Hello and welcome to another episode of the Odd Lots podcast. I'm Tracy Alloway.
Joe, how about that hawkish cut?
Exciting, interesting times in macroeconomics. The Fed, the markets, plenty to talk about right now. We're recording this December 20th.
Yeah, we're recording this December 20th, so two days after we had what is being called a hawkish cut from the Fed. The central bank decided to cut by 25 basis points, but at the same time they unveiled their new forecasts for next year. It looks like the expectation is that inflation maybe is going to be a little bit more stubborn, maybe we're only going to get two cuts next year, and markets promptly fell out of bed. They did not like that revised forecast to say the least.
Yeah, and it's a little surprising, and we'll get into it. I think to some extent a lot of it was expected, but there are real tensions right now. We have had stubborn, sideways inflation prints in recent months, maybe not quite the soft trajectory back down to target. The fact that we might not be down to target completely in 2025, some questions about labor market stability, plenty to dive into, plenty of crosswinds for investors, traders, and so forth to digest.
Crosswinds is a nice way of putting it. I feel like anyone who was hoping for a quiet end to the year might be disappointed with everything going on. But Joe, I have to say we really do have the perfect guest to dive into all of this. We're going to be speaking with Federal Reserve Bank of San Francisco President Mary Daly, herself a voting member on the FOMC. So Mary, thank you so much for coming on Odd Lots.
I'm delighted. My lucky day.
So why don't I start with the obvious question, and one I suspect you've been asked multiple times over the past couple days: but why cut at all if you think that inflation is expected to show not that much progress into next year and maybe not reach 2% until 2027?
It's a great question, and if I can take a minute, I'll explain exactly how I thought of it. We had policy, rightly so, at a highly restrictive level. Remember, the interest rate was really high, historically high, and that was to fight very high inflation and a very robust labor market was helping spur high inflation. The economy was out of balance. So now that we have inflation that is much lower, we've made tremendous progress towards getting it back to 2%. We're not there yet, and the labor market is balanced now, completely balanced. It's appropriate to move into a more moderate level of restrictiveness. Otherwise, what you end up doing is breaking the economy. If you leave the higher level of restrictiveness on while you're closer to your goals, the economy just starts to falter and you end up getting inflation down but at the expense of people's jobs. And that's not a recipe for a soft landing, that's a recipe for a very hard landing. And it takes away what people have really wanted their entire time that we've been in this high inflation period, which is low and stable inflation and jobs that help them grow their careers and communities and families. So that's why we cut the rate, in my judgment. That's why I supported it. It was a close call whether it's 75 or 100 basis points in total that's the right level to get from highly to moderate. For me, we now have completed that recalibration, right-sizing, and now we can look at the data and the incoming information and our projections of how the economy will evolve and take our time to make any additional policy adjustments.
So if the labor market is, as you put it, in balance and no longer a driver of inflation, and yet inflation has been sideways above target—in fact, the inflation forecast per the dots for 2025 ticked up—what is the residual source of the inflation if it's no longer the labor market?
Yeah, that's another great question and one that we think a lot about. I think a lot about, and really it traces to two things right now. One is driving it up, maybe temporarily, it's hard to say, and the other one is a more persistent issue. So let me start with the first one: it's non-market prices. And what that means for people who are really into this, like me, is that it's prices we don't actually measure, we estimate. And we're not doing this, the BLS are doing all the data collection, but it's really these prices that we don't know, we can't see them exactly, and so we estimate them. And so financial services prices, for instance, are based on asset values and those have been up, so it feels like inflation high in those areas partly because of the estimates. But it's hard to get your mind on that as a fundamental underlying inflation. It's not really what people think about when they think of high inflation is hurting me, they're thinking about other things. So that's one factor. The second factor that's really been elevating inflation is housing services, the price of housing and the price of rentals. Now what's interesting there is rental prices have been coming down, but home prices haven't been falling as much, and we're not seeing that gap close. And unfortunately, we have a structural issue there that has nothing to do with Fed policy. It's really about the substantial, significant, very, very large shortfall in housing relative to the number of people who want it. And so that's something that may be stickier for a longer period of time than we thought and will cause inflation to be elevated.
I mean, housing inflation, is that something that the Fed would attempt to offset? And I guess, with what tools at your disposal? Because you have benchmark interest rates, and when rates go up as they have been up until relatively recently, the cost of capital increases for all these home builders, and if anything, we see housing activity tend to slow. Like, what is it that you can actually do about housing inflation?
So what we do—and this is—we do have a limited set of tools for the kind of housing inflation we're seeing, the driver of that being the imbalance between supply of housing and demand for housing. We don't have a surgical tool for that problem. But what we do have is the interest rate. And one of the things you saw is that building really was stifled when we had interest rates at those very high levels, but as we started to move the interest rate down, then we saw builders start to come off the sidelines. So I'll tell you an anecdote or some stories from my context. So I have the nine states in the western US, that's the 12th District of the Federal Reserve, and that's the coastal states, Alaska and Hawaii, and all the mountain states, so Utah, Nevada, Arizona, and Idaho. Those states, we saw immediately when we took the first 50 basis point reduction in the interest rate, our contacts—I was out in those areas—our contacts said we're going to take some projects off the sidelines. And I said, really? That's just a 50 basis point reduction in the interest rate? And they said, yes, but the direction of change is down, and so now we're ready to come out. And that has been happening since we've been on this relaxation of policy. And the consequence of that is that we're seeing some improvement, but that's not going to be sufficient. And another thing you learn, especially if you travel into Idaho, Utah, where they've had significant housing challenges, is the public sector and the private sector businesses are joining together to try to get some relief on the housing side. It's a problem for everyone, and the Fed only has that limited tool.
Mary, I'll give you a cookie if you can name the three American territories that are in addition to the nine states in the San Francisco Fed catchment area.
Very good. You'll never get the third one.
I know. What are the other two?
American Samoa and the Northern Mariana Islands. I just want to say, Mary, earlier this year, Tracy and I—I don't know if you know—we took a trip with one of your colleagues, Richmond Fed President Tom Barkin, to Myrtle Beach. If you ever wanted to record an Odd Lots with us on the road in Hawaii, I'm just throwing it out there. I'm just throwing it out there.
Anyway, you can come to any of the states. I'm going to Alaska, I go to Hawaii, Idaho, yeah, anytime. I do road trips all the time, and you're welcome to do it.
Okay, I'm making a note of that for producers. Now, I want to go back to the inflation outlook specifically. And I take your point about some of these non-market prices, and I certainly take your point about housing, because there are lots of crosswinds there, the degree to which the rate can affect things, some of the gap between some of the market private measures that come out on rents versus the public measures, and so forth. All that being said, there has been some sort of shift in the outlook since September. So these are long-standing structural issues, and yet since September, obviously, the inflation outlook has firmed per the dots. What has evolved since September such that the inflation outlook for 2025 has gone up?
Well, one thing that has evolved for me is just my better understanding as the data have come in and we've dug into them a little bit more, that housing inflation might just be more persistent. So if you think about how it usually works, you would see, even with these gaps, you would see housing services inflation come down, and it has not come down as quickly as we would have thought. And so re-evaluating how we think about it and just allowing more time and persistence there. Another thing that's happened is we have geopolitical issues and trade back and forth. It doesn't depend what administration you've been in, the one we're in now or the one that's upcoming, it really is that trade relations between the US and China haven't been as strong as they have been in past years, and that's spread out to other countries. And so that affects your outlook for just the price of goods. And then of course, the economy has been—consumer spending's just been stronger and growth has been stronger than most forecasters, including us, have penciled in. And so there's an adjustment to the growth forecast as well. So the way it typically works in economics models is that growth falls below potential growth, that puts downward pressure on inflation, but when growth is above potential growth, then we're going to see whether that's boosting inflation. I did allow it to boost inflation in my own forecast a little bit, but if it's coming out of productivity gains and labor force growth, then it may not. So that's why you have to be agile as a banker. You put a forecast in, but you don't get too attached to it.
I definitely want to ask you more questions about the outlook for things like trade and some of the forward-looking things, but before we do, just in terms of this week, were you surprised at all by the market reaction to the decision? Because there is an irony here, which is you cut 25 basis points and it was sort of the first time we've seen a real tightening of financial conditions since the summer, basically.
Well, they're really forward-looking. They're never going to adjust just—I mean, this is one of the things about markets, they're extremely forward-looking. So it seems like they were really looking forward on what we said for next year. Now, you asked if I was surprised. I was a little surprised. I mean, they had expected the rate cut that we made, so that wasn't the surprising piece. And they had penciled in in their market prices three interest rate cuts next year, not the four we had thought we would make in the September SEP. And so then when they saw the median come out at two, it seemed to be a very large response. And yes, that was surprising, because three doesn't seem that far from two, and it's certainly in the range of the dispersion of forecasts. I mean, we had some with no cuts, we had some with—one person with five cuts in the participant list, if I remember correctly. And so I think the uncertainty bands about what we'll actually need to do going forward are very wide, and I was surprised the market didn't see that and say, okay, we were roughly in line with what the Fed thought. But they didn't, and so that's unclear why. Maybe there's a lot of other things going on in the economy and the world that caused them to take this more risk-off approach.
But you're talking about, okay, at one point a year ago or so, the Fed was in highly restrictive territory and now it's coming down to something that's a little bit more moderate. But either way—and of course we don't really know, and those two dots, it could change again at the next dot update—but either way, at least right now, it looks like rates, whenever this sort of cutting cycle comes to an end, are not going to look like pre-COVID levels. And so people talk about the neutral rate of interest having gone up. What's changed since pre-COVID such that regardless of where this ends, we do appear to be in a sort of new higher rate band than we were if we had been having this conversation in say 2019 or 2018?
Yeah, no, a lot's changed since then. And so let's walk through some of the factors that I think are really material that the Fed and other central banks around the globe are going to have to deal with. So one thing that's changed is the neutral rate of interest is just the price that clears the desire for investment and the desire for savings. So you have the savings and you have the investment and you balance those two out and you get an interest rate that's the neutral rate of interest. And it is the one that persists when there's no shocks to the economy. The thing that we were facing coming out of the financial crisis and for the decade that preceded the pandemic is that we had an abundance of savings and a dearth of investment, and that drove the neutral rate of interest down. Supply of savings was plentiful, interest and demand for investment was not as plentiful, and the neutral rate of interest fell, and it fell across the globe, it's a global rate. So now we have that unwinding. We have lesser supply of savings, the sovereigns, the countries are all out there borrowing quite a lot of money, and that pushes the demand for investment or spending up. Companies are coming off the sidelines on investment, looking to take advantage of automation or AI. I haven't been a labor economist my whole career, and one of the things you see again and again and again is when we have tight labor markets like we had, it drives firms into investments to automate so that they don't feel so frantic when they can't find workers. So we've seen that normal process, and I think that's been spurred even more by people recognizing that AI is a thing now. There's sometimes—and mostly not even using generative AI, I mean some companies are absolutely reaching into generative AI—but when ChatGPT was announced right before Thanksgiving of 2022, suddenly people said, oh, I can do robotic process automation, I can do machine learning, I can do all these things, and it's my companies that sell me things to make my life better are going to give me those things. So I think that's really spurred some investment. Companies want to manage their potential workforce shortages going forward, they want to get better at doing their jobs faster, better, cheaper, and they're investing in these things. So then ultimately what drives our star is this balance between investment and savings, and that's changed. Another thing that's changed, which is really material to how we do our work at the central bank, is we spent a decade or more fighting inflation from below our target. Our target's 2%, we were stuck at 1.5, 1.6, 1.8, never got over 1.8. That's below the target we're trying to push it up. Now we're back to the normal thing that central banks have done for most of their histories, which is fight inflation from above the target, pulling it down, and that means that interest rates are just going to be higher in order to keep that inflation at bay.
Speaking of r-star, how much confidence do you have in your estimates of the neutral rate right now? Because I do get the sense, all the talk of data dependence, there is an interpretation out there that's basically, well, the Fed is looking at the data and emphasizing data dependence because they have less confidence in a lot of their models at the moment. A lot of the traditional relationships that we've seen, things like the Beveridge curve, have broken down in the post-pandemic period, and there is a lot of uncertainty over how things are working at the moment.
I'm going to take the opposite view. I actually think the models have done remarkably well. So the Beveridge curve is like a grand success, for example. If you take this vacancy ratio and you look at that, we were on the very steep portion of the Beveridge curve, and research at the San Francisco Fed has demonstrated this along with many others across the system. But I was really pleased when I saw we're coming down the straight portion of the Beveridge curve, which means firms just reduce vacancies and it has almost no impact on unemployment. And that's the happy world we've been living in while we were raising interest rates to fight inflation. Vacancies came down, unemployment didn't go up very much, and we got a lot of balance in the labor market. Now this vacancy-to-unemployment ratio is one, so one vacancy for every one unemployed worker, and that's a lot of really pain-free adjustment. Now I'm talking pain-free at the aggregate, certainly we want to make sure that we don't say that it was pain-free for those who had to re-sort themselves and change jobs or maybe even lose their jobs, but from an aggregate economy perspective, that was great. So that's a model doing well. Another place where the model is doing well is it's telling us the Phillips curve is a little flatter than it had been for a long time, where once the unemployment rate comes up to a certain level, it just doesn't put additional pressure on inflation. And so at this point, we don't think the labor market is really a source of inflationary pressure, and that would come out of the models. Our data dependence is really related to this, in my judgment. This is how I think of it: the incoming information we have always used. We were data dependent after the financial crisis, we went to a dashboard of indicators. What we've really done in my history here at the Fed is expand what we look at. We're not satisfied just looking at these headline numbers, so we look at all the real side indicators, all the price indicators. It sort of reminds everybody, data is a plural word. It doesn't mean three series. It also doesn't mean simply the quantitative data that you see the big institutions publish. It means talking to our contacts. You said you had Tom Barkin on, well, Tom and I share a particular attribute: we gather a lot of information, and many other presidents do too, but we gather a lot of information from talking to CEOs. Those are the people who are going to tell us, I am going to hire next year, I'm not going to hire, I'm getting ready to lay off, I'm dusting off my strategic plans and I'm investing. Those are also data. So I think that our focus on data dependence is our focus on collecting that information and letting it affect our decisions so we can make better ones.
Since you mentioned the specific thing, whether you're looking at the data that we see on the screen or the data that you collect from talking to CEOs, what is your assessment of the health of the labor market right now? The proclivity to hire, the ease of finding a job, how worried or happy are you about the state of the labor market?
I say the labor market is really balanced, and that's something I've been watching for. It hasn't ever gotten into a dangerous weakness. It hasn't. It's definitely slowed, and earlier in the year it was slowing at a rapid pace. Now that slowing has settled out a bit. What we hear from firms—so we do a lot of questions and surveys with firms and we talk to them—what we're hearing is they don't have the kinds of problems hiring workers that they once had, and they're increasingly able to find workers of all different skill levels, which they had pockets of where they just couldn't find anyone. Importantly, they're also saying that they think they can now bring workers back to the office because they have more bargaining power, if you will. Before, nobody wanted to come back to the office, and now they don't have to say yes to that, and they feel really good about that from their productivity perspective. So then you go to workers and you say, is it hard to find jobs? And they're saying, well, it takes a little longer now, and I'm hanging on to my existing job a little longer because I don't want to take the risk, but no, I can find jobs if I really want them. So that's what, when I think of a perfectly balanced labor market, I think of workers might take a little bit, but they find jobs. Firms say, I can't get everything I want, but I can get workers, and they're staying a little longer. But I am watching it to see if any weakness emerges where workers start to say it's really challenging out there, and that would be something we would want to avoid.
By the way, I have some good news to report for everyone in the room. You might be happy to hear this: core PCE just came in as you were answering, 0.1% month-over-month versus expectations of 0.2%. So just a little live update on the economic situation. Maybe makes your life a tad easier in 2025.
Well, I think it's just good news. I mean, one of the things when I see that incoming information, I remind myself of a couple of things: it's just a one data point. We are not a data-point-dependent Fed, we're data-dependent. Can't react too much on one data point. And for all the households and families and businesses out there thinking about how can they manage inflation, I feel a huge amount of relief that it's going in the right direction. So we got a lot of work to do, but that's good data.
