Christopher J Waller: The economic outlook and a word of caution on
inflation
Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal
Reserve System, at the 59th Annual Economic Forecast Luncheon, Phoenix, Arizona ,
16 November 2022.
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Thank you, Dean Kadan, and thank you for the opportunity to speak today about the
outlook for the U.S. economy and the implications for the Federal Reserve's ongoing
fight to reduce inflation.
I will begin with some comments on the overall outlook for economic growth and then
try to explain how tighter monetary policy this year is intended to dampen demand and
put downward pressure on inflation. One way is by influencing the labor market, so next
I will give an update about labor market conditions and how I expect them to evolve. I'll
then turn to the outlook for inflation, where we saw moderation in some measures in
October, but to a level that remains unacceptably high. I'll finish up with how I expect
monetary policy will evolve in the coming months to reduce inflation and return it to the
Federal Open Market Committee's (FOMC) 2 percent goal.
Economic growth in the United States has slowed significantly in 2022, and I expect
that slow growth to continue into next year. After shrinking slightly in the first half of this
year, real gross domestic product rebounded in the third quarter to a 2.6 percent annual
growth rate. But all indications are that this was a temporary boost, and that weak
growth has returned in the last quarter of this year and will persist into 2023. Consumer
and business spending has softened, amid deteriorating business sentiment in most
sectors of the economy and near-record-low readings on surveys of consumer attitudes
about the economy. There is no secret about why-inflation is very high, something
people are reminded of every day when they see the prices of things they buy go up.
On top of that, higher interest rates are raising borrowing costs for businesses and
households.
At any other time, I would be pretty unhappy about slowing growth, but not now. If you
believe, as I do, that supply bottlenecks in the economy have mostly abated and that
elevated inflation is primarily a function of high demand, then slowing down economic
growth is absolutely necessary to bring inflation down to our 2 percent target. This
slowing in activity is a sign that actions taken by the Federal Reserve this year to
reduce inflation are working. Let me take a few minutes to explain how.
The Federal Reserve tightens monetary policy to reduce inflation primarily by raising
short-term interest rates, which has the effect of boosting interest rates throughout the
economy. Higher borrowing costs curtail spending and investment by households and
businesses. Since the FOMC pivoted in late 2021 in response to upwardly revised labor
data and higher than anticipated inflation data, rates for 30-year fixed-rate home
mortgages are up from around 3 percent to 7 percent today. Rates for triple-B corporate
bonds have roughly doubled in 2022, and rates on higher yield debt have increased
even more. As a result, there is a slowdown in the volume of financing in most markets,
with some effect on various prices.
The sector that has seen the most significant slowing is housing. New home
construction and new and existing home sales, which grew strongly before and during
the pandemic, have all fallen in 2022. As purchases of homes fall, so does demand for
goods that typically accompany purchases-new carpeting, new furniture, new lawn
mowers and so on. So slowing home sales will decrease demand for goods that
complement the purchase of a new home and that will put downward pressure on the
prices of those goods.
Furthermore, housing prices that were increasing at an annual rate of 20 percent as late
as May slowed to about a 2 percent rate in October, according to data from Zillow.
Housing may be the first but won't be the last sector of the economy where higher
interest rates will have the effect of dampening demand and will ultimately help
moderate price increases. Our goal is to rein in demand, bringing demand and supply
into better balance, which will help reduce upward pressure on inflation.
One sector where improving this balance will be crucial is the labor market. Even as
economic output has slowed, the labor market remains very tight. While there was
roughly one job vacancy for every job seeker in what was a strong labor market before
the pandemic, now there are almost two jobs for every person looking for work. Wages
have been rising more quickly than they have in decades, much faster than productivity
growth plus 2 percentage points that I think of as consistent with the FOMC's 2 percent
inflation objective. But I do see tentative signs of some cooling in the labor market,
which is vital to keep rising labor costs from putting upward pressure on inflation.
The employment report published November 4 showed that payrolls grew by 261,000 in
October. This increase, while large, was a step down from the pace earlier this year,
when payrolls grew an average of 539,000 per month in the first quarter, 340,000 per
month in the second quarter and 381,000 per month in the third quarter. At the same
time, we also saw the unemployment rate tick up to 3.7 percent, though still close to its
more than 50-year low.
Other labor market data are also showing evidence of slight cooling. Various surveys of
job vacancies are down from their peaks reached in March but are still historically very
high. There have been some tech layoffs, which had been one of the fastest growing
parts of the economy, but so far not in other sectors. And quits-which are mainly
workers switching jobs for higher pay-are also down from their peak late last year.
These tentative signs of cooling are mixed with many stories of continued labor market
tightness. Business contacts tell me of empty offices and idle production capacity
because employers cannot find workers. Retailers who hire seasonal workers say they
will try to hold onto these employees after the holidays to fill future vacancies from
attrition. And that is even with some expectation of slower sales growth in the next
couple quarters.
That said, we are starting to see some tentative signs of a moderation in wage growth.
The 12-month increase in average hourly earnings continued to slow in October and the
3-month change continued to run lower than the 12-month rate, a promising signal of
ongoing moderation. Wage growth has been a contributing factor to inflation, especially
in the service sector, so it is important to get the labor market into better balance to
bring future wage growth down to a more sustainable level that will assist in moving
overall inflation lower.
Let me now turn to the outlook for inflation. Last week's consumer price index (CPI)
report was a very welcome moderation in the pace of increasing prices. Headline
inflation rose 0.4 percent from September to October, the same pace as the month
before, and was up 7.7 percent over the previous 12 months, down from 8.2 percent in
September and 9.1 percent as recently as June. Core CPI, which excludes food and
energy prices, increased 0.3 percent in October from September, a marked step-down
from the 0.6 percent readings in the previous two months and the average of 0.5
percent over the first nine months of 2022. On a twelve-month change, core inflation
came in at about 6.3 percent, down from 6.6 percent the previous month. The step
down in October was widespread, involving both a deceleration in services prices and
the first decline in core goods prices since March.
Though welcome news, we must be cautious about reading too much into one inflation
report. I don't know how sustained this deceleration in consumer prices will be. But, as
a snapshot, the 0.3 percent increase in core CPI inflation in October from September,
(actually 0.27 percent rounded up) works out to an annualized rate of about 3.25
percent. I focus on core over headline inflation because I believe it is a better indication
of future inflation. This increase is much improved from the past several months but still
very far from our 2 percent target. Looking at the categories that make up the CPI, we
see that about half still have inflation over 3 percent. And, if you weight the categories
by their contributions to the CPI, over 70 percent of the CPI basket continues to see
inflation above 3 percent.
I cannot emphasize enough that one report does not make a trend. It is way too early to
conclude that inflation is headed sustainably down. In 2021, monthly core CPI inflation
fell during the summer-it fell from 0.9 percent in April 2021 to 0.2 percent in August
2021 before accelerating back to 0.6 percent and 0.5 percent in October and November
of that year. More recently, monthly core CPI inflation fell from 0.7 percent in June 2022
to 0.3 percent in July, only to rebound to 0.6 percent the next two months. We've seen
this movie before, so it is too early to know if it will have a different ending this time.
Inflation remains too high relative to the FOMC's target, and I thought it would be
helpful to offer some detail of what I will be looking at to see continuing improvement in
the inflation outlook. One area is goods inflation, where there was a widespread
deceleration across durables and nondurables in October. With drops in core import
prices and processed materials excluding food and energy over the past few months,
I'm looking for continued downward pressure on core goods prices going forward.
Housing, which is a large share of expenses for households, is another sector I will be
watching closely in the months ahead as an indicator of the direction of overall inflation.
As I discussed in a recent speech, escalating rents have played a large role in driving
up inflation this year, and because turnover of leases occurs only periodically, I expect
measures of rents and the equivalent for homeowners will continue to increase
1
significantly for at least several more months. But I will be watching for signs of
moderation.
Finally, I will be looking for a slowing in price increases in non-housing services, which
have been quite robust in recent months and running at about twice their pre-pandemic
level. As I said a moment ago, the inflation outlook for this sector will partly depend on
the growth of wages. I will be looking closely for continued slowing in wage growth back
to a more sustainable rate. Given that medium- and longer-term inflation expectations
remain stable, an indication that investors and consumers retain confidence in the Fed's
commitment and ability to achieve its inflation goal, I believe we can expect wage
growth to slow.
So, the recent CPI report is a positive development, but I'll need to see further progress.
Like many others, I hope this report is the beginning of a meaningful and persistent
decline in inflation. But policymakers cannot act based on hope. I will not be head-faked
by one report and will continue to watch the data between now and the December
FOMC meeting before deciding on the next step for policy.
Now let me turn to the implications of this outlook for monetary policy. Since my last
outlook speech in October, we have gotten some additional data that reinforces my
sense that the labor market may be loosening, and that inflation pressure may be
easing. But as I said a moment ago, this hasn't been sufficient to significantly alter my
outlook or my view of appropriate monetary policy. Achieving the FOMC's dual mandate
of maximum employment and price stability is still a one-sided campaign. With the labor
market still strong and extremely tight, the Committee does not face a trade-off between
employment and inflation. Inflation has been running significantly above our objective
for more than a year, so monetary policy can and must be used aggressively to reduce
it.
To pursue that goal, the Federal Reserve has been aggressive. In nine months, we
have raised the target range for the federal funds rate from near zero to 3-3/4 to 4
percent, a historically rapid pace of increases. In addition to that, the Fed is continuing
to reduce its balance sheet each month by allowing the runoff of maturing securities,
which supports the tightening of financial conditions.
Despite these actions, I believe that policy is barely in restrictive territory today, so more
interest rate hikes are needed to get inflation down. In the FOMC's November
statement, the Committee added two new sentences on its view of the future path of
policy, elaborating on our "reaction function," which is the basis for those future
2
decisions. Let me explain how I view this new language.
The first new sentence is about "where we are going," which is the level of interest rates
at which it will be appropriate to stop hiking. If asked what that sentence means, I would
say that, with the current strength and outlook for the labor market, my decision for the
"terminal rate" for policy will focus on progress toward our inflation goal. So, assuming
the labor market and financial stability remain in check, the endpoint of the tightening
path is highly dependent on the evolution of the inflation data.
The second new sentence in the statement is about "how" we will get to the terminal
rate-that is, the pace of rate increases to arrive at that destination. The FOMC language
notes the pace will depend on several factors. The first is "the cumulative tightening of
monetary policy." I have noted how significant and aggressive this tightening has been.
We have gone from a low interest rate economy to one with fairly significant interest
rates (although in historical terms, rates are still not that high for a tightening cycle).
There is a tendency for Fed watchers to view each meeting's policy decision as solely
determined by what has happened in the preceding six weeks. For me, this new
sentence is an important reminder that each decision we make in the coming months
will be heavily influenced by the significant, cumulative effect of the decisions we made
earlier this year.
Another factor listed by the Committee was "the lags with which monetary policy affects
economic activity and inflation." In my view, the Committee will reach the terminal rate
well before inflation reaches 2 percent because of the abundance of evidence that it
takes months, and perhaps even longer, for the full effects of a rate increase to work
through the economy.
Considering the cumulative effect of tightening and the likely lags for policy doesn't
mean these factors are more important than new information about the economy. On
the contrary, new data, especially on inflation, are much more important now, well into
the tightening cycle, than when the only direction for the federal funds rate to go was
up- and up by a lot.
I am going to take a considerable risk here and employ an airplane simile to illustrate
how I think of our past policy actions and where we are going. When an airplane is
taking off, the pilot fires the engines as much as possible to get off the ground. The goal
is to get to cruising altitude quickly, so the initial ascent is steep. But as the plane gets
closer to cruising altitude, the pilot slows the rate of ascent, while continuing to climb.
The final cruising altitude will depend on many factors, most notably details about the
weather. Turbulence may force you to a higher or lower altitude, but you adjust as you
go to have a smooth ride.
This is similar to our policy actions this year. When the Fed was faced with rapidly
escalating inflation and a strong labor market, it lifted rates aggressively off the effective
lower bound including several 75-basis-point steps. But as the policy rate gets higher,
the stronger is the case for slowing the rate of ascent while continuing to climb. This
would correspond to slowing to 50-basis-point hikes. At a certain point, policy will reach
an optimal cruising altitude, but we don't know exactly what that level will be because it
depends on the data. Maybe new data will point to a shallower climb and a lower
cruising altitude, which would suggest stepping down to 25-basis point hikes. Or maybe
it could be necessary to continue climbing a little longer to a higher final attitude by
implementing a sequence of 50 basis point hikes. In the end, the higher we raise the
policy rate, the more pressing it is to think about the terminal rate and how policy should
be adjusted to get there, but that will depend on the incoming data.
Looking toward the FOMC's December meeting, the data of the past few weeks have
made me more comfortable considering stepping down to a 50-basis-point hike. But I
won't be making a judgement about that until I see more data, including the next PCE
inflation report and the next jobs report.
If the FOMC were to step down to a 50-basis-point increase, it is important to remember
that this would still be a very significant tightening action-in other words, just pulling
back on the rate of ascent a little bit. At this angle of ascent, with policy already in
restrictive territory, the federal funds rate can still be increased quite rapidly with several
50-basis-point increases, a pretty aggressive path for policy.
So, although I believe we are seeing some progress in the economy to dampen
demand that will help moderate inflation, we have not yet made enough progress. As I
have said recently, I expect that getting inflation to fall meaningfully and persistently
toward our 2 percent target will require increases in the federal funds rate into next
year. We still have a ways to go. Until then, I support continued rate increases and
ongoing reductions in the Fed's balance sheet to restrain aggregate demand. When we
reach our terminal rate, how long we stay at that level will largely be driven by our
progress in bringing down inflation.
1
See Christopher J. Waller (2022), "The Economic Outlook with a Look at the Housing
Market," speech delivered at the Mark C. Berger Workshop Series, University of
Kentucky, Lexington, Kentucky, October 6.
2
See Board of Governors of the Federal Reserve System (2022), " Federal Reserve
Issues FOMC Statement (PDF)," press release, November 2.