Q&A with Neel Kashkari at the St. Paul Area Chamber

Thanks for having me. It's great to be here with you. If it's okay, if I just start for two minutes, I want to just share with you why meetings like this are important and helpful. When Congress created the Federal Reserve in 1913, they did something unique. They said we need a central bank but we want it to be spread out around the country. So they created 12 regional Federal Reserve banks, the ninth of which is here in Minnesota covering this region of the country. And a big part of our jobs are to know what's happening on the ground in our regional economy. And then I go back to Washington DC every six weeks for what are called FOMC meetings, meetings of the Federal Open Market Committee where we set interest rates for the nation. And part of what I'm doing in those meetings is I'm talking about what's happening here in our regional economy. Now, we cannot set a different interest rate for Minnesota and for California and New York. It's the same dollar. It's the same economy. So, we have to pick a monetary policy that's right for the country as a whole. But my job is to make sure that this region is represented in that deliberative process. So, meetings like this are very helpful for me to hear from you. What's happening in your businesses? What are you seeing on the ground? What's the job market like? Are you able to find the workers you need? What's happening to wages? What's happening to your prices of the goods that you buy? All of that will help us make sense of the data that we're seeing. Last thing I'll say, we look at a lot of data at local, state, and especially federal data. Usually that data is sending us conflicting signals. So, it's hard to make sense of where's the underlying economy headed. It's discussions like this that can really help us make sense of those confusing signals. So hopefully we can see the signal and not get distracted by the noise. So thank you for having me. I really appreciate it.

Yeah. So when Congress created us, they've given us our assignments, our goals. We talk about a dual mandate, two primary goals. One of which is stable prices, what we've defined as 2% inflation. The other is maximum employment, as many Americans working as possible and contributing to our economy. Now, sometimes these things are trading off each other where if the job market heats up a lot, the unemployment rate gets low, businesses have to pay up to find workers, but then they have to pass those costs on to their customers and then that can lead to inflation. So, think about a seesaw that's tipping one way. In that scenario, we would typically raise rates to tap the brakes on the economy and level it off. Or if the economy is headed into recession, we may have very high unemployment and very low inflation. In that case, we would typically cut interest rates to try to level it off the other direction. Well, right now, I don't need to tell you inflation is still too high. It's been above our target now for more than five years. Before the Iran war started, I had some confidence. We made a lot of progress bringing inflation back down. It wasn't all the way back down yet, but I had confidence it was heading in the right direction. The Iran conflict and the shock wave of oil prices around the world. And not just oil prices, fertilizer prices, other related commodities that has really upended the inflation outlook. And now there's just a huge question mark of how long is the Strait of Hormuz going to be closed because that is going to have a big effect on what is the path forward for inflation and so we just don't know right now.

Yeah. Well, I'm going to say definitely not. We do not want that. That is not where the Federal Reserve is. And let me tell you why. If all of you, you and I and your employees and your partners start to believe that 3% is now the new normal for inflation, your employees are going to come to you and say, 'Hey, I need a bigger raise because my family is falling behind.' And so that starts to get woven into your investment and planning decisions. And then you're going to pass those costs on to your customers. And then that becomes a self-fulfilling prophecy. We have said that 2% is our inflation target. It's been our inflation target for a long time. Most advanced economies in the world have the same inflation target of 2%. We need to get back down to 2% to let people know we're not going to move the goalpost because if we move the goalpost to three, maybe you're going to think, well, maybe they're going to move it to four next time it gets hard. Or maybe you're going to move it to five and then it becomes a creeping standard and then that really undermines confidence in the economy. So, we're committed to our 2% target. We need to finish the job. What's been challenging the past five years is economists call these shocks. Different things keep hitting the economy. COVID, the supply chains coming out of COVID, Russia invading Ukraine, now the war in Iran. These things are all inflationary like one after the other after the other. That doesn't mean that doesn't let us off the hook. We still have to get inflation back down, but it's made the job challenging.

A few different ways. One thing as I mentioned a moment ago is before the Iran conflict started I had some sense of confidence that inflation was slowly heading back down to our target and I can walk you through why but the data that we looked at, the analysis we looked at, I said okay it's moving gently in the right direction and the labor market has mostly been moving sideways. The unemployment rate nationally is around 4.3%. I would call it a lukewarm labor market, it's continued to move sideways. So what has changed in the last four months. The Iran shock has upended the inflation environment, created a lot more upside risk on inflation, but we've also gotten more data on the labor market, but the labor market looks like it's hanging in there. I think at the beginning of the year, I had a little more concern that maybe the labor market was weakening underneath the headline. The data that we've gotten since then says actually the labor market seems to be kind of treading water. So labor market looks a little bit better than maybe I thought in January or February. Inflation definitely looks worse.

You know, there are a lot of confusing messages coming out of the economy. So first of all the economy if you look at overall GDP it's held up pretty well. If you look at corporate profits especially for big companies they've held up very very well. So in some estimates the economy looks like it's doing well. If you survey people and you survey businesses generally they're much more gloomy. They're much gloomier than the actual statistics would suggest. A few years ago we talked about everybody was gloomy about the economy but then they were spending a lot of money on Taylor Swift tickets, right? People wanted the experience economy. That trend seems like it has continued but it really has fragmented more where more well-to-do families are feeling confident enough to go out and spend and lower income families are really having to pinch pennies to just try to make ends meet so to speak. You know, we talk to a lot of businesses that have strong retail footprints and they can see how their own retail customers are changing their behavior and lower income customers are really cutting back because they're feeling the pain of inflation and their wages are not keeping up with the climbing prices. And so that is an example of the K-shaped economy. Well-to-do folks who own their own homes and/or who have 401ks and stock portfolios are feeling more confident, continue to spend. People on the lower end of the economic distribution are really struggling a lot more and I think that that has continued.

I think overall this region is performing a lot like the country as a whole. You know, our region broadly. So what we cover is bigger than Minnesota. Minnesota, the Dakotas, Montana, the upper peninsula of Michigan and Northwestern Wisconsin. This region, it's a big geography, looks a lot like a miniature United States of America because we have manufacturing here. We got a lot of ag, we have oil and gas in North Dakota. We have exports. We have healthcare. We have financial services. In a way, it's a mini United States of America. And some sectors are doing better, some sectors are more stressed but that gives us a resilience because usually some sectors are doing better while others are more stressed. So I think in many ways we look a lot like America as a whole. Some of the dynamics are a little bit different. Of course we had Mosaic surge here which had a profound impact here in our local economy. From what we can tell it didn't really get into farms and agriculture as much. It seems like they were carved out. It was really more focused on the urban areas. But those are some differences. But if I were to say right now, I think our region looks a lot like the country as a whole.

Housing affordability if interest rates are not lowered. Let me talk for a second about why interest rates are where they are. There's a notion that's really important for monetary policy makers is what is the neutral interest rate? What interest rate neither stimulates the economy nor restrains the economy? This interest rate is set by broader economic forces such as savings and investment. So savings and investment, all of us save some money. You put it either in the bank or a savings account or some kind of a portfolio and that money is made available for businesses that want to invest. And that where that neutralizes, where that evens out, that sets the interest rate environment. And the Fed is now raising rates or lowering rates around that neutral level. But we don't set the neutral level. Well, in the last four or five years, you all know, you've seen it. Massive demand for new investment capital for data centers, for AI, for chips, for power systems to power the data centers, for water systems to cool it. Hundreds of billions of dollars a year. Well, when you have hundreds of billions of dollars a year of new investment demand, all else being equal, it's going to push up interest rates because how do those data centers get funded? Those data centers get funded by capital that would have invested over here instead getting reallocated over here. So why am I telling you that? Imagine I'm going to make up a number. Imagine an apartment building that would have gotten funded. It would have penciled out if it could get a 3% mortgage. Well, now that apartment building is not going to get funded because mortgage rates have gone up to say 6%. And that capital that would have built that apartment building is now going to go over here and build the data center. The reason I'm telling you that is mortgage rates are a little bit influenced by what we do at the Fed. But mortgage rates are much more of a long-term interest rate. Let's say you're going to have 10 years or more. That really is set by these broader economic fundamentals. And so it's my long way of saying I'm not sure what the Fed does on interest rates to get inflation back down is going to have much of an influence on mortgage rates and therefore on affordability from a whole bunch of different perspectives because of these broader dynamics that are taking place right now. And we can get into that in more detail if folks want in the Q&A.

Yeah. So, I would just say the data I think you're referring to came out today. I don't focus too much on any one inflation report because these things tend to move around quite a bit. We do know a few things. We do know that oil prices have shot up and other commodities adjacent to the Middle East have shot up. Now, you'll often hear us talk about core inflation instead of headline inflation. And the reason we do that is because food and energy prices tend to be volatile. And it's not that they don't matter. You know, you have to pay for food, you have to pay for energy. Those components matter a lot. But if we want to get a read of where's underlying inflation going, we tend more to focus on core. So we know the headline numbers have shot up really rapidly because of what's happening in the Middle East and oil prices. Having said that, even if you strip out oil, oil goes into everything, right? It goes into diesel for trucks that maybe bring your produce. It goes into the plastics that are in the products that you buy. And so it really for me it comes back to if I were to simplify it, how long is the Strait of Hormuz going to be closed? And even if it were to reopen tomorrow, some very large companies who have global supply chains have said to me, even if it reopens tomorrow, it's going to be months before their supply chains return to normal. And so, I'm not that surprised by the numbers that you're talking about. I want to see how persistent they are. And then I want to see what happens in the Middle East and how persistent the closure is of the strait because that's kind of the root cause that's driving all of this.

I don't actually know if that's true. A few years ago, I'd seen some data that said that the Minneapolis-St. Paul region actually had built marginally more than many similar metros around. I don't know what the last year or two data is, but there's no question that the single most important driver is going to be supply. We just need a lot more supply of all types of housing. And there's, you know, think about four different components of costs. One component is the cost of materials. Inflation is obviously up. Not much you can do about that. It's our job to get inflation back down. Second is labor availability. Obviously, if there are fewer immigrant workers to build homes on the margin, that's going to make labor somewhat less available, potentially causing some inflationary pressure there. Third, of course, is the rate environment that I already talked about. That really is driven by broader macroeconomic forces, though the Fed has some effect. And then the last piece of it is really about regulation and local zoning. And I always say to people, I say, you know why it's so hard to build? It's because of people like me and people like you who own their own homes and who don't want people building more homes in our neighborhoods. And so we say, 'Okay, you can build someplace else. You just can't build in my neighborhood.' And when we all do that, you can't build anywhere. And then all of a sudden, the home prices skyrocket because we just limit new supply from coming online. So there are at least four different components that are driving costs up. Inflation, labor availability, long-term interest rates, and what I would say zoning. The one that is most easily in our control, I think, is the zoning. And if you look around the country, there are some regions where it's a lot easier to build. They still have inflation. They still have labor availability challenges. They still have the same interest rate environment, but the zoning piece actually can make a big difference on how much new supply you can bring online if you're able to tackle it. I know it's not easy to tackle because I'm part of the problem, which I'm admitting to. But some regions do a much better job of that than others.

Why don't you turn it off and see if you can turn it back on?