Federal Reserve Alert! Cleveland Fed President Loretta Mester in speech: 'Given the current level of inflation, its broad-based nature, and its persistence, I believe monetary policy will need to become more restrictive in order to put inflation on a sustainable downward path to 2 percent.'
Other notes of interest from Mester's speech:
Given the current level of inflation, its broad-based nature, and its persistence, I believe monetary policy will need to become more restrictive in order to put inflation on a sustainable downward path to 2 percent. Given appropriately restrictive financial conditions, my modal outlook is that inflation will move down appreciably next year, to about 3-1/2 percent, and continue to decline, reaching our 2 percent goal in 2025. I anticipate that the return to price stability will entail a period of output growth that is well below trend over the next two years. This below-trend growth will lead to slower employment growth, with the unemployment rate moving up to 4-1/2 percent by the end of next year and up a bit more in 2024. We are likely to experience higher-than-normal levels of financial market volatility as well.
None of this is painless, but the high inflation we are experiencing is already inflicting pain on many people. The necessary costs incurred now for the economy to transition back to price stability are much lower than the costs borne later were inflation to become embedded in the economy, influencing wage- and price-setting behavior, investment decisions, and longer-term productivity growth. Perhaps Paul Volcker said it best as he fought inflation in the 1980s: “…failure to carry through now in the fight on inflation will only make any subsequent effort more difficult, at much greater risk to the economy.”
The inflation we are experiencing today stems from many factors, but fundamentally, it reflects an imbalance between strong demand and constrained supply, which has led to significant upward pressures on prices. Indeed, both aggregate demand and aggregate supply were affected by the pandemic and by the responses of households, businesses, and policymakers to it.
Economic growth is slowing down from last year’s robust 5-3/4 percent pace. Indeed, the level of real GDP decreased in the first half of this year, but current estimates suggest that it resumed rising in the second half. Activity is slowing partly in response to the monetary policy actions taken this year, which have led to tighter overall financial conditions.
In addition to tighter financial conditions, the slowdown in economic activity more broadly reflects how households and businesses are responding to very high inflation and their concerns about the economic outlook, to the waning effects of the pandemic fiscal stimulus, and to slower growth abroad. Both consumer spending and business investment have decelerated from the robust pace seen last year, and as the effects of the pandemic have waned, consumption has begun to shift from goods to services.
We are seeing some signs of moderation in the labor market, but overall conditions remain very strong and labor demand is still outpacing labor supply. The number of job openings has fallen this year, but there are still 1.7 openings per unemployed person.
So it is likely that much of the rebalancing will need to come on the labor demand side. This could occur mainly through firms reducing the number of workers they are seeking rather than through layoffs.
The imbalance between labor demand and supply has put upward pressure on wages. The employment cost index for private industry workers accelerated over the six months ending in June, rising at a 6 percent annual pace.
Despite some moderation on the demand side of the economy and nascent signs of improvement in supply side conditions, there has been no progress on inflation. Inflation readings have persisted at the highest levels in 40 years. Measured year-over-year, in August, PCE inflation was still running over 6 percent and CPI inflation was over 8 percent.
Monetary policy acts with a lag on the economy so we need to be forward looking. It is unlikely that we have seen the full effects on households and businesses of the latest rate increases we have implemented and it would not be appropriate to continue moving rates up until inflation is back down to 2 percent. But it is also the case that based on Fed communications, financial conditions began to tighten well before our first rate increase in March and those effects have been passing through to the economy. Yet high inflation persists, an indication that we need to increase rates further.
In order to put inflation on a sustained downward trajectory to 2 percent, policy will need to move into a restrictive stance. That means that short-term interest rates adjusted for expected inflation, that is, real interest rates, will need to move into positive territory and remain there for some time. Although we have raised the nominal fed funds rate by 300 basis points, policy is not yet restrictive. The median projection for the longer-run nominal fed funds rate in the September Summary of Economic Projections (SEP) of FOMC participants is 2.5 percent, which is my own estimate as well. This means that if inflation were 2 percent, and inflation expectations were well anchored at levels consistent with that goal, a real fed funds rate of half of a percent would be neutral in the sense of neither stimulating nor restraining economic activity. But that is an important “if.”
Because I see more persistence in inflation than the median SEP projection, the funds rate path I submitted for the September SEP was a bit higher over the next year than the median path, and I do not anticipate any cuts in the fed funds target range next year.
We will be operating in an uncertain environment for some time. High uncertainty is usually associated with being cautious, and being cautious is often associated with acting inertially.