C. Peter McColough Series on International Economics With Christopher J. Waller

Friday, January 20, 2023

Member, Board of Governors, Federal Reserve System


Senior Economics Reporter, CNBC

Introductory Remarks

Senior Fellow and Director of International Economics, Council on Foreign Relations

Christopher Waller discusses the economic outlook for the United States in the year ahead.


STEIL: Welcome. Good afternoon, everyone. My name is Benn Steil. I’m the director of international economics here at the Council. And it’s my great pleasure to introduce our speaker for today’s meeting, which is part of the C. Peter McColough Series on International Economics.

Our speaker today is Dr. Christopher Waller. Dr. Waller had a distinguished academic career before joining the Federal Reserve Bank of St. Louis in 2009, where he was executive vice president and director of research. Since 2020, he’s been a member of the Board of Governors of the Federal Reserve down in our nation’s capital. And Dr. Waller, I understand, has some introductory remarks for us.

And then he’ll be joined on stage by Steve Liesman, senior economics reporter at CNBC. He’ll join him for a discussion.

So thank you, Governor Waller, and welcome to the Council.

WALLER: Well, thank you, Benn. And thank you to the Council on Foreign Relations for inviting me to be part of this discussion. It’s been close to a year since the Federal Open Market Committee began tightening monetary policy. We began raising interest rates in March of 2022 and shrinking our security holdings in June in order to bring inflation down towards our 2 percent target. Today I thought I would spend a few minutes taking stock of the year behind us, and talking about what’s next.

A year ago, inflation was elevated and rapidly accelerating. And the Fed moved quickly and dramatically to tighten monetary policy. At the end of the December, the Federal Funds Rate target was set in a range of 4.25 percent to 4 ½ percent, the highest it’ been in fifteen years. Economic activity meanwhile has been holding up well. I mean, if you thought we were going to raise the fed funds rate 400 basis points in about nine months, and everything’s just great, for the most part. Hard to believe that happened.

After shrinking slightly in the first half of 2022, real gross domestic product grew at an annual rate of 3.2 percent in the third quarter, and monthly data suggests it grew around 2 percent in the fourth quarter. I expect such a slowing to continue in this quarter. This is both expected and desirable in our ongoing fight to lower inflation. The FOMC’s goal in raising interest rates is to dampen demand and economic activity to support further reductions in inflation. And there is ample evidence that this is exactly what is going on in the business sector.

On the manufacturing side, industrial production declined for the second month in December, and the institute for supply management’s forward-looking indicators of orders in customers’ inventory suggested that further weakening is in train. Meanwhile, the ISM Survey for Nonmanufacturing Business, which had reported expansion since April of last year, indicated a slight contraction in December. This slowdown in services activity was widespread, affecting eleven of seventeen sectors in the survey, with significant slowdowns in construction and real estate, two industries heavily affected by higher interest rates.

This slowing in business activity is consistent with the FOMC’s goal of dampening demand and reducing production so that it is in better alignment with the productive capacity of the economy. The goal is not—I would emphasize—to halt economic activity. We just want to slow it down. And so we are watching these sectors closely to see how this moderation continues.

Growth in consumer spending has begun to slow. While that growth was surprisingly strong through most of the second half of 2022, personal consumption expenditures growth slowed to 0.1 percent in November and retail sales fell 1 percent. We don’t have spending data on goods and service for December yet, but retail sales fell another 1.1 percent. While the latest readings of consumer sentiment from the University of Michigan moved up from some historic lows, I continue to expect that last year’s decline in real incomes, along with higher

borrowing cost, will moderate consumer spending this year and help return inflation more promptly to the FOMC’s 2 percent target.

Job one is maintaining the progress we are making in lowering inflation. And moderation in consumer spending will support that progress. The slowing in output growth has occurred alongside the continuing strength of the U.S. labor market. Total nonfarm employment grew 223,000 in December, close to the average of 237(,000) a month for the fourth quarter. Now, that’s down quite a bit from the monthly increase of 539,000 jobs in the first quarter of 2022, but still a solid growth rate, far above the number of new jobs needed to keep pace with population growth.

Employment grew robustly in the leisure and health care sectors, where labor shortages are reportedly severe. While the labor market is strong, it’s also very tight. The unemployment rate was 3.5 percent in December, matching the low reach before the pandemic, and is the lowest in fifty-three years. But there are signs that demand for labor is moderating. Job openings reported by the November JOLTS survey and job postings from December’s Indeed Data are down from their recent peaks. Temporary help employment, which has sometimes been a leading indicator for overall employment, has declined in recent months, but that decrease may be due, at least in part, to employers opting to hire full time workers in place of temps to keep jobs filled.

A robust labor market, despite modest economic growth, is a plus for workers and allows the Fed to focus on lowering inflation. It shows that jobs and income can hold up to the effects of higher interest rates, which is helping the FOMC continue its efforts to lower inflation to our 2 percent goal by furthering tightening monetary policy. A potential downside of a tight labor market is if labor cost, which heavily influence inflation, grow so fast that they slow progress towards our FOMC’s 2 percent objective. Wages and other measures of compensation accelerated as inflation surged in the second half of ’21, and wage growth remained high in 2022.

But as overall inflation has begun to moderate in recent months, so have some measures of growth, and wages, and other compensation. For example, the twelve-month increase in average hourly earnings hit a recent peak of 5.6 percent in March, which is when the Fed began raising interest rates, and has been falling gradually over 2022, reaching an annual rate of 4.6 percent in December. The three-month annualized change in average hourly earnings, 4.1 percent, is running below the twelve month rate, and is thus a signal of ongoing moderation in wage growth in the labor market.

These are encouraging signs, but we need to see continued improvement across various measures of labor cost, because additional moderation is needed to bring inflation down to our 2 percent goal. And because a significant escalation in wage growth could drive up longer-range inflation expectations, those longer-range expectations have been fairly stable through this period of very high inflation and we want it to stay that way, because escalating inflation expectations could drive inflation higher.

Now, let me turn to the outlook for inflation. Last week’s report on the Consumer Price Index showed that inflation continued to moderate in December, which was very welcome news. So first, I’m going to spell out why this was such good news and then I’m going to turn around and explain why I’m still cautious about the inflation outlook and supportive of continued monetary policy tightening.

Overall inflation—overall inflation—headline inflation fell a tenth of a percent month over month in December, the first monthly drop since May 2020. The twelve-month change in inflation peaked at 9 percent in June, and has fallen every month since to 6.5 percent in December. A big factor in the monthly decline in headline inflation in December was a significant drop in energy prices, which more than offset an increase in food prices. The FOMC targets headline inflation because food and energy are considerable expenses for most people. But they are more volatile than other components of the index. And by factoring them out, core inflation can provide a picture of where inflation is headed.

Here also we are seeing some progress. Yearly core inflation was down in December to 5.7 percent from 6 percent on November, and a peak of 6.6 percent in September. Over the past three months, core PCI inflation

has run an annualized average rate of 3.1 percent, a noticeable drop from earlier in 2022. Another encouraging sign was that higher inflation was less concentrated. The share of categories of different goods and services with inflation over 3 percent has declined in the past several months from almost three-fourths of all goods and services in early 2022 to less than half in December. That’s good news because it indicates broader inflationary pressure across the economy is easing.

Now, despite the good news, here’s why I’m cautious about these latest results, and why I’m not ready yet to substantially alter my outlook for inflation. Month over month core CPI inflation actually ticked up in December from November, and is pretty much where it was in October and where it was in March of last year, when we began raising interest rates. So although inflation, measured over twelve months, has been falling, December’s reading, year over year, is close to where it was a year ago. Core inflation was, year over year in January ’22, was about 6 percent. And it was 5.7 percent in December, last month. So while—this has basically been moving sideways for a year.

So while it’s possible to take a month or three months of data and paint a rosy picture, I’d caution against doing so. The shorter the trend, the larger the grain of salt when swallowing a story about the future. Back in 2021, we saw three consecutive months of relatively low readings of core inflation before it exploded in our face. We do not want to be head-faked like we were in 2021. I will be looking for recent improvement in headline core inflation to continue. Wages, as I indicated earlier, are another stream of data that I’ll be watching for evidence of continued progress to help ease overall inflation.

Though recent hourly earnings data are a positive development, I need to see more evidence of wage moderation to sustainable levels. The Federal Reserve of Atlanta’s wage growth tracker has been running higher lately, and has moderated less. The employment cost index for December won’t be out until the end of this month. Over time, we need to see wages grow more in line with productivity growth plus 2 percentage point, consistent with our FOMC inflation target.

So those are the reasons I was cautious about the recent good news, but it is good news. We’ve made progress in lowering inflation. Six months ago, when inflation was escalating and economic output had flattened, I argued that a soft landing was still possible, that it was quite plausible to make progress on inflation without seriously damaging the labor market. So far, we’ve managed to do so, and I remain optimistic that this progress can continue. I believe that monetary policy should continue to tighten, but, using a comparison I employed in a speech a couple of months ago, the view from the cockpit of a plane is very different at thirty thousand feet than when it's close to the ground.

When the FOMC began raising the federal funds rate last spring from near zero, that’s the ground, it made sense to move quickly and rapidly upwards. But after frontloading monetary policy with many unprecedented seventy-five basis point hikes in the federal funds rate target, by early December I believe the policy stance was slightly restrictive. And I supported a decision by the committee to hike by another fifty basis points. To return to the airplane image, after climbing steeply and using monetary policy to significantly raise rates throughout the economy, it was apparent to me that it was time to slow, but not halt, the rate of ascent.

And in keeping with this logic and based on the data in hand at this moment, there appears to be little turbulence ahead. So I currently favor a twenty-five basis point increase at the FOMC’s next meeting at the end of this months. Beyond that, we still have a considerable way to go to our 2 percent goal, and I expect to continue tightening policy past this meeting. OK, I think that’s probably enough for me, so there’ll be plenty of time for you to ask questions. So thank you, again, to the Council for Foreign Relations and the opportunity to be here today.

LIESMAN: Thanks for agreeing to sit and answer some questions.


LIESMAN: And thank you to the Council on Foreign Relations for having me do these, and to my good friend, Richard Haass, who keeps inviting me to do these things. It’s funny how time is. All of a sudden, the guy you’ve known for years you’ve suddenly known for decades. So Richard’s been a great person to know over the years.

Governor Waller, let me start off with this. The market has looked at all of the data that you just laid out, and it’s come to a very different conclusion about where rates ought to be and what you ought to do at the Federal Reserve. The gap between the market and the Fed for the end of 2020 is seventy basis points, which is towards the high side of where you guys were concerned with that gap back in July. So there’s really two questions that come off of it: What do you think explains the different attitude of the market towards the same data that you just laid out? And, secondly, is that a problem for the Fed in the execution of monetary policy?

WALLER: So if you look at the market’s perception of the terminal rate, it’s not far from where we think it is. So it’s not the peak. That’s maybe a heightened different. That’s not a big deal, to be absolutely honest. But, as Steve mentioned, the market has a much more rapid decline in the policy rate this year than we project. (Coughs.) Excuse me. And I think that’s driven by one key thing: The market has a very optimistic view that inflation is just going to melt away. It’s the immaculate disinflation is going to occur. Inflation is just going to come down very rapidly. And once that happens, there’s no reason for the Fed to keep policy rates high, and we’ll start cutting rates.

We have a different view. Inflation is not going to just miraculously melt away. It’s going to be a slower, harder slog to get inflation down, and therefore we have to keep rates higher for longer and not start cutting rates by the end of the year. The other issue that we have to deal with that the markets don’t is we have, from a risk management point of view, we have to ensure that inflation doesn’t take back off. And that means we’re going to have to kind of keep rates higher for longer than we normally would say we would do from a Taylor Rule or some policy rule, because of the risk management side. It’s worse for us to have inflation take back off, and then have to start raising rates again, than to just kind of keep them there until we are fully convinced inflation comes down. So I think that’s really the big difference is just the markets have a very different path for expected inflation than we do.

LIESMAN: Does it make monetary policy tougher, in that lower rates are essentially an easing of financial conditions and you’re trying to tighten them?

WALLER: Yeah. I mean, this is the thing. It’s hard to talk people out of their forecast. So if they believe that’s what the forecast is, and they’re going to bet their money, it’s very hard for me to get them to change the view.

LIESMAN: Do you have to respond by making rates even higher than they otherwise would be, if the market doesn’t respond?

WALLER: Well, we’ll kind of see how the data comes back, right? I mean, if this loosening conditions makes things looser in the sense that it really takes off, if employment doesn’t loosen, and inflation starts kind of taking off again then, yeah, it’s going to require us to do a lot more.

LIESMAN: Are you at all humbled in your certainty about the trajectory of inflation by what happened a year ago? In that the Fed was all decided that inflation was going to be transitory, and it was going to go away, and most of the Fed members ended up being wrong about that? What’s the chance that you’re wrong again this time? Why should markets be any more confidence in your outlook on inflation?

WALLER: Yeah. Everybody that does forecasting should be humble, by definition, because you’re mostly always going to be wrong. But for—we go do it anyway, right? We know we’re going to be wrong, but we have the guts to go out and make our prediction.

2022 really was—it was a humbling experience. I mean, it clearly was. When you sat in April or May or 2021 and you saw this inflation you said, what’s causing it? Every possible explanation was a transitory effect. I mean, the logic of it—just the logic just leads you to say this can’t persist for very long. It’s going to unwind. It’s going to unravel. The demand’s going away. The supply stuff’s going to go away. And inflation will come right back down.

And that story held from April until September of 2021. Inflation was monthly coming down. It looked transitory. And then October, November, December of 2021, it just exploded. So once that happened, we had to quickly change pace and say, you know, this story, this belief, it’s just not there. So, you know, it was a mistake. We corrected it. And so that’s the thing, is we don’t really want to make that mistake again. So we’re taking a—

LIESMAN: But what as the mistake? Was the mistake being too, you know, locked into your view? Or was the mistake that you were simply low in terms of your trajectory on inflation?

WALLER: So I’ve made these comments before. The mistake in my mind, that we made, was we bet the farm on the transitory story. And any risk management model, you would have said, what if it doesn’t go away? What should you be doing to get ready for that event, if it doesn’t go away?

LIESMAN: When I look at the projections of Fed officials right now, seventeen of nineteen above 5 percent, two are at 4.90 (percent). Aren’t you betting the farm on inflation being—only falling slowly now? Aren’t you doing the same betting the farm, just on the other side this time?

WALLER: Yeah, but the beauty is it’s a lot easier to go down, right? If we—if we’re—I tell you, if I’m wrong on this, I am going to be a happy man, right? If inflation comes down much more rapidly than I think, that’s fantastic. I will have no problem saying I was wrong, right, because it’s good for the economy. It’s not about me being right. It’s what I think is good. But, again, from the risk management side, I have to protect against that it does—that it stays up or takes back off. That’s what I have to protect against. The markets don’t have to protect against that.

LIESMAN: Did I hear your, or read your, comments correctly, that you think you ought to go a quarter at the next meeting and then a quarter a second time? And would that be the end of it, as far as you’re concerned?

WALLER: It depends on the data. Ever since September, I’ve stopped really kind of giving very long forward guidance and just said: Whatever the data tells me is what I’m going to do. And right now—

LIESMAN: But the next quarter, you think it’s pretty much what you’re going to do? It sounds like in your speech.

WALLER: Well, we’ll see what happens. I mean, if inflation starts popping back up again, rate hikes are not going to stop.

LIESMAN: So that brings me to my next question here, which is: You said you were a happy man. It’s, like, what does it take to make Governor Waller happy? You made a—

WALLER: Inflation going like that.

LIESMAN: Well, here’s the thing, you spoke—

WALLER: And unemployment staying right there.

LIESMAN: In “Wizard of Oz,” Dorothy wants to get back to Kansas, right? (Laughter.) But they keep moving the goalposts on her, right? They keep making her do new things and more things. You in November said that one month’s worth of inflation wasn’t enough.

WALLER: Exactly.

LIESMAN: And that was October’s inflation.


LIESMAN: Then you got November inflation. That’s two. Then you got December inflation, and that’s three. And in all their cases inflation came down, and that’s still not enough. We’re Dorothy trying to get back to Kansas. You keep moving the goalposts.

WALLER: Well, that’s the beauty. By the March meeting, we’ll get two more. Then you got five. And that’ll give you a much clearer idea. But I just gave you an example in 2021, where we had basically five months of this thing coming down, and then it shot up and exploded in our face. So if we have five months—

LIESMAN: So what’s it going to take, Governor Waller? What’s it going to take in order to make you feel like enough is enough already?

WALLER: Yeah, like I said, if you inflation continuing on this path, we know that sheltered costs or equivalent, those are going to start coming down four, five, six, months. So we know that’s coming on. If wages start continuing to moderate, so where, you know, wages are going up consistent with productivity growth and inflation, that’s a good sign. So all of these things—you know, Chair Powell has pointed out that, you know, services are very heavily labor dependent. So wages are a critical factor for passthrough. Again, if we continue to see wage data kind of softening more consistent as inflation comes down as well, that just makes our job a lot easier.

LIESMAN: Let me ask you to comment on some of the recent news that we’re—an announcement this morning of a pretty substantial tech layoffs at Alphabet. Six percent of the workforce. There has been layoffs at Microsoft. How do you process that right now? Do you fear that there’s going to be a surge in joblessness, a surge in unemployment?

WALLER: So a couple things on this is all these layoffs that are hitting the tech sector aren’t showing up in any important way in the data. I mean, when we look at the JOLTS data, which gives you involuntary separation rates, they haven’t moved in a year. So there’s a lot of noise and attention to this, but it’s not having big, aggregate effects. The other point I always try to make out, for two years the rest of the economy was tech starved. They couldn’t get enough tech workers. So, you know, guess what? Now there’s a bunch of tech workers available to the rest of the economy to hire and get the stuff done they need to get done.

So I think there’s going to be a fair bit of reallocation of tech talent across the rest of the—unlike maybe some other sectors. We’ve just seen tech-starved economy for the last two years, and now some of that’s loosening up from the tech companies and can move somewhere else.

LIESMAN: When you look at the jobless claims numbers, 190,000 this week, below two hundred thousand, continuing claims not going up. The first thing I look at when the jobs numbers come out is not even the headline number. I look at duration of unemployment. That seems to still be going down. Is it your sense at all that these workers are losing their jobs and picking up jobs real quickly right after that?

WALLER: Oh, yeah. No, this is kind of a common thing, I even know in my own family. A relative lost their job in the tech sector, had three offers in a week. Never even going to show up in the data as being unemployed.

LIESMAN: You could argue that this is a great time for workers right now. It’s a time when capital, or the share of GDP, will be reallocated to workers from what is a very high profit margin. Why does the Fed want to stand in the way of that?

WALLER: So I’m all for workers getting real wage growth. That’s fantastic. The concern is when wages grow above inflation and productivity. If your real wage growth is growing too much, the next thing that happens, your firm gets rid of your job. So, yeah, real wages are growing, but employment starts crashing. This is kind of the concern with too much wage growth. People keep saying this. You guys are trying to hurt American workers. No, I’m not. I just don’t want wages to go up so much that firms are saying, I don’t need you, I’m going to fire you. I want you to keep your job, that’s what I want.

So that’s more the concern, is getting the right wage growth to where firms don’t start laying off workers because labor’s just too expensive. Now, when you look at real wage growth, income growth, over the wage distribution, lower income workers did very well the last two years. Very significant real wage gains. The ones that got—tended to get hurt were more the upper income groups. But they have more longer-term relationships with firms, these things can kind of be made up more over time.

LIESMAN: We’ve seen this story before, Chris, in the sense that firms tend to horde labor, and then all of a sudden they shed it, right? Is that you can get to a situation where the job market looks really good, and then all of a sudden it doesn’t. Is that a concern of yours, that people are—that companies are holding onto workers, even if they don’t need them, and at some point they’re going to have to draw the line and let them go?

WALLER: Yeah, we always had this kind of line in St. Louis is the unemployment rate never goes up slowly, right? It goes up fast and it goes up a lot. And it’s exactly this kind of idea. This time, I actually honestly believe it’s just going to be different. We are not facing a labor market we’ve ever seen, at least in my professional lifetime, where there’s still 1.6, 1.7 job openings for everybody looking for a job.

LIESMAN: And you believe that data? Because some people are—think maybe—

WALLER: Well, I certainly believe in the sense that every time I talk to firms it’s exactly the story I hear. They’re trying to find workers. They can’t find them. And when they get somebody, they’re not going to let them go. I mean, I just hear this anecdotally over, and over, and over, and over. So it’s consistent with that data.

LIESMAN: Talk a bit about inflation. Somebody help me out with time. I don’t have a clock, so we’re going to turn to questions from the audience in just a minute. Five more minutes? OK, as in television, I’ll take seven, and we’ll be perfect. (Laughter.)

Yesterday the—no, sorry—on Wednesday, the Beige Book said that many retailers are basically having increased difficulty passing along costs. Are consumers doing a job now in terms of helping the Fed with inflation and making it more difficult for companies to pass along price increases?

WALLER: Yeah. I’m hearing the same anecdotes. I was up in Boston yesterday talking to firms, and that was exactly one of the things I’ve heard, that customers are suddenly much more price conscious than they were the last years. You know, it’s going to be a combination of things, which is, you know, their incomes are stretched. Certainly food and energy—energy has held, but food is still very high. And these are the necessities. Rent is still high for most people. So they’re having to be much more price conscious on the non-food, non-rent part of their lives. And they’re starting to think, you know, I am going to go look. You know, if you sit there and the place you normally buy stuff from raising their price a lot, your first thought usually is, hey, your price is too high compared to what I can get at somewhere else. So you start looking somewhere else.

But when everybody’s raising their prices, and they all have the same reason for raising them, you kind of stop looking and you just pay it and move on. So I think we’re back to the part where people are more willing to start searching around and it starts taking away pricing power from firms. And they’re starting to feel it.

LIESMAN: Is that going to help both the service sector and the goods sector?

WALLER: Yep. Yep. As soon as you take off some of the pricing pressure—and, again, that’s the same thing. Because if wages don’t moderate for particularly service firms, they’re kind of stuck. They don’t have a lot of other ways, margins to cut costs. And, you know, a lot of service industry’s profit margins aren’t that high. So this is why we kind of want to keep the—keep wage growth consistent with our 2 percent target and productivity growth.

LIESMAN: Talk about your 2 percent target. Yesterday Governor Brainard said that three month annualized PCE inflation is running at 2.3 percent.

WALLER: What was that?

LIESMAN: Two-point-three percent. She said three-month annualized inflation. And she said core inflation, PCE, is running at 3.1 percent. That’s darn close to your target, isn’t it?

WALLER: That would great if it keeps up. That’s what I said. I’d be a happy man if this continues. This is—

LIESMAN: But it’s not enough? Three-month annualized and six-month annualized at 2.3 percent is not enough to just—

WALLER: Well, we know that’s—a lot of that’s just driven by energy costs.

LIESMAN: Yeah, but it was energy that brought it up.

WALLER: Right? And brought it back down. But if you look at core services, that’s going up with energy. That’s 6 percent annualized January and then again still in December. That was my kind of point. So core, even in the three month, is still over three.

LIESMAN: All right, I’m stubborn but I’m not stupid. (Laughter.) So I’ll just—let’s move on, to see if we have questions. The gentleman right over here, please. Here she comes.

Q: A great deal of the reporting of inflation emphasizes the year over year rate. But isn’t that really misleading? It has much to do with current inflation as with the inflation of a year ago. Wouldn’t it be much better to put the emphasis on the latest month, versus the preceding month on the seasonally adjusted basis? Or the latest three months versus the preceding three months on the seasonally adjusted basis? After all, this is how we report on GDP growth?

LIESMAN: That’s not a plant, just so you. (Laughter.)

WALLER: Yeah, no—no, no, that’s fine. But we looked at both of those. I cited both numbers in my speech today, which is what I was trying to point out with the speech, if you look at year over year January 2022 and year over year December 2022, it’s basically 6 percent. Nothing really improved over 2022, taking out all the past base effects and everything else. So the last three months have been a big surprise. But we know that with kind of monthly data, these things can go like that. I gave you an example in 2021. We saw five months of declining monthly data, and then it exploded. And it was before the Ukraine war, and all that. It’s not about energy and war. It was October of 2021. So that’s where you just can’t put a lot of weight on just a few months. You need to see it go longer. But I agree, that’s—what you’re pointing out is exactly what we’re looking at and paying attention to.

LIESMAN: Michelle Caruso-Cabrera.

Q: Thank you, Steve. Thanks so much for doing this.

Just as you seem incredibly committed to making sure that you reduce inflation by hiking rates enough, in Japan they seem very intent on keeping their rates as low as possible. They had that one little adjustment and then surprised everybody this week. Can you give us any insight into why it is that they’re just holding their—you know, their hand on the spring, so to speak, even as they get 4 percent inflation? I know it’s very tough for you to talk about foreign monetary policy, but if they ever do start to really move aggressively on interest rates, it will impact U.S. interest rates and could be dramatic.

WALLER: Yeah, we usually just don’t comment on other central banks’ policies. I mean, the only thing I would just say is that from the Japanese point of view, they dealt with deflation and zero for 20 years. So they get this temporary runup. If they’re thinking it’s really transitory, then they don’t want to kind of let their foot off the gas. That’s the only thing I could—the only thing I would say. But in general, whether it stays, whether it goes, whether they let up, that’s something they have to decide.

LIESMAN: But could you comment on this idea? Both yields in Japan are higher and the ECB has become more aggressive and rates are higher there. Does that help the Fed in its job, in that it looks like at least the ECB is doing more of a job fighting inflation?

WALLER: Yeah, I mean, the thing with the central banks—there’s a lot of talk about central bank policy spillovers, but we’ve all kind of moved at different paces. Like, we got out of—you know, Bank of England moved first, then we kind of got going, and then the ECB was kind of behind us, but now they’re taking off. So these things are all kind of helping. And I’ve kind of been arguing recently that because of the timing of when we move, it’s not like we’re all moving at exactly the same time and creating this kind of amplification of policy. Because we’re staggered in when we did it, the spillovers tend to be smaller.

So when we were moving first, the dollar went way up. And now everybody else started raising rates, and the dollar’s coming back down. I mean, that’s perfectly expected when you look at the timing of when policy was tightened.

LIESMAN: I have to ask you one more question that was on my list, just for a second here. Back in November, Chris, you said that rates were barely restricted. In that time, inflation has come down and rates have come up. So what noun and adjective would you use to describe rates right now?

WALLER: Well, if you were to look at very short-term forecast out, they’re restrictive. But when you get close to 5 (percent) and inflation forecasted out is 3 to 3 ½ (percent), you’re talking about real rates of 1 ½ to maybe 2 (percent). Those are restrictive real rates. So looking forward, not—you can’t using existing, and you got to look forward. And the market’s view of inflation is, as you said, it’s kind of looking like 2 ½ to 3 (percent) by the end of the year. So in that case, if we’re at 5 (percent) and rates are at—inflation’s at 3 (percent), that’s a 2 percent real forward-looking rate.

LIESMAN: Is that sufficiently restrictive?

WALLER: By most models, I would say that’s probably pretty close.

LIESMAN: OK. You have a question from the web there. Sorry, could I get one maybe from the Zoom call?

OPERATOR: We’ll take our next question from Grace Gu.

LIESMAN: Who’s speaking?

Q: Hi. This is from the web. Dr. Waller, if you can hear me OK, thank you for coming here. Appreciate your leadership at the Fed. I always think of you as well the voice of reason. (Laughter.) And this today, you did not disappoint us.

So my question is the following: Financial market is quite confident that by midyear we are going to see 3.5 percent core PCE, which is currently the Fed projection for end of the year. And by that definition, financial market is quite confident that we will start cutting rates in the second half of the year by about fifty basis points. So I would like to understand your thought of what type of criteria would you be looking for to start cutting rates. Thank you.

WALLER: Well, like I said, if the market’s views of inflation come true, this kind of very rapid disinflation, that’s great news. I mean, I’m happy for that. Like I said, my concern is we have to guard against, you know, in six months it looks great, everything is rosy, and then something takes off. And then we would have to start raising rates again that we were thinking about starting to cut. That’s the thing we can’t do. So this risk management idea, where we have to guard against the upside risk of inflation jumping up, ties us to staying higher for longer than maybe the market would typically want you to do.

So that’s the best explanation I can say. We got to wait and see through the summer how inflation is going. And if this story looks—if the markets are right and inflation’s coming down and it looks like it’s all—wages, everything, are falling into line, that’s great news. I got no problem saying, you know, we should think about changing policy.

LIESMAN: Let’s take one more in house here then we’ll go to the Zoom again. In the back there.

Q: Hi. My name is James Tisch.

So raising rates isn’t always for free. The more you raise rates, the more opportunity there is, in my opinion, for some sort of calamity to happen. Think something like long-term capital. It could happen in the markets, and it could happen in the economy. So my question is, since for the past several months inflation really does seem to be under control, why is your position nonetheless let’s continue raising? And why not—why not say instead: Let’s take a pause for two or three months? When you talk about looking at data, I would argue you’re looking at data points. And you’re looking at one data point at a time, which is hardly data. I consider three or four months to be data. So why not say to the market: We’re going to take a pause. We’re going to see what the data shows. And after three or four months, then we’ll decide whether to continue raising, or whether to stand pat, or whether to go down in rates?

WALLER: Look, I would say if you look at the SEP we’re talking about, you know, maybe seventy-five more basis points of hikes to get to the terminal point. That means you’re going to pause at some point in the first half of the year probably, if it just carried straight out and you hit exactly your target. So the argument is just whether you should pause after three months of data, or pause after six months of data. I’m going to be—from the risk management side, I’m going to lean towards I need six months of data, not just three.

LIESMAN: Can I add to that question? Where do you put recession risk in all that?

WALLER: You know, like I said, I’ve been fairly optimistic about the soft landing story. And so far, it seems to be holding up. But there’s always a recession risk. I mean, I’m kind of on the—everybody thinks we’re going to have a recession. And I think we can just slow growth and it will achieve the same thing. We don’t necessarily have to go into a recession. Even those I talk to who say it’s a recession, I don’t hear anybody thinking it’s going to be severe. It’s going to be mild and pretty short-lived. So, you know, that’s the good news about all this, is we can bring inflation down and the worst that happens is you have, like, a mild, short recession, that’s not too bad.

LIESMAN: Let’s take a Zoom call and then we’ll do one more in house here.

OPERATOR: We’ll take our next question from Jay Bacow.

Q: Thank you for taking the time to speak with us. This is Jay Bacow from Morgan Stanley.

The focus is clearly on the policy rate, but in the same way that you have two mandates you have two tools as well. How do you think about the usage of the balance sheet versus policy rate? And in the future, if the data got to the point that you felt it were appropriate to cut the policy rate, how would you think about the reduction of the balance sheet in that time? Can they work in opposite directions? Thank you.

WALLER: Yeah. I think the balance sheet’s just kind of running in the background. The biggest effects from the balance sheet runoff is when you do the announcement. When we made the announcement, we basically said: Here’s what we’re going to run off. Here’s roughly the time period that it’s going to be, because you kind of get some idea where the terminal point would be. And once you do that, the markets fully have price it in, right off the bat. So all the interest rate effects from balance sheet tightening happened right away, and now all you’re doing is fulfilling those beliefs. You’re not really doing anything—all the pricing occurred right away.

So that’s how I think of balance sheet tightening, is all you’re doing is fulfilling the expectations that you are going to follow this path, and that was going to have this effect on interest rates back when we started, and we’re just carrying that out. It’s just a credibility kind of mechanism. Now, our biggest concern with the balance sheet is just how far we want to shrink reserves. We’re in the sample reserves regime. We don’t know exactly what the kind of the least amount of reserves. We kind of got shocked by that in 2019.

So most likely what we do is we continue to shrink the balance sheet, reserves come down. We’ll start slowing down as we approach maybe reserves being 10 percent, 11 percent of GDP. And then we’ll kind of feel our way around to see where we should stop. But the issue about whether you’re going to cut rates and shrink the balance sheet, like I said, all those price effects have already occurred. You’re not kind of contradicting what you’re doing to cut policy rates.

LIESMAN: So you would be cutting—you could imaging cutting policy rates and continuing to shrink the balance sheet?

WALLER: Yeah, yeah, because all those price effects have already been priced in. You’re not really adding anything by actually doing it.

LIESMAN: I think I got this idea from you, I don’t know how many months ago. But it’s an opportune time to ask it again. You posited this notion of a—I guess I call it a binding level of reduction in the balance sheet. In that there’s froth at the top. And you get rid of some of that, and the balance sheet it has almost no effect on the economy. But at some point, the reduction becomes binding. Where is that level, do you think, right now? And does that also explain why there hasn’t been added pressure in financial markets or added pressure in the economy, because you’ve not reached a binding level of reduction in the balance sheet?

WALLER: Yeah. So I make this point that we have this standing reverse repo facility. Every day firms are handing us over $2 trillion in liquidity they don’t need. They give us reserves. We give them securities. They don’t need the cash. Two trillion (dollars) a day. So I’ve—this argument, it sounds like you should be able to take two trillion (dollars) out and nobody will miss it, because they’re already trying to give it back and get rid of it.

Now, at some point, as reserves are draining out, it’ll come out of the banks. And then the banks, if they need reserves, it’s sitting over there at this—on RP, being handed over by money market mutual funds. They’re going to have to go compete to get those funds back. The kind of rule of thumb we have is—or, my rule of thumb is that in January of 2019, when reserves were about 8 to 9 percent of GDP, everything was working fine. So I would use that as a benchmark. When reserves get to about 8 or 9 percent. There’s a lot of arguments that it actually has to be higher than that now. Banks are growing faster, bigger than the economy has. So it might be more like 11 to 12 percent is the target for where reserves have to go. But, you know, like I said, we’ll start slowing down probably before we get there.

LIESMAN: And where are you now?

WALLER: Right off the top of my head, I don’t know.

LISMAN: It’s nine divided by twenty-one, is what it is. That’s where you—what nominal GDP—

WALLER: Whatever reserves are, yeah.

LIESMAN: I hope that—oh, it’s reserves, right, OK. There was another question in house here. Did you—right here.

Q: Thanks. Two, if I might. One, just quickly following up on the online question. There were a couple estimates by different governors over the past couple months of the rate equivalent impact of QT. I believe last fall Governor Daly estimated seventy-five to 150 basis point range of impact. And then Governor Brainard the other day said fifty to seventy-five. If you have a specific view, what is it? And given those are two pretty different ranges, and the Fed is thinking about, like, cumulative impact of policy rate plus QT on overall restriction, what does that then kind of imply for, you know, the terminal rate, step one?

Second question is just around—going a little bit deeper on data dependency. There’s obviously a ton of, you know, alternative data, real-time data series on the economy that paint a different picture than the kind of headline rates that have significantly lagged components. So maybe just going forward, from a methodological standpoint, is there really a reason for the Fed to be driven by kind of legacy-determined, kind of non-technologically advanced, data points, versus what’s currently ascertainable with modern tools in the economy?

WALLER: So on the first point, I mean, there’s been some Fed research that goes back a number of years. And these numbers are really rough. Don’t bet money on them. But kind of the rule of thumb was about for every trillion of QT, it’s about the equivalent of reducing rates twenty-five basis points. So if you’re going to shrink your balance sheet by two trillion, then you’re somewhere in that 50 percent ballpark. And if it’s 2 ½ (trillion), maybe a little above fifty basis points. Going back to what I said about the announcement, when we announced Governor Brainard gave a speech back right before we made the announcement of QT, which kind of gave pretty much the details of what was going to happen.

Long-term rates jumped—ten year rates jumped thirty-five basis points on her speech. That’s, like, one and a half hikes. Which, not a bad estimate of where the market thinks this is equivalent to doing one and a half hikes. So, you know, it’s somewhere in that ballpark. But, like I said, if you take her speech, it was priced in and it’s been there ever since. They already know what it’s going to be. It’s been priced in, that thirty-five basis point, forty basis points, it’s already there. So all we’re doing is confirming the promises we made about how our balance sheet would run off.

In terms of the data, this is a great point. I mean, we use a lot of real-time data, all sorts of different stuff. I was just in Boston yesterday talking to the Billion Price Project people about what they’re seeing daily in terms of prices, you know? And, you know, what’s interesting is you do get some insight ahead of time, but it’s kind of amazing how consistent it is with more of the legacy data. So you’re getting maybe a little lead time on it, but it’s not like it’s wildly different from what you’re going to get when you get the actual BLS data.

LIESMAN: I’m going to ask, we’ve been talking a lot of sort of short-term, medium-term questions, and I want to ask a long-term question, Governor Waller. The pace of early retirement is still accelerated. Hasn’t really stopped, according to a speech that Chair Powell gave. Immigration levels are back up, but we still have this huge deficit of immigrants that have not come into the country over a period of time that even comes before the pandemic. Fertility rates are lower and science has advanced but not enabled women to give birth to twenty-five-year-old working-age people. (Laughter.)

In that, the dirty little secret of economics is all you need is two numbers to figure out the growth rate, which is productivity and hours worked or population growth. We don’t know what’s going to happen to productivity, but doesn’t it look like the labor force growth is going to be something that’s going to be damaged permanently

over a period of time, such that potential growth of the United States is actually lower than it had been estimated before?

WALLER: Yeah, so this is a long-time standard argument. If you’re just going to look at GDP growth, population or labor force growth input is a factor. Now, if you adjust for GDP growth per capita or per worker, then that gets netted out and you’re just left with productivity. So you have to be kind of careful when you’re looking at growth numbers because you’re adjusting it actually per person, then this gets washed out. But it’s true. I mean, if you have fewer workers coming in, you’re going to have less output and less growth. That’s just kind of the nature of the beast.

LIESMAN: And what does that mean for monetary policy? All things being equal, shouldn’t it mean a lower long-run neutral rate?

WALLER: Yeah. That’s exactly the implication.


WALLER: In any economic model I’ve ever seen, that’s the—

LIESMAN: Yeah, see, I’m good dancing on the regular theoretical stuff. Here’s the next one, though. Short-term, though, doesn’t it mean that you have further to go, in that you are further above that lower potential right now?

WALLER: Yeah. I mean, the things you’re describing we’re going to see out in twenty years. Lower fertility rates—so that’s not going to happen now. That’s going to happen way out in the future. So for what I’m going to do in the next two years, this has no impact.

LIESMAN: But it does, in the sense that you’re not—you don’t have the workforce to get back to the economy you had, do you?

WALLER: The—excuse me, I know you’re talking about population—

LIESMAN: Yeah, no, no, but that’s true too, in that we’ve lost workers in the pandemic. Retirement has been early. And we don’ have the immigrants. So the workforce right now is lower than it was before.

WALLER: Yeah. And in some sense, that’s a negative and a benefit. I mean, the negative part is, yeah, firms can’t hire the workers they need. The benefit’s going to be, as we keep tightening, they’re not going to let people go. So you’re not going to see big—I don’t think you’ll see big jumps in unemployment and these kind of things. So for the existing workers, you’re going to get through a very severe tightened period. And maybe your job market still looks pretty good.

LIESMAN: We have another question on Zoom.

OPERATOR: We’ll take the next question from Tony Padilla.

Q: Yes. Good afternoon, Dr. Waller. Tony Padilla, here. CFR member and also I’m a former Navy supply chain officer.

My question is to any linkage between inflation and supply chains. To what extent have the supply chain challenges that we’ve experienced in the last two years influenced or contributed to inflationary pressures? Was increased consumer demand the predominant cause of our supply chain challenges, or the other way around? Have supply chain disruptions helped to contribute to high inflation? Any insights are appreciated. Thank you.

WALLER: Yeah. So on the supply chain disruption, there’s a couple things to keep in mind. One is if you take about—the following example: If you have a huge surge in demand for something that overwhelms the productive capacity, that’s not a supply shock. That’s a demand shock that overwhelmed capacity. Too often people think of this as, like, oh, it’s a supply shock. It had nothing to do with demand. But, you know, if fifty of us walk into restaurant that can only seat twenty people and they run out of food, it’s not a supply shock. It’s supply being overwhelmed by capacity.

And in that situation, two things have to happen. Demand has to come back down and capacity has to improve. So that is what we’ve been seeing, certainly in goods for the last, you know, number of periods. Demand for goods has been falling. Capacity has improved. So a lot of the stuff we saw with goods, that wasn’t—I don’t really want to call that a supply shock. There was really a demand-driven—and it got hit—it just drove up capacity constraints.

The other problems are things like chips, you know, silicon chips, where they just couldn’t produce them. The demand was there, they couldn’t produce them, they couldn’t get them there, period. If demand hasn’t changed, they still couldn’t produce enough. So what we’ve seen in the last few months, we have seen dramatic changes in supply chain costs. Just look at in oceanic transportation shipping rates. They skyrocketed and they’re right back to where they were pre-pandemic. So all that decline in shipping cost is now being passed through in the form of lower cost to firms. It’s showing up in lower prices. That’ll all put some downward pressure on prices as we go.

Our job at the Fed is to try to pull back on the demand side to put downward pressure on demand. So how much of this is demand and how much this is supply, no one’s really going to know. But both things have been big contributors to the inflation we saw.

LIESMAN: Let’s do one here.

Q: Thank you so much.

A number of governments around the world are experimenting with central bank digital currencies. I know that the Federal Reserve has not made a decision about whether or not to pursue a central bank digital currency. I’m curious what some of the concerns that the Federal Reserve is considering as they decide whether or not to do that. Thank you.

WALLER: Yeah, I’m not a fan of it, as if anybody follows this is aware of. (Laughs.) I’ve kind of asked a couple of basic questions with this, which is: What is the major market failure in the payment system that requires the Federal Reserve to step in and fix this problem, and it’s only the Federal Reserve that can fix this problem? I haven’t had anybody explain that to me yet, why we need—for that reason, why we need a central bank digital currency.

The other thing is for the central bank digital currency, the way it’s going to be enacted, mainly through an account base, which is you get an account at the Fed—there’s lots of legal issues with that, by the way, whether we can give you an account if you wanted to. But the issue is then for a—since the Fed was founded, we were given the responsibility to provide a safe and efficient payment system. And the model we picked was we let the banks be the front-facing part of the payment system and we sit in the background and we just make sure the money clears across all the different banks.

A central bank digital currency is basically the Fed is going to step front and center and interact more directly with the customer than they have done for the last—and I want to know, what has changed that that is now the appropriate business model for the Fed to think about? I haven’t heard any good answers to that.

LIESMAN: What if I told you $3 ATM fees and three-day waits for checks to clear?

WALLER: That’s the private sector’s job, and that’s called competition.

LIESMAN: Yeah, but it’s not there.

WALLER: I’m not the form of competition you want.

LIESMAN: But it’s not there. Why hasn’t it—why haven’t they arbitraged away ATM fees? And why do you still wait two days for a check to clear?

WALLER: That is going to change. By the way, this is changing. We have real-time payments coming in. This is all being developed. So you’ll get—if you want to go through a real-time payment, you’ll get your money in two seconds.

LIESMAN: I’m ready for that.

Is there one more question on the web? Let’s do that, then.

OPERATOR: We’ll take our next question from Krishna Guha.

Q: Thanks very much, Steve and Governor Waller. Very much enjoyed your discussion.

I wanted to raise the question of policy timelapse. So as you, I know, are fully aware, there is an interesting debate about how long it takes for the monetary policy actions taken today to have their maximum impact on the real side of the economy growth and activity and also on inflation. That seems to be very pertinent to the question of where exactly we are in terms of the balance of risk going forward, and the appropriate conduct of policy strategy. So can you walk us through how you personally are thinking about the question of lags right now?

WALLER: Yeah, so the famous long and variable lags that Milton Friedman put forth in the 1960s, you have to remember, this was a world in which when the Fed did something, they never told anybody. It was not public. There was no statement. There was no nothing. The markets had to kind of go figure out that the Fed was in there doing something. So in that world, policy takes a while because nobody knows you’re really doing anything. And if nobody knows you’re really doing anything, it’s not going to have an impact. So the old idea was: Lags take twelve to eighteen months.

That’s not how we do things anymore. We start telling people in advance when we’re going to start doing things. We started signaling rate hikes last December starting in March, long before they started. So when do you want to think of a rate hike having impact? When we started signaling it or when you actually did it? That’s kind of the problem with the old Friedman view of the world about lags versus the way things tend to work now.

The other thing that’s very clear is that it varies by the transmission mechanism for monetary policy. So I was down in Australia in November. In Australia, they have adjustable-rate mortgages. And by adjustable, I mean, when rates go up, your mortgage payment goes up immediately. It doesn’t wait a year or two years. It goes up that month. Now, if you think about that type of rate environment, as soon as you raise rates you have immediately impacted the cash flow of every household. There’s no long and variable lag there. So it really is going to hinge on what the structures are, how debt is affected by interest rates, how cash flows and payments. And that’s going to vary by country.

So I don’t think there’s a straight answer for, you know, like, it’s always twelve months to eighteen months. I think it’s much shorter now, myself. I think it tends to be nine to twelve months. So I think we’re seeing a lot of the impact for monetary policy coming through in the next quarter or so. I hope that helped, Krishna.

LIESMAN: I don’t know if you wanted to follow up? Because I have a follow up, which is also in Milton Friedman’s time you didn’t have zero interest rates for a period of time before. You had that period of time. Corporations were smart, at least most of them were. They termed out their debt. So when you look at the restructuring and refinance schedules, this is not a big year for it, especially corporate debt, high-yield, and investment rate. Twenty-four and twenty-five, either for commercial real estate even, as well as corporate bonds and high yield. Does that mean that the lags are longer in that case? In the sense that companies termed out their debt, and so you’re not having an impact on the real economy, because that debt is not restructuring or refinancing this year?

WALLER: Yeah, I mean, that argument applies no matter what the rates are. You’re just saying if the rates are going to go up, and I think they’re going to go up, I lock in my financing now. That’s true whether it’s at 2 percent or zero. You lock in now, before rates started going up. I thought you were going to go a different way, which is in a way that kind of benefit is as we raise rates and put downward pressure on total demand, you’re not going to create a lot of financial distress, which is the benefit, right? I mean, it’s a benefit that everybody can absorb this and not have huge problems.

It's sort of like with the housing market. If a lot of your house is equity financed and housing prices come down, it’s not going to cause a housing crisis. So these are kind of good things to have this. So I’m not too worried about the long and variable lag from that, in the sense that unless you think these firms should go out of business and they’re going to be hanging around longer than they should, that’s not my view, but.

LIESMAN: Right. Governor Waller, I think it’s terrific, you sitting and taking these tough questions for the time you did. I really appreciate it.

WALLER: Thanks, Steve.

LIESMAN: Please join me in thanking Governor Waller. (Applause.)


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