Lectures of the Governor - With Christopher J. Waller

All right, thank you. Always got to turn on the mic, that always helps. I'll start over. So thank you and thank you for the honor of initiating this new series of lectures from central bankers. I'll begin with a few words on the US economic outlook and the implications for US monetary policy, but on this occasion I thought it appropriate to then widen my perspective to address what I see as the leading challenges that OECD economies face that are of particular importance to central bankers in how we approach monetary policy and our other responsibilities. So looking at the US, I continue to believe that the US economy is on a solid footing. Real gross domestic product growth has been above 2% for eight of the last nine quarters and is expected to grow above 2% in the fourth quarter of 2024. Despite this robust economic growth, the labor market softened over 2024 and employment is now near what I judge to be the Federal Open Market Committee's maximum employment objective. I have seen nothing in the data or forecasts that suggests the labor market will dramatically weaken over the coming months. With regard to inflation, after a period of rapid disinflation in 2022 and 2023, progress appears to have stalled in the final months of 2024. Our latest reading of core personal consumption expenditures inflation is 2.8% for the 12 months ending in November. This is down just a bit from where it was a year earlier at 3.2%. This minimal further progress has led to calls to stop or slow reducing the policy rate. However, I believe that inflation will continue to make progress toward our 2% goal over the medium term and that further reductions in the policy rate will be appropriate. Now let me explain why I expect inflation to continue toward our goal. First, as we saw a year ago when inflation briefly increased, progress has been uneven, but disinflation is more apparent if one smooths through the recent upticks to tease out the underlying trend in inflation. I often look at the six-month percentage change in core PCE prices, which is running at 2.4% at an annual rate for November and has mostly been moving down toward 2% over the course of the year. Second, the monthly reading for November came in much lower than expected at 0.11% after rising 0.26% in October. Third, inflation in 2024 has largely been driven by increases in imputed prices such as housing services and non-market services, which are estimated rather than directly observed, and I consider a less reliable guide to the balance of supply and demand across all goods and services in the economy. These two categories represent about one-third of the core PCE basket of goods. So if you look at the prices associated with the other two-thirds of that market basket, they on average increased less than 2% over the past 12 months through November. I don't support ignoring our best estimates of prices for housing and non-market services, but I want to point out that I find it notable that imputed prices rather than actual observed prices were driving inflation in 2024 and thus expectations of the policy rate path. Finally, the higher inflation readings from early 2024 will begin to drop out of inflation numbers beginning in January. This should result in a significant step down in the 12-month inflation numbers as we go into March. Looking further forward, geopolitical conflict could boost prices as it has at times in the past. In addition, tariff proposals raise the possibility that a new source of upward pressure on inflation could emerge in the coming year. Projections of the economic impact of these possible policy changes vary widely, but if, as I expect, tariffs do not have a significant or persistent effect on inflation, therefore they are unlikely to affect my view of the appropriate path for monetary policy. Of course, we need to see what policies are enacted before we seriously consider their effects. So what is my view? If the outlook evolves as I have described here, I will support continuing to cut our policy rate in 2025. The pace of those cuts will depend on how much progress we make on inflation while keeping the labor market from weakening. Based on the most recent Summary of Economic Projections, the median of policymakers expected appropriate policy rate this year implies two more 25 basis point cuts, but the range of views on the FOMC on this is quite large, with some participants advocating for no cuts and some as many as five cuts. So as always, the extent of further easing will depend on what the data tell us about progress toward 2% inflation. But my bottom line message is that I believe more cuts will be appropriate. So now let me turn to what I consider some of the leading challenges that will frame monetary policy actions for OECD members in 2025. Each of the issues I raise are sizable challenges for all OECD countries, but some are bigger challenges in some places than others. I have not tried to rank these challenges in importance, so please don't take any signal from the order in which I talk about them. I will start with the ongoing challenge all central banks face in reaching our targets for inflation. While 12-month measures of headline inflation are close to target in most jurisdictions, most central banks target inflation in the medium term and indicators of the trajectory of future price changes such as core inflation are still running persistently above target. Like the Federal Reserve, most central banks in OECD countries are gradually easing monetary policy as inflation falls. I believe policy is still restrictive in most cases, which should support the goals of policymakers to have inflation at their targets going forward. This common challenge in the months ahead has its roots, as we all know, in the common experience of the COVID-19 pandemic. Economic conditions before and during the pandemic varied widely across OECD countries, as did the focus, timing, and forcefulness of policy responses. The surge in inflation during the pandemic was a result of both supply and demand factors, and while the timing of the inflation surge varied across countries, the COVID inflation was a largely global phenomenon. As shown by research conducted by Federal Reserve research staff, a common factor that drove inflation across our economies was the disruption of goods production and delivery. Shortages of key components and waves of COVID variants repeatedly disrupted supply chains, causing inflation to persist. Fortunately, these disruptions have receded and delivery times have returned to pre-pandemic levels. That said, there are many geopolitical factors that are still keeping deliveries of supplies volatile, which potentially could affect economic activity and inflation. Another common experience has been the fiscal response to the pandemic. The extent to which fiscal policies rolled out in support of households and businesses during the pandemic contributed to inflation is the subject of ongoing debate, but regardless of the effects on inflation, fiscal policy actions across OECD countries led to a doubling and tripling of budget deficits as a percentage of GDP, with even larger percentages in some places. Those deficits have steadily fallen since but are still higher in many countries than before the pandemic, and the debt levels have grown for many OECD countries. Another recent challenge for OECD economies is the widespread weakness in manufacturing. Manufacturing boomed in many places with the onset of the pandemic when consumers switched their spending from in-person services to goods, but as businesses and economies reopened with the easing of pandemic-related restrictions, the swing to service spending by consumers began what has been a sustained slide in manufacturing in OECD economies. This slide has been compounded by three other factors. First, because manufacturing is capital intensive, interest rate increases over the past couple of years raised capital costs in this sector. As monetary policy eases across countries, this effect may unwind. Also, higher energy costs after Russia's attack on Ukraine have hurt manufacturing more than other sectors. And lastly, China's push to reduce its reliance on imports and expand its global share in sectors such as autos has had a big impact across OECD countries. While the manufacturing sector is a smaller share of economic activity in the United States than in some OECD countries, we shall see whether the weakness in global manufacturing is affected by the prospect of changes in trade policy in the US and elsewhere. The extent and timing of tariffs are highly uncertain, as are the effects. Overall, the evolution of manufacturing adds uncertainty to the forecasts of central bankers' outlooks. A short- to medium-term challenge that is and will remain widespread among OECD countries is geopolitical risk. Indices of geopolitical risk suggest that risks are elevated but not nearly as high as they were when Russia invaded Ukraine in February of 2022. Shockingly, today you certainly can't see much evidence of geopolitical risk affecting financial markets; they're about as frothy as they can be in the US. But geopolitical risk will nevertheless remain a challenge that central bankers will need to keep in mind. The outbreak of war in Europe and more recently in the Middle East were shocking developments that continue to reverberate, as we have seen recently in Syria. It is unclear how these events will ultimately affect security, trade, and migration flows around the world. The fact that these conflicts have not affected the global economy to a greater extent than they have so far doesn't mean they won't and can't. Research shows that higher levels of political risk and economic uncertainty more broadly tend to foreshadow lower investment and employment. I expect that central bankers in OECD economies will continue to consider geopolitical risk in the medium term. The next challenge for central bankers that I would like to address also has shorter and longer-term dimensions to it, and that is something that I will refer to as a rethink of globalization. For close to a decade now, many countries have been re-examining the costs and benefits from steadily freer global movement in capital, labor, and goods that was the norm over previous decades. Although global trade has not decreased in the last decade, we have clearly seen changes in trade patterns with more countries and firms putting greater emphasis on rerouting trade flows and shortening supply chains to avoid geopolitical risk and tariffs. This isn't simply the result of some failed ministerial meeting or bilateral conflict; rather, it has been a persistent and widespread trend that has been underway for some time. The presumption that the increasingly tighter global integration of our economies and financial markets would inevitably continue is no longer as safe as it long was. At the same time, I have refrained from calling this development, as some have, the end of globalization, because I don't believe this will be the outcome. As I think about the 38 governments represented by the OECD and consider how this organization has grown in size and in the depth of its engagement on different issues, I would say that globalization is not going away. What I do expect, however, is that there will be more thought and consideration among our leaders for how globalization affects the people we serve, with a more careful weighing of both the potential costs of close integration and potential benefits. As these decisions by governments are made, central bankers will need to be prepared to respond appropriately in setting monetary policy and promoting financial stability. Another longer-term challenge involves demographic trends. What I mean here is the aging of populations in OECD countries and to some extent everywhere else. While I view this mainly as a problem for fiscal authorities, it does have some ramifications for central bankers in terms of long-run growth rates, productivity, and asset prices. In the United States, those between the ages of 16 and 54 were 72% of the population in 2003. It fell to 62.7% in 2023 and is now projected to be 61% in 2033. Aging is happening even more quickly in some other OECD countries. This is a slow-moving development, but as populations age and move from working to retirement, employment and economic output will fall. This by itself lowers per capita GDP, which can affect consumption, investment, and inflation. As aging populations sell accumulated assets to support retirement consumption, asset prices and interest rates will adjust as well, with the latter potentially affecting the central bank's estimate of the neutral policy rate. There are mitigants to soften the effect of aging populations, such as an increase in retirement age, immigration, and higher productivity growth for younger workers. Again, these demographic factors are more important for fiscal policy, but there are spillovers to monetary policy. Productivity growth is another issue facing central bankers, and I know has been a subject of conversations at the OECD gatherings this year. According to one set of estimates, labor productivity growth is responsible for more than half of the cumulated GDP growth in the United States since the end of 2019, compared to much smaller shares in other countries. Productivity growth is notoriously volatile, and even years later it's hard to say exactly what technological or other factors caused it to happen. Having some understanding of the trajectory of productivity growth is helpful for policymakers thinking about how fast their economies can grow without inducing inflation. Central bankers must keep their eyes on productivity in judging whether wages can grow quickly without igniting inflation or whether potential growth has increased. Productivity growth also plays a role in assessing the real neutral policy rate, otherwise known as r-star. Higher productivity growth is often associated with a higher value of r-star for some policymakers, and thus would have implications for the interpretation of the degree of monetary accommodation or restrictiveness of policy. One way to try to understand some of the factors affecting productivity is to compare the United States to other OECD countries. It's not particularly new for productivity to grow faster in the US than in other advanced economies. Some differences in our economies may have been particularly salient during and after the pandemic. First, there was more disruption in employment in the United States during COVID than in many other OECD countries, and after the pandemic subsided, this may have led to better matching of workers with new jobs in which they could be more productive. Second, during the acute US labor shortages in 2022 and 2023, I heard numerous anecdotes that firms had to invest more in worker training to raise skill levels to what was necessary for positions. In other words, they would normally have never hired certain workers for jobs, but the labor shortage was so severe they were willing to hire people who weren't skilled and then try to get their skills up. This raises labor productivity with a delay and may have been an important factor recently. Third, business creation is by all evidence easier in the United States, and new firms are often more productive than existing firms. There was a surge in US business creation after COVID, which could reasonably have led to a more productive reallocation of labor. There may have been other factors I haven't touched on, but I don't think artificial intelligence was one of them. AI investment will take place over many years and most likely has not done much yet to add to aggregate productivity and productive capacity. While it is possible AI could increase longer-run productivity growth, that remains to be seen. But the other possible reasons—the flexibility of labor rules, ease of business entry, barriers to innovation, lower regulatory hurdles—would sound familiar to people attending the OECD discussions a decade ago. The barriers to innovative risk-taking are probably lower and the rewards higher in the United States. So while I am skeptical that AI is already making significant contributions to aggregate productivity growth, I have little doubt that it will do so in the future. AI and allied innovations in computing have the potential to bring productivity advances to high-skill labor-intensive services, akin to the way robotics transformed high-skill manufacturing. If such advances do occur, one challenge for governments will be fostering an economy in which those dislocated by such a shift can obtain new skills and find productive and meaningful employment. As ever, prudent regulation should be balanced with support for innovation that has the potential to deliver widespread improvements in living standards, but regulatory policies should not strangle innovation in its infancy. So at the end of this list of challenges, how should central banks meet them? There will always be new challenges, but the right approach to monetary policy hasn't changed, nor should it. In every case, the answer begins with sticking to our mandates and resisting the temptation to go beyond them. We must closely monitor economic and financial conditions and look in every direction and down the road for emerging risks. In keeping to our mandates, we can see that seeing all these risks clearly is hard, so we need to remain focused. We also need to be nimble. That's one thing we've learned in the last couple of years: you've got to sometimes move fast and break things, as they say in Silicon Valley. And we have to be prepared to use our monetary policy tools in new ways to prepare for unprecedented challenges that present themselves. When conditions are uncertain, as they often are, we must move deliberately but also be ready to act quickly and decisively when the situation demands it, as we did in subduing inflation. Effective monetary policy depends on clearly communicating our intentions so that the public will act on those intentions. That also requires credibility, and this is most effectively maintained when monetary policy decisions are made according to our mandates and in the longer-term interest of a healthy economy and stable financial system. Guided by these basic principles, I believe central bankers are up to the considerable challenges of today and those they will face in the years ahead. Thank you very much for your time.

Yeah, so I think one of the things that people are talking about is one, there is still a concern that inflation may not be beaten, so it may persist longer, so there's potentially more of an inflation premium. I'm going to tell you we're going to fix that problem, so don't worry about it. The other thing that I think is getting more and more attention is the concern about fiscal deficits. I mean, we're borrowing close to two trillion dollars a year at present, and if that doesn't seem to change going forward, at some point the markets are going to demand a premium or compensation to accept the risk for financing that amount of spending. So that would just mean that you see lower prices on the assets and higher yields. So that may be what's going on. That's basically what I read in some things I've warned about over the last two years: if we don't get fiscal deficits down, you'll start seeing higher long-term bond yields, and that's starting to be what we're seeing. Thank you.

Yeah, I mean, I think to some extent... I think to some extent, we'll see some reduction in service price inflation. Some of that is still lagging wage increases. If you look at the data correctly, services, particularly in management, higher-skilled jobs, they never went up when inflation was going up. It was mainly lower-skilled workers who were getting big raises, but the typical management professional level, they were not seeing huge increases in their nominal wages. And that has been starting to catch up over time, and I think that's generating some persistence in services inflation. It's just service wage inflation, and services labor is the biggest input, so labor costs are going to drive a lot of that. But again, as that catch-up finally gets to where it should be, then it'll stop and you should see this start coming back down. That's the simplest answer I got.

Yeah, so I just... we don't really know what's going to happen. We don't know how broad-based, how big. I mean, there's a lot of tremendous uncertainty around what's going to happen. I just have based my thinking on analysis I've seen by various private sector forecasts going through the numbers. And if you think about tariffs, if you did them all at once and never did them again, they would just be a one-time jump in the price level. You'd see a spike in inflation and then it would kind of go away. So that's kind of what I'm thinking is likely to happen. I don't think these Draconian tariffs that everybody's talking about are necessarily going to be implemented. But we don't know. You just don't know. But I think whatever it is, at least in the near term, which is the key part of your question, I think in the near term, I am only speaking for myself, nobody else, I just don't think we're going to see a huge impact on inflation from this or a very long and persistent impact. We'll just have to wait and see. But after what we just went through with very high inflation, people are always very nervous about prices now. They might have been able to look through them a lot easier a couple of years ago than they do now.

Yeah, so... that was kind of the issues I was trying to get at. Aging is really a fiscal issue more than a monetary issue, but if it affects things like productivity growth, that's going to affect what our estimate of r-star is. That's what a bunch of my colleagues think. Productivity growth is a big factor. If productivity growth falls, the equilibrium neutral interest rate falls, then for the same level of interest rate, there's more restrictiveness in the economy. So that's one factor that would come into play. There could also be fiscal implications for dealing with an aging economy or aging populations that may lead to bigger deficit spending, more debt. Again, that affects interest rates in terms of what governments have to pay to finance all this. So those are kind of the two simplest ones. And then just kind of thinking about it, just because you're aging doesn't mean there's nothing you can do about it. I mean, I'm going to age, I'm going to die. I know that part, I can't do anything about that part. But for society, there are ways you can deal with this transition from work to retirement that aren't as disruptive as if we all woke up one day and said we're all going to retire and then who's going to do anything. So there are ways that we're thinking about dealing with that problem, and most governments are.

Well, you know, like I said, we gave guidance with our December SEP, which was, I'll be honest, speaking just for myself, filling out a forecast for the coming year that you try to say as an honest projection. I shouldn't say honest projection when I have no idea what's going to happen with incoming policies. I mean, I know there'll be tariffs, I know there'll be some other things, but the magnitudes of them. And yet on a projection, I'm putting down a number. I'm not just saying well it might be a little higher, it might be a little lower. They're like put a number in. That makes things a lot harder when you have this much uncertainty. So in terms of the markets reacting to the number of rate cuts, I would just say that's what I was trying to say. The range right now in that SEP goes from members saying zero to members saying five. That's a huge range of what people think is an optimal policy. So it's just going to be tough for markets and tough for all of us to figure out what's going on until we start seeing some actual policies implemented.

Well, I mean, we went decades with interest rates nowhere near zero and somehow we all survived. I find it amazing. When I hear my own children talk about buying a house and they say, 'Oh my God, I can't afford a house with a 6% mortgage,' and I said, 'My first house had a 13.3% mortgage. What are you talking about?' It's just a thing of what you're used to, and then the new reality comes along, and I think people will adjust and they'll deal with it. But the history is not what we saw the last decade. It is not zero. That is not what we've seen through decades of US financial or any financial market. So we have to kind of think of the 2010 to 2018 period as being an outlier in financial market history in terms of rates being that low. There's a lot of debate about what caused it and why, but I think right now it's not looking like we're going to see a return to the zero lower bound anytime soon.