Christopher J Waller: Something's got to give
Speech by Mr Christopher J Waller, Member of the Board of Governors of the Federal
Reserve System, at the Distinguished Speaker Seminar, European Economics and
Financial Center, London, United Kingdom, 18 October 2023.
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Thank you, Professor Scobie. Thank you to the European Economics and Financial
Centre for inviting me to speak and for the honor of referring to me as a "distinguished
speaker." I have noticed that people started calling me "distinguished" only after my hair
turned white. I suspect that "distinguished" is a polite way of saying you are old.
My subject today is one I trust is of interest in this center of global finance-namely, the
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outlook for the U.S. economy and the implications for monetary policy. It has been one
year and seven months since the Federal Reserve began raising interest rates to rein in
inflation, and there has been considerable progress. But uncertainties remain, both
about the forces that will shape the economic outlook in the coming months and about
whether monetary policy has reached a level that is sufficiently restrictive to support
continued progress toward the Federal Open Market Committee's (FOMC) target of 2
percent inflation. Let me share my thinking about what recent economic data can, and
in some cases, cannot tell us about the outlook and the appropriate setting for monetary
policy.
The data in the past few months has been overwhelmingly positive for both of the
FOMC's goals of maximum employment and stable prices. Economic activity and the
labor market have been strong, with what looks like growth well above trend and
unemployment near a 50-year low. Meanwhile, there has been continued, gradual
progress in lowering inflation, and moderation in wage growth. This is great news, and
while I tend to be an optimist, things are looking a little too good to be true, so it makes
me think that something's gotta give. Either growth moderates, fostering conditions that
support continued progress toward our 2 percent inflation objective, or growth doesn't,
possibly undermining that progress. But which is going to give-the real side of the
economy or the nominal side?
I find myself thinking about two possible scenarios for the economy in the coming
months. In the first, the real side of the economy slows. This is the scenario broadly
reflected in the September Summary of Economic Projections (SEP) by FOMC
participants, where an easing in demand helps bring the economy into better balance
with supply and allows inflation to move closer to our 2 percent objective. In this
scenario, I believe we can hold the policy rate steady and let the economy evolve in the
desired manner.
But I also can't avoid thinking about the second scenario, where demand and economic
activity continue at their recent pace, possibly putting persistent upward pressure on
inflation and stalling or even reversing progress toward 2 percent. In such a scenario,
failing to take action in a timely way carries the considerable risk of undermining what
have been fairly stable inflation expectations and possibly unwinding the work that we
have done to date. Thus, more action would be needed on the policy rate to ensure that
inflation moves back to target and expectations remain anchored.
Before getting into the economic data, let me address the increase in medium- and
longer-term interest rates that has occurred since July. The 10-year Treasury yield is up
about 90 basis points, while shorter-term maturities increased only a quarter of this
amount and primarily early in the period. There are several factors that have been
mentioned to explain this movement, including stronger-than-expected incoming data
on third quarter economic activity, an increased focus on U.S. deficits and the
associated increase in Treasury issuance, as well as geopolitical events and a flight to
safety. Whatever the causes, I will be watching how these interest rates evolve in
coming months to evaluate their impact on financial conditions and economic activity.
Let's now dig into the recent economic data, starting with those on economic activity
that help us get a handle on the strength of demand. Real gross domestic product
(GDP) grew at about a 2 percent annual rate in the latter part of 2022 and the first half
of 2023. Recent data suggest that this pace stepped up in the third quarter. The latest
consensus estimate from the Blue Chip survey of business forecasters was that
thirdquarter real GDP grew 3.5 percent, and the Atlanta Fed's GDPNow model is coming in
even higher. We'll get a first look at the third quarter GDP number next week, but it
seems clear that economic activity was substantially higher for July through September
than earlier in the year.
The question is whether that acceleration of real activity will be sustained. Sometimes
an uptick in activity is followed by some payback, or slowdown. For example, if firms
pull construction forward because of good weather, then current structures investment
will be high now but lower in the next period. Thus, we want to be careful and not pay
too much attention to the specific month activity took place but instead average growth
over a couple of quarters to get a clearer picture of the underlying strength of the
economy.
To see this point more clearly, recall that at the start of this year, personal consumption
expenditures increased dramatically in the first quarter but subsequently grew less
rapidly in Q2 of 2023. A similar dynamic may be playing out now. On the other hand, if
the third quarter data represents the beginning of persistently stronger demand, then
we can expect that strength to show up in the fourth-quarter data, including by putting
upward pressure on prices, which could have ramifications for upcoming decisions on
monetary policy.
In thinking about these two possibilities, let me tell you how I view two key components
of GDP growth this year.
Consumer spending, which represents nearly 70 percent of GDP, has been quite strong
thus far in 2023. While household spending has been volatile, smoothing it out over the
past several quarters indicates underlying momentum. Yesterday's September retail
sales data indicated continued strong spending.
The solid spending in the face of tightened monetary policy suggests consumption is
likely supported by households' strong balance sheets as well as confidence in future
labor income. I will be watching the spending data carefully, including those that hint at
a slowdown. Though hard to measure, it seems that households are drawing down their
liquid assets. Some other data supporting a slowing include more use of credit cards
this year and a return of delinquency rates for consumer loans, which plunged over the
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course of the pandemic, to essentially their pre-pandemic levels. Also, as I mentioned
earlier, financial conditions have tightened considerably since July. Of course, I have
been waiting a while for tightening financial conditions to cause a significant slowing of
spending, and I have been consistently surprised at the resilience of consumer
spending. So I will be patient in waiting for the data to document how spending evolves.
Another component of GDP that I'll be watching is investment in non-residential
structures. Manufacturing investment boosted real GDP growth in the first half of the
year, partly driven by a surge in the construction of semiconductor and electric battery
factories that began before new government subsidies were enacted and driven higher
by that legislation. Recent data suggests this spending is leveling off at a new, higher
level: Construction spending growth has flattened out in recent months, and so have
new project starts. In addition, the considerably higher interest rates over the past three
months can dampen this growth. Only time will tell whether these factors slow
investment activity or whether the subsidy programs and the enthusiasm for onshore
chip and battery production continue to encourage higher investment spending.
Let me turn now to the labor market. Since the FOMC's September meeting, the labor
market data indicate continued tight conditions. The economy created 336,000 jobs in
September, a robust figure that was much higher than forecasters expected. While the
previous two job reports had signaled softer job growth, revisions to those reports
added another 100,000 jobs. While down from the elevated levels seen in the first part
of last year, the latest three-month average for new jobs of 266,000 is not that much
different from the three-month average at the end of 2022 of 284,000. The inference is
that job growth is still exceptionally strong and hasn't slowed much this year.
Other data, however, are showing some continued loosening of conditions in the labor
market. For example, looking through some monthly volatility, the number of job
openings for every person counted as looking for a job was 1.2 in 2019 and shot up to a
peak of 2 in March 2022. As we tightened policy and put downward pressure on labor
demand, this ratio fell to 1.8 at this time last year and is currently 1.5. In addition, labor
force participation has moved up notably this year, particularly among prime-age
workers. Looking across various measures of labor compensation, the rate of wage
growth has also moderated, despite an unemployment rate that is near a 50-year low.
These metrics are not yet at their pre-pandemic levels but are moving closer to levels
that would be consistent with 2 percent inflation.
In sum, although the labor market is showing signs of loosening by various metrics, it is
still unusually tight. While I anticipate that it will continue to loosen, I will be watching
closely to see that this remains true.
Now let's talk about inflation. As reported a week ago, headline inflation based on the
consumer price index (CPI) was 3.7 percent in the 12 months through September,
down significantly from 8.2 percent the year before. Core inflation, excluding energy
and food prices, was 4.1 percent, down from 6.7 percent last September. We will get an
update on personal consumption expenditures (PCE) inflation next week, but based on
data we received through August, the 12-month percent change in PCE inflation was
3.5 percent and core PCE inflation was 3.9 percent.
Focusing on the annualized three-month change in inflation gives a better, albeit noisy,
indicator of inflation dynamics. With this measure, core CPI was 3.1 percent based on
data from July through September. Core PCE, increased 2 percent based on June
through August. Across the categories that make up these price indexes, one finds that
more than half of them had annualized monthly price increases of less than 3 percent.
Clearly, this is progress. And there are some factors that would be expected to put
downward pressure on inflation in the coming months. Monetary policy is restrictive.
Households are spending the excess saving accumulated during the pandemic and
have growing levels of debt, which are likely to moderate spending growth. The
increase in medium and longer-term interest rates over the past several months should
weigh on both household and business spending.
But, while core PCE inflation over the last three months has declined to our 2 percent
target, there are a couple of reasons to be concerned that this progress might not
continue. First, in the latest CPI report, despite expectations of continued deceleration,
housing services prices jumped from a monthly change of 0.3 percent to 0.6 percent. I
have been concerned since May about a resurgence of housing services inflation and
this number heightens my concern that housing services inflation has not slowed, and
may not slow, to the rate needed to sustain a return to our 2 percent target. Similarly,
supercore inflation, which is core services excluding housing, has continued at a robust
monthly rate of about 0.5 percent the past two months. Again, this reading is not at a
level needed to make progress toward our goal and we need to watch and see if these
numbers indicate that inflation is reaccelerating.
The second reason to be concerned is that, while there is some basis for expecting that
inflation will continue to fall, let me remind you, as I have done repeatedly, that we have
seen a string of good inflation reports evaporate multiple times in the recent past. So I
will be watching the next several reports for clearer indications that inflation is on a
trajectory to 2 percent.
What does that mean for monetary policy? I will be looking carefully at the data to see
whether the real side of the economy begins to cool off or whether prices, the nominal
side of the economy, heat up. As of today, it is too soon to tell. Consequently, I believe
we can wait, watch and see how the economy evolves before making definitive moves
on the path of the policy rate. Should the real side of the economy soften, we will have
more room to wait on any further rate hikes and let the recent run-up on longer-term
rates do some of our work. But if the real economy continues showing underlying
strength and inflation appears to stabilize or reaccelerate, more policy tightening is
likely needed despite the recent run up in longer term rates.
So I will be watching to see if core inflation comes in higher than expected, perhaps
sustained by continued strength in spending and investment or, if demand and the real
economy slow, moderating core inflation. My views on the appropriate path for policy
will be based on a careful assessment of incoming data and financial market
developments and a judgement about whether we are continuing on a path of sustained
progress toward 2 percent inflation.
Thank you. I am happy to take some questions.
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The views expressed here are my own and not necessarily those of my colleagues on
the Federal Open Market Committee.
2
This fact holds for both auto and credit card delinquencies across all levels of the
income distribution.