How Did the Economy Get Here

Tom Barkin

President, Federal Reserve Bank of Richmond

Baltimore Together Summit
Baltimore Center Stage
Baltimore, Md.

Highlights:

• A strong but choosier consumer, coupled with a more productive and better valued workforce has landed the economy in a good place.
• As a consequence, the FOMC has started the process of recalibrating rates to somewhat less restrictive levels.
• Tomorrow looks different based on whether you take more signal from levels or trends.
• With the economy now in a good place and interest rates off their recent peak but also off their historic lows, the Fed is in position to respond appropriately regardless of how the economy evolves.

Thank you for that kind introduction. I thought I'd use my time to share how I see the economy today and where we may be headed. I caution you 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.

I want to start by calling out the strength of the overall data. Twelve-month headline PCE inflation has come all the way down to 2.1 percent. GDP growth for the third quarter was 2.8 percent, well above its trend rate of just under 2 percent. The unemployment rate is 4.1 percent, near estimates of its natural rate. I don't want to jinx things, but you have to acknowledge that - as of today - the economy looks pretty good.

I think it is fair to say: No one predicted this. When the FOMC raised rates aggressively in 2022 and 2023, a recession was in pretty much everybody's forecast. The traditional recession indicators were flashing. The yield curve inverted in 2022 and stayed that way for over two years. The Conference Board's Leading Economic Index has been negative for 2 1/2 years. Shocks like the failure of Silicon Valley Bank and the conflict in the Middle East looked like they would complicate the outlook further. Yet here we are.

How did we get here? I'd, of course, love to give the FOMC full credit, and I hope you think our efforts to quiet inflation have been of value. But there are multiple contributors. I want to discuss four of them today.

First: the strength of the consumer. The U.S. economy has returned to its pre-pandemic GDP trend, a feat we never achieved after the Great Recession and one that I don't think any other advanced economy can claim. While fiscal spending and the data center growth sparked by artificial intelligence (AI) have played a part, it's consumers that are the story. They represent almost 70 percent of GDP. Those with higher incomes have seen their asset valuations rise. Those with lower incomes have largely held on to jobs and have seen their real wages grow. Both segments are spending more and don't seem to be slowing down.

Second: increased price sensitivity. Early improvement on inflation came from the supply side, with supply chains healing and the labor supply recovering. But now, we're getting help on the demand side: Consumers have become increasingly price conscious. Frustrated by high prices, they are trading down from beef to chicken, from sit-down restaurants to fast casual, from brand names to private label. They're waiting for promotions, or shopping at lower-priced outlets. The old saying is that the cure for high prices is high prices, and that's what we're seeing. Price-setters are learning their ability to raise prices is now limited by consumer responses. I call that price elasticity in action.

Third: a shortage of workers. Coming out of the pandemic, employers across the economy found themselves short-staffed. Part of the shortage was temporary, as workers stayed home due to illness or lack of child care. But part of it has persisted, especially in the skilled trades. Five years of the huge baby-boom generation retired and labor force participation of those 65 and over dropped. The percentage of our population that is employed is a full point below pre-pandemic levels.

The pain of being without enough workers has been hard to forget, and employers tell me they don't want to get caught short again. As a result, they have been slow to reduce staff - the layoff rate remains historically low and initial jobless claims have been quite muted. Job gains have moderated, but cautious employers share they are just allowing headcount to drift downward through attrition and reduced hiring. A low hiring, low firing labor market is still a resilient one.

Fourth: a surge in productivity. If we take a step back, all of this is pretty remarkable. How is inflation coming down to target amid strong growth? How are we growing so robustly even as job gains have slowed? The answer seems to be a healthy step up in productivity. In the 2010s, productivity grew at a 1.2 percent annualized rate; in 2023 and 2024, it has grown at 2.3 percent.

What's driving stronger productivity growth? Everyone's thoughts immediately jump to AI, and perhaps that will be the case in time, but I believe the more likely story behind this most recent surge is our most recent experience: Firms, unable to find workers two years ago, invested heavily in automation and more efficient processes and are now reaping the benefits. Also, more recently, as the labor market has normalized, turnover has come down and, as you all know, experienced workers tend to get more done.

A strong but choosier consumer, coupled with a more productive and better valued workforce has landed the economy in a good place. As a consequence, the FOMC has started the process of recalibrating rates to somewhat less restrictive levels. With inflation close to target and unemployment near its natural rate, the fed funds rate seemed like the one number out of sync. In our last two meetings, we have cut the fed funds rate 75 basis points.

I've been talking a lot about where we are today. But you're probably more interested in tomorrow.

Tomorrow looks different based on whether you take more signal from levels or trends. What do I mean by that? The level of the unemployment rate is solid, as I've said. But the rate has moved up from its low of 3.4 percent. Similarly, job gains have averaged 104,000 over the last three months, a level consistent with longer-run estimates of the breakeven pace of growth. But job growth has slowed from an average of 251,000 per month last year. So, the labor market might be fine, or it might continue to weaken. On the inflation side, the trend has been great with core inflation down to 2.7 percent from its peak of 5.6 percent in February 2022. But the level is still above our 2 percent target. So, inflation might be coming under control, or the level of core might give a signal that it risks getting stuck above target.

Let me paint two potential scenarios.

The first is positive for demand with the challenge being inflation. As rates come down and the election moves into the rearview mirror, we see employers start to feel more comfortable investing in the future. After having their recession playbooks open for two years, they finally place them back on the shelf. They trust the solid demand they keep seeing and they hire to ensure they can meet it. Real wages stay healthy. Workers stay employed and continue to spend. The Fed's focus would be more on upside inflation risks.

The more pessimistic demand story has businesses keeping their recession playbooks out and turning the pages. With pricing power limited, firms decide they need to cut costs more to maintain margins. They turn to layoffs. Workers who lose their jobs, as well as those who fear for their jobs, pull back. Spending suffers. The net is likely disinflationary, so the Fed's focus would turn more to downside employment risks.

Of course, there are more extreme scenarios. In particular, we remain attuned to the potential for financial market turmoil, supply side positive and negative shocks, geopolitical discontinuities and the like.

Where does that leave us? If I had told you two years ago that we would be where we are today, you wouldn't have believed me. And to be fair, I didn't predict it either. So, I am going to resist giving you a forecast today and instead say that - with the economy now in a good place and interest rates off their recent peak but also off their historic lows, the Fed is in position to respond appropriately regardless of how the economy evolves. After the challenges of the last several years, that's a good place to be.