
As a result, financing conditions have tightened significantly. Borrowing costs have risen, stock prices have fallen and the dollar has appreciated on balance.
Rate-sensitive sectors of the economy have slowed. Residential investment detracted nearly 1 percentage point from GDP growth last year as higher mortgage rates constrained housing demand. Business fixed investment held up last year but appears to have slowed recently. Manufacturing activity has slowed in response to tighter financing conditions, the stronger dollar and some backtracking of the pandemic-driven shift from services to goods.
As energy prices have softened and supply disruptions have eased, inflation has gradually eased. However, the process of bringing inflation back to 2 percent still has a long way to go and is likely to be uneven and bumpy.
In fact, the inflation picture is less benign than it appeared earlier this year. Some of the encouraging disinflation initially seen in the fourth quarter of last year has been corrected away while inflation has been elevated for the first two months of this year.
Inflation data show some consistency. The 3-, 6- and 12-month changes in February prices for the core PCE index – excluding food and energy – are all around 4 1/2 to 5 percent. Housing services inflation continues at a rapid monthly rate, adding much more to inflation than before the pandemic. Non-housing core services inflation remains high. Even core commodity prices rose in January and February after three months of decline, underscoring the unevenness of the disinflationary process.
Still, several factors are likely to contribute to disinflation. Long-term inflation expectations remain well anchored, and shorter-term expectations have recouped much of last year’s rise.2 Rent increases for new leases have slowed sharply over the past six months, which should gradually pull measured housing services inflation lower over the course of this year year. In addition, a significant supply of apartment buildings is coming online, which should further relieve the rental market.
Core inflation should continue to converge towards its slightly negative pre-pandemic trend as supply chains continue to recover and demand for goods continues to fall. The recovery in auto production should help prices for new and used cars continue to fall as cars become more available. More broadly, margins in the economy can narrow as buyers become more price sensitive and cut back on spending. Earnings calls from non-financial companies are already showing growing awareness of resistance to price hikes.
Non-housing core services inflation is a broad category, accounting for more than half of the core PCE index. Inflation in this category seems fairly stubborn given the strong post-pandemic demand for travel, restaurants and medical supplies. Disinflation in these services will likely require a combination of weakening demand and further recovery in supply.
One possible route to disinflation is that a fall in the price of some goods can help drive down prices for related services. For example, an eventual fall in car prices could result in lower prices for car insurance, repairs and rentals, reversing some of their increases over the past two years.
Another potential source of disinflation is that wage growth has moderated somewhat, although the labor market remains very strong by most measures. Payroll employment growth was exceptionally robust in January and February, unemployment remains near record lows and job vacancies remain very high.
Still, there are some signs that the labor market is marginally weakening. The Federal Reserve Board’s measurement of private employment using data from payroll company ADP suggests that job gains slowed in January and February. Job postings from Indeed are showing a noticeable decline. And the smoking cessation rate has retraced more than half of its pandemic-era surge, falling steadily from a peak of 3 percent in late 2021 to 2.5 percent in January. That could be significant, as much of the pick-up in wage growth a year ago could have come from outsized wage increases on job changes and wage increases by employers to retain existing workers.
This wage moderation may partly reflect some improvement in labor supply. Labor force participation rose to 62.5 percent in the latest data. Prime-age participation is now back to pre-pandemic levels. Additionally, new estimates show higher population growth over the past year amid a rebound in immigration.
Over time, there is reason to believe that increasing productivity can also support supply. I see three potential sources of increased productivity growth.
First, increased innovation linked to the onslaught of new businesses since the pandemic began can boost productivity. Second, the current labor shortage is leading to increased investment in automation, which should increase labor productivity over time. Finally, a recent study by David Autor, Arin Dube, and Annie McGrew suggests another way the strong labor market might increase productivity.3 They find that faster wage gains for lower-paid workers have come from switching jobs to higher-wage companies that can also be more productive companies.
At present, however, the supply in the economy is still not sufficient to satisfy the continued robust demand. Importantly, consumer spending has picked up momentum this year after slowing late last year. Consumer spending will be supported by robust household real disposable income growth amid strong employment growth. Strong household balance sheets have also supported spending, although lower-income consumers seem to have used up most of their excess savings.
Overall, incoming data for this year would point to slightly higher inflation and stronger economic growth. However, I am closely monitoring developments in the banking sector, which have the potential to tighten credit conditions and counteract some of this dynamic.
The US banking system is solid and resilient. The Federal Reserve, in cooperation with other agencies, has taken decisive action to protect the US economy and increase public confidence in our banking system. We will continue to closely monitor the conditions in the banking system and stand ready to use all our tools if necessary to keep the system safe and sound.
At the same time, I monitor overall financial conditions in the US economy, including credit availability indicators. I am familiar with the vast body of literature linking monetary policy, credit conditions, economic activity and inflation. For the past 15 years, this literature has made up about a quarter of the curriculum in the macroeconomics course I have taught.
A particular focus of my career, including in my December NBER paper with Matt Marx and Emmanuel Yimfor, is the importance of smaller financial institutions in lending to small and medium-sized businesses.4 These smaller banks have acquired relevant expertise in small business lending and over time have worked to maintain relationships with small businesses. As such, I am alert to whether recent developments in the banking sector will restrict lending to small businesses, which could slow innovation and potential output growth over time.
Data dependency and monetary policy
Regarding monetary policy, I have often said that my approach to policy making in uncertain times should be data dependent. And like everyone else, my own research and experience informs my views on the setting of these policies. I was a member of the Council of Economic Advisers during the Eurozone crisis and my work on emerging markets – particularly Russia and some African economies – taught me how difficult it can be to forecast in a highly uncertain environment.
With all of these lessons in mind, I approach all of our monetary policy discussions with the same mindset:
- Be prepared to adjust the outlook based on the data coming in and be humble about our ability to draw safe conclusions and therefore not overreact to some data points.
- Look for useful data sources, including high-frequency data, that can better capture evolving economic trends.
- And follow a risk management approach that considers not only expected outcomes but also various risks to the outlook.
Of course, it’s tempting to follow the old adage: “Never make predictions, especially about the future.” But ultimately, policy must be forward-looking, which means relying, at least in part, on forecasts. The challenge is to find out which models apply. For example, when I began my dissertation on banking in the post-Soviet era, I found that the standard models used in normal times and for mature, industrialized economies are less useful in highly uncertain environments.
Since my first FOMC meeting last June, my data-driven risk management approach has led me to support the Fed’s response to prioritize monetary tightening to bring inflation under control.
After the rapid reaction of politicians in the past year, monetary policy is now moving in restrictive territory. For example, real interest rates are positive across the yield curve.5
Looking ahead, I weigh the impact of increased economic momentum against potential headwinds from recent developments. On the one hand, if tighter funding conditions are holding back the economy, the appropriate path for the federal funds rate may be lower than it would be without it. On the other hand, if the data shows continued strength in the economy and slower disinflation, we may have more work to do.
The FOMC has hiked rates in smaller increments as we aim for a sufficiently tight monetary stance to bring inflation back to 2% over time. By taking smaller steps, we can monitor economic and financial conditions and consider the cumulative impact of our policies.
For the econometrician, this approach is similar to the iterative process in maximum likelihood estimation, where large early steps are followed by smaller steps as the local optimum is approached.
In its March policy statement, the FOMC scaled back its forward guidance on interest rates.6 We shifted from expecting “continued hikes” to saying “some additional monetary tightening may be warranted”. I think this communication is appropriate as we try to calibrate monetary policy to be sufficiently tight given the uncertainty about the economic outlook.
What should not be uncertain, however, is our commitment to our dual mandate goals of maximum employment and price stability. We will do everything we can to bring inflation back to our 2% target over time, which lays the foundation for sustained strength in the jobs market and the US economy.
1. These views are my own and do not necessarily reflect those of the Federal Reserve Board or the Federal Open Market Committee. Back to the text
2. As shown, for example, in surveys by the University of Michigan and the Federal Reserve Bank of New York. Back to the text
3. See David Autor, Arindrajit Dube and Annie McGrew (2023), The Unexpected Compression: Competition at Work in the Low Wage Labor Market, NBER Working Paper Series 31010 (Cambridge, Mass.: National Bureau of Economic Research, March ) . Back to the text
4. See Lisa D. Cook, Matt Marx and Emmanuel Yimfor (2022), “Funding Black High-Growth Startups”, NBER Working Paper Series 30682 (Cambridge, Mass.: National Bureau of Economic Research, November). Back to the text
5. These real interest rates are based on Treasury Inflation-Protected Securities (TIPS) and inflation swap market prices and survey expectations. Back to the text
6. See Board of Governors of the Federal Reserve System (2023), “Federal Reserve Issues FOMC Statement”, press release, March 22. Back to the text