Why Not Declare Victory

Tom Barkin

President, Federal Reserve Bank of Richmond

2024 UNCW Economic Outlook Conference
Wilmington Convention Center
Wilmington, N.C.

Highlights:

• The FOMC cut the fed funds rate 50 basis points at our September meeting. This cut came largely because of the progress we've made on inflation.
• At times, in the past, the FOMC has made such a significant rate cut in response to a troubled economy. Happily, that is not the case today.
• I see our September decision as a recalibration to a somewhat less restrictive stance.
• Victory means different things to different people, and - while we have made real progress - there remains significant uncertainty on both inflation and employment.
• As we decide how fast to move and how far to go during this rate reduction cycle, we are just going to need to be attentive and learn as we go.

Thank you for that kind introduction. I thought today I might talk about how I see the economy and where it may be headed. I'll then turn it over to you, and I look forward to your questions and comments. I should caution that these are my thoughts alone and not necessarily those of anyone else on the Federal Open Market Committee (FOMC) or in the Federal Reserve System.

As you've likely seen, the FOMC cut the fed funds rate 50 basis points at our September meeting. This cut came largely because of the progress we've made on inflation. Twelve-month headline PCE inflation is now 2.2 percent, well down from its peak of 7.1 percent in June 2022. Core is at 2.7 percent. Near-term inflation expectations are back in line with our 2 percent target. If we look at the most recent data, the inflation picture is even better: Three-month core inflation is only slightly above target at 2.1 percent. Importantly, the decline in inflation appears to be broad-based, not just limited to goods as we had seen previously.

Consumers are driving this drop. Frustrated by high prices, they have become increasingly price conscious. They're still spending, but they're choosing: trading down from beef to chicken, from sit-down restaurants to fast casual, from brand names to private label. They're waiting for promotions: opting for the $5 value meal at McDonald's or jumping on discounts at Target. This is how it is supposed to work! The old saying is that the solution to high prices is high prices. And that's what we are finally seeing. Their choices are pressuring price-setters to finally moderate price increases.

At times, in the past, the FOMC has made such a significant rate cut in response to a troubled economy. Happily, that is not the case today. As inflation has moderated, economic activity has remained robust. GDP came in at 3 percent in the second quarter, a more than healthy growth rate. Consumer spending, which accounts for nearly 70 percent of GDP, has risen at an annualized rate of 3.1 percent in the last two months, supported by low unemployment, higher real wages and high valuations. Thanks in part to this strong spending, the U.S. economy has returned to its pre-pandemic GDP trend, a feat that we never achieved after the Great Recession and that most other advanced economies can't claim.

The labor market has remained in good shape as well. We've added an average of 116,000 jobs over the last three months. Unemployment has ticked up but remains low at 4.2 percent, near most estimates of its natural rate. Given how overheated the labor market was just a few years ago, some normalization was to be expected.

Why did the FOMC reduce rates so significantly if we are not seeing a troubled economy or weak labor market? I see our September decision as a recalibration to a somewhat less restrictive stance. After over a year at a 5.3 percent fed funds rate, headline inflation had come down closer to target while unemployment was near its natural rate. The number that now seemed out of sync was the fed funds rate, which no longer needed to be as restrictive given the progress that's been made. Going forward, the median member of the FOMC forecasted another 50 basis points in cuts this year, assuming the data come in as expected. This dial back in restraint just takes a little bit of the edge off.

I assume many of you were happy to see us start to bring rates down. But please remember that our focus has never been on the rates themselves but on inflation. High rates are merely a tool to get inflation under control, and I've been glad to see that we have done so with limited collateral damage to date.

Does this cut signal that we are declaring victory? Let me start with some history. "Let's declare victory and go home" is a pretty cynical phrase traced back to the 1960s, when Sen. George Aiken proposed that the United States should call Vietnam a win and begin to de-escalate, regardless of the realities on the ground. As an aside, it's never good to adopt a strategy from the Vietnam era.

So, I'm not yet confident nor cynical enough to declare victory. I'll walk through three reasons:

First, victory means different things to different people. I talk to many people for whom victory would be returning to 2021 interest rates or to pre-pandemic price levels. Both would be challenging absent a significant recession, which I venture to say would not be a win. Some define victory as a stock market that continually moves up, but of course, we can't and don't seek to control the stock market. And you may yearn for the stability of the 2010s, when GDP and employment grew consistently and inflation barely moved. That decade, however, was unique in recent history. So declaring victory seems bound to disappoint.

Second, there is still work to do on inflation. While down from its high, inflation remains above our 2 percent target. I don't expect 12-month core inflation to drop much further until 2025, as we are still lapping low inflation numbers from late last year.

Forecasting inflation going forward is challenging. On the positive side, we may continue to get help from supply-side factors like immigration, increased labor force participation and productivity, as well as from global factors like disinflation coming from China and increased energy production. Last I saw, per-barrel oil prices were down in the $70s. On the other hand, I just got my homeowner's insurance renewal, and it reminded me that inflationary pressures have not fully disappeared. Recent union actions or a pullback in labor supply could drive higher wages. Health care cost trends could raise premiums further. Deglobalization could increase import prices. The conflict in the Middle East could worsen.

I am paying particular attention to the potential impact of our recent rate move on pricing for houses and cars. Buyers will welcome lower rates, but there is a risk that demand is stimulated in excess of available supply. Remember, it takes time to get new houses built and move cars onto lots. Locked-in homeowners may well start to list their homes as mortgage rates drop, but these sellers will also be buyers, increasing demand while they are adding to supply.

So it remains difficult to say that the inflation battle has yet been won.

A third reason not to declare victory is risk to the labor market. The levels, as I mentioned, look healthy, but the trends bear watching. Job gains are being continually revised down, and those sectors (like health care) that have been catching up from pandemic shortages are moderating their growth. In fact, the hiring rate has dropped down to 2013 levels. But while employers aren't hiring, they also aren't firing: The layoff rate is near 25-year lows and initial claims remain muted. Cautious employers are allowing head count to drift downward, but largely through attrition. I hear very few employers planning layoffs (and layoffs do take planning).

This low hiring-low firing environment is unlikely to persist, but again I could make a case that it could evolve in either direction. Of course, a cycle of layoffs could start given profit pressures and the excess staffing many have chosen to keep after their pandemic-era shortages. But demand remains healthy and lower rates could add momentum. Those employers running lean could well find themselves short again, particularly if labor force growth starts to slow. At some point you have to hire to serve your customers.

You might notice that I'm wearing a suit, not a "mission accomplished" bomber jacket. It's not that I'm particularly humble (or formal). I'm just realistic. Victory means different things to different people, and - while we have made real progress - there remains significant uncertainty on both inflation and employment. And while we are working hard to deliver for the U.S. economy, we almost certainly won't get it perfect. Perfection would be a high bar when we operate in an environment fraught with uncertainty, under a mandate requiring trade-offs, with a primary tool - the federal funds rate - that works with long and variable lags and without a finish line. So as we decide how fast to move and how far to go during this rate reduction cycle, we are just going to need to be attentive and learn as we go. I'm hoping to start that process with your questions and comments today.