Financial conditions and the monetary policy outlook
October 09, 2023
Thank you, Greg, for that introduction, and thank you, Julia, for inviting me to speak today. Good morning and welcome to Dallas and the Eleventh Federal Reserve District. It was great to see so many of you at last night’s reception and personally welcome you to the region.
As some of you may know, I am proud to have Pia Orrenius, who is just completing her service as a NABE director, and Roberto Coronado, who is starting his term as a director, on my leadership team at the Dallas Fed. Two of our former research directors, Harvey Rosenblum and Mine Yücel, have served as president of NABE. Together with my colleagues, I am working to continue the Bank’s thought leadership in economics. And we greatly value our collaboration and partnership with NABE.
The Eleventh District in 2023 is a highly diversified and globally connected economy—transformed from the heavy concentrations in cotton, cattle and oil as recently as the 1980s. The region has grown to include a sizable high-tech industry in Austin, solid manufacturing in Fort Worth and Arlington, a global energy capital in Houston, and a vibrant finance and professional services sector here in Dallas.
It’s been a little over a year since I came here as president and CEO of the Dallas Fed. In that time, I have visited with business owners and community leaders from small towns, oil drillers and solar farm operators in the Permian Basin, tech executives in Austin, and CEOs of some of the biggest companies in our largest metro areas. These conversations are so important because they provide a deeper understanding of the region’s economic landscape as we work to advance an economy where everyone has opportunities to thrive.
In diversifying its economic base, the Eleventh District has in many ways become more similar to the nation over time. The oil booms and busts that once ruled the region have diminished in impact, and the region’s business cycle looks more similar to the nation’s. But the region still has many unique features that set it apart from the rest of the country. The dynamism here is visible every day, driven by in-migration of people and businesses and adding to the economic growth that consistently outperforms the national average.
Understanding the trajectory of our regional economy and connecting with regional businesses have been particularly valuable to me in my role contributing to the formulation of monetary policy on the Federal Open Market Committee (FOMC). Aggregate statistics can get us only so far in understanding the economy. They are often backward looking and subject to revision. Information from business contacts provides context on the reasons underlying economic developments. And reports from these contacts can be more timely than aggregate statistics, especially when the economy is near turning points. So, the Dallas Fed’s Texas Business Outlook Surveys and my conversations with business leaders provide a critical complement to the hard data. This has never been more true than in recent months as the economic picture has become more complex.
Today, I’d like to share how I’m seeing the economic outlook and how financial conditions are influencing my perspective on monetary policy. As always, the views I share are not necessarily those of my FOMC colleagues.
The economic outlook
I remain focused on returning inflation to our 2 percent target. 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 undermine the long and stable expansions that particularly benefit the most vulnerable in society.
Over the summer, we saw welcome progress on inflation. However, the monthly inflation data have been somewhat uneven. Smoothing through the monthly fluctuations can give a more accurate picture. Of course, waiting to declare victory until 12-month inflation rates get all the way back to target would be a recipe for undershooting our inflation target. So, I see averages over three or six months as a sensible middle ground to watch.
In formulating my inflation outlook, I also focus on measures like core and trimmed mean that drop volatile categories and one-off factors. These measures typically give a more reliable sense of where headline inflation will trend.
The most recent release of the FOMC’s preferred inflation gauge, the price index for personal consumption expenditures, or PCE, showed some further improvement. Through August, the three-month PCE inflation rate excluding food and energy, or core PCE inflation, was 2.2 percent. The three-month Dallas Fed trimmed mean was 2.6 percent. Measured over six months, core has fallen to 3 percent and trimmed mean to 3.1 percent. These developments are encouraging, but it is still too soon to say with confidence that inflation is headed to 2 percent in a sustainable and timely way.
The labor market is also an important input to my assessment of the economic outlook. Employment is important in its own right as one leg of the FOMC’s dual mandate. And restoring balance in the labor market after the pressures of recent years will be important to restoring price stability and sustaining it over time.
While the job market isn’t as hot as it was a year ago, it remains very strong overall. The U.S. economy has been adding more than 250,000 jobs per month. That’s significantly more than enough to keep pace with trend growth in the labor force. My Eleventh District business contacts continue to report tight hiring conditions. Of those seeking more workers, more than half still say a lack of applicants impedes hiring. Data such as the quits rate, the ratio of vacancies to unemployed workers, and surveys of consumers and businesses show progress toward better balance. Many of these measures are near or at 2019 levels. However, 2019 was a very strong labor market. Conditions like those of 2019 don’t necessarily mean labor supply and demand are in balance.
And wage growth remains solid. Many national and regional statistics continue to show that wages are rising faster than would be consistent with 2 percent inflation in the long run, given typical estimates of trend productivity growth. In the Dallas Fed’s latest regional survey on labor costs, Texas businesses penciled in 5 percent wage growth for this year. That’s down slightly from the last time we asked the question. But higher labor costs are now tied with higher input costs as our survey respondents’ top reason for raising their selling prices.
Output and spending have come in surprisingly strong in 2023. GDP growth has been at or above 2 percent for the past year. Growth in the third quarter is tracking to be even stronger. The strength is broad based. Consumption is robust, business investment is solid, the drag from the housing sector has declined, and recession fears have faded.
Some of my contacts highlight a significant increase in manufacturing and nonbuilding construction, both nationally and in this region. The number of manufacturing construction projects in Texas is the highest in 22 years. With so many projects in the pipeline, construction contract values are also at record highs. Some of this activity appears related to initiatives to spur clean energy, infrastructure and the domestic semiconductor industry.
But my business contacts do report mixed outlooks for the consumer. Some anticipate continued strength, while others are finding it difficult to pass through cost increases or are noticing softer growth.
Putting all this information together, I expect that continued restrictive financial conditions will be necessary to restore price stability in a sustainable and timely way. I remain attentive to risks on both sides of our mandate. In my view, high inflation remains the most important risk. We cannot allow it to become entrenched or reignite.
The role of financial conditions
You’ll note that I referred to restrictive financial conditions rather than to the setting of the federal funds rate. That’s because, while the FOMC controls the overnight fed funds rate, households and businesses usually borrow at longer tenors. Longer-term rates therefore influence economic activity more directly than does the fed funds rate. Yet the relationship between the fed funds rate and longer-term rates is not fixed. So, in setting the stance of monetary policy, the FOMC needs to account for how that stance will translate to the broader financial conditions, including long-term rates as well as credit spreads and other factors, that influence economic activity. In addition, broader financial conditions can contain important information about how market participants are seeing the economic outlook.
Financial conditions tightened substantially in recent months. Much of the tightening came from movements in longer-term interest rates. Higher long-term interest rates have also contributed to equity price declines and dollar appreciation over recent months. In the remainder of my remarks, I’ll discuss how I interpret the rate moves and what they might mean for monetary policy.
Since the July meeting, the yield curve has steepened notably. The market-implied peak fed funds rate is little changed, and policy-sensitive rates through 2025 are 60 basis points higher. But the 10-year Treasury yield is up roughly 90 basis points, and the five-year yield, five years forward, is almost 130 basis points higher.
Importantly, the rise in rates has come almost entirely in real interest rates. Inflation compensation has hardly moved. Market participants remain confident, as they should, that the FOMC will achieve the inflation target.
Interpreting the rate increases
A term interest rate can be broadly decomposed into the expected average level of overnight rates plus a term premium that compensates for the risk of interest rate fluctuations.
Conceptually, therefore, there are several reasons why longer-term rates may have risen. First, market participants may anticipate that the economic data will call for a higher fed funds rate target in the next few months or years. Second, market participants may judge that overnight rates will be higher, on average, over the long term, as a result of lasting changes in the structure of the economy or financial system. And, third, term premiums may have increased.
A rise in term premiums can itself have many drivers, including increases in the stock of debt relative to investors’ demand for debt, changing correlations between the returns on different asset classes—which can influence the portfolio diversification properties of long-term bonds—and reductions in expectations for the Federal Reserve’s asset holdings.
The July FOMC minutes indicated that runoff of the Federal Reserve’s balance sheet “need not end when the Committee eventually begins to reduce the target range for the federal funds rate.” In my view, while it is far too soon to think about rate cuts in our monetary policy strategy, there will presumably come a time when we are returning the fed funds rate to a neutral level from above. Normalizing the fed funds rate in that way would be entirely consistent with continuing to normalize our asset holdings. Additionally, the more than $1 trillion of balances in the overnight reverse repurchase agreement facility leave plenty of room to reduce our balance sheet without making bank reserves scarce. As market participants have taken on board these perspectives on the balance sheet, market expectations for the end of runoff have shifted out. In turn, the expectation of lower Federal Reserve asset holdings over time implies that other investors will need to hold more long-duration securities, which appears to be one factor among the many contributing to higher term premiums.
The decomposition of changes in yields into near-term rate expectations, long-term rate expectations and term premiums matters for monetary policy.
Near-term policy-sensitive rates rose on a number of occasions in recent months in response to strong economic data. Market participants understand that, to the extent stronger economic growth poses risks to inflation, the FOMC may need to offset that strength with higher interest rates.
Economic data can also lead market participants to reassess their outlooks for the average level of overnight rates that will be consistent with achieving the FOMC’s goals over the long run. For example, the economy has shown surprising resilience over the past year in the face of sustained real interest rates north of 1.5 percent. I’m starting to take some signal from that resilience, not only about the rates needed to restore price stability in the next few years, but also about the rates that will need to prevail to sustain price stability and maximum employment over a much longer horizon.
And higher term premiums have a different implication altogether. Higher term premiums result in higher term interest rates for the same setting of the fed funds rate, all else equal. Thus, if term premiums rise, they could do some of the work of cooling the economy for us, leaving less need for additional monetary policy tightening to achieve the FOMC’s objectives.
The persistence of all these changes also matters. If technical factors are temporarily raising term premiums, for example, monetary policy shouldn’t overreact.
Decomposing yield changes
Although the decomposition of yield curve moves is an important input into appropriate monetary policy, calculating this decomposition is anything but straightforward. Surveys, term structure models, event studies and anecdotal information from market participants can all shed light on the decomposition. But each of these techniques requires critical assumptions, and they ultimately deliver mixed results.
Survey-based decompositions suggest a limited rise in expected overnight rates and a large role for term premiums. The simplest way to identify the expected overnight rate is to survey informed professionals. In fact, the New York Fed’s surveys of primary dealers and market participants ask this very question. A term premium can then be estimated by subtracting the surveyed expectation of overnight rates from a zero-coupon Treasury yield. In July, the median modal primary dealer expectation for the average fed funds rate over the next 10 years was just under 3 percent, implying a 10-year term premium of 80 basis points based on market rates at the time of the survey. The September survey has not yet been publicly released. But market contacts mostly say their expectations for the average fed funds rate changed little over the summer, suggesting a good share of the rise in longer-dated yields reflects increased term premiums.
Of course, the survey-based approach has shortcomings. Modal expectations don’t reflect the distribution of risks. If that distribution skews up or down, the expected value of the overnight rate could differ from median modal expectations. Respondents to the Open Market Trading Desk’s surveys may not be representative of the market more broadly. And survey results tend to be inertial. Respondents may be disinclined to adjust their reported expectations until they have high conviction that a change is warranted.
Term structure models can overcome some of these drawbacks, but estimates can vary dramatically depending on model specification and inputs. Two commonly cited models were built by current and former Fed economists: the Kim-Wright model and the Adrian, Crump and Moench, or ACM, model. The Kim-Wright model estimates that about one-third of the increase in 10-year Treasury yields since the July FOMC meeting is from a higher expected policy rate path, with the other two-thirds reflecting higher term premiums. The ACM model, on the other hand, estimates a decline in the expected path of future short-term rates and an increase in the 10-year term premium of 115 basis points. That includes a roughly 55-basis-point increase since the September meeting. The marked divergence in signals provided by these two models underscores just how sensitive model-based results are to modeling decisions, especially over short windows. In this case, the key difference is that the KW model incorporates Blue Chip surveys of short rate expectations in the data used for estimation.
A third approach is to evaluate whether yield moves on specific days or in specific time intervals were driven primarily by changes in the expected path of short rates or by shifts in the price of duration risk. Yield changes in response to economic data surprises or to Fed communications on rate policy might reasonably be assigned to changes in interest rate expectations. Yield moves on news unrelated to Fed rate policy might be chalked up to term premiums. This approach is subject to a great degree of judgment but can deliver ballpark results. My back-of-the-envelope estimates using this approach suggest that more than half of the total increase in long-dated yields since the July FOMC reflects rising term premiums.
Market participants’ perspectives can supplement these calculations. My staff and I are in frequent touch with contacts including investors and traders at pension funds, leveraged funds and other firms that are part of Texas’ growing financial market industry.
Putting together analytic estimates with the information I have gathered through these channels, I see a mixed story. There is a clear role for increased term premiums in recent yield curve moves. But the size and persistence of the contribution are subject to uncertainty.
So, what does this mean for monetary policy? As I said earlier, inflation remains too high, the labor market is still very strong, and output, spending and job growth are beating expectations. I anticipate that we will need continued restrictive financial conditions to return inflation to 2 percent in a timely way and sustainably achieve our goals of maximum employment and price stability.
Financial conditions have tightened notably in recent months. But the reasons for the tightening matter. If long-term interest rates remain elevated because of higher term premiums, there may be less need to raise the fed funds rate. However, to the extent that strength in the economy is behind the increase in long-term interest rates, the FOMC may need to do more. So, I will be carefully evaluating both economic and financial developments to assess the extent of additional policy firming that may be appropriate to deliver on the FOMC’s mandate.
I am grateful to Sam Schulhofer-Wohl for assistance in preparing these remarks.
The views expressed are my own and do not necessarily reflect official positions of the Federal Reserve System.