Welcome to Central Bank Central. I'm Kathleen Hayes here today with a very special guest, a leading academic who has held just about every top economic policy job at the Federal Reserve and in government. I'm so honored to welcome Janet Yellen. She started her career as an economics professor and she's been back and forth between academics and public service ever since. She started as a Fed staffer at the Board of Governors. She became a Fed governor herself, served as chair of the Council of Economic Advisers. I guess she just had to break up some of all that Fed focus. Then she became president of the San Francisco Fed, went on to become vice chair at the Board of Governors, and then rose to be the chair. And to top it all off, she took on the job — I guess she wasn't quite ready to stop looking at all, having a hand at all this stuff — the job of US Treasury Secretary. Janet, it's so great to have you here.
Thank you so much, Kathleen. It's really nice to be with you.
Well, you won't be surprised that I'm going to start on inflation. You've been dealing with this many years. You've been writing policy papers, research papers, all kinds of things. And the bottom line is we've got an inflation target missing its target of 2% for five years. And new inflation challenges, it seems, popping up all the time. Particularly, you know, the Middle East, oil prices going up. All of this is making the Fed's job, I think, harder and harder. What would you be looking to do right now? I know you say, 'Oh, price stability, right?' But in terms of the next steps to take, in terms of the policy steps, rate hikes, no. What would you be doing or at least thinking about?
Well, I guess I would be assessing the economy from the standpoint of both of the Fed's congressionally mandated objectives: maximum employment and price stability. And from the maximum employment standpoint, we have an unemployment rate of 4.2%, which exactly matches the FOMC's central median estimate of the longer-run normal rate. So, it seems to me, although there are things going on in the labor market that concern me — the pace of job creation is low, it's a no-hire, no-fire kind of labor market, people seem worried about losing their jobs, quit rate is very low — but all in all, the unemployment rate is quite low. It's actually fallen some, and job creation, while low, pretty much matches. We've got a low pace of increase in labor supply because immigration has declined a lot. We have increasing numbers of people retiring. The baby boom has gotten to that point. So, you know, I've seen estimates of the break-even level of job creation as low as zero. What I mean by break-even level is what pace of job creation do you need to keep the unemployment rate constant? I guess over the last year, the average rate of job creation has been around 40,000 jobs a month. I think the labor market's okay. So, you know, I feel the Fed is doing what Congress has asked it to do in terms of that objective. And I'd say I'm a little bit less worried about downside risk to the labor market now than I might have been five, six months ago. Then with respect to inflation, obviously inflation is too high. It remains very meaningfully above the Fed's 2% target. The PCE inflation rate year-over-year is 3.4%. Core inflation running a little bit lower, but still 3% is not 2%. And we have a bad starting point in that inflation has been above, and sometimes well above, the FOMC's target now for five years. So that makes me feel a major focus should be on inflation.
Okay. But then the question is, why is inflation above target? Okay.
I think that the major reason is not that we have a labor market that is so hot that wages are increasing at a pace that you would see as creating chronic labor cost pressures on firms that would be driving inflation. Wage growth has actually been declining. It's at a level that is not a threat to inflation, especially given that productivity growth has been running about, around 2%. In fact, unit labor cost, which is a nice measure of what firms are seeing with respect to their labor costs, that's running about 1.4% is the number that sticks in my mind over the last year. So firms are not charging prices that exceed the Fed's inflation target because of pressures coming out of the labor market. So what is it? And I would argue it's three things. First, well, of course, we had all of the inflation associated with the pandemic, but inflation was coming way down and arguably on a trajectory that would have brought it down to 2%. And then what happened is Trump came in, put these high tariffs in place. The composition has changed quite a bit, but those tariffs have boosted the level of prices. Now, they are a one-time type of supply shock that should in principle boost the level of prices, but not on an ongoing chronic basis. So they cause higher inflation for a while, then prices have gone up, then inflation should subside, and I think we were on a path to see that happen. Then along comes the Iran war, which boosts oil prices and even more refined product petroleum prices. There are shortages in refining capacity. We think that's going to go away and get settled, but it doesn't. And who knows when it will or if it will. But again, as serious as that is, and that has the potential to boost costs throughout the economy — transportation, logistics costs — again, it's potentially a one-shot thing in that it should cause prices to rise, like tariffs, as the supply shock finds its way into higher prices. But then the inflation should subside.
It should subside, but will it subside? People have had a longer and longer — like you said, five years, five years above target, all kinds of things.
But it's different things. It's a series, to my mind, it's a series of supply shocks. And yes, it's very unfortunate that just when inflation would have been dying out, along comes tariffs. And just when they would be dying out, along comes energy. And then the final thing I put on this list is the AI boom, which is causing semiconductor prices to rise, construction costs to rise, everything that's used in data center construction, and that's boosting consumer prices as well. So many of the things we buy have some kind of semiconductor or memory chip, a storage chip, embedded in it. And again, this should be something that's one-shot. Okay. So I think you can tell a story, and I think people in the FOMC who are on the dovish side of policy have been saying that if you sit there and hold out long enough, eventually inflation should still, within the next couple of years, get back to 2%. So that's part of what I think, and I agree with that analysis. The problem is inflation was too high to start with. It's been too high for five years, and it can become ingrained in the economy. And if it finds its way into inflation expectations, or if further supply shocks come along, we can find ourselves with inflation expectations influencing wage and price setting. And now we're back to a '70s problem that becomes difficult to deal with.
Okay. And of course, it's very hard on families. It's very hard on a lot of businesses to have inflation up and have many people have a concern that it will continue to rise. Right. But when you say it's a '70s problem, distill that for us. What does that mean? Been doing this a long time.
Sure. Only if inflation expectations rise. What happened in the '70s is a series of supply shocks boosted inflation in a manner that, just like I described, should be an increase in the price level, then inflation dies out. But that isn't what happened because inflation expectations moved up. The Fed didn't really move in a meaningful way to address these supply shocks. Inflation moved up. Unions were much stronger then, and they began to incorporate in their wage demands wage increases high enough to cover inflation. We ended up in a situation where firms and workers demanded wage increases, and firms expected and were allowed essentially to pass those wage increases into prices. And we were in a situation where we were now locked into high inflation. And really the only way to deal with that was to tighten monetary policy enough to get inflation down.
Well, so isn't that what monetary policy is all about? You've got, you can say dual mandate, but one of your biggest mandates is inflation. And of course in the '70s, as you just said, the Fed was slow to move, and then, you know, Paul Volcker came in and he cracked down. Alan Greenspan continued with opportunistic disinflation, etc. So at this point then, where we are — oh, inflation expectations haven't moved — actually the longer term, that's important.
Well, I think most measures of inflation expectations by professionals and by market participants — I'm excluding households here because I think they have moved up to some extent — but certainly if you look at TIPS spreads, measures of inflation compensation based on that, or surveys of professional forecasters, they really haven't moved up. And market participants still believe inflation is going to be consistent with 2% over the longer term. So, we're not in the situation that we were in in the '70s because their inflation expectations did move up. But we could be there. And the problem is we can't count on that. And if the Fed sits there and does nothing, it's possible, it's possible that inflation expectations will move up and we'll go back to the '70s. And that's what the FOMC has to make sure they avoid, because then it becomes very painful and expensive to get inflation down. But let's take another view on this too, for a second. Suppose the Fed does tighten. And okay, they've increased recently the funds rate by 25 basis points.
Right. I mean, they had cut several times to take out insurance against labor market weakening, and now they've increased once. And many of the participants have described it as essentially addressing what's become an upside risk to inflation at a time when there's less concern about the labor market, but essentially a risk-based adjustment. What is that going to do to bring down actual inflation? It's not going to lower oil prices. It's not going to stop the AI boom from raising semiconductor prices. It's not going to affect tariffs. The tariffs are probably largely already passed into prices. It's not going to do any of those things. So how is it actually going to work to bring down inflation? Normally the way tighter monetary policy works is by weakening the labor market and bringing down wage growth, that brings down unit labor cost growth, and brings down inflation. Well, look, that's pretty costly. Wage growth isn't the problem. Wage growth is consistent with 2% inflation. Well, of course, they can weaken the labor market a lot and they can bring wage growth down below 2% and that'll bring inflation down, but the so-called short-run Phillips curve we've seen to be quite flat. And so there could be a big cost in terms of lost employment to get inflation down. And anyhow, if we were patient and waited a couple of years, inflation, you know, according to the argument I gave that I think many FOMC members would endorse, is going to on its own come down to 2%.
The people don't really want to wait for that, do they? I mean...
Well, how are you going to actually get it down? You might have to tighten monetary policy a lot because the main channel is to weaken the labor market.
Okay. Okay. So, but if the Fed — look, first of all, many people criticize the insurance cuts that were probably not needed. Okay. So maybe that was a misstep. And the longer you let inflation stay high, the more people are going to what? Accept it, be part of it. So, so let's take a real simple question. Janet Yellen's at the Fed. She's the chair. Whatever she's doing, she's there and she's got to be in this policy conversation. And in effect, you are. But okay, rate hike — the Fed, John Williams, you know, president of New York Fed, 'There's no urgency, we can wait.' People are saying, 'Oh, maybe they're going to raise their rates every quarter instead of every meeting.' So that looks at December. But the SEPs, you know, the Summary of Economic Projections that produce the dot plots and, you know, the expectations, they are showing nothing after the end of the year potentially, right? So is that — and what you just said, labor market's doing well, we've got all this investment in AI, there's, you know, a lot of demand for capital, there's many things showing strength, and in fact the economy, many people say, looks strong right now on many levels. So why risk entrenched inflation? Why risk? Why not take a step that would be more clear and maybe keep inflation expectations down, but basically just, you know, get something on the other side to move in the right direction? A couple years sounds pretty dramatic.
Well, that's exactly what they're doing by having taken away one of the insurance cuts and indicating in the SEP that they expect, if the outlook remains essentially what they assessed it to be in September, that they expect to do another. Now, I call that a modest adjustment in the stance of monetary policy. And it's meant to say to markets, we're paying attention to this. We are prepared to move. We are not prepared to accept over the longer term inflation that remains in excess of our target. And we don't want to see inflation expectations move. They shouldn't move because this is telling you, market participants, we are awake, we are not ignoring this risk, we will address it, we're doing something to address it. On the other hand, it is not so aggressive that on its own this path of rates — and I believe you see that in the SEP as well — it still takes a while to get inflation back to 2%. They're saying, do we think it's appropriate given what we now know, which includes that these shocks should ebb, their impact on inflation should ebb, and inflation should come down over the next couple of years, and we maybe see evidence already that that is happening when we look at detail behind the inflation numbers. So, they're doing something, they're not doing nothing. They're very attentive to inflation expectations, but they're not trying to do something so aggressive that they weaken the labor market so much that they're going to get inflation back to 2% at the end of this year.
