Responding to High Inflation, with Some Thoughts on a Soft Landing
Remarks by
Christopher J. Waller
Member
Board of Governors of the Federal Reserve System
at
Institute for Monetary and Financial Stability Distinguished Lecture
Goethe University
Frankfurt, Germany
May 30, 2022
Thank you, Professor Wieland, for the introduction, and thank you to the Institute
for Monetary and Financial Stability for the opportunity to speak to you today.1 I come
here at a moment of great challenge for Germany and Europe, and a moment in which it
has never been more evident that the interests of Europe and the United States are closely
aligned. America stands with Europe in defending Ukraine because we all understand
that an assault on democracy in Europe is a threat to democracy everywhere. We also
face the common challenge of excessive inflation, which is no coincidence, since
Germany and other countries are dealing with many of the same forces driving up
inflation in the United States.
Fortunately, in response to this moment of common challenges and interests,
Europe and the United States have strengthened our ties and I believe we are more
unified today than we have been for decades. We see that in the deepening and possible
broadening of our security commitments, and we also see it in the strong commitment
that central banks in Europe and elsewhere have made to fight inflation.
In today's distinguished lecture I will deal with two distinct topics, both of which
I believe will be of interest. First, I will provide my outlook for the U.S. economy and
how the Federal Reserve plans to reduce inflation and achieve our 2 percent target. Then
I will pivot to a more academic discussion of the labor market and the possibility of a soft
landing in which taming inflation does not harm employment.
Let me start with the economic outlook for the United States. Despite a pause
early this year in the growth of real gross domestic product (GDP), the U.S. economy
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continues to power along at a healthy pace. The contraction in output reported in the first
quarter was due to swings in two volatile categories, inventories and net exports, and I
don't expect them to be repeated. Consumer spending and business investment, which
are the bedrock of GDP, were both strong, and more recent data point toward solid
demand and continuing momentum in the economy that will sustain output growth in the
months ahead.
Another sign of strength is the labor market, which has created 2 million jobs in
the first four months of 2022 at a remarkably steady pace that is down only slightly from
the 562,000 a month last year. Unemployment is near a 50-year low, and both the low
numbers of people filing for unemployment benefits and the high number of job openings
indicate that the slowdown in the economy from the fast pace of last year isn't yet
weighing on the job market. Some look at labor force participation, which is below its
pre-COVID-19 level, as leaving a lot of room for improvement. However, there are
underlying factors that explain why participation is depressed, including early retirements
and individual choices associated with COVID concerns. Whatever the cause, low
participation has contributed to the fact that there are two job vacancies for every one
person counted looking for a job, a record high. Before the pandemic, when the labor
market was in very solid shape, there was one vacancy for every two unemployed people.
As I will explain, this very tight labor market has implications for inflation and the Fed's
plans for reducing inflation. But on its own terms, we need to recognize that robust job
creation is an underlying strength of the U.S. economy, which is expanding its productive
capacity and supporting personal income and ongoing economic growth, in the face of
other challenges.
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Let me turn now to the outlook for the Fed's top priority, inflation. I said in
December that inflation was alarmingly high, and it has remained so. The April
consumer price index (CPI) was up 8.3 percent year over year. This headline number
was a slight decline from 8.5 percent in March but primarily due to a drop in volatile
gasoline prices that we know surged again this month. Twelve-month "core" inflation,
which strips out volatile food and energy prices, was also down slightly to 6.2 percent in
April, from 6.5 percent the month before, but the 0.6 percent monthly increase from
March was an acceleration from the February to March rate and still too high.
Meanwhile, the Fed's preferred measure based on personal consumption expenditures
(PCE) recorded headline inflation of 6.3 percent and core of 4.9 percent. These lower
readings relative to CPI reflect differences in the weights of various categories across
these indexes. No matter which measure is considered, however, headline inflation has
come in above 4 percent for about a year and core inflation is not coming down enough
to meet the Fed's target anytime soon. Inflation this high affects everyone but is
especially painful for lower- and middle-income households that spend a large share of
their income on shelter, groceries, gasoline, and other necessities. It is the FOMC's job
to meet our price stability mandate and get inflation down, and we are determined to do
so.
The forces driving inflation today are the same ones that emerged a year ago. The
combination of strong consumer demand and supply constraints-both bottlenecks and a
shortage of workers relative to labor demand-is generating very high inflation. We can
argue about whether supply or demand is a greater factor, but the details have no bearing
on the fact that we are not meeting the FOMC's price stability mandate. What I care
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about is getting inflation down so that we avoid a lasting escalation in the public's
expectations of future inflation. Once inflation expectations become unanchored in this
way, it is very difficult and economically painful to lower them.
While it is not surprising that inflation expectations for the next year are up, since
current inflation is high, what I focus on is longer-term inflation expectations. Recent
data that try to measure longer-term expectations are mixed. Overall, my assessment is
that longer-range inflation expectations have moved up from a level that was consistent
with trend inflation below 2 percent to a level that's consistent with underlying inflation a
little above 2 percent. I will be watching that these expectations do not continue to rise
because longer-term inflation expectations influence near term inflation, as well as our
ability to achieve our 2 percent target. When they are anchored, they influence spending
decisions today in a way that helps inflation move toward our target. To ensure these
longer-term expectations do not move up broadly, the Federal Reserve has tools to reduce
demand, which should ease inflation pressures. And, over time, supply constraints will
resolve to help rein in price increases as well, although we don't know how soon.
I cannot emphasize enough that my FOMC colleagues and I are united in our
commitment to do what it takes to bring inflation down and achieve the Fed's 2 percent
target. Since the start of this year, the FOMC has raised the target range for the federal
funds rate by 75 basis points, with 50 basis points of that increase coming at our meeting
earlier this month. We also issued forward guidance about the likely path of policy. The
May FOMC statement said the Committee "anticipates that ongoing increases in the
target range will be appropriate."
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I support tightening policy by another 50 basis points for several meetings. In
particular, I am not taking 50 basis-point hikes off the table until I see inflation coming
down closer to our 2 percent target. And, by the end of this year, I support having the
policy rate at a level above neutral so that it is reducing demand for products and labor,
bringing it more in line with supply and thus helping rein in inflation. This is my
projection today, given where we stand and how I expect the economy to evolve. Of
course, my future decisions will depend on incoming data. In the next couple of weeks,
for example, the May employment and CPI reports will be released. Those are two key
pieces of data I will be watching to get information about the continuing strength of the
labor market and about the momentum in price increases. Over a longer period, we will
learn more about how monetary policy is affecting demand and how supply constraints
are evolving. If the data suggest that inflation is stubbornly high, I am prepared to do
more.
My plan for rate hikes is roughly in line with the expectations of financial
markets. As seen in slide 1, federal funds futures are pricing in roughly 50 basis point
hikes at the FOMC's next two meetings and expecting the year-end policy rate to be
around 2.65 percent. So, in total, markets expect about 2.5 percentage points of
tightening this year. This expectation represents a significant degree of policy tightening,
consistent with the FOMC's commitment to get inflation back under control and, if we
need to do more, we will.
These current and anticipated policy actions have already resulted in a significant
tightening of financial conditions. The benchmark 10-year Treasury security began the
year at a yield of around 1.5 percent and has risen to around 2.8 percent. Rates for home
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mortgages are up 200 basis points, and other credit financing costs have followed suit.
Higher rates make it more expensive to finance spending and investment which should
help reduce demand and contribute to lower inflation.
In addition to raising rates, the FOMC further tightened monetary policy by
ending asset purchases in March and then agreeing to start reducing our holdings of
securities, a process that begins June 1. By allowing securities to mature without
reinvesting them, the Fed's balance sheet will shrink. We will phase in the amount of
redemptions over three months. By September, we anticipate having up to $95 billion of
securities rolling off the Fed's portfolio each month. This pace will reduce the Fed's
securities holdings by about $1 trillion over the next year, and the reductions will
continue until securities holdings are deemed close to the ample levels needed to
implement policy efficiently and effectively. Although estimates are highly uncertain,
using a variety of models and assumptions, the overall reduction in the balance sheet is
estimated to be equivalent to a couple of 25-basis-point rate hikes.
All these actions have the goal of bringing inflation down toward the FOMC's 2
percent target. Increased rates and a smaller balance sheet raise the cost of borrowing
and thus reduce household and business demand. On top of this, I also hope that over
time supply problems resolve and help lower inflation. But the Fed isn't waiting for
these supply constraints to resolve. We have the tools and the will to make substantial
progress toward our target.
The United States is not alone in facing excessive inflation, and other central
banks also are responding. There is a global shift toward monetary tightening. In the
euro area, headline inflation continued to edge up in April, to 7.5 percent, while its
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version of core inflation increased from 2.9 percent to 3.5 percent. Based on this
broadening of price pressures, communication by the European Central Bank (ECB) is
widely interpreted as signaling that it will likely start raising its policy rate this summer
and that it could raise rates a few times before year-end. Policy tightening started last
year, as emerging markets including Mexico and Brazil increased rates substantially amid
expectations of accelerating inflation. Several advanced-economy central banks,
including the Bank of England, began raising interest rates in the second half of last year.
Like the Fed, the Bank of Canada lifted off in March and, also like the Fed, picked up the
pace of tightening with a rate hike of 50 basis points at its most recent meeting. Central
banks in Australia and Sweden pivoted sharply to hike rates at their most recent meetings
after previously saying that such moves were not likely anytime soon.
Slide 2 shows the similarly timed policy responses across advanced and emerging
economy central banks in terms of actual and anticipated increases in their policy rates.
Emerging market economies started the year with a policy rate that averaged around 3.5
percent, and they are expected to end the year averaging a bit over 5 percent. Advanced
foreign economies started a bit below zero and at this point are expected to move up, on
average, by around 1 percentage point. This worldwide increase in policy rates,
unfortunately, reflects the fact that high inflation is a global problem, which central banks
around the world recognize must be addressed.
Finally, like the Fed, many other advanced-economy central banks that expanded
their balance sheets over the past two years are now reversing course. In recent months,
as shown in slide 3, the Bank of Canada and Bank of England have begun to shrink their
balance sheets by stopping full reinvestment of maturing assets, similar to what the Fed
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will commence in June. Although the ECB has committed to reinvesting maturing assets
for quite some time, it has tapered net purchases substantially since last year and has
indicated it will likely end those purchases early in the third quarter.
Some have expressed concern that the Fed cannot raise interest rates to arrest
inflation while also avoiding a sharp slowdown in economic growth and significant
damage to the labor market. One argument in this regard warns that policy tightening
will reduce the current high level of job vacancies and push up unemployment
substantially, based on the historical relationship between these two pieces of data, which
is depicted by something called the Beveridge curve. Because I am now among fellow
students of economics, I wanted to take a moment to show why this statement may not be
correct in current circumstances.
First, a little background. The relationship between vacancies and the
unemployment rate is shown in slide 4. The blue dots in the figure show observations of
the vacancy rate and the unemployment rate between 2000 and 2018. The black curve is
the fitted relationship between the log of vacancies and the log of unemployment over
this period. It has a somewhat flat, downward slope. From this, the argument goes,
policy to slow demand and push down vacancies requires moving along this curve and
increasing the unemployment rate substantially.
But there's another perspective about what a reduction in vacancies implies for
unemployment that is just as plausible, if not more so. Slide 5 shows the same
observations as slide 4 but also adds observations from the pandemic. The two larger red
dots show the most recent observation, March 2022, and January 2019, when the vacancy
rate had achieved its highest rate before the pandemic. These two dots suggest that the
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vacancy rate can be reduced substantially, from the current level to the January 2019
level, while still leaving the level of vacancies consistent with a strong labor market and
with a low level of unemployment, such as we had in 2019. To see why this is a
plausible outcome, I first need to digress a bit to discuss the important determinants of
unemployment.
Many factors influence the unemployment rate, and vacancies are just one. Thus,
to understand how a lower vacancy rate would influence unemployment going forward,
we need to separate the direct effect of vacancies on the unemployment rate from other
factors. To do that, we first need to review the factors that account for unemployment
movements.
There are two broad determinants of unemployment: separations from
employment (including layoffs and quits), which raise unemployment, and job finding by
the unemployed, which lowers unemployment.2 Separations consist largely of layoffs,
which are typically cyclical, surging in recessions and falling during booms. Job finding
is also highly cyclical, rising as the labor market tightens and falling in recessions.
To see how separations and job finding affect the unemployment rate, it's helpful
to start with equation (1) on slide 6, which states that in a steady state (that is, when the
unemployment rate is constant), flows into unemployment, the left side of equation (1),
must equal flows out of unemployment, the right side. Flows into unemployment equal
the separations rate, ss, times the level of employment. For simplicity, I've normalized
the labor force to 1, so that employment equals 1 minus unemployment, UU. Flows out of
unemployment, the right side of the equation, equal the rate of job finding, ff, times the
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number of unemployed. Rearranging this equation yields an expression for the steady-
state unemployment rate, equation (2).3 Because flows into and out of unemployment are
quite high, the actual unemployment rate converges to the steady-state unemployment
rate quickly, and the steady-state unemployment rate typically tracks the actual rate
closely.4 So, going forward, I'm going to think of the steady-state unemployment rate as
a good approximation of the actual unemployment rate.
Now let me focus on job finding, which is often thought to depend on the number
of job vacancies relative to the number of unemployed workers. To see why, start with
equation (3) on slide 7, which states that the number of hires is an increasing function of
both the number of job vacancies and the number of unemployed individuals searching
for jobs: The more firms there are looking for workers and the more workers there are
looking for jobs, the more matches, or hires, there will be. For convenience, I'm
assuming a mathematical representation of this matching function takes a Cobb-Douglas
form. If we divide both sides of equation (3) by unemployment, we get equation (4),
which expresses the job-finding rate as a function of the ratio of vacancies to
unemployment, or labor market tightness.
Because we have data for both the left and right sides of equation (4), we can
estimate it and obtain parameter values for the elasticity of job finding with respect to
labor market tightness, sigma, and matching efficiency, mu.5 Matching efficiency
represents factors that can increase (or decrease) job findings without changes in labor
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market tightness. On the one hand, if the workers searching for jobs are well suited for
the jobs that are available, matching efficiency will be high; on the other hand, if many
searching workers are not well suited for the available jobs, matching efficiency will be
low.6
The last step is to plug our expression for job finding into equation (2), the steady-
state unemployment rate, yielding equation (5). Equation (5) shows how vacancies affect
the unemployment rate. To illustrate this relationship, I solve equation (5) for different
values of VV and ss, holding the matching efficiency parameters constant. That is, I pick a
separation rate at some level and trace out what happens to the unemployment rate as the
vacancy rate changes. Then I pick a different separation rate and again trace out the
effect of vacancies on unemployment. The result is shown on slide 8, which plots four
curves showing the effect of vacancies on unemployment for four different separation
rates. Each curve is convex; as the number of vacancies increases relative to the number
of individuals looking for work, it becomes harder for firms to fill jobs with suitable
workers, and more jobs remain vacant. This is exactly the situation many employers are
now experiencing. Because more vacancies generate fewer and fewer hires, they result in
smaller and smaller reductions in unemployment. But large numbers of vacancies are, of
course, a hallmark of tight labor markets and additional vacancies continue to strongly
boost wage growth and quits.
The curve farthest to the right, labeled s=2.5, represents a situation when the
separations rate is 2.5 percent, a historically high level. This rate is approximately the
level seen in the middle of 2020, just after the onset of the pandemic. You can see that
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when the separations rate is this high, the unemployment rate is also going to be high, no
matter the level of vacancies.
Now let's think about what happens as the economy recovers, as it has over the
past two years. In an expansion, layoffs fall, pushing down separations and moving the
curve to the left. At the same time, greater labor demand increases vacancies, causing the
labor market to move up the steep curves. The combination of these movements is
shown in slide 9 as the black fitted curve, which I've reproduced from slide 4. As you
recall, the black curve fits the actual observations on unemployment and vacancies we
saw before the pandemic. And we now can see that these observations are produced by a
combination of changes in vacancies and separations (as well as other influences on
unemployment). Decreases in the separations rate reduce the unemployment rate without
changing vacancies, imparting a flatness to the fitted curve relative to the steeper curves
that only reflect the effect of vacancies. If we want to just focus on the effect of
vacancies, then we should be looking at the steep curves, especially when the labor
market is tight, as it is now.
What does all this suggest about what will happen to the labor market when, as I
expect, a tightening of financial conditions and fading fiscal stimulus start to cool labor
demand? Slide 10 focuses on the Beveridge curve (the relationship produced by the
direct effect of changes in vacancies on unemployment) when the separations rate is low,
as it is now.7 The March 2022 observation lies at the top of the curve and is labeled point
A. If there is cooling in aggregate demand spurred by monetary policy tightening that
tempers labor demand, then vacancies should fall substantially. Suppose they decrease
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from the current level of 7 percent to 4.6 percent, the rate prevailing in January 2019,
when the labor market was still quite strong. Then we should travel down the curve from
point A to point B.8 The unemployment rate will increase, but only somewhat because
labor demand is still strong-just not as strong-and because when the labor market is
very tight, as it is now, vacancies generate relatively few hires. Indeed, hires per vacancy
are currently at historically low levels. Thus, reducing vacancies from an extremely high
level to a lower (but still strong) level has a relatively limited effect on hiring and on
unemployment.
Now, I also show the January 2019 observation of vacancies and unemployment.
Recall, this is also where the economy was over the year prior to the pandemic. As you
can see, moving from the March 2022 observation to the January 2019 observation is not
that different from the change in the unemployment rate predicted by my estimated
Beveridge curve, which suggests the predicted small increase in unemployment is a
plausible outcome to policy tightening.
If labor demand cools, will separations increase and shift the curve outward,
increasing unemployment further? I don't think so. As shown on slide 11, outside of
recessions, layoffs don't change much. Instead, changes in labor demand appear to be
reflected primarily in changes in vacancies.
Now, it's certainly possible, even probable, that influences on the unemployment
rate other than vacancies will change going forward. In terms of the equations we have
been discussing, layoffs could increase somewhat, instead of staying constant. Matching
efficiency could also improve or deteriorate. The vacancy rate could also change more or
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less than I have assumed. Thus, I'm not arguing that the unemployment rate will end up
exactly as the Beveridge curve I've drawn suggests. But I do think it quite plausible that
the unemployment rate will end up in the vicinity of what the Beveridge curve currently
predicts.
Another consideration is that non-linear dynamics could take hold if the
unemployment rate increases by a certain amount, as suggested by the Sahm rule, which
holds that recessions have in the past occurred whenever the three-month moving average
of the unemployment rate rises 0.5 percentage point over its minimum rate over the
previous 12 months.9 We certainly need to be alert to this possibility, but the past is not
always prescriptive of the future. The current situation is unique. We've never seen a
vacancy rate of 7 percent before. Reducing the vacancy rate by 2.5 percentage points
would still leave it at a level seen at the end of the last expansion, whereas in previous
expansions a reduction of 2.5 percent would have left vacancies at or below 2 percent, a
level only seen in extremely weak labor markets.
To sum up, the relationship between vacancies and unemployment gives me
reason to hope that policy tightening in current circumstances can tame inflation without
causing a sharp increase in unemployment. Of course, the path of the economy depends
on many factors, including how the Ukraine war and COVID-19 evolve. From this
discussion, I am left optimistic that the strong labor market can handle higher rates
without a significant increase in unemployment.
In closing, I want to again thank the institute for the invitation to address you
today, at a time of considerable challenge for Germany and the United States. It's not the
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first time we have faced such moments together. Just south of the Frankfurt Airport is a
surprising sight-a couple of antique military cargo planes, parked on the side of the
Autobahn. They were built by Douglas Aircraft, nearly 80 years ago, and stand today as
monuments to one of the greatest achievements of cooperation between the freedom-
loving people of Europe and those of the United States.
For 11 months, these two planes, and many others, took off and landed in
perpetual motion, delivering 2.3 million tons of food, fuel, and other essentials to the
people of Berlin, who were surrounded and besieged by Soviet forces. The commitment
and ultimate triumph of this improbable airlift was in many ways the beginning of an
alliance that has included ongoing economic cooperation that has strengthened both our
democracies. In that spirit, I am certain we can both overcome the economic challenges
that lie ahead.
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References
Ahn, Hie Joo, and Leland Crane (2020). "Dynamic Beveridge Curve Accounting,"
Finance and Economics Discussion Series 2020-027. Washington: Board of
Governors of the Federal Reserve System, March,
https://doi.org/10.17016/FEDS.2020.027.
Ahn, Hie Joo, and James Hamilton (2020). "Heterogeneity and Unemployment
Dynamics," Journal of Business & Economic Statistics, vol. 38 (July), pp. 554-
69.
Barnichon, Regis, and Andrew Figura (2015). "Labor Market Heterogeneity and the
Aggregate Matching Function," American Economic Journal: Macroeconomics,
vol. 7 (October), pp. 222-49.
Elsby, Michael, Bart Hobijn, and Aysegul Sahin (2015). "On the Importance of the
Participation Margin for Labor Market Fluctuations," Journal of Monetary
Economics, vol. 72 (May), pp. 64-82.
Elsby, Michael, Ryan Michaels, and David Ratner (2015). "The Beveridge Curve: A
Survey," Journal of Economic Literature, vol. 53 (September), pp. 571-630.
Elsby, Michael, Ryan Michaels, and Gary Solon (2009). "The Ins and Outs of Cyclical
Unemployment," American Economic Journal: Macroeconomics, vol. 1
(January), pp. 84-110.
Fujita, Shigeru, and Garey Ramey (2009). "The Cyclicality of Separation and Job
Finding Rates," International Economic Review, vol. 50 (May), pp. 415-30.
Sahm, Claudia (2019). "Direct Stimulus Payments to Individuals," report. Washington:
Brookings Institution, May,
https://www.brookings.edu/wpcontent/uploads/2019/05/ES_THP_Sahm_web_20190506.pdf.
Shimer, Robert (2012). "Reassessing the Ins and Outs of Unemployment," Review of
Economic Dynamics, vol. 15 (April), pp. 127-48.
1. Federal Funds Rate Path
2. Foreign Policy Rates
3. Central Banks' Securities Holdings


6. Determinants of Unemployment
Steady state: flows into unemployment equal
flows out of unemployment
1 - UU ∗ ss = UU ∗ ff
(1)
Steady state unemployment rate:
ss
UU =
(2)
ss+ff
UU ss
Note. =unemployment rate; =separations rate; ff=job finding rate.
7. Effect of Vacancies on Unemployment
Matching function:
HH = FF VV, UU = μμVVσσUU1-σσ
(3)
Job finding:
σσ
HH VV
ff = = μμ ∗
(4)
UU UU
Implied Relationship between Vacancies and Unemployment:
ss
UU =
(5) σσ
VV
ss+μμ∗
UU
Note. HH=hires; VV=vacancies; μμ=matching efficiency; σσ=matching parameter.


10. Beveridge Curve and Future Unemployment
11. Vacancies and Layoffs
Endnotes
•
Figure 1: The line's solid segments are historical policy rates and dashed
segments are implied projections of the federal funds rate. Projections are
not adjusted for risk premiums and assumes rate changes happen only at
Federal Open Market Committee meeting dates.
•
Figure 2: The lines' solid segments are weighted averages of foreign
countries' historical policy rates. The dashed segments are based on
market-implied projections of future policy rates. AFE refers to the
Advanced Foreign Economies aggregate and EME to the Emerging Market
Economies aggregate. The aggregates are weighted using bilateral U.S.
trade weights.
•
Figure 3: Net asset purchases are the quarterly change in the following
asset categories: for the Bank of England (BOE), total assets minus assets
held under term funding schemes; for the Bank of Canada (BOC),
Government of Canada direct and guaranteed securities; for the European
Central Bank (ECB), assets held in the Asset Purchase Programme and in
the Pandemic Emergency Purchase Programme; for the Bank of Japan
(BOJ), Japanese government securities, commercial paper, corporate
bonds, index-linked exchange-traded equity funds, and real estate
investment trusts; and for the Federal Reserve Board (FRB), treasury
securities and mortgage-backed securities.