Vice President Jefferson’s speech on the US economic outlook and the transmission of monetary policy

Vice President Jefferson’s speech on the US economic outlook and the transmission of monetary policy

Thank you for inviting me to join this conference and for the kind introduction. It is a pleasure to be here.

Before I begin, let me remind you that the views I will express today are my own and not necessarily those of my colleagues in the Federal Reserve System.

I will take this opportunity to share with you my expectations about the US economy. I will also discuss the risks facing the economy. Next, I turn to the transmission of monetary policy, including some recent evidence about the source of the lagged effects of policy. Finally, I will discuss monetary policy considerations that stem from efforts to manage risks given the delayed effects of monetary policy. These considerations include the need to proceed cautiously as the risks of monetary policy tightening are closer to those associated with not tightening monetary policy sufficiently balanced. Next, let me turn to my forecast for the US economy.

Inflation expectations
Although recent inflation data has been encouraging, inflation remains very high. Over the 12 months ending in August, total PCE prices rose 3.5%, which is the black line in Figure 1. Excluding the volatile food and energy categories, core PCE prices rose 3.9%, which is the red line. In order to better understand core inflation trends, I find it useful to look at three broad categories that together make up the core PCE price index, because the causes of inflation in each of these sectors are somewhat different. The first category, commodity inflation, which is the red line in Figure 2, has slowed strikingly, as supply chain-related price pressures continue to ease. The second category, housing service price inflation, or the black line, has clearly declined, as expected given the previous slowdown in rent increases for new tenants. In contrast, price increases for the third category, which are basic non-residential services, or the Blue Line, have not yet shown a significant slowdown. Since this sector represents more than 50% of the total core PCE index, we will need to see further deceleration in this area to achieve our inflation target. However, I believe core PCE prices will moderate further as the labor market improves.

Labor market
Despite the strong September labor market data we received last week, there is evidence that the imbalance between labor demand and labor supply continues to narrow, with labor demand slowing and labor supply improving. However, the job market remains tight.

In line with the decline in labor demand, job opportunities decreased by about one million jobs from the end of January to the end of August. However, as shown in Figure 3, employment is still about 30% higher than its pre-pandemic level. Meanwhile, layoffs remained very low, and the pace of employment gains remains strong, with September’s nonfarm payroll gains higher than expected. In addition, the unemployment rate reached 3.8%, a level that remains near historic lows. The fact that unemployment and layoffs have remained low over the past year amid declining inflation suggests that there is a path to restoring price stability without the kind of large increases in unemployment that often accompany major tightening cycles.

The improvement in labor supply also contributes to rebalancing the labor market. For example, since the beginning of the year, the early-age labor force participation rate has risen, as shown in Figure 4. Immigration rates have also risen, further contributing to increased labor supply. Slowing labor demand and improving labor supply have eased labor market pressures, and I expect a further gradual easing of labor market conditions, with restrictive monetary policy continuing to slow labor demand without causing a sudden increase in layoffs or the unemployment rate.

Overall economic activity
The data we have received so far points to strong economic growth in the third quarter, contrary to expectations earlier this year that the economy would slow. Consumer spending was strong in July and August. Housing construction, as shown in Figure 5, has begun to rebound after a slowdown that was widely viewed as being caused by higher interest rates. Despite signs of resilience in the economy this year, some analysts expect economic growth to slow this fall, which brings me to the next topic: What are some of the risks facing the US economy in the near term?

Risks facing the American economy
So far, the economy has been resilient, and inflation has been falling; However, I attach a high degree of uncertainty to my forecast and see multiple risks. I am particularly interested in upside risks associated with inflation, such as those associated with the economy and labor market remaining too strong to enable further deceleration of inflation, as well as risks associated with unexpected increases in energy prices. Since energy prices are volatile, I tend to look at changes in energy prices and focus more on core inflation in my trading. I recognize that inflation persisting above the Federal Open Market Committee’s (FOMC) target of 2% increases the risk of instability in inflationary expectations. Therefore, regardless of its source, my goal is to bring inflation back to the FOMC’s target (2%).

I just mentioned the upside risks to inflation, but there are also important downside risks to economic activity, such as a slowdown in foreign economic growth. The Chinese economy appears to have lost momentum with real estate activity declining, and other indicators, including retail sales, point to weak economic activity. In Europe, PMIs in the manufacturing and services sectors have been in contractionary territory recently. I am following these developments to the extent that they may have impacts on the American economy, especially if conditions deteriorate sharply abroad.

On the transmission of monetary policy
As you know, monetary policy is transmitted to the rest of the economy by influencing broad financial conditions, including market interest rates. Rising market prices raise the interest rates faced by households and firms and reduce their spending – most notably spending on fixed business investment, housing construction, and consumer durables. Rising interest rates also affect asset prices. For example, high interest rates, all other things being equal, raise the exchange value of the dollar, which subsequently boosts imports and reduces exports. In addition, higher interest rates, coupled with a higher expected path of policy, prompt investors to discount cash flows associated with long-term investments at higher rates. This reduces the value of the stock market, which then reduces consumption through wealth effects and business investment through the cost of capital. In addition, monetary policy affects risk premia.1 Tight monetary policy tends to reduce investors’ appetite for risk, increase yield spreads, reduce prices of a range of asset classes and increase the direct effects on interest rates and asset prices described previously.

Figure 6 shows how long-term interest rates move in anticipation of changes in the federal funds rate. The red line is the average rate of long-term Class B corporate bonds, a measure of corporate borrowing costs. The blue line is the average 30-year mortgage interest rate, a measure of households’ borrowing costs. Note that both measures were increased in early 2022 in response to the Fed’s communications Anticipation of increases in the effective federal funds rate, the black line. Recently, these long-term rates have increased further. More generally, financial conditions have tightened further, and real long-term Treasury yields have risen significantly. More on this later.

In a speech last spring, I noted that we are still learning about the full impact of our policy tightening in the post-pandemic cycle.2 Therefore, I am also aware of the factors that may mitigate or delay the transmission of monetary policy. One such factor is that the bulk of corporate debt issued by large companies has not yet been refinanced since the FOMC began tightening monetary policy in March 2022.

Large corporations rely on corporate bonds and bank loans as sources of debt financing. Corporate bonds tend to be fixed-rate debt, while bank loans tend to be variable-rate debt. Since most non-financial corporate debt is in the form of corporate bonds issued before 2022, the average interest rate for all outstanding corporate debt remains low, as shown in Figure 7. This rate is likely to rise next year when A larger portion of outstanding corporate debt. Corporate bonds need to be refinanced. Given that this additional tightening is underway, it may be too early to confidently say that we have tightened policy enough to bring inflation back to our 2% target. At the same time, I will consider additional tightening following past interest rate hikes when considering whether further policy tightening is needed in the future. This brings me to my next topic: the monetary policy considerations that flow from my economic outlook and the risks to it that I mentioned before.

Monetary policy considerations
Having increased the target range for the federal funds rate by 525 basis points since early 2022, my view is that the FOMC is in a position to proceed carefully in assessing the extent of any additional policy confirmation that may be necessary. We are in a sensitive period of risk management, where we must balance the risk of policy not being tight enough, with the risk of policy being too restrictive. Balancing these two risks was a good reason to keep interest rates steady at the last meeting of the Federal Open Market Committee.

As I mentioned earlier, real long-term Treasury yields have been rising recently. In part, the upward movement in real yields may reflect investors’ assessment that the economy’s underlying momentum is stronger than previously acknowledged and, as a result, a restrictive monetary policy stance may be needed for a longer period than previously thought for a return. Inflation to 2 percent. But I also recognize that increases in real returns can arise as a result of changes in investors’ attitudes toward risk and uncertainty. Looking ahead, I will remain aware of tightening financial conditions through rising bond yields, and will keep this in mind as I evaluate the future course of policy. I will take financial market developments into account along with the overall data in assessing the economic outlook and risks surrounding the outlook and in judging the appropriate future course of policy.

Thank you!

Bernanke, Ben S., and Kenneth N. Kuttner (2005). “What explains the stock market’s reaction to Federal Reserve policy?” Finance magazine, Vol. 60 (June), pp. 101–1 1221–57.

Campbell, John Y., and John H. Cochrane (1999). “By the force of habit: A consumption-based explanation of aggregate stock market behavior,” Journal of Political Economy, Vol. 107 (April), pp. 101-1 205-51.

Gertler, Mark, and Peter Karady (2015). “Monetary Policy Surprises, Credit Costs, and Economic Activity” American Economic Review: Macroeconomics, Vol. 7 (January), pp. 44-76.

Hanson, Samuel J., and Jeremy C. Stein (2015). “Monetary Policy and Long-Term Real Interest Rates,” Journal of Financial Economics, Vol. 115 (March), pp. 429-48.

Jefferson, Philip N. (2023). “Implementation and Transmission of Monetary Policy,” speech delivered at the H. Parker Willis, Washington and Lee University, Lexington, Virginia, March 27.

Piazzisi, Monica, and Martin Schneider (2006). “Equilibrium Yield Curves (PDF),” National Bureau of Economic Research Working Paper Series No. 12609. Cambridge, MA: National Bureau of Economic Research, October (revised January 2007).

1. Bernanke and Kutner (2005), Hanson and Stein (2015), and Gertler and Karady (2015), among others, highlight that monetary policy affects risk premia. Tighter policies tend to reduce investors’ willingness to take risks – for example, by lowering expected levels of consumption (Campbell and Cochrane, 1999). If policy is tightened in response to inflationary shocks, term premiums also tend to rise when longer-dated bonds become riskier (Piazzisi and Schneider, 2006). Tightening policies can also reduce stock prices by increasing the expected stock premium – for example, by weakening the balance sheets of leveraged companies and making their stocks riskier. Return to text

2. See Jefferson (2023). Return to text

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