A Conversation with Mary C. Daly and UC Berkeley’s Fisher Center for Real Estate & Urban Economics

Absolutely.

Do I have to say? 30 years. It'll be, I'm having my 30 year. I started in 1996.

2018.

I could have just gotten away with 2018. I realized I didn't have to say 30, but I started young.

Thank you.

Sure. And you know, when I think about the economy and the outlook, I always start with economic fundamentals. Let's move away from the shocks and the uncertainty and let's just talk about the fundamentals. So the fundamentals of the economy are quite solid. Business investment is strong. Businesses are cautiously optimistic. If you look at surveys or we spend a lot of time as regional Fed presidents talking to CEOs out in the world and cautious optimism is what I hear. Then you think about consumers. Despite the fact that they're a lot more uncertain about their jobs and they feel nervous about the state of the economy they find themselves in, they're spending. They're not giving in. They're continuing to be out there. And so those are strong pillars of how our economy goes forward and you see productivity growth is rising. It's above what is our normal historical trend. That's a good thing for the economy. So those are the fundamentals and I would say prior to the conflict in Iran and then the oil price increase we had inflation coming down towards our 2% target making good progress there and the labor market had stabilized itself. So that's the backdrop. So then of course we get the conflict in Iran and we get the rise in oil prices and the uncertainty about how long the conflict will persist and that has caused a lot of what I think of as scenario analysis because the world is so uncertain. It's depending on how long the conflict lasts and whether the oil price rise is a persistent increase or continuing to go up or whether it comes back down to its pre-conflict levels and the economy goes back to those fundamentals. And that's where the outlook is right now. It's the good fundamentals but a lot of uncertainty about what really persists and ultimately that creates scenarios for monetary policy making us unable really effectively to say we think we will do this by the end of the year. You can say here's what we would do if this happens, here's what we would do if this happens, here's what we would do if this happens.

Sure. So that as you said Alex, you know that the way we think about potential output growth is just the labor force growth. How many people are going to come in and work and then the productivity growth. So productivity growth has been good. It's been above its historical average. But labor force growth, if we just think of the domestic population, we're heading towards zero labor force growth per year. And at some point in the outer decade, it can even fall to be negative. And that's simply because we have smaller birth cohorts that are coming in and we have the aging of the baby boom, right? And they're moving out. So that's going to be domestic labor force growth of near zero. We have been augmenting that essentially with strong immigration growth which is meaning if we can't find workers here then we go and get them from abroad and that creates that labor force input. So with immigration now at almost zero and many people even leaving that just means we're close to this zero level of labor force growth. So what does that mean first for the job market? It means that when you see a monthly number that is even zero, it isn't necessarily a sign that we have a recessionary dynamic forming. That might be our new steady state that you know benchmarks depending on who's estimating them are around 20,000 jobs a month is normal. But if you have any statistical fluctuations, you could easily end up negative or a little bit above that. So the benchmarks have to change. The other thing of course is if we don't make it up with productivity growth then our potential output growth will fall. Now right now we are making it up with productivity growth. So we still have trend output growth of two or a little bit above but it could easily slip if productivity growth goes back down to 1.5. Then we'd have a 1.5 potential output growth and that's because we'd have zero labor force growth. So the absence of immigration really does matter for that arithmetic calculation and it really matters that businesses are investing in productivity enhancing technologies so that they can augment the workforce we have and they move forward. I mean the only lever we can pull if we don't have immigration is labor force participation. How many of us of working age actually participate and there's a lot of room because we have one of the lower labor force participation rates especially for males in the industrialized world. So that's a problem that you know policy makers not the Fed could work on. And I think there's some interest in doing that but that is a lever that still remains that is something that could be changed but it takes work.

Well, you know, what happened so far and let's use just what happened recently as an indicator. That is a complicated question to answer. It really depends on where you are. So we had a lot of immigration right around the pandemic and after and we absorbed all of those workers and all the workers who were domestic workers who wanted to work because the labor market was extremely strong at some points when we would go out and do our rounds. The CEOs would call it frothy. You probably remember this in your own business. It's really hard to find workers in that environment and so we could absorb all the workers. As the economy slowed, we saw something else. So immigration slowed and those workers went away and there was a concern if you remember that this was going to raise wages and make the labor market frothy again but it didn't because the economy slowed at the same time. So that doesn't have to happen. It could be that you've got strong labor demand and you have a limited number of workers and wages rise and there's tightness but that didn't happen this time. So it really depends on what's happening elsewhere in the economy and again whether you can make up the difference in productivity. So one of the things I am very curious about is how do businesses that have relied a lot on immigration to fuel their labor force what are they doing and so a place where you see this a lot is leisure and hospitality. In leisure and hospitality I don't know if you've noticed this but there's a lot more technology doing things for you than people doing things for you and you end up ordering things on your phone and things that's a response to a tighter labor market and technologies that are available to make that all easier. And so that's how the economy typically evolves. It adjusts to whatever the inputs are. But this is a transition dynamic that we will continue to have to face if immigration policy stays constrained.

It's really hard to say because you know...

Okay. I'm gonna tell you. I'm gonna give you my, I mean I am Alex an economist after all. Clarity before certainty. Okay so here's how I think of it. If immigration came in, we have more immigrants and businesses responded by saying well now that I have more labor I don't have to invest in labor saving technologies. Then that wouldn't cause a rise in unemployment. If they said I'm not going to do that. I'm still going to invest in labor saving technologies, then you might have a rise in unemployment. But here's the dynamic that I think is underappreciated. Immigration doesn't usually rise in a time when our economy isn't very robust because immigrants come oftentimes for work. And so if they come for work and they say that the economy is not very good, they go back home to the home country. So it is a self-equilibrating dynamic in many ways and that's been true historically. It's not always the case, but it is often true. So I think that nexus between unemployment and immigration is just harder to find in the data than it is in our sensibilities historically.

They do. Yes.

No, it's really, you know this is why other countries not our country has had guest worker programs because you come during your work life and then you return other places. So there's a lot of ways to solve this problem. The problem that all these countries are trying to solve really is not just ours is how do you get enough workers to meet the demands of business or in the other case you can do it how do you get enough technology to meet demands of business that it works together. You can use capital or you can use people, but either way, you're trying to produce output.

You know, I am very interested in history. So, I go all the way back. You think about the Luddites. They didn't want technology and they thought that if they didn't want it enough, it wouldn't actually happen. But honestly, technologies are just coming and the best thing for humans to do is embrace them and use them effectively as opposed to letting them run. You know, I think of technology as a tool and we are the deciders of how to use that tool. But I'm actually fairly bullish on AI and here's why. It has the power to transform in a way that electrification had the power to transform. But if you ever looked at the history of electrification, that was a 100-year process of discovering electricity, harnessing it, finding ways to create it yourself. And then ultimately what transformed was that the factory floors got redesigned built on electricity. If you think about how it started, it began with electric motors replacing steam motors, but the factory floors worked exactly the same. The increase in productivity was very modest. But it was only when they basically redesigned the entire factory and said we can have little electrical motors all over the place and the factories can run much more efficiently. They don't have to be on one steam line. That everything changed. So what I see right now and I say all that because I'm seeing something happen. Three years ago there was a lot of interest in AI but businesses were trying to catch up, they saw other people using it or their employees using it. They're like we got to get ahead of this. Then last year there was a little bit of like let's figure out if we can be productive and now they're saying let's stop what we're doing and figure out what AI can really do and then let's build our business processes around that. Let's figure out what skills we're going to need to harness that going forward. That's the beginnings of this kind of transformative productivity enhancing use that is there. And I will say, I say this a lot, people get comforted when I say this, especially if they're young. No technology has ever reduced employment on net ever. But what does happen is it changes who gets employed and more importantly, it changes what skills get employed. So the thing that is going to be important in the transition dynamic is for the workers who were trained for the other economy start to learn and grow in the new economy. And that's the piece that we have not always been perfect at. We are just not good at helping people re-enter in a new technology. And I think that's ultimately, go back to the lessons of the Luddites. That's ultimately what they were afraid of. They knew how to do one thing but they were worried about being displaced in a new world. And that's the piece that I think the Fed can't do. That's not the policy lever we have. But I think it's an obligation of society to help in this way or else we're going to find a lot of workers who were not able to make that transition.

You know, it's interesting. And so there's an argument if you look at all the theory of economics, Alex, and you know this yourself is that it'll tell you that when you invest in AI and productivity is going up, investment goes up and you have the same amount of savings and so the neutral rate of interest should rise, not go down. But we don't have many periods of history where that's been true in the data. And so that could be because other things are going on. So I think it's really hard to directly tie an increase in productivity growth to the neutral rate of interest with any certainty but it's certainly something to watch on both sides where I do think a lot of work is being done where I've done a lot of work myself is thinking through if productivity rises does that give us an ability to expand the pie much more quickly which would allow inflation to settle down right because we've had constrained supply and constrained supply against strong demand inflation goes up. I'm looking for something that helps us with disinflationary pressure and I think the productivity growth can do that. Whether we can see that in the next year is hard to tell. So I think it's a possibility to watch but it's not something we can just count on. And with the oil price shocks pushing inflation up, you know, that dynamic is going to dominate the productivity one. But I came to work at the Fed in 1996. One of the first things I had to do, which you know and many of us do know, was work on how the productivity growth coming from computerization and the internet was going to allow policy makers at the time not to raise the interest rates. It's really interesting if you think about it. Inflation was 3% back then and there was a lot of and that labor market looked tight and there was a lot of concern that if policy makers didn't raise the interest rate they would find themselves behind the curve and Chair Greenspan kept that at bay in part because he saw productivity growth everywhere except in the data and we're seeing that a little bit now we see a little bit of productivity growth in the data and that's a good thing but there's probably more green shoots of productivity growth out there in the business world than we are currently measuring and so that's the thing to think about but I think there is a possibility that it puts some disinflationary pressure on the R-star question you know R-star is one of those variables we know very little about.

Go ahead okay so supply of...

You do love R-star. There's only two things you love about the Fed more than me and that's the balance sheet and R-star. True. It's like completely. Okay. So, R-star is just the neutral rate of interest. The neutral rate of interest is the price at which supply of savings and demanded savings settle. Right? So, we had the savings glut which we had a decade ago when Ben Bernanke was chair that would push R-star down. And of course now there's a lot of conversation about maybe we don't have enough savings and we have a lot of investment demand and so that's going to push R-star up. So productivity growth gets in there because when people want to grow investment then that's just going to move investment up and R-star is going to rise in theory. But again when you look historically you just don't see these movements as clearly as the models would tell you. So I think we have to be very open-minded in this area and not reflexively just say what's going to go up so we need to keep the policy rate higher. So many other things go on in the economy that would matter for that. So R-star to just go where I was headed, it's a theoretical concept. There is a price at which supply and demand for savings settle but it's a longer run concept. It's not something you would ever make policy decisions on in a short, you know, it doesn't looking outside and saying, 'Oh, there's going to be productivity growth, so R-star is going to be higher or lower in a quarter.' That just isn't going to be helpful. It's more we're going to give it more precision than it deserves.

So, you know, right now the, let me speak, you know, just make sure everybody knows I'm only speaking for myself right now. For me, I think of this as it's too early to know whether this is a longer run persistent shock or a short-run shock that will dissipate and the conflict will end. So, ultimately it depends on the duration of the conflict. If the conflict ends more quickly, then oil prices go down and we're back on that path for interest rates that we were before and there's not any lasting persistent damage to that relationship where we were before. Of course, if it persists, well then, you know, at some point you start to have infrastructure issues. You start to have, you know, oil production is not a light switch. You don't turn it off and then turn it back on. It takes some startup time and so at some point you're going to have all of that and that means a more persistent shock and that means that there's more inflationary pressure for a longer time. And it's interesting, you know, typically you would think of an oil price shock having both inflation and growth effects, but we're not that energy dependent in the United States. And so it's probably less on a growth effect and probably more on the inflation effect because consumers are already paying higher prices at the pump. The piece that I worry the most about in this is that, you know, consumers are already facing a lot of things that are vulnerable, persistently high oil prices chip away at their disposable income and that means that at some point they'll have to give up on other goods and services and that means that you get into this dynamic of a slowing economy, slowing demand. So those are the things we're watching. I haven't seen those things form yet. You just see a little bit of indication, but consumers are still out there and most businesses we talked to, we just had a variety of meetings this week, think this is going to be done quickly and they're optimistic about the second half of the year. We'll see.

So you build from there.

Yeah, slightly restrictive. I'd say slightly restrictive is where I think we are because we're above that 3% area, but you know, we're right on the cusp of completely neutral.

We're in the range. So given all these factors that we've just talked about, what do you project will be the consensus on where rates are going, short-term rates are going.

T-bill. Oh, yeah. Well, that's got a variety of factors in it. So I would be, I don't, you know, that I really, I'm, you know, clarity above certainty but seriously I think that there's a lot of factors pushing the 10-year up and one of those factors is our policy. The other factor is a lot of concern about where all of these things are headed what's going on with inflation. A lot of it is just how financial market regulations changing the global the geopolitical risk. And so at this point, I think what you know, I've always cautioned people not to use the 10-year as an indication of just inflation expectations. There's also a term premium, lots of other things in there and a risk premium. And I think the world when there's a lot of uncertainty, it tends to move that in a way that doesn't align completely with our policy. So our policy, you know, what I would look at if you want to know how, and this wasn't exactly your question, but it's an important question to me. Do people still believe we can achieve 2% inflation? And if you look at medium and longer run inflation expectations, they're well anchored and haven't budged in the oil price movements. But what has moved is short term, but that's logical, right? People are already paying the higher price at the pump. So, of course, their short-term inflation expectations have gone up.

You know, tariffs are still uncertain. I mean, we're hearing more and more as we talk to firms that they're already starting to think about how to get the monies that they spent on tariffs returned to them. They're, you know, moving forward with their goods and service deployment and but there's a lot of uncertainty about what a different policy might be. I think Secretary Bessent said we'll know more in July and so we'll wait until the administration announces the next piece. But for us, you know, I mean, for me and let me think about and also how most of my colleagues have commentated this, you know, tariffs generally in economics and policy would be thought of as the tariffs come, they move price levels up, but they don't keep raising inflation. And so those would have been rolling off at this point anyway. And then with the reversal of some of the tariffs, they've rolled off a little faster. But then, of course, the next thing that came was the oil price shock. And so the inflation in goods and some services remains elevated all the same.

Yes, I think that's right. And I think you know there is, we did, you know I do think there's reasons to move it up because productivity growth has risen. I just wouldn't move it up dramatically because we just don't have enough evidence to suggest that's true.

So first thing is that's the Board of Governors' responsibility and in particular Vice Chair Bowman's responsibility not regional Fed presidents. But one of the things that you know is and I'll leave it to her and her colleagues and also the other regulators to make the work through determinations of what we'll have finally as a capital plan. But one of the things that policymakers of any era balance is how do you put more money in the banking system to promote more lending and financial intermediation while you're creating safety and soundness for the system. And I think we're, you know, that recalibration is always going on. There is no, you know, perfect system. You're always recalibrating. So, we'll see what happens. One of the things that's true though is that it looks like there'll be more capital in the system than there was in previous four years. And that's something I think many are getting certainly in the banking industry are excited about. But also in the business world excited about because it just allows more lending to take place. For the Fed. It means that there might be less demand for reserves and it would allow our balance sheet to come down a little bit in terms of its overall size because our balance sheet is, you know, it's 6.7 trillion. So 3.7 of that is roughly things that we have to have to meet our non-reserve liabilities. The other are just the reserve demand. And so as reserve demand would fall because of capital requirements changing then you might see that footprint shrink in terms of our balance sheet size.

It's really hard to say because the capital plans aren't finished. And so I think you know I really feel hesitant to front-run Vice Chair Bowman or any of her colleagues as they finalize these plans. But I think that just getting that sensibility that as reserve demand comes down because as capital requirements change, reserve demand could come down and that would mean that an overall balance sheet size would fall at the Fed. But it's early days. We just don't know yet. And you know, banks can demand reserves for a variety of reasons, not just the capital requirements.