Lisa D Cook: The US economic outlook and monetary policy
Speech by Ms Lisa D Cook, Member of the Board of Governors of the Federal Reserve
System, at the 2023 Midwest Economics Association 87th Annual Meeting, Cleveland,
Ohio, 31 March 2023.
* * *
Thanks to President Kasey Buckles and the program committee for affording me the
opportunity to give the C. Woody Thompson Memorial Lecture. It is a pleasure to be
back in the Midwest. Before joining the Federal Reserve, I taught economics at
Michigan State University, which I chose for its bird's-eye view of the industrial Midwest.
Big 10 rivalries aside, Ohio and Michigan share quite a lot, including many of the same
economic concerns and interests.
Today I would like to outline my views on the trajectory of U.S. economic developments
and what they imply for the appropriate path of monetary policy.1
This is an especially challenging time to be an economic analyst or policymaker. Recent
developments in the banking sector have added to existing uncertainties about recovery
from the pandemic shock and developments abroad. In that context, the economic and
policy outlook needs to balance data dependence with forward-looking analysis. Recent
data show greater momentum in inflation and economic activity, but recent banking
developments may suggest greater headwinds for financial conditions and the economy
going forward.
The U.S. economy
Assessing the current state of the economy requires revisiting the pandemic and its
economic repercussions. From the perspective of the NBER Business Cycle Dating
Committee, the 2020 recession was unprecedented. Of the 35 recessions since 1858,
only 8 spanned months in the single digits from peak to trough. The one in 2020 was
severe, but it spanned only two months from peak to trough and was the shortest
recession on record.
However, the pandemic's economic effects reverberated through 2021 and 2022.
Inflation surged during the recovery amid pandemic-induced disruptions to supply, while
demand for goods was boosted by a shift away from in-person services, and overall
demand was supported by monetary and fiscal policy. Russia's invasion of Ukraine in
February 2022 was a further supply shock to the global economy, driving up prices for
energy and other commodities. Last June, U.S. inflation hit a peak of 7 percent as
measured by the 12-month change in the personal consumption expenditures (PCE)
index.
In response, the Federal Reserve has been using its monetary policy tools to restore
price stability by bringing demand into line with still-constrained supply. Over the past
year, we have raised the federal funds rate nearly 5 percentage points and have begun
to reduce the size of our balance sheet.
As a result, financial conditions have tightened significantly. Borrowing costs have risen,
equity prices have declined, and the dollar has appreciated on net.
Interest-sensitive sectors of the economy have slowed. Residential investment
subtracted nearly 1 percentage point from gross domestic product growth last year, as
housing demand was curtailed by higher mortgage rates. Business fixed investment
held up last year but appears to have slowed more recently. Manufacturing activity has
slowed in response to tighter financing conditions, the stronger dollar, and some
retracement of the pandemic-related shift from services to goods.
As energy prices have moderated and supply disruptions have eased, inflation has
started to abate. However, the process of returning inflation to 2 percent has a long way
to go and is likely to be uneven and bumpy.
Indeed, the inflation picture is less favorable than it appeared earlier this year. Part of
the encouraging disinflation initially observed in the fourth quarter of last year was
revised away, while inflation over the first two months of this year came in high.
The inflation data show some persistence. The 3-, 6-, and 12-month changes in
February prices for the core PCE index-excluding food and energy-are all around 4-1/2
to 5 percent. Housing services inflation continues at a rapid monthly clip, contributing
much more to inflation than it did before the pandemic. Inflation in non-housing core
services remains sticky at elevated levels. Even core goods prices rose in January and
February, after three months of declines, highlighting the uneven nature of the
disinflationary process.
Even so, several factors are likely to contribute to disinflation. Long-term inflation
expectations remain well anchored, and shorter-term expectations have retraced much
2
of last year's rise. Rent increases on new leases have slowed sharply over the past six
months, which should begin to pull down measured housing-services inflation over the
course of this year. Moreover, significant supply of multifamily housing is coming online,
which should take further pressure off the rental market.
Core goods inflation should continue converging toward its pre-pandemic trend of
slightly negative numbers, as supply chains continue to heal and demand for goods
continues to slow. Rebounding automobile production should help prices for new and
used cars continue to moderate as cars become more available. More broadly in the
economy, profit margins may narrow as buyers become more price sensitive and pull
back on spending. Earnings calls from nonfinancial corporations already show
increasing awareness of resistance to price increases.
Non-housing core services inflation is a broad category that accounts for more than half
of the core PCE index. Inflation in that category looks quite persistent amid strong
postpandemic demand for travel, dining out, and medical care. Disinflation in these services
will likely require some combination of slowing demand and further recovery in supply.
One potential avenue of disinflation is that a decline in prices for some goods may help
lower related services prices. For instance, an eventual retreat in car prices may feed
into lower prices for car insurance, repairs, and rentals, reversing some of their
increases over the past two years.
Another potential source of disinflation is that wage growth has moderated somewhat,
even as the labor market remains very strong by most measures. Payroll employment
growth was extraordinarily robust in January and February, unemployment remains
near record lows, and job openings remain very elevated.
Nonetheless, there are some signs that the labor market is softening at the margin. The
Federal Reserve Board staff's measure of private employment using data from the
payroll processing firm ADP suggests that job gains slowed in January and February.
Job postings from Indeed show a noticeable decline. And the quits rate has retraced
more than half of its pandemic-era rise, falling steadily from a 3 percent peak in late
2021 to 2.5 percent in January. That could be significant, as much of the surge in wage
growth a year ago may have been driven by outsized wage gains of those changing
jobs and by employers raising wages to retain existing workers.
This wage moderation may partly reflect some improvement in labor supply. Labor force
participation edged up to 62.5 percent in the most recent data. Prime-age participation
is now back to pre-pandemic levels. In addition, new estimates show higher population
growth over the past year amid a rebound in immigration.
Over time, there is reason to believe that rising productivity also may aid supply. I see
three potential sources of rising productivity growth.
First, increased innovation associated with the spurt of new businesses since the onset
of the pandemic may raise productivity. Second, current labor shortages are spurring
increased investment in automation that should boost labor productivity over time.
Finally, a recent paper by David Autor, Arin Dube, and Annie McGrew suggests another
3
way that the strong labor market could boost productivity. They find that faster wage
gains for lower-paid workers have come from job-switching to higher-wage firms, which
may also be more-productive firms.
Currently, however, supply in the economy continues to be insufficient to meet
stillrobust demand. Importantly, consumer spending has gained steam this year after
slowing late last year. Consumer spending is being supported by robust growth in
households' real disposable income amid strong employment growth. Strong household
balance sheets have also supported spending, although lower-income consumers
appear to have mostly exhausted their excess savings.
Altogether, the incoming data would suggest a somewhat higher inflation rate for this
year and stronger economic growth. However, I am closely watching developments in
the banking sector, which have the potential to tighten credit conditions and counteract
some of that momentum.
The U.S. banking system is sound and resilient. The Federal Reserve, working with
other agencies, has taken decisive actions to protect the U.S. economy and to
strengthen public confidence in our banking system. We will continue to closely monitor
conditions in the banking system and are prepared to use all our tools, as needed, to
keep the system safe and sound.
At the same time, I am monitoring overall financial conditions in the U.S. economy,
including indicators of credit availability. I am well aware of the extensive literature
linking monetary policy, credit conditions, economic activity, and inflation. Over the past
15 years, that literature came to be roughly a quarter of the syllabus in the
macroeconomics class that I taught.
A particular focus over my career, including in my December NBER paper with Matt
Marx and Emmanuel Yimfor, is the importance of smaller financial institutions in lending
4
to small and medium-sized firms. Those smaller banks over time have developed
relevant expertise in small-business lending and have worked to maintain relationships
with small firms. Thus, I am attentive to whether recent banking developments will
restrain credit to small businesses, which could slow innovation and growth in potential
output over time.
Data dependence and monetary policy
Turning to monetary policy, I have said frequently that my approach to policymaking in
uncertain times is to be data dependent. And, like everyone, my own research and
experiences shape my views on setting that policy. I was at the Council of Economic
Advisers during the euro-area crisis, and my work on emerging economies-particularly
Russia and some African economies-has taught me how difficult it can be to forecast in
highly uncertain environments.
Taking all these lessons into account, I approach all our monetary policy discussions
with the same mindset:
Be prepared to adjust the outlook based on incoming data while being humble
about our ability to draw firm conclusions and thus not overreacting to a few data
points.
Seek out useful data sources, including high-frequency data that may better
capture evolving economic developments.
And follow a risk-management approach that considers not only the expected
outcomes, but also various risks to the outlook.
Of course, it is tempting to follow the old adage of "never make predictions, especially
about the future." But ultimately, policymaking must be forward-looking, which means
relying, at least in part, on forecasts. The challenge is to figure out which models apply.
For example, when I began studying banks in the post-Soviet era for my dissertation, I
found that the standard models used in normal times and for mature, industrialized
economies are less useful in highly uncertain environments.
Since my first FOMC meeting last June, my data-dependent, risk-management
approach has led me to support the Fed's response of frontloading monetary policy
tightening to bring inflation under control.
After the swift policy response of the past year, monetary policy is now in restrictive
territory. For instance, real interest rates are positive across the yield curve.5
Going forward, I am weighing the implications of stronger momentum in the economy
against potential headwinds from recent developments. On the one hand, if tighter
financing conditions restrain the economy, the appropriate path of the federal funds rate
may be lower than it would be in their absence. On the other hand, if data show
continued strength in the economy and slower disinflation, we may have more work to
do.
The FOMC has been raising rates in smaller increments as we seek a sufficiently
restrictive monetary policy stance to return inflation to 2 percent over time. By taking
smaller steps, we can observe economic and financial conditions and consider the
cumulative effects of our policy actions.
For the econometricians, this approach is similar to the iterative procedure in maximum
likelihood estimation, where large early steps are followed by smaller steps as you
approach the local optimum.
In its March policy statement, the FOMC dialed back its forward guidance on the path of
6
the policy rate. We shifted from anticipating "ongoing increases" to saying that "some
additional policy firming may be appropriate." I think this communication is appropriate
as we seek to calibrate monetary policy to be sufficiently restrictive amid uncertainty
about the economic outlook.
Yet what should not be uncertain is our commitment to our dual-mandate goals of
maximum employment and price stability. We will do what it takes to bring inflation back
to our 2 percent target over time, which will lay the foundation for sustainable strength
in the labor market and the U.S. economy.
1
These views are my own and do not necessarily reflect those of the Federal Reserve
Board or the Federal Open Market Committee.
2
As shown, for example, in surveys from the University of Michigan and the Federal
Reserve Bank of New York.
3
See David Autor, Arindrajit Dube, and Annie McGrew (2023), "The Unexpected
Compression: Competition at Work in the Low Wage Labor Market," NBER Working
Paper Series 31010 (Cambridge, Mass.: National Bureau of Economic Research,
March).
4
See Lisa D. Cook, Matt Marx, and Emmanuel Yimfor (2022), "Funding Black High-
Growth Startups," NBER Working Paper Series 30682 (Cambridge, Mass.: National
Bureau of Economic Research, November).
5
These real interest rates are based on prices from Treasury Inflation-Protected
Securities (TIPS) and inflation swap markets, as well as survey expectations.
6
See Board of Governors of the Federal Reserve System (2023), "Federal Reserve
Issues FOMC Statement," press release, March 22.