Christopher J Waller: Economic outlook
Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal Reserve
System, at the Center for Financial Stability, New York, 19 November 2021.
* * *
It is a pleasure to speak today at the Center for Financial Stability, and I look forward to our
conversation. Let me take the next several minutes to speak about the continued improvement of
1
the U.S. economy, recent inflation data, and their implications for monetary policy. I will also
discuss the Federal Open Market Committee's (FOMC) recent decision to begin reducing
monthly purchases of securities and how incoming data may affect the pace of tapering. Finally, I
will address issues concerning the size of our balance sheet.
Let me start with my views on the economy. Since I last spoke on the subject exactly a month
ago, the basic shape of my outlook hasn't changed: The economy continues to grow and add
jobs at a strong pace, making steady progress toward the Federal Reserve's goal of maximum
employment. New data shows that employment gains were better than first reported in August
and September and were back to a strong level in October. But we also have learned that supply
constraints-both bottlenecks and labor shortages-are having a larger and more persistent
effect on the economy. Due to a combining of those supply constraints with strong demand,
inflation pressures are becoming more widespread and may last longer into 2022 than I thought
they would. These factors haven't dented my optimism that the strong recovery will continue but
they have raised the risks that supply constraints may limit job gains and output growth, and that
inflation may complicate the FOMC's management of monetary policy in 2022.
These factors weighed on output growth in the third quarter, which was down considerably from
the three months before but which I expect will rise again to a strong rate in the fourth quarter.
The explanation for the downturn is the same story we have all been living through since March
2020: the ups and downs of the pandemic. The Delta variant and supply chain problems threw
the economy off its very strong growth track in the third quarter, but I anticipate it will return to that
path in the fourth quarter, as society continues to learn how to manage the disease and
everimproving treatments reduce the likelihood of death and hospitalization. Assuming another
damaging COVID-19 variant does not arise this winter, I expect gross domestic product (GDP) to
resume its robust growth not only in the fourth quarter of 2021 but also in the first half of 2022.
In terms of the job market, households and businesses perceive that conditions are as tight as or
tighter than they were pre-COVID, even though the unemployment rate is more than a
percentage point higher. There are certainly ample data showing labor demand is very strong.
Job openings remain at a record level. New businesses are starting up at a much higher pace
than they did from 2017 to 2019. People are quitting jobs, either to take new ones or because
they are confident that they can find new ones, likewise at a record rate. The improvement I
expect in managing COVID should drive demand higher but also provide a boost to labor supply
as those who have been on the sidelines return to a job market that keeps improving.
With respect to employment data, revisions to the August and September job numbers indicated
that the summer slowdown in job gains wasn't nearly as bad as initial reports suggested. Job
creation averaged 442,000 a month from August to October, down from the 641,000 average for
the other seven months of 2021. Nevertheless, this is a healthy pace for job creation and will
speed the recovery of the labor market if it continues. Adjusting for early retirements, we are only
2 million jobs short of where we were in February 2020. Regarding the unemployment rate, in
October the rate stood at 4.6 percent. Compared with one year ago, that rate has fallen 2.3
percentage points. If the decline continues at about that pace in coming months, the
unemployment rate could be below 4 percent before too long. In light of these data, in my view,
the labor market is rapidly approaching maximum employment. But I will be watching for factors,
from continued supply bottlenecks and a winter surge of COVID cases, that could slow this
progress.
Turning to inflation, inflation has escalated substantially this year, along with a significant rise in
inflation expectations. The October consumer price index report showed an unexpected surge in
inflation. The monthly print corresponds to an annualized rate exceeding 10 percent, while the
year-over-year increase was 6.2 percent-the highest since December 1990. Despite the
highest wage gains in years, inflation this year has wiped out any real wage increase for the
average worker. High inflation is painful to Americans who have little choice about the goods and
services they buy for everyday living. Prices are up significantly at the grocery store, which is a
major problem for many individuals and families. Unlike earlier this summer, price pressures are
2
no longer concentrated in a few categories, they appear to have broadened. There has been a
notable increase in the prices of energy, food, goods, and services as well as the cost of owning
a home. Even trimmed mean measures of inflation that exclude some big price increases, such
as the Cleveland Fed and the Dallas Fed measures, report inflation rates above the Fed's 2
percent target. Diffusion indexes of price changes, which are often useful in detecting turning
points in the data, show an increasing number of categories with 3 or 12-month inflation
exceeding 3 percent, compared with earlier this year.
I expect that these pressures are related to both supply constraints, which may be beginning to
improve, and strong demand, which shows no sign of abating. Wages continue to grow quickly
on a more sustained basis than they have in more than 20 years, most recently reflected in a
striking increase in the employment cost index, which considers both pay and benefits. Wages
and employment costs seem to be widespread across industries and among businesses of
different sizes. Crucial to the path of inflation will be whether we see input cost increases
consistently reflected in final goods prices. Our business contacts report that companies are
comfortable passing along these cost increases to their customers.
It has been argued that because price pressures connected to supply constraints are transitory,
they will come to an end, so monetary policy does not need to respond to temporary price
pressures. I find this argument puzzling for a few reasons. First, all shocks tend to be transitory
and eventually fade away; by this logic, the Fed should never respond to any shocks, but it
sometimes does, as it should. Second, the macroeconomic models we use to guide policy
typically have cost shocks built in that cause inflation to move. In those models, appropriate
monetary policy responds to these inflation movements; it doesn't ignore them, even though they
are transitory. Finally, the choice to take a policy action depends on how large the shocks are
and how long they are expected to persist. To make this point clearer, consider a snowfall, which
we know will eventually melt. Snow is a transitory shock. If the snowfall is one inch and is
expected to melt away the next day, it may be optimal to do nothing and wait for it to melt. But if
the snowfall is 6 to 12 inches and expected to be on the ground for a week, you may want to act
sooner and shovel the sidewalks and plow the streets. To me, the inflation data are starting to
look a lot more like a big snowfall that will stay on the ground for a while, and that development is
affecting my expectations of the level of monetary accommodation that is needed going forward.
Inflation expectations on the part of the public also play a role in the conduct of monetary policy.
Two surveys of consumers-by the University of Michigan and the New York Fed-show
medium inflation expectations running over 4 percent, and bond investors are requiring over 3
percent compensation for future inflation and inflation risks. It is very concerning to me that
households and markets are no longer expecting us to keep inflation near our 2 percent target
over the next three to five years. Now, it is true that there is some evidence that these consumer
survey measures of future inflation tend to move around a lot based on changes in current
inflation. So I hope these large movements in inflation expectations are-wait for it-transitory
and will come back down as bottlenecks and labor shortages resolve themselves over the
coming months. But if these measures were to continue moving upward, I would become
concerned that expectations would lead households to demand higher wages to compensate for
expected inflation, which could raise inflation in the near term and keep it elevated for some time.
This possibility is a risk to the inflation outlook that I'm watching carefully.
So, what are the implications of all these considerations for monetary policy? The economy
made faster progress in 2021 than most of us expected back in December 2020. This
substantial progress toward our dual mandate goals allowed us to begin reducing the $120 billion
a month in asset purchases that are aiding the recovery by steadily providing accommodation to
financial conditions. When we started tapering a few days ago, it happened several months
earlier than was expected by market participants in the early months of 2021. We cut both the
amount of Treasury securities purchases to $70 billion per month from $80 billion per month, and
the amount of agency mortgage-backed securities (MBS) to $35 billion from $40 billion. We will
make another $10 billion and $5 billion cut to the monthly purchases in mid-December.
The next few months will be critical, however, in determining how the tapering process plays out.
The Committee has been very clear, in the months leading up to our decision, and in making that
decision, that the pace of reducing asset purchases would depend on progress toward our dual
mandate goals. If COVID or some other factor substantially slows the recovery, hindering the
progress toward maximum employment, the FOMC could slow the taper. But if the economy
makes quick progress toward maximum employment or inflation data show no signs of retreating
from their currently high readings, the Committee may choose to speed up the taper, which
would position it to accelerate subsequent steps in tightening monetary policy if necessary. The
timing of any policy action is a decision for the FOMC, but for my part the rapid improvement in
the labor market and the deteriorating inflation data have pushed me towards favoring a faster
pace of tapering and a more rapid removal of accommodation in 2022.
Another policy action already being discussed in public by market participants is the timing of the
first increase, or liftoff, of the target range for the federal funds rate. The FOMC has described
the conditions that must be met to consider liftoff. They are when the economy has reached
maximum employment, and when inflation has risen to 2 percent and is on track to moderately
exceed 2 percent for some time. Assuming inflation expectations are well-anchored, I judge that
the timing of liftoff is any time after both of these conditions have been met.
I believe the condition for inflation has been met and we are making great strides towards
achieving the employment leg of our mandate. I will be looking at the incoming data to determine
when we have achieved both these criteria. After that point, whenever the Committee ultimately
decides to raise the target range for the federal funds rate from zero, monetary policy will still be
providing an extraordinary extent of support for the economy-short-term interest rates will still
be very low, and the large amount of securities holdings on the Fed's balance sheet will continue
to put significant downward pressure on longer-term interest rates.
This fact leads to another policy action that the FOMC needs to consider: when to begin reducing
securities holdings. It is important to remember that the FOMC makes monetary policy decisions
with the best interest of the American people in mind and not based on how these actions affect
the balance sheet. Between March of 2020 and today, the Fed's securities holdings have
increased by $4.2 trillion to stand a bit over $8 trillion. These holdings are about 35 percent of the
level of annual real GDP. This percentage sounds quite large, but the Fed's share is not out of
line with what is found on the balance sheets of other advanced foreign economies' central
banks. For example, our share is larger than that of the Bank of Canada, but it is about the same
as the Bank of England's, and much smaller than the shares of the European Central Bank and
the Bank of Japan.
One must remember that there is no economic theory that tells us what the optimal size of a
central bank balance sheet should be. So, just because our balance sheet is "large" does not
mean there is anything wrong with it. However, arguments can be made that we should reduce
the size of our balance sheet. First, we expanded it for emergency reasons due to the pandemic.
As the emergency passes, we can undo those actions and get the balance sheet down to
something close to its pre-pandemic trend. Second, by doing so, we free up balance sheet
space in the event we need to expand it in the future to deal with economic shocks. Third, the
private sector appears to be inundated with liquidity, as evidenced by the large take-up at our
overnight reverse repurchase agreement facility. Draining some of this liquidity would help
maintain smooth market functioning.
Going forward, the Committee will need to decide what type of reinvestment policy to have in
place. Currently, when securities on the Fed's balance sheet mature, the proceeds are
reinvested in new securities, keeping the balance sheet growing in line with net purchases.
Under this policy, when net asset purchases cease, reinvestment will keep the balance sheet
constant at the size at that time. Based on past experience, an effective way to gradually reduce
the balance sheet to a more efficient level is to change that reinvestment policy to limit, or cease,
reinvestment. Allowing this "runoff" was the main way the FOMC shrank the balance sheet
before the pandemic.
I expect the reinvestment strategy will be heavily influenced by the Fed's experience with this
policy between 2017 and 2019. During that time, the FOMC recognized that the monthly maturity
of securities was lumpy; some months there were many securities maturing, and others few.
The FOMC ensured a gradual and predictable roll-off of securities that allowed market
participants to plan for the Fed's gradual retreat from the Treasury and MBS markets, which was
done by instituting monthly redemption caps that gradually increased over time. I would support a
similar process when the time comes to alter reinvestment policy.
As securities holdings declined, so did reserves in the banking system. In mid-September 2019,
upward pressures emerged in funding markets as reserves dropped to about $1.4 trillion or 6.6
percent of GDP at that time. Most thought the Fed's balance sheet could be reduced further. In
fact, the median of the respondents to the June 2019 primary dealer survey conducted by the
3
Federal Reserve Bank of New York indicated reserves could fall to $1.2 trillion. But, the
underlying level of reserves wanted by financial markets seemed to be more than we anticipated.
In response to the emerging pressures at that time, the Fed stopped redemptions and instituted
a number of actions over a few days that boosted reserves to at least the level seen in early
4
September of that year.
With this experience in hand, we will need to proceed with caution with future securities
redemptions. That said, clearly today's balance sheet is elevated, and we can decrease our
holdings. Should we drain reserves too quickly, we have a new tool to help correct this action
should our pace of runoff prove to be too fast again. The standing repurchase agreement facility
provides a backstop in cases where demand for liquidity is more than the Fed otherwise thought.
Counterparties can come to the facility and obtain financing for their Treasury securities. Of
course, I do not anticipate reducing reserves to a level where this tool would be used, but it is
nice to know that, as we move forward, we have an additional support available to us that we did
not have in 2019.
To close, I have outlined how I see the economy evolving and mentioned several policy steps in
the future that underly that outlook. The tapering of our asset purchases has started and should
continue over coming months. Then the Fed will turn to normalizing other aspects of monetary
policy as the economy continues to recover from the severe COVID shock we encountered last
year. I believe that policy may need to pivot to a faster taper based on incoming data that I will be
monitoring.
October 19
3
In June 2019, the median of the respondents to the Survey of Primary Dealers indicated a $1.2 trillion level of
reserve balances in 2025. Responses to the survey are available on the Federal Reserve Bank of New York's
website at www.newyorkfed.org/medialibrary/media/markets/survey/2019/jun-2019-spd-results.pdf.
4
Against a backdrop of declining reserves and high levels of Treasury securities outstanding, in mid-September
2019, imbalances in the supply of and demand for short-term funding led to pressures in the repurchase
agreement (repo) market. In response to elevated rates, the Federal Reserve began conducting repo operations
to help stabilize money markets and provide reserves to keep the federal funds rate within its target range.
These operations boosted reserves to levels averaging about $1.6 trillion in early 2020. For a detailed
discussion of the pressures in money markets and the Fed's response, see Sriya Anbil, Alyssa Anderson, and
Zeynep Senyuz (2020), "What Happened in Money Markets in September 2019?" FEDS Notes (Washington:
Board of Governors of the Federal Reserve System, February 27).