Monetary Policy in a World of Conflicting Data
Remarks by
Christopher J. Waller
Member
Board of Governors of the Federal Reserve System
at
Rocky Mountain Economic Summit
Global Interdependence Center
Victor, Idaho
July 14, 2022
Thank you, Mike, and thank you to the Global Interdependence Center for the
invitation to speak to you today.1 Let me start at the place that all remarks about U.S.
monetary policy should start, which is with the Federal Reserve's dual mandate of
maximum employment and price stability.2
As I discuss below, we have a very strong labor market, with an unemployment
rate that is below the median of policymakers' expected longer-run level, and high
inflation that is far above our target.3 We are achieving our mandate when it comes to
maximum employment, but we are far from achieving our goal of stable prices.
Consequently, while any monetary policy decision has implications for achieving
maximum employment, and I will address those implications in a moment, the FOMC is
now, and must be, utterly focused on moving inflation down toward our 2 percent target.
We must be focused on reducing inflation because, despite a lot of talk about
recession lately, the evidence from the labor market indicates the economy is on track,
while inflation continues to be far too high. It must be our focus because high inflation is
the biggest challenge to sustaining our employment goal, and the greatest burden for
individuals and families, especially lower- and moderate-income households that dedicate
a larger share of their spending to necessities. Inflation has to be our focus, every
meeting and every day, because the spending and pricing decisions people and businesses
make every day depend on their expectations of future inflation, which in turn depend on
whether they believe the Fed is sufficiently committed to its inflation target.
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So let me be clear: I am going to vote to set policy in a manner that will reduce
inflation and achieve our price stability goal, and today I will explain why I don't see that
progress conflicting with our maximum-employment goal. Let me start with my view of
the labor market and inflation, then turn to the implications for monetary policy, and
conclude with where I think the economy is headed.
A Puzzle: Very Tight Labor Market but Declining GDP
As many economists are discussing, recent economic data have created a puzzle.
The labor market continues to be very strong, but the real economy appears to be
faltering. How might gross domestic product (GDP) fall in the first half of 2022 while
the economy created 2.7 million jobs in the same time period? Is the labor market not as
strong as it appears or is the economy doing better than the data suggests?
To assess the strength of the labor market, there are numerous indicators of its
health, and sometimes they point in different directions. Today isn't one of those times.
Based on every major labor market indicator, the labor market is very strong and, in
historical terms, very tight. The timeliest evidence for this strength was the jobs report
that came out last Friday for the month of June, which found that the economy created
372,000 jobs. Now, I will admit my vision isn't what it used to be, but with revisions to
May and April, it is hard to see any slowing in the pace of monthly job creation since
February: 398,000 in March, then 368, 384, and 372. In the first half of 2022, the
economy has created 2.7 million jobs. That isn't a picture of a weakening job market.
The unemployment rate in June was steady at 3.6 percent. It is often said that this is
"close to a half-century low" and that is true, but you really have to go back 69 years, to
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1953, to find the unemployment rate more than a couple tenths of a point lower than it
was in June. This is about as good a job market as any worker has ever seen.
The June job report is consistent with other labor market indicators. Job
vacancies-an indicator I have highlighted in past speeches-are unprecedentedly high,
with nearly two jobs for every person looking, and that hasn't changed very much this
year. Job postings, measured by the Labor Department for May and by Indeed for June,
have fallen a bit in recent months but are still at historically high levels, consistent with a
very tight labor market. As a share of the labor force, weekly initial claims for
unemployment insurance are near record lows and have been fairly steady all year.
Businesses continue to report that jobs are plentiful and small business owners say that
jobs are very hard to fill.4 Looking more broadly across 24 labor market metrics
summarized by the Federal Reserve Bank of Kansas City, we see that activity is above its
pre-pandemic level, and the Atlanta Fed's labor market distributions spider chart shows
that the vast majority of labor market indicators are about as tight or tighter than just
before the pandemic.5 The broad range of data showing a very strong labor market
indicate that this isn't a mismeasurement issue.
Turning to GDP, there are signs of slowing in economic activity. The Commerce
Department estimates that there was a modest contraction in real GDP for the first quarter
of the year, and "nowcasting" projections of economic activity, such as the Atlanta Fed's
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GDPNow tracker, foresee a similar contraction in the second quarter.6 There is also
softness in recent spending data, which has been widespread across consumer spending,
business investment, housing, and government purchases, as well as some weaker
indicators for the manufacturing sector and a deterioration in consumer sentiment, which
by some measures are at historically low levels. Some argue that a recession has already
started.
But I don't see how that squares with the job creation data, the low
unemployment rate, and overall strong labor market that I described earlier. In addition
to the contrasting evidence in the labor market, there are several other reasons why I am
very cautious about acting on the GDP estimates and on projections of an output
slowdown. One is that while first quarter real GDP is now estimated to have shrunk by
1.6 percent, according to another estimate, real gross domestic income (GDI) increased
by 1.8 percent. GDP and GDI are basically measuring the same activity in different
ways, and in the past when such wide gaps in the two numbers have appeared initially,
they tend to move toward each other when the data are finalized. We know that there
were some unusual trade-related reasons for the low GDP number in the first quarter that
are unlikely to be repeated, and revisions in both GDP and GDI could largely erase that
contraction in output.
And, the data that point to some slowing don't convince me that it will damage
the labor market. Measures of manufacturing activity and indicators of future activity,
such as the purchasing manager's index, have moderated but are still in expansionary
territory. Rather than a recession, the softening data seem consistent with the pandemic-
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related transition underway since last year among consumers from spending on goods to
spending on services. And we should expect that as policy tightening feeds through the
economy it will dampen household and business spending decisions-that is the
objective of our policy tightening.
Past experience has shown that job creation and the unemployment rate are timely
indicators of a recession, more timely than quarterly GDP. I will watch all the data
carefully, but the factors I just cited, along with the evident strength across different
measures of the labor market, leave me feeling fairly confident that the U.S. economy did
not enter a recession in the first half of 2022 and that the economic expansion will
continue.
Persistently High Inflation
Now let's talk about inflation. Yesterday's report on the consumer price index
(CPI) for June was a major league disappointment. On a twelve-month basis, total
inflation stood at 9.1 percent, the highest in 40 years. Core, which came down slightly in
the last couple months, has averaged over 6 percent this year, and is too high as well. No
matter how you look at the data, inflation is far too high and my job is to move it down
toward our 2 percent target.
We know that supply shortages and bottlenecks, including the tight labor market,
have contributed to the high inflation readings we are observing. We also know that the
surge in demand during the pandemic that was driven by excess saving, significant fiscal
stimulus, and accommodative monetary policy also has contributed to the high inflation
we are now experiencing. There is some research estimating how much of this inflation
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came from supply problems and how much from high demand.7 The main point is that
both played a large part in driving the inflation that we have seen over the past year.
But the causes of inflation don't affect my approach to policy because in writing
the FOMC's mandate, Congress did not say "Your goal is price stability unless inflation
is caused by supply shocks, in which case you are off the hook." We want to reduce
excessive inflation, whatever the source, in part because whether it comes from supply or
demand, high inflation can push up longer-run inflation expectations and thus affect
spending and pricing decisions in the near term. These decisions can then push up prices
even more and make inflation harder to get under control.
I pay attention to both surveys of the public's inflation expectations and measures
of inflation expectations derived from trading of inflation-indexed securities. I prefer the
latter market-based measures, which are down from recent peaks but still elevated. The
Board staff combines various surveys and market-based measures in our Index of
Common Inflation Expectations, which has moved up slightly in recent months after
being flat for a long time. We need to avoid expectations rising so much that they
become a factor that drives inflation higher.
The Path of Monetary Policy
So, based on persistently high inflation and the very tight labor market that I have
described, let's talk about the implications for monetary policy. Since March, the FOMC
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has raised the federal funds rate three times for a cumulative 150 basis points. This is the
fastest pace of tightening in close to 30 years. At our last meeting, we raised the policy
rate by 75 basis points, which is a large move by historical standards. That size increase
was not an over-reaction to one data point on inflation-it was primarily the response to a
sequence of excessively high inflation readings since the beginning of the year. It was
appropriate given the lack of progress on inflation and clearly signals the FOMC's
commitment to get inflation under control as soon as possible.
The response of financial markets to the FOMC's policy actions and
communications indicate to me that the Committee retains the credibility and the public
confidence that is needed to make monetary policy effective. Longer-term interest rates
have moved up to levels not far from those reflected in Committee members' estimates of
the final destination for the federal funds rate in this tightening cycle, effectively
implementing policy ahead of time. The average rate for a 30-year conforming fixed rate
home mortgage has increased by more than two percentage points since the end of 2021.
While there is some slowdown in home sales, lenders and borrowers are still doing
business at these rates, which indicates that they believe the FOMC's policy intentions
are credible, as broadly reflected in the interest rate paths in the Summary of Economic
Projections (SEP).
As I have said before, with inflation so high, there is a virtue in front-loading
tightening so that policy moves as soon as is practical to a setting that restricts demand.
Getting there sooner will bolster the public's confidence that we can get inflation down
and it will preserve options for adjusting the pace of tightening later if needed.
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With this view, it should not be surprising that looking toward the FOMC's next
meeting July 26-27, and with the CPI data in hand, I support another 75-basis point
increase, bringing the target range for the federal funds rate to 2-1/4 to 2-1/2 percent
before August. I judge that level is close to neutral, by which I mean a level that neither
stimulates nor restricts demand, assuming that the economy is growing moderately (at its
potential) and unemployment is roughly where it is now.
However, my base case for July depends on incoming data. We have important
data releases on retail sales and housing coming in before the July meeting. If that data
come in materially stronger than expected it would make me lean towards a larger hike at
the July meeting to the extent it shows demand is not slowing down fast enough to get
inflation down.
Based on what we know about inflation today, I expect that further increases in
the target range will be needed to make monetary policy restrictive, but that will depend
on economic data in the coming weeks and months. Between the end of July and the
FOMC's September meeting, we will get two employment and CPI reports with data for
July and August. I will be looking for signs that inflation has started its move down
toward our 2 percent target on a sustained basis.
I anticipate a decline in inflation will come as actual and anticipated hikes by the
FOMC cool demand for products and labor, which will help demand and supply come
into a better balance. The decline in the rate of inflation will also be assisted by
continued improvement in goods supply bottlenecks, which is occurring in some sectors,
and an increase in labor force participation, which is still significantly lower than it was
before the pandemic. I hope these supply recoveries happen, but my expectations for
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policy don't rely on it. I expect rate increases will continue after July at a pace that is
dependent on the incoming data.
After the July meeting, further increases will be restricting demand. Looking
further in the future, I will need to see how the tightening this year is affecting the
economy and bringing inflation down toward our 2 percent target. Based on my forecast
for the economy, I expect monetary policy to be restrictive until there has been a
sustained reduction in core personal consumption expenditure (PCE) inflation, which
excludes food and energy. Food and energy prices tend to be volatile, so focusing on
core PCE inflation is a good guide to inflation pressures in the near and medium term.
Importantly, as futures prices for commodities-food, energy, raw materials-have
declined recently, I am expecting total PCE inflation to decline in coming months. But
until I see a significant moderation in core prices, I support further rate hikes.
In talking about where monetary policy is headed, it is helpful to get a fix on
where it is right now. I mentioned the concept of a "neutral" interest rate, and the belief
that the federal funds rate will be close to neutral after another 75-basis point increase at
the end of this month. But some would argue that monetary policy is actually further
away from neutral, based on the fact that current inflation is so much higher than the
federal funds rate.
In my view, that rests on a flawed idea of how monetary policy affects spending
decisions. That's because spending decisions that require borrowing are based on an
outlook that extends several years. This means taking into consideration longer-term real
rates, which are tied to the expected path of policy and inflation over the next several
years.
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As a result, I think that estimates of the real federal funds rate should be based on
the expected policy rate one to one and a half years in the future. Based on trading in
inflation-indexed Treasury securities of different maturities (compared to nominal
Treasury securities), investors see federal funds rates above expected inflation starting
about six months from now and steepening thereafter. Primary securities dealers
surveyed by the New York Fed likewise estimate the real federal funds rate will be a
positive 0.7 percent in mid-2023 and 1 percent by mid-2024. This gives me some
confidence that tightening now anticipated by markets and expected by FOMC
participants will be sufficient to reduce demand and inflation.
Evolution of the Economy
The FOMC's plan for getting inflation under control depends on a view of the
economic outlook. As I have noted in past speeches, accurate economic forecasting is
very hard, especially when unusual factors, like a war, and unprecedented factors, like a
pandemic, buffet the global economy.8 FOMC participants record their individual
outlooks that are presented every three months in the SEP. At our June meeting, the
latest SEP shows that there is some expectation among participants for what is often
referred to as a soft landing. With a policy path like what I described for this year and a
bit more tightening next year, the median SEP respondent projected that total PCE
inflation is expected to fall from its current elevated level today to 2.2 percent in the
fourth quarter of 2024. At the same time, the unemployment rate is projected to rise to
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3.7 percent at the end of this year and to 4.1 percent by the end of 2024, while GDP
would grow below its long-run trend for the next two years.
Of course, we can't be very certain about the path of the economy more than a
few months in the future, but this medium-term view of a soft landing is very plausible. I
say this based on the optimistic view I expressed earlier about the strength of the labor
market and on my analysis of the relationship between job vacancies and the
unemployment rate. In a recent speech, I noted that we have an historically high number
of job vacancies compared to the number of unemployed people.9 Some people have
argued that past experience indicates we cannot reduce this large number of vacancies
without a big increase in the unemployment rate. But I have showed that past experience
actually indicates that a reduction in vacancies can take place without a big loss of
employment, and this is the kind of soft landing anticipated by FOMC participants. So,
while some data measures suggest the chances of recession have increased, I believe it
can be avoided.
Uncertainty over how the pandemic could afflict the economy in the future, and
global economic risks related to the war in Ukraine are considerable. These factors could
make future policy decisions more difficult than they are today. However, for the reasons
I have laid out, and considering the evidence on the state of the economy and the outlook,
I don't find it difficult to reaffirm my strong conviction that continued policy tightening
will be appropriate to move inflation down toward our 2 percent target. I think we need
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to move swiftly and decisively to get inflation falling in a sustained way, and then
consider what further tightening will be needed to achieve our dual mandate.