Waller Suggested Fed is Ready to Cut If Inflation Continues Falling
Something Appears to Be Giving
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Last month, I gave a speech entitled “Something’s Got to Give.”1 That message was prompted by the fact that we were observing strong economic growth and employment data in the third quarter, while simultaneously seeing a clear moderation in core personal consumption expenditures (PCE) inflation. While this was good news for employment growth, the pace of real economic activity seemed inconsistent with continued progress toward the Federal Open Market Committee’s (FOMC) goal of 2 percent inflation. It seemed clear to me then that something had to give— for inflation to continue falling to our 2 percent target, the economy needed to slow from its torrid third-quarter pace. If it did not cool off, then it was likely that progress on inflation would stop or even reverse. So, what remained to be seen was whether the economy would cool or inflation would heat up.
I am encouraged by what we have learned in the past few weeks—something appears to be giving, and it’s the pace of the economy. Data for October indicated an easing in economic activity, and forecasts for the fourth quarter show the kind of moderation that is more in keeping with progress on lowering inflation. In addition, after watching core PCE inflation increase in September from its summer lows, the latest data showed inflation moving in the right direction in October, albeit gradually.
While I am encouraged by the early signs of moderating economic activity in the fourth quarter based on the data in hand, inflation is still too high, and it is too early to say whether the slowing we are seeing will be sustained. But I am increasingly confident that policy is currently well positioned to slow the economy and get inflation back to 2 percent. That said, there is still significant uncertainty about the pace of future activity, and so I cannot say for sure whether the FOMC has done enough to achieve price stability. Hopefully, the data we receive over the next couple of months will help answer that question.
Let’s start by updating the picture on economic activity. The initial estimate was that real gross domestic product (GDP) grew at a vigorous 4.9 percent pace in the third quarter. We’ll find out tomorrow if that estimate holds up, but growth in the quarter clearly picked up from the first half of 2023, when real GDP grew at a little more than a 2 percent pace. Growth in consumer spending, which accounts for most of GDP, was strong in the third quarter.
Data on economic activity in October indicate that consumer spending is cooling from its pace in the third quarter. Retail sales fell 0.1 percent, the first drop since March. Spending was down on motor vehicles, an interest-sensitive sector, which may be evidence that the FOMC’s tightening of monetary policy is having some effect. Spending was also down at gasoline stations, mostly because of a sizable decline in gas prices, often a larger factor for this segment of retail than shifts in demand. But even without motor vehicles and sales at gas stations, retail sales barely increased in October, which may reflect a broad-based moderation in demand.
Beyond consumer spending, there are indications that manufacturing and non-manufacturing activity by businesses slowed in October. If we factor out a big drop in motor vehicle and parts production due to the United Auto Workers strike which ended October 30, manufacturing output edged up only 0.1 percent last month.2 Surveys of purchasing managers by the Institute for Supply Management indicated that both manufacturing and non-manufacturing activity slowed in October.
Nowcasting models that forecast GDP based on available data are predicting a significant moderation in economic activity in the fourth quarter. After the retail sales report for October, the Atlanta Fed’s GDPNow model is forecasting a 2.1 percent pace of increase for these three months, nearly identical with the actual growth rate for the first half of the year. Something that significantly boosted GDP in the third quarter was a buildup in inventories, which are quite volatile from quarter to quarter. This volatility reflects how businesses manage their inventories by building them up and drawing them down at other times to manage cash flow and anticipate swings in demand. Private inventory investment contributed 1.3 percentage points to GDP in the third quarter and that likely won’t be sustained. Inventory swings could even subtract from GDP in future quarters.
One thing to bear in mind is that the GDPNow estimate does not include the effects of the auto workers strike. A range of estimates suggest the strike will cut roughly half of a percentage point off the GDP growth rate in the fourth quarter and then boost GDP in the next quarter around the same amount, so I will tend to look through the strike impact in considering the strength of economic activity. All in all, it seems like output growth is moderating as I had hoped it would, supporting continued progress on inflation.
The labor market is also cooling off. Job creation is down this year from the high rates of 2022, and the unemployment rate has risen from a more than 50-year low of 3.4 percent in April to 3.9 percent in October. The ratio of job vacancies to people seeking work has fallen, and so has the rate of people voluntarily quitting their jobs. Average hourly earnings, which grew at an annual rate of more than 5 percent last year, have decelerated more or less steadily in 2023 to 4.1 percent in October.
These are all signs of a loosening labor market. But for all of the measures I have mentioned, they are still at levels that, historically, would be associated with a fairly tight labor market. We have 10 months of data on job creation in 2023, and for the 5 months through May, the monthly average was 287,000. Even with the strong month in September, the average for the past five months has been 190,000, which is close to the 10-year average from 2010 through 2019.3 That’s a significant slowing, but job creation is still happening at a rate that is higher than what would be required to absorb new entrants to the labor force, factoring out changes in labor force participation. And while 3.9 percent unemployment is higher than the April low, it is still basically as low as unemployment got during the booming job market of the late 1990s. Members of the National Federation of Independent Businesses (NFIB) report job vacancies are down significantly from 2022, but still at a level that is higher than the late 1990s or any time in the 36 years of the NFIB survey.4 The bottom line here is that the labor market is still fairly tight and I will be watching closely to see whether it continues to moderate in ways that keeps inflation moving toward 2 percent.
So, let’s talk about that progress on inflation. Consumer price index (CPI) inflation for October was what I want to see. For the month, there was no inflation, prices were virtually flat, and unlike earlier moments where improvements were concentrated in some goods and services, the moderation in inflation was broadly distributed. Over the previous 12 months, CPI inflation was 3.2 percent, a dramatic improvement from 2022, when CPI inflation was above 8 percent for most of the year. For October alone, a drop in energy prices offset increases in other categories, but the increase that month in core inflation excluding food and energy was still a modest 0.2 percent. Core CPI inflation was 4 percent over the past 12 months, but a better sense of the recent trend comes from the annualized rate of 3-month inflation, which for core was 3.4 percent in October.
As you may know, the FOMC uses another measure of inflation for its 2 percent target, based on personal consumption expenditures, and this consistently runs a bit below CPI inflation. We’ll get October PCE inflation on November 30, but a rough estimate based on differences with CPI and the producer price index indicates that headline PCE inflation was 3 percent over three months and 2.5 percent over six months.
The question is whether inflation can continue to make progress toward 2 percent. There are some factors favoring this outcome, so let me walk through them.
First, housing services inflation, based heavily on rents, has slowed from its peak last year, and the lagged effect of moderation in rental prices in the past year should keep this sizable component of inflation at a moderate level.5 Goods prices have contributed a lot to the decline in inflation recently and have moderated so much that they probably won’t be contributing much more. But services excluding housing, which accounts for about half of PCE inflation, has not moderated as much as other categories, and there will have to be some improvement there for overall inflation to reach 2 percent.
Labor costs are a significant share of these service price increases, and the moderation in wage growth I mentioned earlier should help lower this segment of inflation. The increase in average hourly earnings has slowed to an annualized rate of 3.2 percent over the past three months, below the 4.1 percent 12-month rate, a sign of continuing improvement. That is also the indication from the Atlanta Fed’s Wage Growth Tracker, which uses household survey data to estimate annual wage increases. It was as high as 6.4 percent in March and was down to 5.2 percent in October. A broader measure of compensation, the quarterly employment cost index, has improved less dramatically this year. A services-oriented measure of wage increases constructed by the St. Louis Fed also showed slowing. This research, based on data from the payroll company Homebase, shows wage pressure continuing to moderate in a way that is similar to broader measures of wage growth.6
This is encouraging, but it is not enough evidence to be sure it will continue. Just a couple of months ago, inflation and economic activity bounced back up, and the future was looking less certain. And while it is encouraging to see inflation by the FOMC’s preferred measure dipping below a 3 percent rate over the last three or six months, our target is 2 percent, and policy needs to be set a level that moves inflation to 2 percent in the medium term. I will be closely monitoring the pressure on various categories of goods and services prices in the coming weeks to help me decide if inflation is continuing on its downward path. Let me turn now to the implications of all this for monetary policy. I would start with the point I made at the outset—monetary policy is restrictive, and it is clearly contributing to the rapid improvement in inflation in the last year. The FOMC raised the federal funds rate from near zero to more than 5 percent, the sharpest increase in more than 40 years, and, as some people have noted, we have seen the most rapid decline in inflation on record. Elevated inflation was partly the result of supply-side problems related to the pandemic, and some of the improvement in inflation that we have seen has been due to the easing of those problems. But most data indicators and anecdotal evidence suggests that supply side problems are largely behind us so they will provide little support in the future in returning inflation to our 2 percent goal. Monetary policy will have to do the work from here on out to get inflation back down to 2 percent.
There has been chatter that robust economic growth and falling inflation may be the result of higher labor productivity growth. In fact, productivity growth over the last two quarters has averaged over 4 percent, more than double the long-term rate. However, measures of labor productivity are very noisy, and for the 15 quarters since the advent of the pandemic, productivity has increased at an annual rate of 1.4 percent, close to the 1.5 average over the past 15 years. So, relying on the productivity growth story to guide the current stance of monetary policy appears to be premature.
There has also been a lot of discussion about the overall easing of financial conditions this month, as reflected in market interest rates and the prices of other assets. To put this easing into perspective, from July to the end of October, the yield on the ten-year Treasury increased about 1 percentage point. Since the FOMC’s last meeting, which ended November 1, the ten-year rate has fallen six tenths of a percentage point. Long-term interest rates are still higher than they were before the middle of the year, and overall financial conditions are tighter, which should be putting downward pressure on household and business spending. But the recent loosening of financial conditions is a reminder that many factors can affect these conditions and that policymakers must be careful about relying on such tightening to do our job.
The October data I have cited on economic activity and inflation are consistent with the kind of moderating demand and easing price pressure that will help move inflation back to 2 percent, and I will be looking to see that confirmed in upcoming data releases. Before the next FOMC meeting we will get data on PCE inflation and job openings, and a job report and supply manager’s survey for November. CPI inflation will come out on December 12, the first day of the FOMC meeting. All of that data will tell us whether inflation and aggregate demand are continuing to move in the right direction and inflation is on a path to our 2 percent goal.
[Q&A]
Michael R. Strain: Okay. A lot to talk about. Thank you, thank you for those remarks. Let me begin by offering some of my reflections on the soft landing scenario, and get your reaction to those. I agree with you, something has to give. I agree with you that we’re seeing a softening in aggregate demand. That seems clear both in terms of business investment, and in terms of consumer spending, and in terms of the labor market. So if that were to continue, then we could tip into recession, or we could have a soft landing, or we could re-accelerate, and those seem like three mutually exclusive and collectively exhaustive possibilities. There seems to be a lot of hope around the soft landing.
And kind of conceptualizing the soft landing in terms of the labor market, the scenario would be that we go from a, you know, 200,000 job-per-month economy, or a 150,000 job-per-month economy, kind of wherever you think we are right now, down to a, 40,000 job-per-month economy, 50,000 job-per-month economy, something above zero, but below the pace needed to keep up with population growth. And then we stay there for four months, five months, six months, something like that, a length of time sufficient to bring inflation back down to target, and then we re-accelerate, and we go back to a 150 per month, 200 per month economy.
That scenario seems to have captivated the imaginations of economists and journalists. It seems to me to be a little too neat and tidy. If you look at post-World War II economic history, you don’t see that happening. What you see is that when the unemployment rate goes up a little, it tends to go up a lot. When you look at employment growth, when year-over-year payroll growth dips below 1.5 percent, it goes on to go negative. On the other hand, we are in, I think, the most unusual period of economic history since the demobilization from World War II. A lot of things that weren’t supposed to happen have happened, and a lot of the laws of economics seem to have been suspended. Maybe this time will be different, and we’ll get the soft landing.
So my question to you, am I unduly pessimistic about this? Or do you think that a soft landing could happen but my general assessment of its likelihood seems reasonable?
Christopher J. Waller: Well, I’m an optimist. So back in May ’22, I gave a speech outlining what I thought a soft landing would be, and how we could actually achieve it. And it was largely the fact that we had so many vacancies to workers that I thought our efforts in raising the policy rate could put downward pressure on labor demand, not through really getting rid of workers, which there seemed to be a big shortage of, but just reducing the number of vacancies. Now inevitably, there’s going to be some increase in unemployment, but through some analysis I did with Andy Figura at the Board of Governors, we said that, look, in unemployment, if there aren’t massive layoffs, if you just keep the involuntary job separation rate stable, you can get vacancies down, get labor demand down, and unemployment would only go up to maybe 4.3 percent or 4.4 percent.
There was a lot of controversy around that argument, but so far, it seems to have played out fairly closely. Unemployment is 3.9 percent, we still haven’t quite got everything down to where it was in 2019, and so I think that is where people are starting to say, yeah, maybe this is going to look like that. But if you go back in US history, when you think about a recession, it’s always caused by some major shock. That could happen again. There could be another major shock, and this whole soft landing disappears. But shocks are shocks. We can’t really forecast it. And when I think about the last 18 months, we saw a Russian invasion of Ukraine, we saw the Silicon Valley shock, banking stresses, the recent events in the Middle East, and these things have all been what normally we think would be a big shock that could tip the economy into recession, but so far they haven’t done it.
So that’s why I think just looking at past recessions isn’t going to be necessarily a good guide in this case. And so that’s why in unemployment, when it goes up, it goes up fast. It doesn’t kind of just gradually go up, and then flatten out. But as long as we don’t get any big shocks, I am reasonably confident that we can pull off this soft landing. And unemployment will probably go up a little bit more, but if we can get inflation to come down, GDP growth to soften but not go negative into a full recession, there’s no reason we can’t pull it off. But there’s always some shock sitting in the background that may happen, and blow the whole thing up.
Michael R. Strain: So let’s stick with that for a minute. When the soft-landing arguments began to be made, I was more optimistic as well for exactly the reason that you mentioned, which is that labor market tightness looked to me to be driven more by excessive labor demand than by excessive employment. Labor demand is normalizing. The job worker gap is shrinking, and we still have inflation that is well above the Fed’s target, and there’s still the risk of inflation kind of getting stuck well above the Fed’s target. And that normalization of labor demand without an accompanying clear path back down to 2 percent for price inflation has increased my level of pessimism regarding the soft landing possibility.
With regard to the shocks, how concerned are you about commercial real estate? How concerned are you about private sector data that show an increase in credit card delinquencies? How concerned are you about the data from . . . or the data that can be gleaned from earnings calls that talk about concern for weak demand, a weak holiday season? How concerned are you about businesses not gearing up for the holidays with October hiring? How concerned are you about corporate earnings? And you know, yes, we’ve seen a loosening of financial conditions due to appreciation of stock prices, but that’s seven stocks out of the 500, and the S&P 500. Does that kind of constellation make you concerned both about a specific shock, maybe it’s commercial real estate, maybe it’s credit card delinquencies, and make you concerned that the economy is actually kind of folding faster than the headline statistics suggest?
Christopher J. Waller: Yeah, so I mean on the labor market side, one thing that has also happened is we’ve seen a very strong comeback in labor force participation mainly among prime age workers from 25 to 54. In women in particular, the return to labor force has been astounding. We’ve seen immigration levels coming back to what they were pre-pandemic in terms of trend, so we’ve also gotten a lot of help on the supply side of the labor market to help with this reducing demand, but not having unemployment go up dramatically.
On commercial real estate, everybody knows there’s going to be repricing in commercial real estate. When repricing occurs, somebody wins, somebody loses. But we all know when that refinancing and repricing is going to happen. It’s not a shock, it’s well anticipated, and everybody sees it coming. So that’s why I’m not as concerned about somehow we’re going to wake up one morning, and go, oh, my God, commercial real estate is repriced. We all know it’s going to do that. That’s not a shock. And it’s going to happen over a couple of years. It’s not going to happen one morning, every commercial real estate prop in the US has to be refinanced and repriced. So that’s why I’m not as concerned about commercial real estate being a shock that throws it into a recession. Is it going to be painful? Yeah, some people are going to lose money when these things have to be refinanced and repriced. But that’s just the way markets work, so I’m not too concerned about the commercial real estate.
On the other elements, remember, we are trying to slow down demand. We are trying to slow down the economy. That’s going to have an effect on delinquencies. It’s going to have an effect on earnings calls. These are things we need to get the economy to slow down, and also get inflation down. So what we don’t want is it to go so bad that the economy goes tanking into a recession, but these are all signs of showing we’re getting the moderation in demand that we want to help us get the economy back on stable footing in terms of inflation, without tossing us into a recession.
Michael R. Strain: So it sounds to me like of the three scenarios I outlined, you’re less concerned about the economy re-accelerating than about either a soft landing or a recession.
Christopher J. Waller: I mean, I was in the third quarter. I was stunned by this third quarter number. I think everybody was. It was like, where is this coming from? We were at 2 percent, 2 percent, 2 percent, 2 percent, 2 percent, and then almost 5 percent. But now, what I said is all the forecasts I’m seeing, all the preliminary data that’s coming in, it’s going to be probably 1 percent to 2 percent in the fourth quarter, depending on which one you’re looking at. So that clearly is in moderation. The things you mentioned, these are all things that are telling you, look, this 5 percent growth isn’t going to continue for a couple of quarters. So, something happened in the third quarter, I don’t know . . . Lots of Taylor Swift concerts, I don’t know what it was, but something blew up the third quarter, and it’s not likely to continue going forward.
So that’s why I’m less concerned. Once I saw the last couple of weeks of data, I felt more confident that this seemed to be a one-off. And as I stress, inventory investment was a big factor, and that can be some evidence, just pulling forward investment from the fourth quarter, which means fourth quarter will be even lower. So that’s why I’m thinking that whatever we get for third quarter, it was a bit of an anomaly, and it’s not going to continue.
Michael R. Strain: How much of the moderation in the fourth quarter would you attribute to Bruce Springsteen having to pull off the tour due to that peptic ulcer?
It seems to me that an elephant in the room for the Fed is the fiscal situation. And of course, fiscal and monetary policy are independent, but the fiscal situation affects monetary policy, I think, in a couple of important ways. High deficits boost aggregate demand at a time when the Fed is trying to cool aggregate demand, as you say. That in turn boosts the neutral rate of interest, which means that the policy rate needs to be higher for contractionary effects. In addition, high defects require that the Treasury sell large amounts of longer term debt. That boosts yields, it could boost the term premium. The Fed, I think, can’t just recognize that higher rates are going up because these two different effects have different implications. A higher neutral rate implies a higher policy rate, a higher term premium implies a lower policy rate.
How do you think about that? How do you think about the fiscal situation as it affects the FOMC? How do you think about those competing effects of extremely large structural deficits?
Christopher J. Waller: Yeah, so I mean the way we’ve always kind of thought about fiscal policy and monetary policy is, look, there’s lots of exogenous external factors that are not under our control. We just take them as given, and we do the best we can in response. The same is true with the exchange rate, foreign government monetary policies, all sorts of trade rules that get put in. Our job is to take that as given, and do the best job that we can. We can’t change those things because they’re not under our control.
So with fiscal policy, you know, that’s Congress’s job, to do whatever they think they need to do in the administration. My job is to say, okay, whatever it is, that’s how I have to respond. Sometimes it might make my job harder, sometimes it might make my job easier. But that’s just that’s just the way that monetary policy works. You know, on the fiscal side, it’s just . . . we typically don’t comment, but just as a former academic economist, running budget deficits of 7 percent, 6 percent of GDP in peacetime at full employment just doesn’t sound sustainable. It doesn’t mean there’s going to be a financial crisis around the corner, but longer term something probably has to be done to address it.
Michael R. Strain: What is your outlook for the longer term neutral rate?
Christopher J. Waller: I have a whole speech on this at some point. There’s so much chatter about the long run neutral rate, and my just general comment is if you look at the real return on safe liquid government debt, that thing has been falling for 40 years. Just go plot it out, it is just a long, long, long downward trend. The rate of return to capital, due to some work by one of my colleagues in St. Louis, Ravi Kumar, if you look at the real return, or the average real return to capital over the last 40 years, it’s constant. It’s very volatile, but there’s no secular downward trend. So there’s something unique about safe liquid government debt, treasuries in particular that is driving this long-term decline. So whenever people tell me it’s going to bounce back up, I always kind of ask, it’s been declining for 40 years. What is it that you suddenly think is now driving it up?
I mean, just a couple of weeks ago we heard it’s all the 10-year treasuries going up because R-star is higher. Well, now it’s fallen back six-tenths. Is R-star coming back down in three weeks? I mean, these just sound like . . . They’re just really not plausible stories. You’ve got to do a lot more work in thinking about, and estimating, and understanding the causes of why it would suddenly start going back up.
Michael R. Strain: Last question from me, and I know you want to stay focused on the economic outlook, but I want to ask you about the Basel Endgame capital requirement proposal, and your vote on that, and kind of how you’re thinking about how you might further engage with that.
Christopher J. Waller: Yeah, I mean, the Basel Endgame is out for comment. We had an open board meeting, we all made our official statements. I voted against it. I thought it was excessive in terms of what it was doing, particularly on one element, which was this operational risk bucket, which is mainly due to, like, lawsuits, and cyberfraud. Those are things that don’t typically occur at the same time as a financial meltdown due to a macroeconomic shock, so they’re not correlated with market risk, trading risk, all the other things that might bring a bank down. So I just argue that because it’s not really a threat to this, you don’t need a separate bucket for this. You can use operational risk paid for out of your standard capital bucket.
So that was my argument. And I think when I looked at the numbers, operational risk is something like over 50 percent of the increase in capital. So if there’s some willingness to move on operational risk and some other things, there is a possibility that this could be put forward in a revamped way that would be acceptable.
Michael R. Strain: Okay, let’s take questions. Yes, sir.
Nick Timiraos: Hi, Nick Timiraos, with the Wall Street Journal. Governor Waller, I want to ask you about something you said at the beginning of the year. At the beginning of the year, there was a disconnect between what you and your colleagues were saying about the path of policy for this year, and what the markets were pricing at. And the markets were pricing in a lower policy rate by the end of this year, and you had said, you had kind of characterized this as a miraculous melting away of inflation that the market expected, that you didn’t see. Since June, we’ve now seen, with this week’s reading, perhaps five months of better behaved core PCE inflation could be annualized around 2.5 percent. And so I’m wondering if that continues, if that would count in your book as this miraculous melting away of inflation.
I guess the question I’m building up to is, at what point would you say maybe policy rates could be lowered, that a 5 3/8 percent policy rate wouldn’t be appropriate if inflation could be sustained at 2.5 percent core inflation? Thank you.
Christopher J. Waller: Yeah, so back in January, yeah, as Nick pointed out, there’s been a couple of disconnects between us and the markets over the last 18 months. And in January, I was saying this was just due to forecast. We just had different forecasts. It wasn’t like somebody was right or wrong, we just had different forecasts of what was going to happen.
The market, I argued, as Nick said, I viewed the market was thinking inflation was going to be at 2.5 percent by the summer. I didn’t think it was going to go down that far. Where we’re looking at being for the 12 months at the end of the year is about what I thought it would be back in January, somewhere between 3 percent to 3.5 percent. That’s kind of what I had in mind back in early January. So it’s kind of played out that way, but it’s been bumpy, you know? There have been months where it was much better, and looked like it was going to be a miraculous disinflation, and then it popped back up, like in September. So I think it’s heading . . . The inflation rate’s moving along pretty much like I thought. Now, if you think about in central banking, we talk about a Taylor rule, or various types of Taylor rules to kind of give us a rule of thumb about how we think we should set policy, and every one of those things would say if inflation is coming down, you don’t need to keep . . . You know, once you get rates or inflation down low enough, you don’t necessarily have to keep rates up at those levels. So there are certainly good economic arguments from any kind of standard Taylor rule that would tell you if we see this inflation continuing for several more months, I don’t know how long that might be, three months, four months, five months, that we feel confident that inflation is really down, and on its way, that you could then start lowering the policy rate just because inflation is lower. It has nothing to do with trying to save the economy, or recession, it’s just consistent with every policy rule I know from my academic life, and as a policymaker, if inflation goes down, you would lower the policy rate.
So yeah, there’s just no reason to say you would keep it really high, and inflation’s back at target, for example.
Michael R. Strain: Other questions?
Aatman Vakil: Aatman Vakil, AEI. My question was about, like, how would you categorize inflation as being attributed to supply shocks in the wake of the pandemic? And then because the supply rebounded, you see inflation coming back down, versus the sudden jump in the money supply when the pandemic first hit? Thank you.
Christopher J. Waller: Yeah, so I mean this is a standard question people always try to sort out, how much of this was supply, and how much of it was demand? And my view is both, right? The thing that always leads me to think about it being a lot of demand is that if it was really all supply, prices went up, but when the thing reverses, all the prices should have come down, and you have deflation. We didn’t get deflation, we just got a slowing of inflation. We got disinflation. So that tells you something happened that permanently raised the price level, and that’s typically something on the demand side. So that’s why I’m not a big believer that this is all supply side stuff, because we should have had deflation as all the supply stuff unwound. So it had to be a very strong demand element to it.
You know, there’s a funny problem sorting out supply and demand shocks, and I kind of use this following example. You know, if 50 of us go to a little restaurant that only has 15 seats, and they run out of food, is that a supply problem, or is that a demand problem? The fact that 50 people showed up is the demand side of it. The fact they ran out of food is a supply thing, but what caused them to run out of food? It wasn’t they forgot how to order, or forgot how to cook, they just had so much demand they couldn’t keep up. And I think that was a large part of what we saw on the supply side. It was just a lot of demand-driven changes, particularly goods in the early part of 2020. There’s a huge shift of goods, they weren’t ready for it, and then this creates all kinds of supply problems in terms of providing those goods. But it was initiated by goods demand, not necessarily some shock to the supply side of the economy.
Michael R. Strain: Let me build on your answer to that question to ask another. Before the pandemic, we were worried about low real interest rates, we were worried about below target inflation, how can we get inflation back to target? We were worried about the possibility of declining inflation expectations. And as you say, over the decades prior to the pandemic, we just saw real rates go down and down and down. This is driven, in my view and the view of many economists, by slow-moving structural factors, demographics, the supply and demand of enforced savings, technological change that affects the way people enter the workforce. And then we had this pandemic, and we had extraordinary fiscal and monetary support, we had substantial supply chain challenges, and now we’re kind of unwinding all of that.
The big debate, does the world after this business cycle look like it did in 2017, 2018, 2019? Or are we in a world of, you know, permanently higher interest rates, are we in a world where the challenge is not to get inflation up to 2 percent, it’s to get inflation down to 2 percent? It seems to me that if you believe that the 2017, 2018, and 2019 world was created by these sorts of slow-moving structural factors, you would conclude that the world after this business cycle will look an awful lot like it did before the pandemic. Is that your view? If not, where are we differing?
Christopher J. Waller: So again, this is back to what I was saying about the whole R-star. When people say declining low real rates, they’re talking about real rates on government debt. I’m telling you, go look at the work my colleague Ravi Kumar at St. Louis Fed did, and other academics that have done it since then, the real return to capital has no secular downward trend in it. It’s bouncing around, but it’s roughly 7 percent in real terms. So technology, productivity growth, these are all things that should be affecting that as well. The fact that real returns on government debt have fallen for 40 years, and the average return to capital hasn’t changed says there’s something special . . . I don’t want to use the word special, about US Treasuries, and that you can’t mix that up. There are explanations, there’s potential explanations, but you can’t mix that up with things that should be driving also the real return to capital. Because if those things were lowering it, that thing should be coming down too, and there’s just no evidence of it.
So there’s something unique about government debt, and you want to sort these two things out. What would be things that would not affect the real return to capital, but would affect the real return on safe liquid government debt? US Treasuries are special objects. They’re very special financial instruments compared to a lot of things in the planet. So just looking at that, and making broad statements about the economy can kind of lead you off in the wrong direction.
Michael R. Strain: Another question?
Attendee 1: Thank you. Mike said the word “demographics,” and that made me wonder. The working age population has sort of flatlined in the last five years, the birth rate and the number of babies born has been falling since the Great Recession. How does it look 10, 20 years from now, when the worker-to-retiree ratio is going crazy, and there’s not the steady increase in working age population that we’ve had for the rest of American history?
Christopher J. Waller: Yeah, I mean, the thing about demographics is they’re very slow-moving. They’re generally . . . right? These are really slow moving, they’re very predictable in terms of what can happen. So for example, the declining labor force participation started back in roughly 2000. It was forecasted out 20 years, and it’s amazing how accurate those predictions are right now. It’s just amazing.
This really surprising thing you mentioned, which you know, I have my own just general concerns as an economist, not as a policymaker, but the huge drop in fertility rates in the US in the last 10 years is really stunning. We went from a fertility, a replacement ratio of about two, fertility rate of two, to like 1.2. I mean, this starts looking like Italy, Eastern Europe . . . I mean, this has got very long-term consequences. Now, whether it rebounds or not, or it’s just a hangover from whatever else . . . But that fertility rate, which hasn’t been talked about a whole lot, is going to have some really long-term implications. Twenty years from now, if instead of two children, every woman’s having one, think about just colleges. How many colleges do you need? Sorry, no offense to my academic colleagues. But it’s these kind of implications that, and that’s . . . you know, if you’re 10 years into this, you’re talking just 10 years from now, you’re going to see a huge drop-off in the number of kids graduating from high school, going to college, labor force. So I think this fertility rate decline is a major issue that hasn’t really gotten a lot of focus. And like I said, you said it started roughly after the Great Financial Crisis, you’re 10-plus years into this already, it’s going to start showing up in the next decade.
Michael R. Strain: Final question? Okay, well, I promised you we’d be out of here at 10:45, and it’s 10:47. So thank you so much, Governor Waller.
Christopher J. Waller: Thank you.