This is part of a series, ‘Economists Exchange’, featuring conversations between top FT commentators and leading economists
After an extended battle against stubbornly high inflation, the US central bank is at a critical juncture. And as president of the New York Federal Reserve, John Williams is a pivotal figure in discussions about the next phase of the Fed’s historic monetary tightening campaign.
Having raised their benchmark interest rate 5 percentage points in just over a year, Fed officials are now engaged in a protracted debate about how much more to wallop the world’s largest economy at a time of vast uncertainty. Unknowns include the pace at which price pressures will recede, the economic consequences of the central bank’s past actions to date and the spectre of financial instability following a brief bout of banking sector turmoil earlier this year.
To take stock of these factors, the Fed last month adopted a more patient approach, opting to forgo raising its benchmark rate after 10 consecutive increases. Now, it appears poised to resume those hikes at its policy meeting at the end of the month, as it plumbs the level of borrowing costs deemed to be “sufficiently restrictive” to ensure a timely retreat in inflation to the 2 per cent target.
Williams — who is a permanent voting member on the policy-setting Federal Open Market Committee and a close ally of Jay Powell, the chair — has already conceded that the Fed has “more to do” in terms of raising interest rates. In this discussion, he reveals how he will determine when the Fed has done enough and the potential pain associated with getting inflation down.
Colby Smith: We got another solid month of job gains in June, although at a slower pace, and steady unemployment. Is this the kind of report that allows you to breathe a small sigh of relief or are there points of concern still?
John Williams: Obviously, it’s not just about one report, but the totality of the data. I think this report is consistent with things that we have been seeing, signs of imbalances in the labour market gradually receding and supply and demand in the labour market coming closer together.
It’s still clearly a very strong labour market with very good jobs growth, so that hasn’t changed. As we saw the unemployment rate has been fluctuating around 3.5 per cent for some time. Other indicators like labour force participation are very strong.
So no signs at all of weakness there, but definitely signs of things slowing in terms of the direction of demand in labour. We saw that in terms of non-government or private job growth, that was more like 150,000. Always look at the revisions, and [those] totalled 110,000 fewer jobs.
I put that in the broader context of what we are seeing with the job openings, the quits data and some other indicators, all of them flashing still very strong labour markets but moving gradually in the right direction.
CS: Do you think labour hoarding is having an impact here?
JW: When labour demand was really strong and we had labour shortages in 2021 and into 2022, we definitely saw the work week go way up as employers were trying to get the work done any way they could. We’ve seen the work week come back down to more normal levels, so that just could be another sign of supply and demand getting into more balance.
There is a question out there [about whether] employers are still holding on to employees that they are not sure they will need, but they know how hard it was to fill those positions. I don’t think there is convincing evidence that is a major part of the story, but it definitely may be part of the dynamic.
When you look at aggregate hours worked in the economy, that has grown very little over the first six months of the year . . . I think that’s another sign that although gross domestic product growth was pretty strong in the first quarter and there are some other signs of strength in payroll employment, overall growth in the number of hours of work being done in our economy is actually not growing that fast.
CS: In terms of participation, there was a lot of scepticism last fall that we would not get that much help in terms of more people entering the labour force to help rebalance the jobs market, but we have seen prime-age participation rise since then. Has that changed your perception of how much help we could get from participation moving up from here?
JW: The participation data have been very positive, especially in the 25-to-54-year-old group. We’ve seen that come back to levels or even in some cases higher than we saw before the pandemic. A worry a year ago was: would we see longer-term scarring of the labour supply in our economy post-Covid? At least in this group, we’re not seeing signs of that.
Monetary policy is part of the story to get demand moving towards supply, but any help we can get from supply increasing, that’s good news.
I don’t think there is a lot of space for that to continue to be a big driver of the rebalancing of supply and demand. Labour force participation, especially in the 25-to-54-year-old group could increase some more, but it is not going to increase as much as it has in the last year or two. And then for people 55 or over, especially over 65, their participation is lower. Some of that is just described by the ageing of the population.
My punchline is that the input increase in labour force participation has been an important contributor to improving supply, but I don’t know if we can get a lot more from that.
Now, there is a second part of that story, and that is immigration and the labour force growing from people coming into the US and adding to the productive capacity in our economy. That obviously slowed quite a bit during the pandemic. We have seen that come back, and come back actually quite robustly. That is another factor that contributes to more labour supply and helping to get the balance back in our economy.
CS: So taking this all together, how has your thinking about how much the unemployment rate has to rise to get inflation down changed?
JW: There’s a lot of debate about how all the different factors come together. One way to think about this is that people, including some of my colleagues, have talked about is in terms of the Beveridge curve. So far, we have primarily seen movement down the Beveridge curve, meaning we have seen a significant reduction in job openings and very little if any increase in unemployment.
To me, this is a great sign of the excess demand for labour. The unemployment rate bottomed out around 3.5 per cent but what we saw was the queueing up in terms of job openings and vacancies. Those vacancies are now coming down to more normal levels, and then the open question is, as labour demand and supply get back more in balance, what do we need to see in terms of that situation and making sure we get inflation all the way down to 2 per cent? So far, it’s gone according to plan.
On the inflation side, I hope we will continue to see some of the factors that are helping bring inflation down really play out. Oil prices and gas prices have come down without needing to have an increase in unemployment in our economy. We’ve seen goods prices come down and again, that doesn’t necessitate slack in the labour market. It’s really a reversal of some of the pandemic-related effects and a relaxation of the supply-chain bottlenecks. It’s a free lunch.
To get inflation all the way to 2 per cent, it will take not only getting the demand for labour further down but some increase in unemployment. My own forecasts would have the unemployment rate rising to around 4 per cent by the end of the year and getting up to 4.5 per cent by the end of next year.
CS: The fear is getting from the current level inflation back down to 2 per cent, that’s the tricky part, but it seems like officials have become more optimistic about avoiding a recession. So in terms of your growth estimates, what are your thoughts for this year and next?
JW: Clearly the fact that first-quarter growth was 2 per cent has to influence my view. Going back even six months, I was thinking growth this year would be lower than that and now I have raised my forecast probably to 1 per cent or a little bit higher than that for the four quarters of 2023.
I have actually lowered my forecasts a little bit for next year. I think that some of the tightening of monetary policy and some effects of credit tightening will weigh on demand in 2024. If you look at my forecast quarter by quarter, the second quarter still seems to be quite positive and then [we will] definitely be seeing slower growth in the second half of this year and in the first half of next year.
I don’t have a recession in my forecast. I have pretty slow growth. Obviously, recessions are very hard to predict. I still think that is the right base case, but again, that will really depend on all the factors influencing especially what is happening in inflation and do we see what I predict to happen, which is overall personal consumption expenditures (PCE) inflation come down to around 3 per cent over the four quarters of this year and then 2.5 per cent next year. In that case, then obviously you don’t need to have a higher unemployment rate or further costs to the economy.
CS: On the credit tightening that you mentioned, is that just a reflection of the tightening the Fed has already put in train, or is that additional tightening tied to the banking stress earlier this year?
JW: I’m thinking of both. The tightening of financial conditions includes the effects of Fed policy tightening, but also the tightening of monetary policy in most countries around the world over the last year or two. Then layering on top of that is extra tightening, perhaps lending standards and credit availability, especially for the banks.
In the Senior Loan Officer Opinion Survey, clearly, banks have been telling us for quite some time now that they are tightening standards and historically, that does lead to a tightening of credit availability from the banking sector, which would affect business and household spending to some extent.
The hard part here is both are happening and, of course, monetary policy tightening is also going to lead to some tightening of credit availability. That is part of how it works. So it’s hard for me to know how big the additional effects of the credit tightening from the banks are, but directionally it is going to weigh on the economy somewhat. There are lags in monetary policy and there are lags in credit tightening, so it is still early days to see how big those impacts will be.
CS: Would you say though that it is perhaps less pronounced as was feared around the March meeting?
JW: If you go back to March, the distribution of possible outcomes in terms of banking stress was quite wide. It could have been that banking stress had more of a contagion effect and spilled over to other institutions and into confidence in the economy. We have not seen that, so that is good news. The situation in the banking sector really has stabilised . . . That clearly means that from a risk management point of view, some of the downside risks to my mind are less.
CS: Regional banks have suffered deposit flight, their share prices have fallen, and there’s also the spectre of regulatory changes. If the Fed is continuing to raise interest rates, how concerned are you about other banks buckling under all that pressure?
JW: The events of March have definitely been a wake-up call to everybody, especially the banks themselves, about making sure that they have access to liquidity, that they are making good risk management decisions over interest rate risks that they have and [that they] position themselves for that. For many banks, there is a reality that interest rates go up, which affects net interest margins. For many banks, it is a positive effect, but for others, maybe not so much or even a negative effect. The banks have become very focused on making sure that they can manage those kinds of things.
Importantly, part of that ability is the bank term funding facility that the Fed created, which provides banks with the ability to borrow using Treasury and mortgage-backed security types of collateral. So not only can they take action to make sure that they have adequate liquidity and sources of that and make good decisions, but that facility is also available to them.
CS: In terms of the outlook for monetary policy, you’ve said you are data-dependent. The big question is, what exactly does sufficiently restrictive mean? How are you applying that data-dependent approach to figuring that out?
JW: I focus on, ‘Do we continue to see the signs that supply and demand are getting back in balance?’ That can’t be a glacial pace. It has to be steady and clear progress. I think we are seeing that, and I want to see that continue.
On the inflation side itself, besides the effects of commodity prices and core goods prices, [which] are coming down, for monetary policy, we need to be focused on the core services prices. That means shelter prices. It also means core services [excluding housing-related costs]. Both of those are affected by overall supply and demand.
We have talked a lot about shelter because that has been by far the biggest driver of core inflation over the last few years. It is also one of the drivers bringing core inflation down and I expect it to continue to do that. But it is only going to do that if supply and demand in the economy rebalance.
I do want to see, in addition to other parts of the inflation picture continuing to move in the right direction, that shelter inflation continues to move towards levels that are consistent with 2 per cent overall inflation and also see that occurring in core services ex-housing. That’s maybe the harder part and also the part that may take longer.
CS: The rate hikes will stop long before getting back to 2 per cent inflation it seems, so is there a certain rate of monthly core inflation for a certain period of time that is your marker for a sufficiently restrictive federal funds rate, or a run rate of monthly jobs growth that is consistent with inflation falling back to target?
JW: On the employment side, the indicators from the labour market have behaved very differently given how much excess demand for labour we had during the pandemic . . . If you look at the unemployment rate, you might say, ‘Well, nothing is happening’, and then if you look at other [indicators like the quits rate and opening rate], clearly, we are moving in the right direction. So it is really looking at the totality of the data but also the indicators of imbalances. That includes wages. Wages move around for a lot of reasons so it is hard to know exactly what is driving it, but it is clearly one of the signs of imbalances in the labour market.
On the inflation side, it is not looking at some six-month inflation rate, it is really looking at how the pieces are working together. Does this appear to be consistent with what we are trying to achieve?
There are always going to be pieces in the core inflation data that are going to be hard to explain because they are moving for idiosyncratic reasons. We are still experiencing the after-effects of the pandemic on demand for goods and services and shifting between them. And if anyone can explain to me what used car prices are doing and why, I would love to have that knowledge because that has been a big mover up and down of inflation.
CS: We have to look past that to a certain extent.
JW: We have to try to understand that because the new car market is a key component of consumer demand. It shows up on the demand side, it shows up on the inflation side. I always think of the used car market as a secondary market and a derivative of the new car market. In a way, it is a bit separate, but it is also a market-based measure of where supply and demand are.
And importantly, another part of this is how are the effects of monetary policy and tightening financial conditions feeding through the economy, because there is not just one lag in monetary policy. It plays out at different speeds and in different parts of the economy over time.
CS: We saw just the mere mention of tapering bond purchases helping to tighten financial conditions back in 2021, and then again before the lead-up to any of the rate increases in 2022, there was the signal that interest rates were going to rise. Some of your colleagues have recently expressed scepticism that there’s going to be a big impact coming from lags later on, and I wonder what do you make of that concern?
JW: It is hard to measure and hard to say with certainty, but at least the research I have seen and the evidence I have seen do not suggest that the lags of monetary policy to the real economy — GDP, employment and inflation — have fundamentally changed in the last few decades. Clearly, all the things we have done to increase transparency over the last several decades affect the ability of financial markets to respond to monetary policy, but it is not that clear that it has had a first-order effect on lags of monetary policy to the real economy . . .
Over the last year, we basically moved from a stance of policy that was still accommodative to one that moved to neutral and then finally got us now to a restrictive stance.
For the economy that we are looking at today, it is a mixture of the lagged effects of accommodative monetary policy, lots of fiscal stimulus and now we are starting to see both of those having shifted course over time. Fiscal policy is not adding nearly so much stimulus to growth now and monetary policy is now slowing growth.
We are not getting the full effects of the restrictive policy that we put in place yet. Those are still ahead of us, although we have gotten some of the effects already in certain interest-rate-sensitive sectors.
CS: A year ago at Sintra, chair Jay Powell said the clock was running on how long we would remain in a low-inflation regime. With core inflation where it is, even though inflation expectations are well-anchored, how much time do you think we have left here?
JW: We needed to act aggressively. The actions we took and the speed at which we took them last year were essential. We do not want the question to be raised in a serious way, ‘Are we committed to achieving price stability?’ We must ensure and assure people that we will achieve price stability and do that in a timely fashion.
How quickly we moved from expansionary policy to restrictive policy, and now we’ve indicated through our projections and our communications that we think we still have some ways to go to get the policy to this sufficiently restrictive stance to get inflation to 2 per cent, all of those reflect a commitment to get price stability not in over 10 years, but over a few years.
You can’t take the anchoring of inflation expectations for granted, but we can through our actions reinforce not only the outcomes that are consistent with price stability, but also I think reinforce people’s understanding that that’s what we’re doing and will achieve . . . The FOMC has shown very unified, strong support on that.
CS: With financial stability concerns becoming prominent this year, has there been any discussion about whether the balance-sheet reduction programme needs to change at all or is it working as intended?
JW: That has been working as intended in all dimensions. We increased the size of our asset holdings dramatically in 2020 for a very good reason given the disruptions to the Treasury market and related markets, but that created a balance sheet that was far larger than is needed to carry out and implement monetary policy.
The FOMC very thoughtfully and carefully planned and communicated [over] a pretty long period decreasing the size of our asset holdings. That’s gone exactly as planned. I think our tools to control interest rates have gone exactly as planned in terms of interest on reserves and our overnight reverse repo programme.
If you were to say, ‘What’s the FOMC’s objective?’, and that is to keep the federal funds rate stable within the target [range], that’s been completely successful, despite the fact that we have had quite a few disruptions to financial markets in 2020. We have clearly had stresses in the banking system.
One of the desired effects of reducing our holdings of longer-term Treasury securities and mortgage-backed securities is we would expect that the term premium on those securities would go up, and that would also work to tighten financial conditions. It’s hard to measure that precisely, but I think that those effects are working in the right direction and we’ve not seen any signs of disruption in the financial markets from the shrinking of the balance sheet.
One thing people ask is when will we stop. I think that’s well off in the future.
CS: Another potential source of disruption was the end of Libor. So far, things are looking stable but I’m curious if that’s what you’re seeing from where you sit, and are you concerned about other vulnerabilities from this?
JW: There was an enormous amount of preparation that went into this by the private sector, by the borrowers, the lenders, the official sector — meaning the Federal Reserve and other agencies working closer together — and then internationally . . .
At one point we had more than $200tn of US dollar-based Libor contracts. Our financial system was built off something that was fundamentally unsafe and unsound, and we needed to replace it. At certain times along this journey, it seemed impossible, but again I give credit to everybody who worked together realising there was really no option. We had to get on to a safer foundation for the financial system. We didn’t want to fix it. We wanted to actually have a new foundation.
CS: There’s a lot of time before the 2025 policy review, but there has been a lot of speculation about whether the 2020 framework needs to be revised. If that review was happening today, what would you propose?
JW: We have a five-year review period, and I think that’s a very healthy thing. You do not want to be changing fundamentally your framework and strategy every year or something like that.
We put a lot of thought into the factors that led to the 2020 framework, as we did in the 2012 one, so I think we really do want to take the time and assess, [especially] how we came out of the pandemic. Right now, core inflation is around 4.5 per cent, and it is not clear what it is going to look like two years from now. We talked about our forecast, but maybe things won’t develop as we expect. I really want to think hard about the lessons of how the economy performed, how inflation performed, how monetary policy did, and to what extent there are implications to thinking about the framework.
The 2012 framework, the 2020 framework, and everything in between always emphasised the importance of price stability and the importance of well-anchored inflation expectations . . . I will just say that the 2020 framework did not in any shape or form impede any decision to make policy decisions in terms of tightening monetary policy as we needed to do, the speed at which we did it, the adjusting of the bond-buying programme. I think we proved that by raising the federal funds rate 75 basis points per meeting several times and 50 basis points per meeting.
We were moving faster than anyone’s done in decades. I don’t agree with some commentary that somehow the framework was impeding our ability to take strong actions to deal with the inflation once we felt that was the right thing.
CS: The blame focused also on the guidance provided at that time. What are the lessons you have learned from having to go from accommodative policy to very aggressively raising interest rates?
JW: We all recognise that we are working in a world of extreme uncertainty. We knew that in March 2020 and in 2021 and continuing forward.
If I think about how you make policy decisions with extreme uncertainty about how this would play out, I don’t think there is a right or wrong answer. One of the theoretical conclusions of some parts of the literature is that you are more cautious, and in the other part of the literature, you act more aggressively and decisively.
The lesson to me is that when you are dealing with extreme uncertainty and risk management, you are going to have to make decisions based on what you think the worst risks are.
Our actions in the spring of 2020 in terms of asset purchases were extraordinary. The speed and the scale at which we did this was just unprecedented. That was not a case of gradualism, that was not a case of caution, it was a case of decisive action. It wasn’t clear in real time how much you needed to do, or how long would you need to do it, but it was clear that we needed to do it.
The tail risk in 2020 and into 2021 was an economy that didn’t recover. Obviously, at the end of the day, it did and that’s great, though the cost of that was that inflation took off faster and much higher than most people expected and we needed to shift gears. That was the risk that we had to face.
The above transcript has been edited for brevity and clarity.
Source: Economy - ft.com
