So, welcome to our last session of the day. In 1984, output per worker in the United States was roughly on par with that of Japan and the group of countries that now comprise the European Union. At the end of 2024, productivity stood at $170,000 per worker for the US, $120,000 for the EU, and $100,000 for Japan. Against this backdrop, in April of 2025, there was a radical change to the economic policies first enumerated in James A. Baker III's 1985 speech at the World Bank IMF meetings that drove the relative rise in US prosperity, the absolute rise in global prosperity, and the decline in poverty across what was once called the third world. Whether the move from free trade and the invisible hand to record tariffs and the state hand is a permanent or temporary change. The uncertainty it has unleashed and its attendant consequences for asset prices, investment, growth, inflation and unemployment are real if not yet fully manifest. In short, the US and global economy have been hit by a multifaceted supply shock that continues to unfold and has consequences for leaders charged with formulating monetary policy strategies. We are very fortunate to have with us today four of those leaders. Isabel Schnabel of the European Central Bank, Alberto Musalem from the Federal Reserve Bank of St. Louis, Beth Hammack of the Federal Reserve Bank of Cleveland, and Lisa Cook from the Federal Reserve Board of Governors will share their big picture perspectives on monetary policy frameworks at this moment in history. Accordingly, I encourage the audience to focus their questions on the strategic intellectual challenges facing these leaders and to resist the tactical temptation, however veiled it may be, to ask them what's next for rates. Turning briefly to logistics, each speaker will have 12 minutes. We will then turn to the floor for questions from the audience. I will gather three to four questions at a time before turning to our panelists to respond. When the microphone comes to you, please identify yourself clearly before asking your question. We will continue with rounds of questions in this fashion as time permits, ending promptly at 6:10 p.m. And Governor Cook has to leave at 6:05 p.m. So, she's excused in advance. Isabel, the floor is yours.
Thank you so much for inviting me to this excellent conference. It's an honor to participate in such a distinguished panel at a time when central banks around the world are examining how to respond to the new shocks that we are facing. In my remarks I will take a European perspective and my main conclusion will be simple: in today's unsteady world, monetary policy should keep a steady hand. A key determinant of optimal monetary policy is the slope of the Phillips curve. As you can see on my first slide, the Phillips curve became noticeably steeper in the aftermath of the pandemic. Before that, it had been essentially flat. These are the blue dots. If the curve is steep, central banks face a smaller sacrifice ratio, as also discussed this morning by Kristen. Meaning they should react more forcefully to deviations of inflation from target even when the economy is hit by a supply shock. Instead, if the curve is flat, a large policy impulse is required to move output to generate aggregate price effects. Then it can be optimal to tolerate moderate deviations of inflation from target in both directions, provided inflation expectations are well anchored. However, as you can see on this slide, identifying in real time if expectations are anchored is far from easy, as different measures may even point in different directions. So, what explained the steeper Phillips curve and the post-pandemic inflation surge? One explanation is firms' price setting behavior, which you can see on this slide. Standard New Keynesian models assume that the probability of firms resetting their prices is constant over time. This is a fair description when aggregate shocks are small, such as during the 2015 to 2019 period, the blue dots. However, the past few years have demonstrated that in the face of large shocks, firms tend to raise their prices more frequently, as shown by the yellow line, and the Phillips curve steepens. My next slide shows that pricing behavior is asymmetric. It acts as an inflation accelerator when firms face positive demand shocks, but it does little to prices in the face of negative shocks due to downward price rigidities. The second explanation relates to the labor market. Downward nominal wage rigidity has been a key factor explaining the missing deflation in the aftermath of the global financial crisis. But when the labor market is tight, as it was in recent years, wages are more flexible. My next slide shows that this seems to have led to a nonlinear Phillips curve both in the United States and in the Euro area. However, new research shows that nonlinearity holds only when controlling for expectations of professional forecasters. But it disappears once inflation expectations of households and firms are considered. Hence, it is conceivable that the Phillips curve did not become steeper in recent years, but rather shifted upwards as inflation expectations rose. The expectations that are relevant for such an upward shift are not necessarily longer-term expectations that central banks typically pay most attention to. This slide shows that the longer-term inflation expectations have remained remarkably stable over the past few years. Rather, one-year-ahead inflation expectations have been shown to explain a significant share of the recent rise in nominal wages and hence inflation in the United States and elsewhere. Drawing the right conclusions from the recent inflation surge matters for our monetary policy today. The relevant time horizon for monetary policy is the medium-term. The past few years, however, demonstrated that inflation forecasting at times of large shocks is inherently difficult. For this reason, the ECB has increasingly turned to a data-dependent approach while remaining forward-looking. At present, high uncertainty, lower energy prices, and a stronger euro exchange rate will likely dampen headline inflation in the short run, potentially pushing it below our 2% target. The question is, however, whether these developments provide meaningful signals about the medium-term. In the Euro area, there are two forces that could pull underlying inflation sustainably away from our target. One is fiscal policy, which is set to expand on a scale unseen outside deep recessions, especially in Germany. This is likely to put upward pressure on underlying inflation over the medium term. The other is global fragmentation. While the scale and scope of tariffs remain highly uncertain, ongoing negotiations still give hope that agreements may be reached. But should these negotiations fail, the euro area will simultaneously face adverse supply and demand shocks as the EU will retaliate. On balance, these shocks are likely to put upward pressure on underlying inflation. The severity of the negative demand shock will depend on two factors. One is the hit to US economic activity and to global demand, which will dampen Euro area foreign demand. The second factor is the degree of demand reallocation, that is the elasticity of substitution between foreign and domestic products. A robust finding in the literature is that products that are more differentiated tend to be relatively price inelastic as they are more difficult to substitute. The left-hand side chart of this slide shows the relevance of this for the Euro area, as the bulk of exports to the US is in pharmaceuticals, machinery, vehicles, and chemicals, which are typically highly differentiated. Let me give you an example. Banknotes in the United States are overwhelmingly printed using machinery from a single German manufacturer, which cannot easily be replaced in the short run. This may limit the hit to foreign demand. In addition, trade diversion may benefit Euro area exports. Should prohibitive tariffs on Chinese imports remain in place, they will measurably raise the Euro area's price competitiveness in the US market. This is relevant as the right-hand side chart illustrates that the number of industries in which both Chinese and Euro area firms have comparative advantages has increased measurably over the past decades. In other words, Euro area foreign demand may prove relatively resilient. The recent appreciation of the euro does not refute this view. Looking through the ups and downs, in effective terms, the euro is trading just 2.6% above last year's average. In addition, invoicing of exports to the US in US dollars limits the exchange rate pass-through. This slide shows that the price inelasticity is also reflected in recent surveys. Manufacturing firms are reporting an expansion in output for the first time in more than two years, and fewer firms are reporting falling export orders. Even if developments partly reflect front-loading by firms, it is still remarkable how resilient sentiment has remained in the face of high uncertainty. Downward effects from lower demand on inflation are likely to be counteracted by the supply shock from retaliatory tariffs. The strength of the supply shock again depends on two factors. One is the pass-through of higher tariffs to consumers. The recent appreciation of the euro provides some margin for Euro area firms to buffer cost increases from retaliatory tariffs. But profit margins have already been squeezed by high wage growth and the sluggish economy. Recent surveys suggest, and Matteo just showed additional evidence, that firms plan to gradually pass higher tariffs on to consumers. The second factor relates to global value chains. Today, 70% of international trade is conducted by multinational firms distributing production across countries. Tariffs can cause shortages of critical intermediate goods and raise firms' marginal costs, which would be propagated through the production network. The left-hand side of this slide shows ECB staff analysis suggesting that even if the EU does not retaliate, the blue bars, higher production costs through global value chains could more than offset the disinflationary pressure coming from lower foreign demand, making tariffs inflationary overall. These effects become stronger with full retaliation. The yellow bars. The right-hand side chart shows that as the trade conflict intensifies, retaliation will increasingly include intermediate goods, as these account for nearly 70% of Euro area imports from the United States, which would constitute a much broader cost-push shock for Euro area firms. Excess capacity in China may mitigate these effects only to a limited extent, as the European Commission clarified that it intends to protect Euro area firms against dumping prices. How then should the ECB respond to current shocks? The lessons from the pandemic suggest that from today's perspective, the appropriate course of action is to keep rates close to where they are today, that is firmly in neutral territory. What I saw from Fala's slide today is that that is fully in line with the Taylor rule he presented. So thank you very much, John, also from my side, for providing us these useful tools for our monetary policy analysis. Such a steady hand policy provides the best insurance against a wide range of potential outcomes. Specifically, it avoids reacting excessively to volatility in headline inflation at a time when domestic inflation remains sticky and new forces are putting upward pressure on underlying inflation over the medium-term. It also avoids overreacting to concerns that tariffs may destabilize inflation expectations once again. This slide shows that households' short-term inflation expectations have recently started rising again, also in the Euro area. However, there are currently no indications that expectations are at risk of de-anchoring. My next slide shows that a steady hand policy also addresses risks of a more substantial decline in aggregate demand. If tight labor markets were the main culprit for the recent steepening of the Phillips curve, risks of a sharp inflation decline are moderate today. Both in the United States and the Euro area, the vacancy-to-unemployment ratio has fallen markedly. We are thus likely to operate close to or at the flat part of the Phillips curve, in stark contrast to the high inflation period. We would only need to react more forcefully to the tariff shock if we observed a sharp deterioration in labor market conditions or a de-anchoring of inflation expectations to the downside. Both seem unlikely at the current juncture. Despite the number of vacancies declining, unemployment in the euro area remains at a record low. And as shown on my final slide, most measures of medium-term inflation expectations remain tilted to the upside. So my main message today is that the ECB should keep a steady hand in the current environment of elevated volatility. We need to remain focused on the medium term. Given long and variable transmission lags, reacting to short-term developments could result in the peak impact of our policy only unfolding when the current disinflationary forces have passed. Over the medium-term, risks to Euro area inflation are likely tilted to the upside, reflecting both the increase in fiscal spending and the risks of renewed cost-push shocks from tariffs propagating through global value chains. Therefore, from today's perspective, an accommodative policy stance would be inappropriate, also because recent inflation data suggests that past shocks may be unwinding more slowly than previously anticipated. By keeping interest rates near their current levels, monetary policy is neither excessively holding back growth and employment nor stimulating it. We are thus in a good place to evaluate the likely future evolution of the economy and to take action if risks materialize that threaten price stability. Thank you very much.
Good afternoon everyone. I'd like to thank the conference organizers Michael Bordo and John Cochrane for the opportunity to participate in this panel with distinguished colleagues and policymakers. Conferences at the intersection of research and policy provide an invaluable opportunity to enrich both worlds. I'll share my personal views, which do not necessarily reflect those of my FOMC colleagues. Let me begin by reviewing my perspectives on the current state of the US economy. Activity has moderated. Business and consumer sentiment has declined. Financial conditions have tightened some but remain broadly supportive of the real economy. The labor market has been cooling but remains resilient and near full employment. Inflation has declined towards our 2% target since 2022 but remains above target and progress has been slow since mid-2024. Inflation expectations have been mixed. Near-term expectations have risen while most measures of long-term inflation expectations have remained stable. Monetary policy is currently modestly restrictive and I believe appropriately so for an economy at full employment with inflation above target and some measures of inflation expectations moving higher. Consequential trade, immigration, fiscal, and regulatory policies are being implemented. They are intended and have the potential to substantially change the flow of goods, services, capital, and people across and within countries including the United States. They also are likely to change the taxation of and the incentives for consumption, savings, and production. Without judging or evaluating the merits, I am focused on the net total effect of these policies on the US economy through the short and long run and through demand and supply channels. In this context, I believe an effective monetary policy can successfully navigate toward our congressionally mandated goals of maximum employment and price stability. Trade policy changes from the beginning of April are likely to move employment and inflation in opposite directions. Monetary policy can manage the resulting trade-off by weighing the size and persistence of inflation's deviation from target and that of the employment shortfall. An implication of this balanced approach is some short-term tolerance of higher inflation to lessen the cost of an employment shortfall, provided that medium to long-term inflation expectations remain anchored. In fact, a balanced approach requires anchored inflation expectations because price stability is necessary for maximum employment. I believe policy must prioritize inflation expectations if expectations threaten to become unanchored. The experience of the 1970s showed that sustaining maximum employment and a durable economic expansion is difficult when inflation expectations are elevated and volatile and when the public expects it to remain so. If inflation expectations are not well anchored, history tells us that restoring price stability is more costly in terms of foregone employment and economic activity. To date, announced tariffs are higher, are broader, and have prompted stronger retaliation than many had expected. If a cycle of high tariffs and retaliation is sustained, economic activity and employment are likely to be meaningfully dampened. The impact on prices and the persistence of inflation will be determined by the relative size and persistence of opposing demand and supply factors. I expect direct one-off effects on the prices of imported final goods, indirect effects on the prices of domestically produced goods and services, and possibly second-round effects on inflation. In the other direction, reduced economic activity will likely have some dampening effect on inflation. After an initial uptick in inflation, I perceive two equally likely inflation scenarios ahead. It is possible that higher inflation will be short-lived and mostly concentrated in the second half of 2025 as businesses run down inventories and pass tariffs on new goods purchased onto consumers as one-off price increases. It is equally likely that inflation could prove to be more persistent. The risks of higher and more persistent inflation are currently elevated because the pre-tariff starting point for inflation is above target. The recent period of elevated inflation likely has raised the public's sensitivity to it. Some measures of inflation expectations have risen and tariffs apply broadly to intermediate inputs prompting supply chain rearrangement. Thus far, I have focused on a scenario of high and broad-based tariffs being sustained along with retaliation. It is also possible that fruitful trade negotiations and de-escalation will lead to a resumption of global trade flows and a modest reconfiguration of supply chains. If this scenario were to happen soon, the US economy could remain close to the path that it was on, one with a resilient labor market and ongoing convergence of inflation to target. Appropriate monetary policy will differ according to which scenario will come to pass. It could be appropriate to look through inflation and potentially ease policy if tariffs are sustained, but inflation is short-lived, inflation expectations remain well anchored, and economic activity is meaningfully slower. Otherwise, I will be focused on a policy path to ensure that a tariff-related adjustment in prices does not turn into persistently higher inflation and that inflation expectations remain well anchored. If instead there's a de-escalation of trade tensions soon, the current policy stance will remain appropriate. That stance is focused on further progress of inflation towards 2% in the context of a full employment labor market. Committing now to looking through the inflation impact of tariffs or to an easing of policy runs the risk of underestimating the level and persistence of inflation. Implementing a corrective policy switch to lean against inflation is a classic issue in central banking. Real-time parsing of direct price level effects from indirect and second-round inflation effects is difficult. Mistiming the policy switch can be costly for the public in terms of inflation and employment outcomes, especially if inflation expectations were to rise further. The difficulty would be further compounded because trade policy does not happen in a vacuum. Beyond tariffs, I'm also focused on the net total impact of evolving fiscal, immigration, and regulatory policies on the outlook. To conclude, I consider it prudent to navigate according to two key principles. First, I continuously update my outlook for the US economy and my assessment of the balance of risks with incoming information to discern the most likely scenario and appropriate monetary policy. Second, prioritizing well-anchored inflation expectations is crucial to ensure that a policy approach that responds both to inflation deviations from target and to employment shortfalls remains feasible. I believe the FOMC's current policy stance aligns with these principles and is best positioned to deliver stable prices and maximum employment for the people we serve. Thank you and I look forward to engaging in a discussion. But before leaving, I would like to also take a moment to thank John Taylor for all of his contributions as celebrated yesterday and especially for arming central bankers like me with a framework, a benchmark, and a principle against which to stress test their policy thinking on a daily basis. And on a personal note, I, like many others, was exposed to John Taylor's work in the early 90s when I was a graduate student and I immediately fell in love with the simplicity of the Taylor rule and the applications of it. 10 years later, I got to meet John Taylor and Kristen Forbes, by the way, when John was in government at the US Treasury. Of course, I was dying to talk about the Taylor rule, but at that time he was interested in sovereign debt restructuring and I was involved in emerging market debts at the time. And so, you know, they were the Treasury. I was not the Treasury. So, we ended up talking about sovereign debt restructuring. So, thank you, John.
My thanks to the Hoover Institution for inviting me to speak on this esteemed panel and for scheduling this during the Cavs game three, providing a much-needed distraction from what could likely be another heartbreaking loss. It's great to be back at my alma mater. I'm especially grateful that I was able to join yesterday in the celebration of John Taylor. When we experience uncertain economic times with a wide range of possible paths for the economy, simple policy rules provide a good starting point for assessing how monetary policy may wish to respond in different scenarios. As Loretta noted this morning, the Cleveland Fed's website has a section that looks at federal funds rate projections based on seven simple policy rules and multiple forecasts, including the rule that John Taylor published in the year that I graduated from Stanford. I combine this information with a variety of economic and financial data, forecasts, and anecdotes from businesses and community contacts as I think about the appropriate path for monetary policy. Recently, the signals about the economy have been decidedly mixed. By many measures, the backward-looking data have been encouraging, but heightened uncertainty surrounding government policies is clouding the outlook and raising the risks of higher inflation, slower growth, and softening in the labor market. So let me briefly share my current views on finishing the job amid current challenges in the economy. And as always, the views I present today are my own and not necessarily those of the Federal Reserve system or my colleagues on the Federal Open Market Committee. The economy entered this year with solid momentum as real gross domestic product increased at a 2 and 3/4% annualized rate during the second half of last year. Based on the first estimate, GDP declined in the first quarter. Behind this week's headline number, consumer spending and business fixed investment both grew at solid rates. A key question is whether this will continue as national survey measures of consumer and business sentiment have declined with many respondents citing policy uncertainty. At the Cleveland Fed, we compile feedback from regional business and community leaders into our source indices which capture recent and expected trends in the fourth district's economy. In general, our contacts report subdued economic activity. In their comments to us, many contacts indicate that they have paused some spending in light of increased uncertainty surrounding government policies, including tariffs, immigration, federal spending, and employment. A growing share of contacts expect that their non-labor costs are going to rise in the coming months, with many noting higher tariffs as a key factor. Looking at our maximum employment goal, the US labor market has been healthy. The unemployment rate was 4.2% in April, a relatively low level and similar to readings over the last 12 months with solid job gains on average through the first four months of this year. On our inflation objective, we've made good progress, but there is still more work to do to return the economy to price stability. Headline PCE inflation was 2.3% through March. Core PCE inflation, which excludes the volatile food and energy sectors, was somewhat higher. The Cleveland Fed calculates several alternative inflation measures that focus on price changes in the center of the distribution in order to limit the influence of outliers and capture the inflation trend, including the median CPI, trimmed mean CPI, and median PCE inflation. These measures have also come down from their highs, but are running above headline inflation and above our objective. While the recent inflation data have been encouraging, they are backward-looking and do not capture very recent developments. On net, the tariffs that have been put in place constitute a substantive change in trade policy. It will take some time for the overall economic effects of these recently enacted and other proposed changes to government policies to become clearer in the hard data. In this dynamic environment, I'm considering a variety of data to inform my view on progress towards our dual mandate goals of maximum employment and price stability. Beyond the usual monthly and quarterly indicators on growth, inflation, and the labor market, I'm looking at higher frequency data on evolving conditions. In these times, I find that anecdotal reports from business, community, and financial market contacts are especially helpful because they provide timely information and additional context to the hard data. Staff at the Cleveland Fed produce and update novel data series to help shed light on current conditions. One recent project uses natural language processing to quantify the sentiment of the Federal Reserve's Beige Book entries as a predictor of recessions. In a second project, Cleveland Fed researchers compiled data from advanced layoff notices filed under the Worker Adjustment and Retraining Notification or WARN Act that serve as a leading indicator for layoffs. I also monitor financial conditions to assess their impact on households and businesses. In recent weeks, financial conditions have been volatile as markets have incorporated new information into asset prices. In response to tariff announcements in early April, financial conditions tightened on net as major equity indices declined, credit spreads widened, and long-term interest rates increased. At the same time, the dollar weakened against a basket of foreign currencies. This pattern was different from recent risk-off episodes in which equity prices declined, credit spreads widened, the dollar appreciated, and US Treasury yields fell as domestic and international investors sought the safety of US government bonds. More recently, as tariff policy has shifted, some of these measures have largely retraced their initial moves. Markets respond to data and announcements at a high frequency. My job as a policymaker is to separate the signal from the noise in financial market fluctuations. Doing so allows me to incorporate into my outlook market trends that are likely to affect the real economy, recognizing that volatility on its own can have a dampening effect on spending and investment. A common theme from talking with business, community, and financial market contacts is that uncertainty is elevated. I see risks around both legs of our dual mandate that could lead to higher inflation outcomes and to lower growth and employment outcomes in the near to medium term. This is a difficult set of risks for monetary policy to navigate. Given the economy's starting point, with inflation still elevated and with both sides of our mandate expected to be under pressure, there is a strong case to hold monetary policy steady at its current modestly restrictive setting. I am usually inclined to take action, but in this case, taking no action may be the best choice to balance the risks coming from further elevated inflation and a slowing labor market. If this scenario comes to pass, then it will be important to ensure inflation expectations remain well anchored while assessing the likely magnitude and persistence of the misses to each side of our dual mandate goals. In terms of inflation, it is certainly possible that increases in tariffs could have only a short-lived effect. But coming after an extended period of elevated inflation, consumers and businesses may respond differently to this event than might have otherwise been the case. When clarity is hard to come by, waiting for additional data will help inform the path ahead. But other scenarios are also possible and instead of focusing on a modal outlook, I'm considering a range of possible outcomes. If the economy should falter and inflation decline, then it may be appropriate to ease policy by lowering the federal funds rate from its current level, perhaps even quickly. If the labor market remains healthy and inflation moves up persistently, then monetary policy may need to follow a more restrictive trajectory. We will simply have to see how events unfold. I would rather be slow and move in the right direction than move quickly in the wrong direction. Fortunately, with policy at its current modestly restrictive level, I think we are in position to assess the incoming data, the risks to the outlook, and the appropriate policy response to achieve our longer-term objectives. Let me conclude with three sets of big picture topics that I've noted in other venues and are worth repeating here. The first topic is our star. There is considerable uncertainty over a fundamental concept for policymakers. How restrictive or accommodative is monetary policy? My view that monetary policy is only modestly restrictive is based on my assessment that the economy has been resilient, the labor market has been healthy, and inflation has come down only slowly under the current setting. Figuring out the neutral rate is always complicated. There's evidence that the neutral rate changes over time with some models and estimates pointing to long-running structural factors and others capturing a role for shorter term forces. Fiscal deficits, productivity growth, and the structure of the Fed's balance sheet are just a few such factors. Recent and prospective changes in government policies could also affect our star. This is a topic that bears watching. My second topic is the Federal Reserve's plan for the balance sheet. Tools, trade-offs, and assessments of the level for ample reserves will all be relevant in the near to medium term. But we also need to think over a longer term horizon. What does a neutral balance sheet look like, especially on the asset side? Should we align assets and liabilities? And if so, how? How much volatility should we be willing to accept in overnight markets? Ultimately, there might be trade-offs between the variability in short rates and the size of the balance sheet. Could there be benefits from separating market functioning balance sheet actions from all other actions? I see these questions about the steady state for the balance sheet as worthy of discussion by the FOMC. My takeaway is that rapidly expanding the balance sheet is easy, but shrinking it with minimal market impact is harder and takes more time, especially after purchasing a lot of long-dated assets. My final topic is the growth of the private credit market. This market fills a financing gap for relatively higher risk middle market borrowers. There are some financial stability benefits of the growth in this market, but there are also some risks. Some of these risks include the market's relative opacity, the growing exposure of pension funds and life insurers, and the potential for systemic risk. We need to monitor this market carefully.
Interconnections between private credit and the banking system. As the rapid growth in private credit investments compresses returns, these funds may employ more leverage. In fact, while the level of private credit fund leverage appears moderate, it has been notably increasing over the past several years, particularly at business development corporations. As a Federal Reserve policymaker, I am attuned to the potential financial stability risks from this fast-growing market. And with that, I thank you for your attention and I look forward to the upcoming discussion.
Good afternoon. Thanks to John again for his multi-dimensional and longstanding contributions to the economics profession and to policy formulation and practice, including during our time at the Treasury Department when he was Secretary and Under Secretary and when I was a postdoc at the Treasury Department. You can see my comments on loop and a video tribute out in the atrium. Thanks also to Michael and John for the opportunity to participate on this panel and to Peter for moderating. It is an honor to be with you here today and it is always good to be back at Stanford and at the Hoover Institution. I spent several formative years of my career here, including as a national fellow, and always enjoy returning. It is a privilege to share the panel with Dr. Schnabel and President Beth Hammack. I look forward to our discussion. Before that, I would like to briefly discuss a topic I see as critical to the path of the economy: productivity growth. Productivity growth has been surprisingly strong in recent years and this has influenced my view of the appropriate stance of monetary policy. I will also explore two ongoing developments that are likely to influence productivity growth moving forward: changes to trade policy and wider adoption of AI. Productivity dynamics are something I have studied closely and will continue to pay careful attention to as I consider the appropriate stance of monetary policy.
It is helpful to start by looking back about three years to the middle of 2022. At that point, the global economy had largely reopened after pandemic closures, a historic amount of federal support had been deployed, and unemployment was falling toward a half-century low. But supply disruptions persisted and the 12-month inflation rate reached its peak at over 7%. The challenge for Federal Reserve policymakers was clear: move inflation back towards its 2% target while maintaining the health of the labor market. The FOMC, which I joined that year, began to raise the Fed funds rate from near zero, ultimately reaching just above 5% in mid-2023. Many forecasters predicted that a recession in 2023 was more likely than not. And yet, one did not materialize. Instead, inflation came down considerably while unemployment remained low. How did this unusual and welcome outcome happen? Two important factors were the unwinding of pandemic-era conditions that previously constrained the supply of both goods and labor, in conjunction with restrictive monetary policy that contributed to a moderation in aggregate demand. Today I would like to call attention to a third factor: a greater than usual increase in productivity during the pandemic recovery. Prior to the pandemic, from 2007 to 2019, productivity growth in the business sector averaged 1.5% annually. In the past five years, productivity growth accelerated to 2%. While some of the productivity gains may reflect situations unique to the reopening of the economy, it is notable that the level of productivity, as measured by output per hour, remained above trend throughout 2023 and 2024. This increase in productivity was partially driven by pandemic labor shortages themselves. When it was difficult to find employees, as many Americans retired or stepped out of the labor force, many businesses innovated. For example, restaurants adopted online ordering apps and retailers accelerated the implementation of self-checkout systems. These changes improved efficiency and contributed to an expansion in potential GDP. As a result, price pressures eased from their peak while demand remained strong. Improved productivity is widely beneficial to the economy. It allows workers to receive pay raises without companies needing to further increase prices, and helps ensure consumers have access to the products and services they demand. Furthermore, and particularly relevant to me as a monetary policymaker, a rise in potential output lessens the need to use monetary policy to slow demand. This effect is good for the obvious reason that it allows economic growth to increase without higher inflation. But importantly, it also lowers the risk of a policy overshoot that could cause the unemployment rate to rise.
Now that I have reviewed the role that productivity growth played in the post-pandemic recovery, I would like to focus on two countervailing forces on productivity that I am currently studying. These are changes to trade policy and the growth of AI. I expect to see a drag on productivity in the near term stemming from the recent changes to trade policy and the related uncertainty for several reasons. First, uncertainty related to trade policy is likely to reduce business investment going forward. At this time, firms do not know the ultimate level and incidence of tariffs nor their duration. Firms contemplating large investments might observe the conditions that could hold under the paradox of thrift, wondering whether they could get a better deal if they just wait. Higher costs of imported materials and components could cause firms to delay or scale back their investment plans. This reduction in capital formation can lead to slower technological innovation and adoption and decreased overall efficiency in production processes. Second, protectionist trade policies, while intended to support domestic industries, may inadvertently lead to a less competitive environment if they prop up less efficient firms. And third, any supply chain disruptions resulting from the policy changes would make production slower and less efficient. These disruptions can lead to inventory mismatches, production delays, and increased costs as firms scramble to find alternative suppliers or redesign their products to accommodate new input constraints. This set of disruptions could pose a particular challenge for monetary policymakers. A reduction in potential GDP means less slack in the economy, which in turn means greater inflationary pressure. According to the Taylor principle, for which no explanation is needed for this conference, taming higher inflation requires a higher policy rate. I believe that keeping inflation expectations credibly anchored is essential. Therefore, all else equal, lower productivity could cause me to keep supporting rates at a higher level for longer.
The second ongoing economic development I see altering productivity is the rapidly expanding use of AI. I view this emerging technology as likely to have a significant positive effect on productivity growth. In fact, I see AI as poised to be at least as transformative as other general-purpose technologies such as the printing press, steam engine, and the internet. With wider adoption of AI, we could have a surge in potential output. As I have discussed in several recent speeches, AI has the potential to revolutionize several sectors of our economy. We already see AI assistance boosting productivity in customer service, software development, and medical diagnosis. AI's ability to process and analyze vast amounts of data could lead to breakthroughs in scientific research and innovation, resulting in an increased arrival rate of ideas, further amplifying its effect on productivity. Of course, an AI productivity boom would come with its own set of challenges. If potential output expands too rapidly, it could leave slack in the economy and the labor market. Moreover, the productivity gains from AI may not be uniform across sectors, job types, or tasks, leading to a transitional period as the labor market adjusts. Despite these challenges, I am optimistic about AI and its potential to drive significant productivity growth in the coming years. To summarize, I see an important role for productivity growth to play in assisting FOMC policymakers to achieve our dual mandate goals. This dynamic played out alongside other factors in recent years when inflation eased from historic highs while the labor market remained solid. Two currently unfolding economic events are likely to influence productivity growth in the coming years: specifically, changes to trade policy and the expansion of AI. Those two developments may prove to run counter to each other, but it is too soon to predict precisely. I will be closely monitoring developments in this space. I look forward to engaging with those studying this topic, including I am sure many in this room and on this campus. Thank you. I look forward to our discussion.
Okay, the floor is open to the audience for questions. I will collect three or four questions and please identify yourself clearly. We'll start with the gentleman here in the middle and then we'll work our way forward.
University of Houston. This is for Lisa Cook. You identified two factors for productivity: tariffs and AI. I was surprised that you didn't mention immigration because it seems to me immigration could have a negative effect on productivity that could easily be more serious than tariffs.
Daryl Duffy was next and then Jason Ferman and then John Cochran.
Thank you. Daryl Duffy. Isabel, last November at your money markets conference, you spoke about liquidity on demand as a way for the ECB to reduce its balance sheet and have banks come to the ECB when they needed more reserves. At the Federal Reserve, it's been a challenge to get banks to come to the Fed when they need reserves. During SVB, there was the bank term funding facility on very generous terms and the banks took that, but your facilities for liquidity on demand like the discount window or the standing repo facility have not been all that effective at generating liquidity on demand when reserves are needed. Could I get some comments on how it's going in Europe and what can be done in the United States to reduce balance sheets while maintaining liquidity in the banking system?
Jason Ferman in the back is next and John Cochran and then we'll have some responses.
Jason. While I generally agree with the approach that the Fed has outlined in dealing with the tariffs, I do wonder and I'm going to ask a contrary question which is partly to Isabel. Europe has had experience with raising VATs and then temporarily changing VATs. I'm wondering how the ECB has looked at that and whether they look through the inflationary changes from changes in VATs or looked at the headline number. And then for anyone from the Fed who wants to answer, why should we think of tariffs differently than a VAT? If the United States established one, would we think that's causing a lot of inflation and we need to worry about the inflation it's causing?
John Cochran's next in the front all the way in the front here.
Hi, I'm John Cochran, Hoover. Both the Fed and the ECB are soon heading into conclaves to do a strategy review and that's entirely a good thing. The last strategies were well constructed to worry about deflation at the zero bound and that's not our problem anymore. I'd like to ask where you think it's going with three issues. First, both the Fed and ECB define their targets as inflation on a forward-looking basis. With I know in the Fed's case we'll make up shortfalls but not overshoots. That implies if you knew the price level was going to go up 20% and then no more inflation, you say inflation's on a forward-looking basis, but the peasants with pitchforks are really mad about the last price level increase. I wonder if this isn't time to promise to reverse overshoots in part for the same reason that might help you a lot on fighting inflation and to anchor expectations. Do you think it's important to distinguish supply and demand shocks? After all, a supply shock that lowers potential output and lowering interest rates isn't going to do much at that point. You would think a different response would be appropriate. And last, the last strategy review promised slow responses, which both ECB and Fed did to the last interest rate, but maybe 1979 and 2021 weren't so great on slow responses. Should we not think about swifter responses and promising responses? Because if you need to raise rates, politicians, budgets, too big to fail banks, everyone's going to be screaming about it. Having a promise in place that says we're going to respond quickly if we had to would seem to be a very useful thing.
Okay, I think I have the order, right? Lisa Cook first and then Isabel Schnabel and then others jump into the other questions.
I can certainly respond to the AI question. So, there are five generations of Baptist ministers in my family and my dad used to say that God only talks to you for 30 minutes. So I just keep things really tight. I didn't include immigration because of our time limits. But if I had more time to talk, I certainly would have talked about immigration. But for a slightly different reason. What you probably know is that more than half of the PhDs in STEM are awarded to those who have a first degree from another country besides the US. So if I'm thinking about incremental additions to the stock of knowledge through patents, through educating the next generation of researchers, I'm really worried about immigration, not necessarily the individuals who might be engaged directly in that but their families and so on. Certainly, we've seen some of our colleagues migrating to places like Canada and Europe. This is our comparative advantage and I think it could have a long-term effect. So, I didn't forget about it. I just thought I didn't have time to cover it, but that's a big concern. Thank you for raising it.
So, maybe first on Daryl's question. As you said, we introduced an operational framework that you could describe as a demand-driven system, which means that once we are in a kind of steady state, it's the banks that actually demand the liquidity and are responsible for then raising our balance sheet, and it's no longer the ECB that is actively buying bonds for example. So in our case, we have already significantly reduced the balance sheet, especially because our longer-term refinancing operations have matured, and we've also embarked on QT, but that is a smaller part of the reduction. Nevertheless, we are still in a situation of abundant excess liquidity and therefore we still don't have much demand at our operations, but that is nothing to worry about. It's simply a reflection of the fact that liquidity is still abundant. Of course, there is a question whether there could be stigma in accessing our weekly operation. I should probably say we've never had any stigma on those operations. So my hope would be that also the transition will work. But of course, we have to see and we are monitoring that very carefully because maybe it is still the case that no larger bank wants to be seen to be the first one to access these operations. This is for example why I published a blog together with the head of our single supervisory mechanism where we made very clear that also from the supervisory side, it's seen as normal business to get liquidity from the central bank in the weekly operations because that's a very important part of addressing stigma. So for now, there's not much to see. But I'm quite optimistic that eventually when we get closer to less ample liquidity, banks are going to start to access our operations. Maybe then quickly on the review. Of course, we are also in the middle of a strategy review. We discarded the makeup strategy last time already very early in the process. I remember we had an academic roundtable. I'm not going to give any names, but basically the first person who spoke said forget about makeup strategies. You may do it in one direction, but you will never push the economy into a recession just in order to get back to this 2% path. I still find that quite plausible. So we never had a makeup strategy and I think I'm not saying too much that we are not going to have it anytime soon. So I still believe that this forward-looking approach is the right one, even though of course as Christine said, people cannot ignore what happened in the past, so we have to think about how to deal with that. And then on your point on the swiftness of responses, I think we have learned that we have to be able to change the course of monetary policy relatively quickly when we are facing large shocks, and I think most central banks didn't do that in the previous episode. So it took a long time to reverse course. It was of course partly due to forward guidance. I would say that asset purchases in general, as we also discussed before, are relatively hard to reverse, and so I think we have to think about how we can be more agile, and that is in both directions. Of course, the previous strategy reviews were very much under the impression of the zero lower bound. Our reaction functions were very asymmetric. I think there is a clear argument for becoming more symmetric there. Beth, Alberto, comments on the strategy and then maybe we'll come back to Isabel to talk about the VAT.
