Navigating in shallow waters: Monetary policy strategy in a better-balanced economy

Thank you, Kunal [Patel], for the kind introduction. And welcome, everyone, to the Dallas Fed. I am so excited to be here today, to welcome my colleague Jeff Schmid, president of the Kansas City Fed, back to Dallas, and to welcome all of you to the Dallas and Kansas City Feds’ ninth joint energy conference. Thank you, as well, to the dedicated teams from Dallas and Kansas City who have worked so hard to make this event possible and to all of today’s speakers for sharing your expertise with us.

Both the Dallas and Kansas City banks have invested deeply in understanding the energy economy. Together, our districts empower the nation, contributing nearly 40 percent of the U.S. energy sector’s GDP. At the Dallas Fed, we’re committed to leading the energy conversation through our research at the intersection of energy and economics. That research includes academic publications, analysis, surveys and extensive engagement with industry leaders through our Energy Advisory Council, individual outreach and conferences like this one.

Our research teaches us that the energy landscape is constantly evolving. This year’s conference, for example, will focus on how the industry is meeting rising power demand from users such as artificial intelligence data centers that were hardly on the radar just a few years ago. Dialogue with experts like you is crucial to helping us stay abreast of these changes in real time, and I’m so grateful to all of you who share your insights. As the energy industry evolves, the topics we study cover an increasingly wide range. Just this year, the Dallas Fed’s energy team has published analysis on topics from oil sanctions against Russia to the potential for new nuclear generation in Texas. I encourage you to check out our website to access our research, view our survey findings and even sign up to participate in our energy survey panel if your firm is eligible.

Besides energy itself , we’re devoting more attention to the wires, pipes and pumps that move energy from its sources to wherever it’s needed. There is an enormous amount of energy in West Texas, for example—in the hydrocarbons under the ground, in the wind and in the sun’s rays. But whether that energy can move out of West Texas to meet the world’s demand depends on the capacity and resilience of infrastructure such as ports, pipelines, electric grids and liquefied natural gas (LNG) facilities.

As part of my own learning about energy infrastructure, I recently visited some of our Texas ports and got to observe oil tankers and LNG carriers up close. Seeing these enormous ships in person brought to mind an essay I once read about how captains train to safely and effectively pilot them. [1] A key lesson was that the right way to maneuver a ship depends on the depth of the water. In shallow harbors, water becomes trapped between the ship bottom and the seafloor and drags along with the ship as it moves, making the vessel more difficult to steer. The faster the ship goes, the more water it displaces and the greater this difficulty becomes. Moreover, captains can’t always be sure precisely how deep the water is, because sometimes the depth finder registers mud on the seafloor as water. And so in water that’s shallow, or that might be shallow, captains learn to slow down, take their time and maneuver carefully.

I may never have the opportunity to pilot a VLCC [2]—though if anyone here today can help me out with that, please see me afterward—but reading about this topic i sn’t purely recreational for me. These lessons also have relevance for me as a central banker.

The Federal Open Market Committee (FOMC) has made a great deal of progress bringing down inflation and restoring balance to the economy. In light of that progress, I’ve supported the FOMC’s decisions at recent meetings to reduce interest rates toward a more neutral level—to dock the ship. But as the economy nears the harbor, it becomes more important to understand just how deep the water is. And with less room to maneuver, monetary policymakers need to be more prepared for winds and waves that could push us off course. Just like a ship captain, I think it behooves us to proceed cautiously at this point.

In the rest of my remarks, I’ll review the economic and monetary policy outlook, with an emphasis on how maneuvering cautiously and taking time to learn can help manage some key risks. As always, these views are mine and not necessarily those of my FOMC colleagues.

The economic outlook

The first time I spoke at this conference was two years ago, and as I’m sure you recall, inflation back then was much too high. The FOMC aims for 2 percent annual inflation as measured by the price index for personal consumption expenditures, or PCE. But as of mid-2022, prices had risen more than 7 percent since a year earlier. Soaring prices strained the budgets of families and businesses and had the potential to destabilize our economy over time.

At the same time, the labor market was incredibly strong—by many measures, unsustainably so. With companies adding jobs faster than the labor force was adding workers, wages surged. While those higher wages weren’t enough for many workers to keep pace with the cost of living, the wage pressures threatened to cause businesses to raise prices even more.

The FOMC responded by rapidly tightening monetary policy. We raised the target range for the federal funds rate by 5.25 percentage points from early 2022 through mid-2023. We also began running off securities holdings that we had accumulated to support the economy during the pandemic.

These measures helped bring the economy into much better balance. The most recent annual PCE inflation reading was 2.1 percent. Progress on inflation has been broad based; it’s not just a few outlying price categories that have cooled. You can see that in the Dallas Fed Trimmed Mean PCE inflation rate, which removes outliers and has fallen from a peak of 5 percent two years ago to 2.65 percent on an annual basis in September. At the same time, that 2.65 percent reading suggests we’re not quite back to price stability yet. While the Fed’s inflation target covers the prices of all consumer goods and services, measures like the trimmed mean that exclude volatile outliers can provide a better read than the headline number on where overall inflation will head in the future.

Meanwhile, economic activity remains resilient, according to both national statistics and more timely but less formal reports from business and community leaders. The Dallas Fed’s contacts overwhelmingly describe a strong economy with robust consumer demand and fading downside risks. And the labor market has been cooling gradually, not weakening materially. Unemployment held steady in October, and although strikes and hurricanes brought payroll job growth to a temporary halt that month, job gains from July through September averaged close to estimates of the amount needed to keep pace with population growth.

After a voyage through rough waters, we’re in sight of the shore: the FOMC’s Congressionally mandated goals of maximum employment and stable prices. But we haven’t tied up yet, and risks remain that could push us back out to sea or slam the economy into the dock too hard.

The economy, of course, is subject to a wide range of risks. But I am paying particular attention to three that, in my view, pose the largest potential challenges for monetary policy in the months ahead.

• One, unexpectedly strong demand or negative supply shocks could keep inflation above the FOMC’s 2 percent goal.
• Two, tightening financial conditions could trigger a rapid deterioration in the labor market.
• Or, three, financial conditions could ease too much if the neutral interest rate, the theoretical level that would neither slow nor accelerate the economy, proves to be higher than expected.

I’ll discuss each of these risks in turn.

Upside risk to inflation

First, returning inflation to target requires keeping aggregate demand in balance with aggregate supply. Yet strong demand persistently pushed real activity above forecasters’ projections in 2024. And the supply side of the economy, though currently healthy, has experienced unusually disruptive shocks in recent years. Both dynamics pose upside risks to inflation.

In late September, the Bureau of Economic Analysis issued its annual revision of the National Economic Accounts. Personal income turned out to be significantly higher than previously estimated. This finding helped explain why spending has been strong, and it resolved a mystery about the savings rate, which the data now show is at a relatively normal level rather than historically low. But higher incomes could also push consumption above current forecasts. The implications aren’t entirely clear-cut, however. If higher incomes and spending result from stronger productivity growth, they may not mean demand is moving out of balance with supply.

I also keep hearing about a possible post-election surge in business investment. All fall, companies said they knew they were going to invest, but they were waiting to see the contours of fiscal and regulatory policies before deciding how to invest. With the election complete, some of that uncertainty is resolved. Just like consumption, a rise in investment could push upward on inflation.

On the supply side, I remain attentive to inflation risks from potential supply chain disruptions and geopolitical developments. The recent port strike was too short to leave a lasting mark, but workers and port operators have agreed to revisit their contract in January, so risks remain. Strains on electric grids represent another potential source of supply bottlenecks. I am also closely watching the conflict in the Middle East. As Federal Reserve Chair Jerome Powell has said, while the human toll is devastating, the Federal Reserve’s institutional role is a limited one: to monitor the economic implications. U.S. and global energy markets are somewhat slack, which has held down risk premiums in oil prices. But the potential for more significant disruptions cannot be ruled out.

Keeping inflation under control also requires well-anchored inflation expectations. Market-based measures of shorter-term inflation compensation have been volatile recently, although longer-term measures remain consistent with the FOMC’s 2 percent goal. If inflation expectations were to become unanchored, the upside risks would only increase.

In coming months, we’ll learn more about how inflation expectations are evolving and how the supply-side risks and consumption and investment are playing out—information that will be valuable for shaping monetary policy.

Downside risk to employment

A second key risk relates to employment. I’m not taking too much signal from the dismal October payrolls print of just 12,000 net jobs added nationwide. It’s too hard to tell how hurricanes influenced that number.

My base case is that the labor market is close to balanced and stable or cooling gradually. That judgment reflects the stable unemployment rate in recent months; the slowdown in job openings, quits and compensation; and positive reports from the Dallas Fed’s business contacts. For instance, employment at temporary help services has been sagging in the national statistics. Weak temp employment can sometimes be a leading indicator of a downturn. But when our team called staffing firms to check on the situation, they told us the statistics reflect post-pandemic normalization and competition from gig-work platforms, not a broader deterioration in the labor market.

Still, I’m not ready to rule out more damaging decreases in employment. Some labor market indicators still show a bit of underlying weakness. The Bureau of Labor Statistics revised down its estimates of payroll job growth for August and September, and you can’t wave off those revisions as the results of hurricanes and strikes that hadn’t yet happened.

Financial conditions represent another source of concern about the employment outlook. Monetary policy influences economic activity only indirectly, because while the FOMC controls the overnight fed funds rate, most households and businesses pay longer-term interest rates that also reflect their creditworthiness. So I closely monitor the evolution of those longer-term rates and other financial market indicators.

Since the FOMC began cutting the fed funds target in September, the 10-year Treasury yield has actually risen by roughly three-quarters of a percentage point. Some of that rise reflects expectations for a higher path of policy rates. And, so far, higher equity valuations and tighter credit spreads have offset the tightening in financial conditions from higher Treasury yields. But a substantial fraction of the increase in long-term yields appears to reflect a rise in term premiums. Term premiums compensate investors for bearing the risk of future interest rate fluctuations. Higher term premiums can tighten financial conditions for any given setting of monetary policy and thereby slow the economy more than the FOMC intends. If term premiums continue to rise, the FOMC may need less restrictive policy, all else equal, to accomplish its goals.

Uncertainty about the neutral interest rate

Uncertainty about the neutral interest rate presents the opposite risk. Besides examining broad financial conditions, economists often consider whether monetary policy is boosting or slowing growth and inflation by comparing the policy rate to a theoretical level, the neutral rate or r-star, that would represent neither a headwind nor a tailwind. That neutral rate is notoriously uncertain and difficult to measure. But you can get a sense for it from economic fundamentals, models, surveys and market prices.

A strategy of repeatedly lowering the fed funds target range toward a more neutral level relies on confidence that the neutral level is materially lower than where rates are now. When I look at the available evidence, though, I see substantial signs that the neutral rate has increased in recent years, and some hints that it could be very close to where the fed funds rate is now.

Structural changes in the economy, such as the energy transition and advances in artificial intelligence, are prime drivers. These developments are fueling strong investment demand and potential increases in productivity. When you all, as energy experts, see a new LNG plant, a solar farm or a data center under construction, you perhaps see sources of energy supply and demand. As a monetary policymaker, I certainly see how these projects change the energy landscape, but what I also see—what you’ll perhaps see after today—is higher investment and a higher neutral rate.

Importantly, uncertainty about the neutral rate has also risen, perhaps because the structural changes in the economy are relatively recent and will take time to fully assess. The FOMC’s own projections display the uncertainty. Four times a year, we release our projections for the fed funds rate as well as unemployment, inflation and GDP growth. Around the FOMC table, participants’ projections for the longer-run fed funds rate now vary by more than 1 percentage point, compared with a spread about half as wide two years ago.

Economists employ a range of models to try to estimate the neutral rate. Like estimates from policymakers and from market participants who fill out surveys, the output of these models ranges widely. Among widely consulted models, point estimates of the neutral real interest rate currently range from 0.74 percent to 2.60 percent. Adding in the 2 percent inflation target, those figures correspond to a neutral fed funds rate of 2.74 to 4.60 percent. Following last week’s rate cut, the fed funds rate stands today at 4.58 percent, right at the top of that range.

Now, I don’t know which estimate is right. Time will tell as the economy evolves and we see how much of a headwind or tailwind the policy stance generates. But when policymakers look at mid-range estimates that suggest there’s meaningful room to cut before reaching neutral, I think we should recall the technique of a ship captain whose depth finder might mistake mud for water. If we cut too far, past neutral, inflation could reaccelerate and the FOMC could need to reverse direction. In these uncertain but potentially very shallow waters, I believe it’s best to proceed with caution.

Conclusion

Let me conclude. Economic activity is strong, inflation is coming down and the economy is approaching a point that can sustainably deliver both maximum employment and stable prices. I anticipate the FOMC will most likely need more rate cuts to finish the journey. But it’s difficult to be sure how many cuts may be needed and how soon they may need to happen. I am keeping an open mind, scrutinizing economic data and financial conditions, and listening carefully to business and community contacts as I assess what next steps may be appropriate for monetary policy.

Thank you for your attention and for joining us today. I look forward to learning from all of you during today’s discussions and to continued engagement with you about both energy topics and the broader economy.

Notes

I am grateful to Sam Schulhofer-Wohl and Rebecca Zarutskie for assistance in preparing these remarks.

1. John McPhee, “The Ships of Port Revel,” The Atlantic Monthly 282(4), October 1998, pages 67–80.
2. Very large crude carrier, a type of tanker that typically carries about 2 million barrels of crude oil.