Opening remarks at the Panel on Policy Challenges for Central Banks, 2023 annual meeting of the Central Bank Research Association

Thank you for that kind introduction, Trish [Mosser]. It’s great to be back at the School of International and Public Affairs and to have the opportunity to discuss current policy challenges with you, Don [Kohn] and Guillermo [Ortiz].

I’d like to begin with some thoughts on the economic outlook and the monetary policy response. These views are mine and not necessarily those of my Federal Reserve colleagues.

To put it concisely, I remain very concerned about whether inflation will return to target in a sustainable and timely way. And I think more-restrictive monetary policy will be needed to achieve the Federal Open Market Committee’s (FOMC’s) goals of stable prices and maximum employment.

The economic outlook

Both inflation and the labor market came in hotter than expected over the first half of 2023. As of December, professional forecasters expected year-over-year core personal consumption expenditures (PCE) inflation to slow to 4.3 percent in the first quarter of 2023, and the unemployment rate to rise to 3.9 percent. In actuality, core PCE inflation for the first quarter was 4.7 percent, and the unemployment rate averaged 3.5 percent.

While the final data for the second quarter aren’t in yet, it was clearly pretty hot, too. Core and trimmed mean inflation measures continued to run around 4 percent—twice our target. Statistics like these that filter out especially volatile prices give an important signal of where overall inflation is headed. And while labor market indicators have eased, the overall pace of rebalancing remains slower than previously expected.

The economy has added an average of 314,000 jobs per month this year. Job openings remain far above the 2019 level. Layoffs remain low. There is no indication of an abrupt deterioration in labor market conditions.

Wage growth remains around 4.5 to 5 percent. The Dallas Fed’s business survey respondents expect roughly 5 percent wage growth over the next year, similar to what they expected at the end of last year. And they cite labor costs as a key driver of higher selling prices.

Some people say a lot of further cooling is in store from lagged consequences of the rate increases the FOMC has already made over the past year and a half. I’m skeptical about the potential for large additional effects from this channel.

The lags have to be measured from the right starting point. Broad financial conditions matter more for economic activity than the policy rate itself. Of course, financial conditions respond to the policy rate and, in particular, to market participants’ expectations for the future path of the policy rate. And so, in the current cycle, financial conditions began to tighten in early 2022—a year and a half ago, and a few months before the FOMC began actually raising rates—as soon as market participants started to expect rate increases. The last major tightening in financial conditions came around the FOMC meeting last September, more than nine months ago. So, although some sectors of the economy will be slower to respond, we have already had a fair amount of time to see the overall effects of monetary tightening.

Moreover, the housing market even looks like it may have bottomed out. Housing starts and home prices have trended up since January. Market rents had been roughly flat at the end of last year but rose at around a 4 percent annual rate in the first four months of this year. While housing inflation will likely continue to soften in the near term as a result of progress on rents last year, a rebound in housing would pose an upside risk to inflation down the road.

Monetary policy

The continuing outlook for above-target inflation and a stronger-than-expected labor market calls for more-restrictive monetary policy.

Credit conditions are continuing to evolve, but based on what we’ve seen so far, tighter credit conditions don’t seem likely to fully offset the need for a higher policy rate. While banking stresses captured headlines this spring, bankers have been cutting back on credit availability since the fall. And the Dallas Fed’s banking contacts say the main reason is tighter monetary policy, not banking stresses. So, at this point, I view credit conditions mainly as the result of the FOMC’s policy stance, not as a separate factor to adjust for. Moreover, banking stresses have calmed since March. Commercial real estate remains a risk, but not uniformly; the challenges are concentrated at some banks and some types of properties, especially office.

While the Fed must remain ready to respond if banking stresses reignite, we have strong liquidity tools, and we know how to use them. Our actions in March showed that. These liquidity tools give us the space to continue setting monetary policy appropriately for our dual-mandate goals.

I also don’t expect the near-term dynamics of the Federal Reserve’s balance sheet to create liquidity pressures that would call for a change in monetary policy strategy. Following the resolution of the debt ceiling, some market participants argued that the rebuild of the Treasury General Account (TGA) balance—coming on top of the ongoing runoff of the Fed’s asset holdings as we return to a more normal level of monetary accommodation—would drain regional banks’ reserves, pose a new risk to financial stability and meaningfully tighten financial conditions. But that wasn’t my expectation, and it hasn’t happened so far. In the weeks since the debt ceiling was resolved, Treasury has issued more than $450 billion in net new marketable debt—mainly Treasury bills—to rebuild the TGA and finance government spending. As investors such as money market funds and foreign central banks buy that debt or lend against it in repo markets, they have pulled a net $340 billion out of the Fed’s overnight reverse repo (ON RRP) facility and foreign and international monetary authorities’ reverse repo pool. Those shifts have largely offset the $360 billion growth in the TGA through last week and, in combination with other balance sheet components, left reserve balances little changed.[1]

My base case is that most of the TGA rebuild will continue to come from ON RRP balances or from reserves at very large banks. We’ve seen over time that even modest yield differentials are enough to encourage money market funds to move balances from the ON RRP facility to T-bills or private sector repos. And large banks have excess reserves that they’ll likely be comfortable allowing to run off as the TGA grows. So, while I’ll be vigilant in case the balance sheet dynamics play out differently, a large drain of reserves from regional banks doesn’t seem like the most likely scenario.

We could still see some temporary upward pressures on money market rates over time as the TGA grows and the Fed’s balance sheet normalization continues. Banks can’t perfectly predict deposit flows. They may have to pay more for short-term funding at times as liquidity redistributes through the financial system. As long as significant balances remain in the ON RRP facility, I wouldn’t see such rate pressures as a sign that liquidity was becoming scarce. Rather, the rate pressures would provide the incentive for funds to leave the facility and move to banks. And the Fed would have plenty of tools for maintaining interest rate control in such a scenario, including the standing repo facility, discount window lending or a technical adjustment in the ON RRP rate. The balance sheet outlook should not affect decisions about monetary policy at this stage.

And history has shown the dangers of central banks easing off too soon on inflation. We are all familiar with the consequences of the Federal Reserve’s insufficiently resolute response to inflation in the 1970s. And recently, a number of central banks have had to resume or accelerate rate increases after pausing or slowing. The example of the Bank of Canada is instructive. The Canadian mortgage market uses more flexible rates that result in faster transmission of monetary policy to the economy. So, uncertainty about lags isn’t complicating the economic picture as much there. As an open economy, Canada appears to be getting a read on the persistence of global inflation. And what they’re seeing, in the Bank of Canada’s words , is that inflation is “stubbornly high.”

In this environment, the FOMC needs to make policy more restrictive so we can return inflation to target in a sustainable and timely way.

In my view, it would have been entirely appropriate to raise the federal funds target range at the FOMC’s June meeting, consistent with the data we had seen in recent months and the Fed’s dual-mandate goals.

But in casting my vote, I was mindful of several factors. In a challenging and uncertain environment, it can make sense to skip a meeting and move more gradually. And as I said earlier, financial conditions matter more for the economy than the precise path of the policy rate. Financial conditions depend not only on how fast rates rise but also on the level they reach, the time spent at that level, and, importantly, the factors that determine further increases or decreases. So, my hope was that the overall package of communications coming out of the June meeting would deliver a strong signal to financial markets and meaningfully tighten financial conditions.

At this point, it is important for the FOMC to follow through on the signal we sent in June. Two-thirds of FOMC participants projected at least two more rate increases this year. Significant unexpected events could always provide a reason to change course. But inflation and the labor market evolving more or less as expected wouldn’t really change the outlook. To have confidence that inflation will return to target on an appropriate timetable, we need to see more than some continued very modest rebalancing.

If we lose ground in our effort to restore price stability, we will need to do more later to catch up. The rate increases we’d need to keep inflation expectations anchored in that scenario would be far worse for workers, communities, households, businesses and banks than more modest increases now.

Thank you. I look forward to our conversation.

Notes

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

1. Figures are as of June 28, 2023, as published in the June 29, 2023, edition of the Federal Reserve’s H.4.1 statistical release.