Speech News

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Fed’s Daly: I do not see CRE being an imminent risk to financial stability.
Fed’s Daly: We can’t wait for inflation to reach 2% before cutting rates.
Fed’s Daly: I don’t agree with the idea that the last leg of inflation will be the hardest.
Fed’s Daly: I’m not expecting disruptions from QT, appropriate to plan.
Fed’s Daly: The Fed wants to convey a single stance of policy with rates and balance sheet. The Fed does not want to go past ample reserves.
Fed’s Daly: Policy is working; we have to see how much longer it will take to get the job done.
Fed’s Daly: The neutral rate estimate is now between 0.5 and 1, with a nominal rate between 2.5 and 3.
Fed’s Daly: The expectation is that in an uncertain world, the Fed can take a gradual approach to policy decisions.
Fed’s Daly: The labor market is cooling, but so far it represents a return to balance as hiring becomes easier in some sectors. I don’t see an imminent weakening in the job market.
Fed’s Daly: The Fed’s challenge is that the labor market is good until it is not, need to look at other data.
Fed’s Daly: It’s premature to think about just letting the economy run.
Fed’s Daly: Business contacts are not clamor for rate cuts, but want the decline in inflation to continue.
Fed’s Daly: Three cuts is a reasonable baseline for the year.
Fed’s Daly: Expectations for the economy remain close to where they were in December when most recent projections were set.
Fed’s Daly: I’m seeing ongoing progress on inflation that will move around month to month.
Fed’s Daly: All of the recent reports are within bounds of recent volatility, and turning points are always bumpy.
Fed’s Daly: None of the recent data was surprising.
Fed’s Daly: We need more time and data to be sure of continued progress on inflation.
Fed’s Daly: Risks ahead include slower inflation progress & a faltering labor market.
Fed’s Daly: The Fed needs to resist temptation to act quickly when patience is needed.
Fed’s Daly: There’s more work to do on inflation.
Fed’s Daly: Remarkable progress on inflation is not victory.
Fed’s Daly: Slowing inflation, without significant a decline in unemployment, is unequivocally good news.

Speech Text

The day after the December Federal Open Market Committee (FOMC) meeting, just a few months back, a man came up to me in the dry cleaner. He told me that he and his wife had gone to dinner the night before, partly to celebrate the end of the Fed’s rate tightening cycle, but mostly to mark the end of the long, hard battle to bring inflation down. He felt the worst was behind us, and that he and his family could finally take a breath.

The relief he described is not unique. I hear it everywhere. Businesses, communities, and families exhaling, just a bit, as they see inflation falling without the economy breaking.

There is no doubt things are better. But progress is not victory, and we, the FOMC, need to deliver more than a few fleeting moments of relief.

Our goals are sustainable price stability and full employment, working together in a balance that will last. There is more work to do to deliver on that commitment.

Today, I will discuss the progress we have made, the risks we face, and what we will need to do to finish the job.

As always, let me remind you that the views I express are my own and do not necessarily reflect those of anyone else in the Federal Reserve System.

Significant Progress

So, let’s start with progress. Relative to a year ago, the economy is in a very good place. Inflation is heading down, the labor market is rebalancing, and many of the post-pandemic disruptions are dissipating.

The inflation progress has been remarkable. In the latest personal consumption expenditures (PCE) inflation release,1 prices were up just 2.6 percent compared to a year ago. Still not price stability, but a lot of improvement from its peak of 7.1 percent back in June of 2022.

A big part of the story on inflation has been supply. Global production, warehousing, and distribution networks have largely returned to normal. Bottlenecks, wait times, and price pressures have followed.2

These things aren’t surprising. They’ve just finally happened. And they’ve helped ease goods price inflation substantially, bringing it back to near pre-pandemic levels.

The supply-side “surprise,” if you will, has been the positive news on labor and productivity. Defying all the pessimists, U.S. workers in the prime of their working age came back to work last year, including women and mothers. This drove prime-age participation to its highest level in two decades.3 At the same time, we saw a surge in immigration.4 Both of these developments boosted labor availability.

But we didn’t just have more workers, these workers also became more productive. Productivity growth picked up notably last year, surpassing its pre-pandemic trend.5

Together, these supply developments eased labor market tightness and helped to bring wage inflation closer to a level consistent with our 2 percent inflation target.6

But perhaps the best news about the decline in inflation is that supply wasn’t the only story. Improvement also has come from a gradual slowing in demand, the portion that monetary policy directly affects.

We hear this from our contacts and see it in surveys, but we can also quantify it using analysis developed at the San Francisco Fed.7 The researchers focus on the PCE index and separate individual price changes into those driven by demand, where prices and quantities move in the same direction, from those driven by supply, where prices and quantities move in opposite directions. Their analysis shows that about two-thirds of the decline in core inflation in 2023 came from the demand side. Demand played less of a role for headline PCE, where supplies of food and energy drive a lot of the inflation dynamic.8

Putting all of this together, it is clear that things changed in 2023. Supply bounced back, tighter monetary policy gained traction, and inflation came down rapidly. For households and businesses, the treadmill of persistently high and rising inflation slowed down. All without a significant decline in growth or employment.

This is unequivocally good news, and real progress.

Minding the Risks

The question is, should we expect it to continue. The modal outlook of many professional forecasters seems to say yes.9 The median of the December FOMC Summary of Economic Projections portrayed a similar view.10

Most striking perhaps is the confidence that households, businesses, and markets show for continued progress on inflation. Among households, once elevated year-ahead inflation expectations have fallen substantially and are now near pre-pandemic levels.11 Business inflation expectations have also improved. According to the Atlanta Fed Inflation Project, businesses see prices in the coming year rising just slightly above 2 percent, about the norm for that series.12 Financial markets have similar expectations—inflation around 2 percent at the end of the year.13

Of course, projections and expectations are just that: views about what we think will happen. We need more time and data to be sure that they will be realized. And we need to monitor risks that could get in the way, especially since uncertainty is so high.

There is a myriad of risks to consider, but I will focus on two: slower inflation progress and fragilities in the labor market.

On inflation, there is a risk that the positive supply developments we saw last year might be hard to sustain. Labor force participation for prime-age workers is close to historical highs, and with the labor market cooling and wage gains slowing, we might not see additional outsized contributions coming from this group.14 The large influx of foreign-born workers also may slow, further limiting labor force growth.15 I always bet on workers, but at this point, it is hard to predict, and it does pose a risk to further rapid reductions in inflation.

The same is true of productivity growth. It’s highly uncertain whether we will continue to see the strong numbers of last year. There are many reasons to be optimistic, but productivity trends are notoriously hard to forecast, and at this point, we just can’t be sure.

And of course, we live in a dynamic world, and there are always new shocks, like disruptions in the Red Sea and Panama Canal, to disrupt supply. I know this was a concern you mentioned in the NABE survey.16 Although not currently binding, these challenges may impair goods distribution and push up costs in the future.

On the demand side, momentum remains a risk, especially among consumers. We’ve repeatedly expected spending to slow, only to be wrong. Ongoing economic momentum that outstrips available supply remains a risk to the inflation outlook.

But slower progress on inflation is not the only risk we face. On the other side of our mandate, the labor market could falter.

Let me be clear. We do not see that right now. So far, labor market conditions have eased without a rise in unemployment. In technical terms, we’ve been sliding down the steep portion of the Beveridge curve, where changes in labor demand reduce vacancies without reducing jobs and pushing up unemployment.17 As the vacancy rate gets closer to its pre-pandemic average, these favorable conditions could end, and the tradeoff between falling labor demand and unemployment could be more stark.

Of course, with employment growth as strong as it has been, this seems like a distant risk. But given the speed at which labor market pivots historically occur, it’s a risk we must keep in mind.

Finishing the Job

So that’s the landscape. The economy is healthy. Price stability is within sight. But there is more work to do.

To finish the job will take fortitude. We will need to resist the temptation to act quickly when patience is needed and be prepared to respond agilely as the economy evolves.

This is not a new situation for the Fed or any central bank. Uncertainty is a fact of life. The economy rarely signals exactly where it is headed.

The constant in our changing environment is our goals. They are always sustainable price stability and full employment for a healthy economy.

And these are more than just words, a fact I’m reminded of nearly every day.

After the dry cleaner last December, I went to the hardware store. I was standing in line behind a dad and his college-age daughter. When the total rang up, the dad asked the cashier why it was so high. Without hesitation, the cashier said, inflation—everything costs more.

As the two walked out of the store, the daughter said, “I never heard about inflation before the pandemic.” Her dad responded, “I hope you never do again.”

That is really what we are after. An economy unburdened by inflation, where people can step off the treadmill and make decisions about their lives and livelihoods without worrying about rapidly changing prices. We want price stability built to last.

Thank you.

Q&A Transcript

Julia: So now we get to have a conversation, thank you very much, that was uplifting.

Daly: It’s unusual. I’m going to have to get used to maybe some more optimistic speeches from me. I’m an evidence-based optimist, so the evidence is creating some optimism right now.

Julia: It is, and you reviewed some of the very favorable developments we’ve had over the past year. So, why don’t we start with some of the messier data we’ve gotten at the start of the year. We had an employment report: jobs were strong but hours were weak, CPI inflation stronger than expected, retail sales fell, housing starts fell this morning, but confidence surged. So, what do you make of all of this? This is sort of consistent with your baseline outlook that you started the year with? Have there been surprises that affect the balance of risks that you just described?

Daly: That’s a great question. The first thing I’d say is none of these pieces of information were surprising to me. They’re well within the bounds of what normal volatility looks like, especially at what are turning points. If you look back over history, I’ve been through this now a number of episodes. The data around turning points in the economy, whether that’s a turning point to expand rapidly or a turning point to slow to a more sustainable pace, they’re always bumpy. It’s just a fact. So, you really have to step back and look at them and say, is this normal bumpiness or is this outsized bumpiness? I don’t see anything abnormal about what I’m seeing. So, it’s another reason to underline that piece of advice: don’t hang your hat on one piece of data. It’s useful to look at the trends. What I’m seeing now is ongoing progress in inflation. That’s going to be moving around in terms of the monthly estimates, but the progress is still there. You’re also seeing the labor market slow in some dimensions, but one number pick up, another one weaken. That’s completely to be expected. So, my expectations for the economy are very much what I had in December. When we release the SEP, I think a baseline outlook that says inflation’s going to come down gradually, the labor market’s going to slow gradually, growth will slow, but nothing is going to be drastic or dramatic. If that happens, we’ll start to gradually normalize policy. That seems to me like a reasonable place to sit.

Julia: Still a good baseline.

Daly: Still a good baseline.

Julia: So, the December baseline did feature, and in that December baseline, you describe this growing sense of optimism amongst firms and households, and some of that is based on that expectation that the Fed will be able to cut rates. So, with that baseline, you’ve got three cuts in the baseline. I don’t know if you agree.

Daly: I think that’s a reasonable baseline. The median of the SEP seems a very reasonable baseline to me.

Julia: So, as you move towards that, how do you communicate that to the public? What are you looking for to initiate that first cut? What do you need to see to have greater confidence that those inflation trends are durable?

Daly: Absolutely, and I want to point out something because that’s a great question. One of the things we do as Regional Fed presidents, as many of you probably know, is we spend a lot of time in our districts and across the country talking to businesses and community groups and worker groups. Interestingly, when they are talking to me about this relief they’re feeling, they’re not talking about rate cuts; they’re talking about the end of rate hikes. They’re not asking me when we’re going to think about cutting rates; they’re asking me if I think this progress on inflation is really going to continue because that’s really where their problems are. Inflation’s high, and they want to know if the rates were going to keep rising. That’s where that belief is now. When you think about how that translates into the economy and how we are communicating with people, I think what we need to continue to communicate is that it’s premature to think about just letting the economy run because they see inflation in their daily lives. One young man who runs a small business said to me, which I thought was very sweet, “President Mary, 3% on a higher price level is a lot more troubling than 2% on a lower price level.” So he said, “Don’t give up.” I think that’s the sentiment. Somewhere between “don’t give up on keeping inflation coming down” and “don’t break the economy” is where the average person I speak to sits. For them, they want us to make the right number of rate cuts so that happens. If that’s two or three or four, they just want us to calibrate so that we hit that middle. That’s why these two risks of “don’t let inflation slow too little” and “don’t break the labor market” are so important. Does that make sense?

Julia: Yes, it does. That means you have to be looking forward.

Daly: Absolutely.

Julia: So, what are the forward-looking indicators you’re relying on?

Daly: This is where I do think that the work that all of us do, but the Fed, this is our job. We have models, we have history, we have data that are largely backward-looking. There are some forward-looking surveys, and then we have what I think is totally misnamed anecdotes. Let’s strike anecdotes from our parlance unless you’re talking to six people at the soccer game and you’re going to go back and report that as your data. It’s not an anecdote; it’s qualitative surveillance or qualitative data collection. We have to talk to businesses, workers, consumers, etc., about what they think they’re going to do in the next year. So, that’s what we add to it. As I’m because you’re right, if we made policy just waiting for the data to appear, well then it’s too late because of the lags in monetary policy. You cannot wait; you have to look forward. We have to ask businesses, what are you doing? Are you going to raise prices? Are you going to raise wages? By how much are you raising wages? Are you hiring more? What would change your plans? And when do all of that come together that’s where I get this sense that the elements of what happened last year are still there. Okay, but we have to see how much they play out by continually checking. Does that make sense?

Julia: Yes, it does, and there are a few questions here, and I have the same question, which is about the labor market. This year we’re starting very solid but not quite the red-hot labor market we had at the start of last year, so that has cooled. And when it cools, there’s a question on the Sahm rule that it’s at the state level we have triggered it in certain states. And that when the labor market, when firms stop hiring and when you start to see layoffs, it tends to go in a nonlinear fashion. In other words, once you’ve seen job losses, it’s too late.

Daly: That’s the historical norm that unemployment looks like this and then it looks like that.

Julia: Right, right. So, how do you assess what are you hearing about the labor market bottom-up? What are the disciplined, not anecdotal, gathering of ground-level information? And how big a risk is that? Do you see that we’ve been on this cooling trend, we got a pop in January, but if we’re on that cooling trend, we’re getting closer and closer to that tipping point.

Daly: Yeah, and I mentioned that this is something we have to look at now. The challenge that we always have is that the labor market is good until it’s not. And so then you have to look at other things outside of it to say what are the elements or the fundamentals in the economy that could slow it. So, one of them is plans for hiring. Right now, I’m hearing interesting things. At the tech sector, people say, “Oh, I’m not hiring as much.” If you’re doing what I call core provision in tech, you’re a core provider. But everybody who has been short of tech people, especially in cyber and other things, are using this to say, “Oh, thankfully, we can get somebody in tech now because we couldn’t get them before.” So, I still think we have room in that chain because there’s still pent-up need that couldn’t be filled because you couldn’t find a technology worker in the hot technology labor market, and now you can find somebody. So that’s still there. In consumer services, we do see a cooling, but a lot of the firms, like think of leisure and hospitality, they were really undersubscribed on their labor, and so now it just brings them back into balance. What they’re seeing is they can do less overtime and come back more into balance. It was interesting, I was talking to someone who works for a union, and he said that the number one issue for his union members is not pay or health benefits, it’s planned hours. They’re working too much overtime, and they want to have planned hours and predictable schedules. And I think that is where we could see more hiring or different kinds of hiring still there but hours coming down, overtime is going to be coming down. I think this is just about bringing an economy back into balance. So, I haven’t seen a sense that this is going to go like that. But one of the reasons you would normalize policy, begin to normalize policy in advance of hitting 2%, I get asked this, “Why would you ever reduce rates before we hit 2%?” And I said, “Well, there’s lag in monetary policy. The closer you get to those lags hitting, you can find this unexpected rise or fragility in the labor market, and then you’ve given people low inflation, but you’ve taken their jobs, and that’s really not the dual mandate.”

Julia: Right, right, right. So, you’re looking forward, you still see some decent momentum. It’s not something that you’re concerned about, an imminent weakening.

Daly: I don’t see an imminent weakening, but we have to be focused on it because the risks are balanced, and so I just want to recognize risks on both sides.

Julia: Right. And so, on the inflation side, we say we’re going to cut before you get to 2%. So again, what you and recent data hasn’t shaken your confidence that the trend is going in the right direction.

Daly: It has not shaken my confidence. We’re going in the right direction. For me, it’s not about are we going to go in the right direction; it’s about how quickly are we going to go there.

Julia: Okay, okay. And so, if the Fed does have the good fortune of being able to initiate a sequence of cuts in the nominal funds rate alongside cooling inflation, how do you go about that? Is there a cadence you have in mind? How do you communicate that? Is there no forward guidance? How does the Fed ensure about that strategy?

Daly: That’s a very important question. So, back in November, I gave a speech on gradualism, that I first learned from Ben Bernanke. He gave a speech in the 12th District back when I was a younger economist, and it was really when you face a lot of uncertainty, you take your time and you don’t go quickly. So, my own expectation is, in a world that’s so uncertain, we would not have the same loosening cycle that we had a tightening cycle because remember, the tightening cycle was rapid, one of the most rapid in history. We’re there; we have to get that; we’re at zero; we need to be higher, and we raised rates quickly. But now we’re in a much better place, policy is where it needs to be, the economy is in a good place, and so we can look ahead but we can take a more gradual approach to this. And gradual doesn’t mean slow, it doesn’t mean weak, it doesn’t mean sleepy. It simply means not abrupt and urgently when you’re facing a lot of uncertainty and you already have policy in a good place.

Julia: Right. So, do you see the current level of the Fed funds rate as restrictive?

Daly: Yes.

Julia: Yes. So, what about the destination? Do we have a sense of where the destination is?

Daly: So, you know, this is an open question that people want to, everybody wants or needs to have a view of. So, I’ll share my own view, all the remarks I make are my own, of course. But let me talk about how I think about it. The neutral rate of interest, our star, is very hard to estimate, and at one point, this was some months back, probably almost a year back, I asked my team to bring me the range of models. There are a lot of models, and the estimates of r-star went from -2 to 11%. So, that tells you there’s a large span. But here’s what I’ve learned about the star variables: trying to estimate time-varying star variables when you don’t even measure the long-run star variables well is somewhat of a fool’s errand. So, you have to learn experientially how things are. If you asked me today, which I think you are, what’s your estimate of the longer-run neutral rate, I think we came into the pandemic thinking it was about 0.5%. If you took those estimates, 0.5% was right, then you had 2% inflation, that’s 2.5% nominal neutral. Now, I see a reason that it could have gone up a little bit, so my ballpark is between 0.5% and 1%. So, that means a nominal neutral between 2.5% and 3%. That’s a starting point for me, and then if you think of that as your starting point, you can figure out if you get better estimates as you go, but you also can figure it out by what you’re seeing in the economy. And I’m seeing the economy slowing, and I’m seeing a lot of the slowing in inflation that we’ve seen come from demand, not just supply. So, that tells me policy’s working, and it’s having its intended effect. The transmission mechanism is not broken, and we just have to see how much longer it’s going to take for us to get the job done.

Julia: Okay, and how does balance sheet policy feed into this? You’re shrinking the balance sheet, which is a form of tightening. Chair Powell indicated you’re going to get a sort of comprehensive briefing on the options for slowing that down at the March meeting. Is there a process in mind, a sequencing? Do you think you’re going to start that before you cut rates, cut rates before you start that? How do you fit those two tools together? You have two policy tools, well three including communication. So, how do those all work together? What are your thoughts on balance sheet policy from here?

Daly: Sure, and I’ll share how I think about it. The first thing is, when we announced that we were going to begin normalization of our balance sheet, a lot of the effects of that get priced in automatically. Markets, if you look at them, they just say, “Okay, this is what the plan is; they’re going to get this down to ample.” “Ample” is an unknown variable, but it’s going to at least be this, and so that gets priced in. I don’t think of it as a flow variable; I think of that as priced in. Now, the next question that markets are asking, and everyone’s asking, is “What’s ample?” And we don’t want to hit the 2019 moment again. How do we get there? And so that’s Chair Powell addressing that by saying we’re starting to think about those things, slowing it down. One of the lessons I took out of feeling a little behind on raising interest rates when inflation was coming up was that the funds rate, and even our forward guidance, is like a speedboat; we can adjust them very quickly. I see those as our primary tool, the funds rate as our primary tool. I see forward guidance as our next best tool; it’s the two we’ve had the most experience with. The balance sheet, we have less experience, but it’s also like a tanker ship because it’s not just we can communicate the stance of policy with the balance sheet, and they should be aligned. That should be one stance of policy, but it takes longer to adjust things like purchases, the pace of purchases, the pace of runoff, because you also have markets to consider; you don’t want to cause dislocations. So, I don’t see that we have to join them together mechanically, but I do see that we want to convey a single stance of policy. And the single stance of policy is we were tightening policy, yes, and have been tightening policy. That meant we were normalizing our balance sheet and raising the funds rate. Now we’re at the point where the funds rate is restrictive, the balance sheet’s been running off, but now we have this mechanical issue of we don’t want to run, we don’t want to go past ample reserves and cause dislocation. So, I don’t see this as having to be so tied. Consistent, those are consistent in my mind; they convey a single policy stance, which is the economy still needs restrictive policy. How restrictive will be determined by the funds rate, and the balance sheet now is a decision about where’s ample.

Julia: Right, and ample, there’s some sense that after last year, one thing we learned was how quickly deposits can leave a banking institution, and that leads banks to want to increase that level of reserves.

Daly: Exactly.

Julia: Is that one reason for being sort of proactively planning that process of slowing it down?

Daly: Well, I think we proactively plan that process as we did the last time; we had a proactively planned program, but ample came faster because banks wanted more reserves than they were saying even that they wanted, if you remember back in that period. And I think now we just realize banks might want them, and we have to be thoughtful about what they’re going to hold on to and then plan accordingly.Okay, and I do think that we’re on the path to do that, and this is really about making sure that we don’t hit that ample. We do have facilities now, though, that really help us out in this transition. So, I’m not expecting disruptions, obviously, but it is appropriate, in my judgment, to plan for this in March, as the chair indicated.

Julia: Okay, all right, so I’m going to shift from the very near term and where we’ve just been to some deeper questions about what we’re learning.

Daly: Deeper than r star?

Julia: I know, it doesn’t get much deeper than that. But productivity, you mentioned productivity, it was the large-scale surprise last year, 2.7% non-farm productivity growth, that’s well above trend as you noted. How do you understand that? Is that mainly just normalizing post-pandemic? Is it a feature of a labor market that saw better matching through quit rates? A hot labor market gave us higher productivity. Is it something that’s more structural and sticky? Is it AI-driven? How are you understanding these productivity gains?

Daly: Well, I think you’ve nicely laid out all the possible things that could contribute. Here’s how I think about it, and I had the benefit of starting at the Fed in the mid-1990s, 1996, and that was right when Chair Greenspan was looking at all the details, trying to figure out if we were having some sort of a productivity boom when none of the statistics showed that we were having a productivity boom. It was confusing why the labor market could be so strong, growth still 5%, and inflation wasn’t taking off. So, I took a lot from that, that you can miss productivity improvements even if they’re happening right in front of you. The way you have to think about this is to go out and ask people what they’re doing. Tight labor market does result in better matching with quit rates but also results in firms saying, “I need to change. I need to make investments in technology because the future of the labor market is just going to be tighter.” That’s what they came away with, so they started making investments. AI, not Gen AI, AI has been around for a long time, so the kiosks that you can order from, but the number of firms that invested in those types of things to do jobs that they normally or typically would have had people doing, when people were in short supply, they invested in those things. So, you see that now, and it’s not just a West Coast thing; it’s everywhere. You go places, you’re checking into your hotels, you don’t have to talk to a person, you can order food, you can get somebody to deliver, the robot can deliver your things at some points. I was in a hotel in Las Vegas, and I just needed some soap they forgot to put in the hotel, and here comes the robot with the soap. These are investments that companies or firms don’t make until they know that the ROI is going to be high enough. One of the things that makes the ROI high enough is the cost going down. Well, that didn’t happen this time. What happened is the shortage of workers made it worth their investment in spending on the fixed cost. That is already happening, and those investments have been made over the last couple of years. That bodes well for productivity growth because they’re still learning how to use all that technology and harness it, but they made those investments. I think the other thing that we’re seeing is that the workers themselves are coming back, and they absolutely want to learn and grow. We’re seeing more divisible education, and that’s going to increase productivity. For the longest time, you were worried about labor quality, and what I’m seeing now is firms taking it upon themselves to say, “We need you to do this; you used to do that, and we’re going to put you through a certificate program or send you to LinkedIn learning or do whatever we can to get you skilled up.” Divisible learning means you can scale the labor force’s skill level faster and more agilely than you could before. So, I think there’s room to be optimistic, but I want to see more evidence. I want to put my Chairman Greenspan hat on and go and pore over the numbers and ask more questions, tour some factories, see how they’re using it, but I’m optimistic. I’m just not confident that it’s going to happen yet.

Julia: Right, right. That’s where I came at the Fed, at the same time, same experience. It was an interesting time.

Daly: It was an interesting time, right?

Julia: It does teach us, I think, that we can’t have good things.

Daly: We can have good things. It also teaches us that the data are really helpful. Yes, we have to look at the data, but you also have to ask questions because you can miss things. The productivity statistics are going to lag the insights you can learn from just going to factories and touring.

Julia: Yep, and so that’s fantastic. I like the optimism, the cautious optimism. Now, let’s talk about inflation dynamics. Like, nobody on the FOMC expected to have inflation where we are right now, according to the SEP. So, at this time, sometime in the future, they expected it. What are we learning? There was a notion that the last leg of inflation is the hardest.

Daly: I don’t agree with that. I’m not in the camp of the last leg’s the hardest. That suggests that we have to grind out the last two tenths of a percentage point on inflation just laboriously, and I don’t see evidence that that’s true. As the labor market and the inflation risk come into better balance, we have to be more thoughtful about how we get there, but I don’t buy into this idea that it’s going to be so much harder. If it is, we’ll be prepared for it, but I don’t think we should expect that. I think we should expect, and I also don’t buy into the idea that it’s all going to be super easy. Somewhere in between the great renormalization, which I call immaculate disinflation, and it’s going to be a grind, and nobody’s, we’re never going to get there unless we break the economy, probably lies where we’re going to be. But it’s going to take careful calibration and a lot of thoughtfulness to do that well.

Julia: It also came, you know, the disinflation has come without labor market pain. And you mentioned the steep part of the Beveridge curve, etc. Are there, what about the supply side? Is there going to be a more expansive approach to thinking about the inflation outlook at the Fed where we’re not just thinking about the labor market, we’re thinking about the structure of industry?

Daly: I’ve always thought of it that way. Supply and demand join together, and prices come out, right? So, you’ve got to look at both sides of the equation. We got a big positive supply shock from globalization, right? Automation has historically given us positive supply, productivity growth. So, you put all those things together, that allows the economy to grow rapidly without spurring inflation. Most of my career has been in that period, and so I’m very bullish on that can happen. But what is happening now is we’ve got all this high inflation that was post-pandemic, and we had, I don’t think we expected, I know I didn’t expect that productivity and labor supply response. I never count out American workers. I’ve been optimistic about this so many times in cycles because I always think they’re going to come back, and they did, but I didn’t expect how fast they would come back. I thought it would take a little bit longer, and then productivity growth, I was surprised about it bouncing back so rapidly. Those are two good supply boosts. The question is, how much more do we have out of those?

Julia: Right, and then the third element, of course, is inflation expectations, which are well anchored.

Daly: Which are well anchored, yes. I’m very passionate about it because the long run always were well anchored. They stayed very well anchored, but short run, which always fluctuate more, those are somewhat more worrisome. Based on some work that they did in San Francisco, and I was really influenced by, those are feeding right into wage negotiations. So, getting those short-run inflation expectations to come back down and people feeling more comfortable in that space just creates a positive dynamic that also helps us. If we can get consumers, which is what’s happening, to do part of the work of bridling inflation, that is a very good thing.

Julia: By becoming more price sensitive?

Daly: Yes. When they go into the retail outlets and say, “No, where’s the bargain? Everybody bargain.” You’re hearing that our firms are telling us that price sensitivity is very much higher now and that they might have the same posted price, but consumers don’t want to purchase it unless they’re seeing a 10% discount, or you know, how many of those Amazon days are you getting where this is discounted and all that? I mean, this is a serious improvement in the role that consumers play in bridling inflation.

Julia: So, Mario Draghi spoke to us yesterday, and he was talking about making the point that, in a world where fiscal policy is more expansionary, the role of inflation expectations is all the more important. And that central bankers need to be very focused on that. Do we have the right measures of inflation expectations?

Daly: I think we have really good information on inflation expectations. We have surveys of consumers, like the Michigan survey; we’ve always had the New York Fed’s survey, which is quite helpful as an augmenting feature. Then we have business surveys, many of them. Then we have financial markets. You can use various measures, and you can’t hang on to any one of them and say, “Okay, that’s the thing.” But seeing how all of them are responding relative to their own norms—this is all about deviations from the normal pattern because you can’t really look at levels, in at least my judgment. You have to look at deviations from their norms, which is why I kept saying “norms” because I do think that’s how you view these. If you look through that lens, you can see a general movement of these patterns in a way that has correlated with the economic dynamics we’ve seen. We can always use more data. So, if you want to have an inflation expectation series, go to it. I think that is always better, but it’s really the collage of evidence that we put together, and I do think we have a lot of good insight into that. There’s also this really cool survey or piece of information that BLS did, where they looked at the frequency and magnitude of price changes. That is a very important part of the dataset because it’s telling you not only what people expect but what firms are doing.

Julia: That’s very helpful, a very rich discussion. So, we’ve done labor market, we’ve done inflation. How about lags in policy, monetary policy transmission? Are the lags longer, are they shorter? What are we learning from this cycle about lags and policy?

Daly: This is how I think about it: There are two components to the lags in monetary policy. One is the transmission of what the policy stance is and the path into financial markets. And the second is financial markets into the economy. When I look at the data, the path from policy stance to financial markets, that’s almost instantaneous now. You can see that by looking back in November of 2021, around Thanksgiving, when we said we were probably going to taper asset purchases faster, and the mortgage interest rate rose immediately. That’s immediate, but it takes about the same time it’s been taking to walk through the economy. Everybody understands that it’s most likely that we are complete with our tightening cycle, but it’s uncertain when we will begin to start cutting rates. And you see markets have moved around quite a bit. They go up on every data point, but in general, the mortgage interest rates are not continuing to rise; it’s even come down a little bit. People are starting to see revitalizations at lower interest rates. I was talking to a CEO round table, and they’re back to doing deals and things because they say, “Okay, now we’re in a different environment.” So, I think that transmission is immediate, but it takes time still to go through the economy, which is why we can’t wait to get to 2% before we do a policy adjustment. That would be not good.

Julia: And that’s excellent. And you touched on commercial real estate (CRE). That seems to be one of the lagging things that’s still feeding through, right? How big a risk to financial stability is that?

Daly: We knew that it was going to be coming in this year. You just look at the contracts, where most of the loans are repricing. So, they’re usually three-year loans. They knew the tightening cycle was coming, they locked in the low interest rate, now the refinance is coming. And so, right now, I don’t see this being an imminent risk to financial stability. CRE is many things: it is industrial, it’s warehousing, it’s multifamily, it’s commercial office properties, office buildings, retail space. So, industrial and warehousing, there’s not much weakness in that sector; in fact, it’s strong in most places. Retail depends on where you are. If you’re in downtown San Francisco, retail is not great. If you’re in the suburbs of the Bay Area, retail is booming. They’re building more retail space. So, you can’t think of retail without thinking of the location of the retail. Some pockets are weak, many pockets are strong. Same with office buildings. Class A office buildings, even downtown San Francisco, those are fine. Class C is okay because Class C is doctors, lawyers, title insurance companies, lots of things that do in-person services. If you’ve got Class B space and you got a lot of it, you’re going to be in for a repricing. But commercial real estate owners already know this, and they’ve triaged. Here are the ones they say they call “take to ground”—they don’t mean tear it down; they just mean shut the lights off and wait for things to get better. And then there are other ones they’ll sell. In this Commercial Real Estate Group, I heard that there are private equity firms, too, and they’re waiting for the price points to get right. So, there’s a natural floor underneath these things when the price gets low enough. If there’s a sale of properties, there are investors wanting to come in because a lot of the weakness is in big downtown cities: San Francisco, Seattle, some in Boston, Austin. But these are desirable places to live, and if you’ve got enough to buy them and last through, the land retains a value, the location, the city itself has an energy and a value, but it just takes a long time to work through. So, right now, I’m not seeing imminent risks, but we are going to have corrective actions. There’s no doubt about that.

Julia: Will that be something that is a restraining factor through the banking system? Is that just the way policy works?

Daly: Well, policy does work with, you raise interest rates, and certain loans that were profitable at lower interest rates, or certain ideas, properties, innovations that were desirable at zero to 1%, aren’t quite as penciling out at three to 5%. And I think that is just something that happens when interest rates rise. So, what real estate owners I talk to are really thinking about is what’s the long-term path for interest rates, okay? Because ultimately, something penciling out is, it’s short term, you have to figure out how to do it, which bank can work with you to restructure, or is the interest rate path or the level of interest rates just going to be higher for a long time because things have changed in the economy, and we’re not going back to the low interest rate environment that they thought this project worked at, and they don’t want to have that project anymore. And I think that’s what we’re going to learn more about in 2024, but this is definitely a risk to watch. It’s just not one that right now, so it really, I’m going to put it in two, these are simplistic, but you could have a, there’s going to be restructuring, reordering. So, is that going to be orderly or disorderly? And there’s a lot of evidence right now that we could have orderly. Doesn’t mean it’s not hard, it just means it’s orderly. Disorderly is the one where you get an abrupt change in things, but I just don’t right now, I don’t see evidence for that, and I actually don’t have a lot of fear, even in the 12th District, that that’s going to happen among real estate owners.

Julia: You’ve got some of the hardest hits.

Daly: I’ve got some of the hardest hits, and they’re the folks who say, “Look, we’re going to lose money, yeah, we’re going to have to take these to ground, we may have to sell these off, my company will lose value, but I’m not going to go under.”

Julia: Yeah, I hear a lot of that kind of thinking in Austin as well. So, we are now out of time. It was a joy to talk to you today. Thank you for being with us.