Restoring price stability requires careful calibration
September 07, 2023
Thank you for that kind introduction, Dom [Haskett].
I was just at the Jackson Hole Economic Symposium, where the Kansas City Fed gathers central bankers and researchers at Grand Teton National Park to discuss the latest global economic issues.
Visiting the Wyoming mountains reminded me of being in the Girl Scouts growing up. I cherished evenings around the campfire with my friends. But you can stay up only so late and eat only so many s’mores. Eventually, you have to put the fire out.
Now, as every Scout knows, when you put out your campfire, you must make sure it is “cold out”—so completely extinguished that you feel no heat when you touch the ashes with your bare hands. Any warm embers could reignite later.
The traditional way to make sure a fire is cold out is to pour water on it—lots of water—until you have eliminated every last bit of heat.
That is a good way to put out campfires, but I will argue today that it is not a good way to put out inflation. The Federal Open Market Committee (FOMC) is strongly committed to our 2 percent inflation target. After the unacceptably rapid price increases of the past several years, I’m not yet convinced that we’ve extinguished excess inflation. But in today’s complex economic environment, returning inflation to 2 percent will require a carefully calibrated approach—not endless buckets of cold water.
Before I go any further, I’ll just note that the views I express are mine and not necessarily those of my colleagues on the FOMC.
The inflation outlook
Let me start with why we need to put out inflation. Congress has charged the FOMC with setting monetary policy to pursue maximum employment and stable prices.
While the labor market is very strong, inflation over the past several years has been much too high. The FOMC aims for 2 percent annual inflation as measured by the price index for personal consumption expenditures, or PCE. But prices rose 6 percent in 2021 and 5.3 percent in 2022 and continued to rise, at a 3.2 percent annual rate, in the first seven months of this year.
People count on the Federal Reserve to keep our commitment to price stability. When inflation is high, people’s incomes fall short of the rising cost of living. Businesses can’t plan well because they don’t know what they’ll pay for materials or be able to charge their customers. And, over time, high inflation tends to make the business cycle more volatile, undermining the long and stable expansions that particularly benefit the most vulnerable in society.
To help bring the economy into better balance, the FOMC has raised the target range for the federal funds rate by 5.25 percentage points since early 2022. We’re also reducing our asset holdings. The significantly lower inflation in recent months is encouraging. But lower inflation isn’t necessarily low-enough inflation. We have to ask whether monetary policy is now sufficiently restrictive to return inflation all the way to 2 percent in a sustainable and timely way or whether the FOMC still needs to do more.
Forecasts are inherently uncertain. My base case, though, is that there is work left to do.
The monthly inflation rate has been around 2.5 percent for the past couple of months. But monthly inflation data can be volatile, and extreme changes in prices for one good or another can also push the numbers around. To get a clearer signal of where overall inflation is headed, it’s helpful to filter out some of the more volatile prices. For example, we can take out the prices of food and energy and look at the core inflation rate. Over the past three months, it was 2.9 percent. And the Dallas Fed trimmed mean inflation rate was 2.8 percent over that period. These numbers indicate it is too soon to confidently say inflation will trend to 2 percent in a timely way.
Labor market conditions also suggest we haven’t finished the job of restoring price stability. To sustain low inflation, supply and demand need to be in balance. Last year, labor demand greatly outpaced supply. Payroll growth and job openings soared. The unemployment rate fell to a half-century low. Today, some indicators, like job openings and the percentage of workers quitting their jobs each month, show substantial progress toward better balance. Yet, overall, the labor market remains very strong. For example, the U.S. economy is adding an average of about 150,000 jobs per month. That’s more than enough to keep pace with trend growth in the labor force.
Wage data show that many employers still have to compete hard to attract and retain workers. Wages nationally have been growing at an annual rate of more than 4 percent by a variety of measures, compared with 3 percent in 2019. Respondents to the Dallas Fed’s business surveys tell us significant wage pressures remain, though they’re less severe than a year ago. To sustain 2 percent inflation over time, wage growth will need to fall, or trend productivity growth will need to rise.
Moreover, the early data for the current quarter suggest economic activity is picking up—contrary to expectations all year that the economy would slow down. Retail sales and real consumption both came in high in July. Residential construction seems to be rebounding from the effects of higher interest rates.
The initial data on a quarter can be noisy. The picture could change. But if stronger economic activity continues, it could lead to a resurgence of inflation.
Monetary policy strategy
So, if the job doesn't appear to be done, why do we need to proceed carefully? The economic outlook isn’t certain. Tighter financial conditions might slow the economy without much further action by the FOMC. And there are risks to doing both too little and too much.
The strong July data might be a blip. If the economy cools, inflation would be more likely to fall. The economy’s strength might not even be a bad sign for inflation if that strength reflects improvements in labor supply or increases in productivity.
Financial conditions also tightened noticeably in the weeks after the July FOMC meeting. The 10-year Treasury yield rose by nearly 50 basis points before retracing partway. And the average 30-year mortgage rate at one point was up 42 basis points, reaching the highest level since 2001.
Part of these moves came in response to strong economic data. Market participants understand that the FOMC may need to offset economic strength with higher interest rates. If, as in my base case, stronger growth poses risks to inflation, the FOMC will need to follow through on that expectation.
But news unrelated to monetary policy also pushed market rates up. That means households and businesses face more-restrictive financial conditions for the same setting of the federal funds rate. To the extent that tighter conditions from this source persist, they should slow the economy and, potentially, require less additional tightening of monetary policy.
In this environment, the stance of policy needs to be calibrated carefully. Tightening too little would allow above-target inflation to persist. If high inflation becomes entrenched, restoring price stability could require much larger and more costly rate increases. However, excessively restrictive policy would also hurt households and businesses and might even lead inflation to undershoot our 2 percent target.
A year ago, we were raising interest rates very rapidly—by 75 basis points at each of four consecutive FOMC meetings—to catch up after inflation had surged far too high. But the FOMC cannot safely throw bucket after bucket of cold water on the economy just in case inflation catches fire again. If we did that, not only inflation but economic activity itself would soon be “cold out”—which is not an outcome we want.
So, at this stage, I believe we must proceed gradually, weighing the risk that inflation will be too high against the risk of dampening the economy too much. You might say we need to drizzle water on the firepit and watch closely for signs that the coals are heating up again.
Last fall and winter, we slowed the pace of rate increases to 50 and then 25 basis points per meeting. The slower pace allowed us to carefully assess the data and reduce the risk of an abrupt and nonlinear deterioration in the economy.
We further slowed the pace by skipping a rate increase at our June meeting before increasing again in July. And another skip could be appropriate when we meet later this month.
But skipping does not imply stopping. In coming months, further evaluation of the data and outlook could confirm that we need to do more to extinguish inflation. The FOMC will need to keep the water bucket close at hand, and we must not hesitate to use it as necessary. But we must also gather the necessary information to use our tools well. This carefully calibrated approach can help us to sustainably achieve our goal of maximum employment and price stability.
The views expressed are my own and do not necessarily reflect official positions of the Federal Reserve System.