Ch27: Inflation, Unemployment, and Federal Reserve Policy – Page 13

FOMC Meeting: Steady as She Goes

Federal Reserve Chair Jerome Powell (Photo from the New York Times.)

This afternoon, Wednesday, January 31, the Federal Reserve’s Federal Open Market Committee (FOMC) held the first of its eight scheduled meetings during 2024. As we noted in a recent post, macroeconomic data have been indicating that the Fed is close to achieving its goal of bringing the U.S. economy in for a soft landing—reducing inflation down to the Fed’s 2 percent target without pushing the economy into a recession. But as we also noted in that post, it was unlikely that at this meeting Fed Chair Jerome Powell and the other members of the FOMC would declare victory in their fight to reduce inflation from the high levels it reached during 2022.

In fact, in Powell’s press conference following the meeting, when asked directly by a reporter whether he believed that the economy had made a safe landing, Powell said that he wasn’t yet willing to draw that conclusion. Accordingly, the committee kept its target range for the federal funds rate unchanged at 5.25 percent to 5.50 percent. This was the fifth meeting in a row at which the FOMC had left the target unchanged. Although some policy analysts expect that the FOMC might reduce its federal funds rate target at its next meeting in March, the committee’s policy statement made that seem unlikely:

“In considering any adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks. The Committee does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent.”

Powell reinforced the point during his press conference by stating it was unlikely that the committee would cut the target rate at the next meeting. He noted that:

“The economy has surprised forecasters in many ways since the pandemic, and ongoing progress toward our 2 percent inflation objective is not assured. The economic outlook is uncertain, and we remain highly attentive to inflation risks. We are prepared to maintain the current target range for the federal funds rate for longer, if appropriate.”

Powell highlighted a couple of areas of potential concern. The Fed gauges its progress towards achieving its 2 percent inflation goal using the percentage change in the personal consumption expenditures (PCE) price index. As we noted in a recent post, PCE inflation has declined from a high of 7.1 percent in June 2022 to 2.9 percent in December 2023. But Powell noted that PCE inflation in goods has followed a different path from PCE inflation in services, as the following figure shows.

Inflation during 2022 was much greater in the prices of goods than in the prices of services, reflecting the fact that supply chain disruptions caused by the pandemic had a greater effect on goods than on services. Inflation in goods has been less than 1 percent every month since June 2023 and has been negative in three of those months. Inflation in services peaked in February 2023 at 6.0 percent and has been declining since, but was still 3.9 percent in December. Powell noted that the very low rates of inflation in the prices of goods probably aren’t sustainable. If inflation in the prices of goods increases, the Fed may have difficulty achieving its 2 percent inflation target unless inflation in the prices of services slows.

Powell also noted that the most recent data on the employment cost index (ECI) had been released the morning of the meeting. The ECI is compiled by the Bureau of Labor Statistics and is published quarterly. It measures the cost to employers per employee hour worked. The BLS publishes data that includes only wages and salaries and data that includes, in addition to wages and salaries, non-wage benefits—such as contributions to retirement accounts or health insurance—that firms pay workers. The figure below shows the percentage change from the same month in the previous year for the ECI including just wages and salaries (blue line) and for the ECI including all compensation (red line). Although ECI inflation has declined significantly from its peak in he second quarter of 2022, in the fourth quarter of 2023, both measures of ECI inflation were above 4 percent. Wages increasing at that pace may not be consistent with a 2 percent rate of price inflation.

Powell’s tone at his news conference (which can be watched here) was one of cautious optimism. He and the other committee members expect to be able to cut the target for the federal funds rate later this year but remain on guard for any indications that the inflation rate is increasing again.

Has the Federal Reserve Achieved a Soft Landing?

The Federal Reserve building in Washington, DC. (Photo from the New York Times.)

Since inflation began to increase rapidly in the late spring of 2021, the key macroeconomic question has been whether the Fed would be able to achieve a soft landing—pushing inflation back to its 2 percent target without causing a recession. The majority of the members of the Fed’s Federal Open Market Committee (FOMC) believed that increases in inflation during 2021 were largely caused by problems with supply chains resulting from the effects of the Covid–19 pandemic.

These committee members believed that once supply chains returned to normal, the increase in he inflation rate would prove to have been transitory—meaning that the inflation rate would decline without the need for the FOMC to pursue a contractionary monetary by substantially raising its target range for the federal funds rate. Accordingly, the FOMC left its target range unchanged at 0 to 0.25 percent until March 2022. As the following figure shows, by that time the inflation rate had increased to 6.9 percent, the highest it had been since January 1982. (Note that the figure shows inflation as measured by the percentage change from the same month in the previous year in the personal consumption expenditures (PCE) price index. Inflation as measured by the PCE is the gauge the Fed uses to determine whether it is achieving its goal of 2 percent inflation.)

By the time inflation reached its peak in mid-2022, many economists believed that the FOMC’s decision to delay increasing the federal funds rate until March 2022 had made it unlikely that the Fed could return inflation to 2 percent without causing a recession. But the latest macroeconomic data indicate that—contrary to that expectation—the Fed does appear to have come very close to achieving a soft landing. On January 26, the Bureau of Economic Analysis (BEA) released data on the PCE for December 2023. The following figure shows for the period since 2015, inflation as measured by the percentage change in the PCE from the same month in the previous year (the blue line) and as measured by the percentage change in the core PCE, which excludes the prices of food and energy (the red line).

The figure shows that PCE inflation continued its decline, falling slightly in December to 2.6 percent. Core PCE inflation also declined in December to 2.9 percent from 3.2 percent in November. Note that both measures remained somewhat above the Fed’s inflation target of 2 percent.

If we look at the 1-month inflation rate—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year—inflation is closer to Fed’s target, as the following figure shows. The 1-month PCE inflation rate has moved somewhat erratically, but has generally trended down since mid-2022. In December, PCE inflation increased from from –0.8 percent in November (which acutally indicates that deflation occurred that month) to 2.0 percent in December. The 1-month core PCE inflation rate has moved less erratically, also trending down since mid-2022. In December, the 1-month core PCE inflation increased from 0.8 percent in November to 2.1 percent in December. In other words, the December reading on inflation indicates that inflation is very close to the Fed’s target.

The following figure shows for each quarter since the beginning of 2015, the growth rate of real GDP measured as the percentage change from the same quarter in the previous year. The figure indicates that although real GDP growth dropped to below 1 percent in the fourth quarter of 2022, the growth rate rose during each quarter of 2023. The growth rate of 3.1 percent in the fourth quarter of 2023 remained well above the FOMC’s 1.8 percent estimate of long-run economic growth. (The average of the members of the FOMC’s estimates of the long-run growth rate of real GDP can be found here.) To this point, there is no indication from the GDP data that the U.S. economy is in danger of experiencing a recession in the near future.

The labor market also shows few signs of a recession, as indicated by the following figure, which shows the unemployment rate in the months since January 2015. The unemployment rate has remained below 4 percent in each month since December 2021. The unemployment rate was 3.7 percent in December 2023, below the FOMC’s projection of a long-run unemployment rate of 4.1 percent.

The FOMC’s next meeting is on Tuesday and Wednesday of this week (February 1-2). Should we expect that at that meeting Fed Chair Jerome Powell will declare that the Fed has succeeded in achieving a soft landing? That seems unlikely. Powell and the other members of the committee have made clear that they will be cautious in interpreting the most recent macroeconomic data. With the growth rate of real GDP remaining above its long run trend and the unemployment rate remaining below most estimates of the natural rate of unemployment, there is still the potential that aggregate demand will increase at a rate that might cause the inflation rate to once again rise.

In a speech at the Brookings Institution on January 16, Fed Governor Christopher Waller echoed what appear to be the views of most members of the FOMC:

“Time will tell whether inflation can be sustained on its recent path and allow us to conclude that we have achieved the FOMC’s price-stability goal. Time will tell if this can happen while the labor market still performs above expectations. The data we have received the last few months is allowing the Committee to consider cutting the policy rate in 2024. However, concerns about the sustainability of these data trends requires changes in the path of policy to be carefully calibrated and not rushed. In the end, I am feeling more confident that the economy can continue along its current trajectory.”

At his press conference on February 1, following the FOMC meeting, Chair Powell will likely provide more insight into the committee’s current thinking.

Another Middling Inflation Report

Photo courtsey of Lena Buonanno.

On the morning of January 11, 2024, the Bureau of Labor Statistics released its report on changes in consumer prices during December 2023. The report indicated that over the period from December 2022 to December 2023, the Consumer Price Index (CPI) increased by 3.4 percent (often referred to as year-over-year inflation). “Core” CPI, which excludes prices for food and energy, increased by 3.9 percent. The following figure shows the year-over-year inflation rate since Januar 2015, as measured using the CPI and core CPI.

This report was consistent with other recent reports on the CPI and on the personal consumption expenditures (PCE) price index—the measure the Fed uses to gauge whether it is achieving its target of 2 percent annual inflation—in showing that inflation has declined substantially from its peak in mid-2022 but is still above the Fed’s target.

We get a similar result if we look at the 1-month inflation rate—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year—as the following figure shows. The 1-month CPI inflation rate has moved erratically but has generally trended down. The 1-month core CPi inflation rate has moved less erratically, making the downward trend since mid-2022 clearer.

The headline on the Wall Street Journal article discussing this BLS report was: “Inflation Edged Up in December After Rapid Cooling Most of 2023.” The headline reflected the reaction of Wall Street investors who had hoped that the report would unambiguously show further slowing in inflation.

Overall, the report was middling: It didn’t show a significant acceleration in inflation at the end of 2023 but neither did it show a signficant slowing of inflation. At its next meeting on January 30-31, the Fed’s Federal Open Market Committee (FOMC) is expected to keep its target for the federal funds rate unchanged. There doesn’t appear to be anything in this inflation report that would be likely to affect the committee’s decision.

A Mixed Employment Report

Photo courtesy of Lena Buonanno.

During the last few months of 2023, the macroeconomic data has generally been consistent with the Federal Reserve successfully bringing about a soft landing: Inflation returning to the Fed’s 2 percent target without the economy entering a recession. On the morning of Friday, January 5, the Bureau of Labor Statistics (BLS) issued its latest “Employment Situation Report” for December 2023. The report was generally consistent with the economy still being on course for a soft landing, but because both employment growth and wage growth were stronger than expected, the report makes it somewhat less likely that the Federal Reserve’s Federal Open Market Committee (FOMC) will soon begin reducing its target for the federal funds rate. (The full report can be found here.)

Economists and policymakers—notably including the members of the FOMC—typically focus on the change in total nonfarm payroll employment as recorded in the establishment, or payroll, survey. That number gives what is generally considered to be the best gauge of the current state of the labor market.

The report indicated that during December there had been a net increase of 216,000 jobs. This number was well above the expected gain of 160,000 to 170,000 jobs that several surveys of economists had forecast (see here, here, and here). The BLS revised downward by a total of 71,000 jobs its previous estimates for October and November, somewhat offsetting the surprisingly strong estimated increase in net jobs for December.

The following figure from the report shows the net increase in jobs each month since December 2021. Although the net number of jobs created has trended up from September to December, the longer run trend has been toward slower growth in employment. In the first half of 2023, an average of 257,000 net jobs were created per month, whereas in the second half of 2023, an average of 193,000 net jobs were created per month. Average weekly hours worked have also been slowly trending down, from 34.6 hours per week in January to 34.3 hours per week in December.

Economists surveyed were also expecting that the unemployment rate—calculated by the BLS from data gathered in the household survey—would increase slightly. Instead, it remained constant at 3.7 percent. As the following figure shows, the unemployment rate has been below 4.0 percent each month since December 2021. The members of the FOMC expect that the unemployment rate during 2024 will be 4.1 percent. (The most recent economic projections of the members of the FOMC can be found here.)

Although the employment data indicate that conditions in the labor market are easing in a way that may be consistent with inflation returning to the Fed’s 2 percent target, the data on wage growth are so far sending a different message. Average hourly earnings—data on which are collected in the establishment survey—increased by 4.1 percent in December compared with the same month in 2022. This rate of increase was slightly higher than the 4.0 percent increase in November. The following figure shows movements in the rate of increase in average hourly earnings since January 2021.

In his press conference following the FOMC’s December 13, 2023 meeting, Fed Chair Jerome Powell noted that increases in wages at 4 percent or higher were unlikely to result in inflation declining to the Fed’s 2 percent goal:

“So wages are still running a bit above what would be consistent with 2 percent inflation over a long period of time. They’ve been gradually cooling off. But if wages are running around 4 percent, that’s still a bit above, I would say.”

The FOMC’s next meeting is on January 30-31. At this point it seems likely that the committee will maintain its current target for the federal funds. The data in the latest employment report make it somewhat less likely that the committee will begin reducing its target at its meeting on March 19-20, as some economists and some Wall Street analysts had been expecting. (The calendar of the FOMC’s 2024 meetings can be found here.)

Another Employment Report Consistent with a Soft Landing

Photo courtesy of Lena Buonanno.

In recent months, the macroeconomic data has generally been consistent with the Federal Reserve successfully bringing about a soft landing: Inflation returning to the Fed’s 2 percent target without the economy entering a recession. The Bureau of Labor Statistics’ latest Employment Situation Report, released on the morning of Friday, December 8, was consistent with this trend. (The full report can be found here.)

Economists and policymakers—notably including the members of the Federal Reserve’s Federal Open Market Committee (FOMC)—typically focus on the change in total nonfarm payroll employment as recorded in the establishment, or payroll, survey. That number gives what is generally considered to be the best gauge of the current state of the labor market.

The report indicated that during November there had been a net increase of 199,000 jobs. This number was somewhat above the expected gain of 153,000 jobs Reuters news service reported from its survey of economists and just slightly above an expected gain of 190,000 jobs the Wall Street Journal reported from a separate survey of economists. The BLS revised downward by 35,000 jobs its previous estimate for September. It left its estimate for October unchanged. The following figure from the report shows the net increase in jobs each month since November 2021.

Because the BLS often substantially revises its preliminary estimates of employment from the establishment survey, it’s important not to overinterpret data for a single month or even for a few months. But general trends in the data can give useful information on changes in the state of the labor market. The estimate for November is the fourth time in the past six months that employment has increased by less than 200,000. Prior to that, employment had increased by more than 200,000 every month since January 2021.

Although the rate of job increases is slowing, it’s still above the rate at which new entrants enter the labor market, which is estimated to be roughly 90,000 people per month. The additional jobs are being filled in part by increased employment among people aged 25 to 54—so-called prime-age workers. (We discuss the employment-population ratio in Macroeconomics, Chapter 9, Section 9.1, Economics, Chapter 19, Section 9.1, and Essentials of Economics, Chapter 13, Section 13.1.) As the following figure shows, the employment-population ratio for prime-age workers remains above its level in early 2020, just before the spread of the Covid–19 pandemic in the United States.

The estimated unemployment rate, which is collected in the household survey, was down slightly from 3.9 percent to 3.7 percent. A shown in the following figure, the unemployment rate has been below 4 percent every month since February 2022.

The Employment Situation Report also presents data on wages, as measured by average hourly earnings. The growth rate of average hourly earnings, measured as the percentage change from the same month in the previous year, continued its gradual decline, as shown in the following figure. As a result, upward pressure on prices from rising labor costs is easing. (Keep in mind, though, as we note in this blog post, changes in average hourly earnings have shortcomings as a measure of changes in the costs of labor to businesses.)

Taken together, the data in the latest employment report indicate that the labor market is becoming less tight, reflecting a gradual slowing in U.S. economic growth. The data are consistent with the U.S. economy approaching a soft landing. It’s still worth bearing in mind, of course, that, as Fed Chair Jerome Powell continues to caution, there’s no certainty that inflation won’t surge again or that the U.S. economy won’t enter a recession.

Economists vs. the Market in Predicting the First Cut in the Federal Funds Rate

The meeting room of the FOMC in the Federal Reserve building in Washington, DC.

As we’ve noted in several recent posts, the inflation rate has fallen significantly from its peak in mid-2022, as U.S. economic growth has been slowing and the labor market appears to be less tight, slowing the growth of wages. Some economists and policymakers now believe that by early 2024, inflation will approach the Fed Reserve’s 2 percent inflation target. At that point, the Fed’s Federal Open Market Committee (FOMC) is likely to turn its attention from inflation to making sure that the U.S. economy doesn’t slip into a recession.

Accordingly, both economists and financial market participants have begun to anticipate the point at which the FOMC will begin to cut its target for the federal funds rate. (One note of caution: Fed Chair Jerome Powell has made clear that the FOMC stands ready to further increase its target for the federal funds rate if the inflation rate shows signs of increasing. He made this point most recently on December 1 in a speech at Spelman College in Atlanta.) There is currently an interesting disagreement between economists and investors over when the FOMC is likely to cut interest rates and by how much. We can see the views of investors reflected in the futures market for federal funds.

Futures markets allow investors to buy and sell futures contracts on commodities–such as wheat and oil–and on financial assets. Investors can use futures contracts both to hedge against risk—such as a sudden increase in oil prices or in interest rates—and to speculate by, in effect, betting on whether the price of a commodity or financial asset is likely to rise or fall. (We discuss the mechanics of futures markets in Chapter 7, Section 7.3 of Money, Banking, and the Financial System.) The CME Group was formed from several futures markets, including the Chicago Mercantile Exchange, and allows investors to trade federal funds futures contracts. The data that result from trading on the CME indicate what investors in financial markets expect future values of the federal funds rate to be. The following chart from the CME’s FedWatch Tool shows values after trading of federal funds futures on December 5, 2023.

The probabilities in the chart reflects investors’ predictions of what the FOMC’s target for the federal funds rate will be after the committee’s meeting on March 20, 2024. This meeting is the first after which investors currently expect that the target is likely to be lowered. The target range is currently 5.25 percent to 5.50 percent. The chart indicates that investors assign a probability of 60.2 percent to the FOMC making at least a 0.25 percentage cut in the target rate at the March meeting.

Looking at the values for federal funds futures after the FOMC’s December 18, 2024 meeting, investors assign a 66.3 percent probability of the committee having reduced its target for the federal funds rate to 4.00 to 4.25 percent of lower. In other words, investors expect that during 2024, the FOMC will have cut its target for the federal funds rate by at least 1.25 percentage points.

Interesingly, according to a survey by the Financial Times, economists disagree with investors’ forecasts of the federal funds rate. According to the survey, which was conducted between December 1 and December 4, nearly two-thirds of economists believe that the FOMC won’t cut its target for the federal funds rate until July 2024 or later. Three-quarters of the economists surveyed believe that the FOMC will cut its target by 0.5 percent point or less during 2024. Fewer than 10 percent of the economists surveyed believe that during 2024 the FOMC will cut its target for the federal funds rate by 1.25 percent or more. (The Financial Times article describing the results of the survey can be found here. A subscription may be requred to read the article.)

So, at least among the economists surveyed by the Financial Times, the consensus is that the FOMC will cut its target for the federal funds rate later and by less than financial markets are indicating. What explains the discrepancy? The main explanation is that economists see inflation being persistently above the Fed’s 2 percent target for longer than do financial market participants. The economists surveyed are also more optimistic that the U.S. economy will avoid a recession in 2024. If a recession occurs, the FOMC is more likely to significantly cut its target than if the economy during 2024 experiences moderate growth in real GDP and the unemployment rate remains low.

One other indication from financial markets that investors expect that the U.S. economy is likely to slow during 2024 is given by movements in the interest rate on the 10-year U.S. Treasury note. As shown in the following figure, from August to October of this year, the interest rate on the 10-year Treasury note rose from less than 4 percent to nearly 5 percent—an unusually large change in such a short period of time. Since then, most of that increase has been reversed with the interest rate on the 10-year Treasury note having fallen below 4.2 percent in early December

The movements in the interest rate on the 10-year Treasury note typically reflect investors’ expectations of future short-term interest rates. (We discuss the relationship between short-term and long-term interests rates—which economists call the term structure of interest rates—in Money, Banking, and the Financial System, Chapter 5, Section 5.2.) The increase in the 10-year interest rate between August and October reflected investors’ expectation that short-term interest rates were likely to remain persistently high for a considerable period—perhaps several years or more. The decline in the 10-year rate from late October to early December reflects investors changing their expectations toward future short-term interest rates being lower than they had previously thought. Again, as in the data on federal funds rate futures, investors seem to be expecting either slower economic growth or slower inflation than do economists.

One other complication about the interest rate on the 10-year Treasury note should be mentioned. Some of the increase in the rate from August to October may also have represented concern among investors that large federal budget deficit would cause the Treasury to issue more Treasury notes than investors would be willing to buy without the Treasury increasing the interest rate investors would receive on the newly issued notes. This concern may have been reinforced by data showing that foreign investors, particularly in China and Japan, appeared to have slowed or stopped adding to their holdings of Treasury notes. Part of the recent decline in the interest rate on the Treasury note may reflect investors becoming less concerned about these two factors.

Can We Now Rule Out One of the Three Potential Monetary Policy Outcomes?

Federal Reserve Chair Jerome Powell (photo from bloomberg.com)

In a blog post from February of this year, we discussed three possible outcomes of the contractionary monetary policy that the Federal Reserve has been pursuing since March 2022, when the Federal Open Market Committee (FOMC) began raising its target range for the federal funds rate:

A soft landing. The Fed’s preferred outcome; inflation returns to the Fed’s target of 2 percent without the economy falling into recession.
A hard landing. Inflation returns to the Fed’s 2 percent target, but the economy falls into a recession.
No landing. At the beginning of 2023, the unemployment remained very low and inflation, as measured by the percentage change in the personal consumption expenditures (PCE) price index from the same month in the previous year, was still above 5 percent. So, some observers, particularly in Wall Street financial firms, began discussing the possibility that low unemployment and high inflation might persist indefinitely, resulting an outcome of no landing.

At the end of 2023, the economy appears to be slowing: Retail sales declined in October; real disposable personal income increased in October, but it has been trending down, as have real personal consumption expenditures; while the increase in third quarter real GDP was recently revised upward from 4.9 percent to 5.2 percent, forecasts of growth in real GDP during the fourth quarter show a marked slowing—for instance, GDPNow, compiled by the Atlanta Fed, estimates fourth quarter growth at 2.1 percent; and while employment continues to expand, average weekly hours have been slowly declining and initial claims for unemployment insurance have been increasing.

The slowing in the growth of output, income, and employment are reflected in a falling inflation rate. The following figure show the percentage change since the same month in the previous year in PCE price index, which is the measure the Fed uses to gauge whether it is hitting its 2 percent inflation target. (We discuss the reasons for the Fed preferring the PCE price index to the consumer price index (CPI) in Macroeconomics, Chapter 15, Section 15.5 and Economics, Chapter 25, Section 25.5.) The figure also shows core PCE, which excludes the prices of food and energy. Core PCE inflation typically gives a better measure of the underlying inflation rate than does PCE inflation.

PCE inflation declined from 3.4 percent in September to 3.0 percent in October. Core PCE inlation declined from 3.8 percent in September to 3.5 percent in September. Although inflation has been declining from its peak in mid-2022, both of these measures of inflation remain above the Fed’s 2 percent target.

But if we look at the 1-month inflation rate—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year—we see a much sharper decline in inflation, as the following figure shows.

The 1-month inflation rate is naturally more volatile than the 12-month inflation rate. In this case, the 1-month rate shows a sharp decline in PCE inflation from 3.8 percent in September to 0.6 percent in October. Core PCE inflation declined less sharply from 3.9 percent in September to 2.0 percent in October.

The continuing decline in inflation has caused some economists and Wall Street analysts to predict that the FOMC will not implement further increases in its target for the federal funds rate and will likely begin cutting its target by mid-2024.

On December 1 in a speech at Spelman College in Atlanta, Fed Chair Jerome Powell urged caution in assuming that the Fed has succeeded in putting inflation on a course back to its 2 percent target:

“The FOMC is strongly committed to bringing inflation down to 2 percent over time, and to keeping policy restrictive until we are confident that inflation is on a path to that objective. It would be premature to conclude with confidence that we have achieved a sufficiently restrictive stance, or to speculate on when policy might ease. We are prepared to tighten policy further if it becomes appropriate to do so.”

In terms of the three policy outcomes listed at the beginning of this post, the third—no landing, with the unemployment rate remaining very low while the inflation rate remains above the Fed’s 2 percent target—now seems unlikely. The labor market appears to be weakening, which will likely result in increases in the unemployment rate. The next “Employment Report” from the Bureau of Labor Statistics, which will be released on December 8, will provide additional data on the state of the labor market.

Although we can’t entirely rule out the possibility of a no landing outcome, it seems more likely that the economy will either make a soft landing—if output and employment continue to increase, although at a slower rate, while inflation continues to decline—or a hard landing—if output and employment begin to fall as the economy enters a recession. Although a consensus seems to be building among economists, policymakers, and Wall Street analysts that a soft landing is the likeliest outcome, Powell has provided a reminder that that outcome is far from certain.

Fed Governor Christopher Waller Gives an Optimistic Speech

Federal Reserve Governor Christopher J. Waller (photo from the Associated Press via the Wall Street Journal)

Fed Governor Christopher Waller has a reputation for being a policy hawk, which means that since the spring of 2022 he has been a forceful advocate of multiple increases in the target for the federal funds rate as the Fed attempts to slow the economy and bring inflation back to the Fed’s 2 percent target. (Waller’s biography on the Fed’s web site can be found here.)

So, it was notable that in a speech at the American Enterprise Institute (AEI) on November 28, he said that “I am increasingly confident that policy is currently well positioned to slow the economy and get inflation back to 2 percent.” Although he also stressed that “there is still significant uncertainty about the pace of future activity, and so I cannot say for sure whether the [Federal Open Market Committee] FOMC has done enough to achieve price stability” his remarks were interpreted as reinforcing the growing view among non-Fed economists and investors that the FOMC is unlikely to increase its target for the federal funds rate further and is likely to reduce the target at some point during 2024. The text of Waller’s speech can be found here.

AEI economist Michael Strain interviewed Waller following his speech. In the interview (which can be found here), Strain made the case for believing that the Fed’s ability to achieve a soft landing—returning inflation to the 2 percent target without pushing the economy into a recession—would be more difficult than Waller seems to believe. Included in the interview are discussions of whether expecting a soft landing is consistent with the historical record, what guidance the Taylor rule can give to monetary policymakers (we discuss the Taylor rule in Macroeconomics, Chapter 15, Section 15.5, Economics, Chapter 25, Section 15.5, and Essentials of Economics, Chapter 17, Section 17.5), the significance of rising labor force participation rates among prime-age workers, and the implications large federal budget deficits have for monetary policy.

Wall Street Journal: “Cooling Inflation Likely Ends Fed Rate Hikes”

The Bureau of Labor Statistics released its latest report on consumer prices the morning of November 14. The Wall Street Journal’s headline reflects the general reaction to the report: The inflation rate continued to decline, which made it less likely that the Fed’s Federal Open Market Committee will raise its target range for the federal funds rate again at its December meeting. The following figure shows inflation measured as the percentage change in the Consumer Price Index (CPI) from the same month in the previous year. It also shows the inflation rate measure using “core” CPI, which excludes prices for food and energy.

The inflation rate for the CPI declined from 3.7 percent in September to 3.2 percent in October. Core CPI declined from 4.1 percent in September to 4.0 percent in October. So, measured this way, inflation declined substantially when measured by the CPI including prices of all goods and services but only slightly when measured using core CPI.

The 12-month inflation rate is the one typically reported in the Wall Street Journal and elsewhere, but it has the drawback that it doesn’t always reflect accurately the current trend in prices. The following figure shows the 1-month inflation rate—that is the annual inflation rate calculated by compounding the current month’s rate over an entire year— for CPI and core CPI. The 1-month inflation rate is naturally more volatile than the 12-month inflation rate. In this case, 1-month rate shows a sharp decline in the inflation rate for the CPI from 4.9 percent in September to 0.5 percent in October. Core inflation declined less sharply from 3.9 percent in September to 2.8 percent in October.

The release of the CPI report was treated as good news on Wall Street, with the Dow Jones Industrial Average increasing by 500 points and the interest rate on the 10-year U.S. Treasury Note declining from 4.6 percent just before the report was released to 4.4 percent immediately after. The increases in stock and bond prices (recall that the prices of bonds and the yields on the bonds move in opposite directions, so bond prices rose following release of the report) reflect the view of financial investors that if the FOMC stops increasing its target for the federal funds rate, the chance that the U.S. economy will fall into a recession is reduced.

A word of caution, however. In a speech on November 9, Fed Chair Jerome Powell noted that the FOMC may need still need to implement additional increases to its federal funds rate target:

“My colleagues and I are gratified by this progress [against inflation] but expect that the process of getting inflation sustainably down to 2 percent has a long way to go…. The Federal Open Market Committee (FOMC) is committed to achieving a stance of monetary policy that is sufficiently restrictive to bring inflation down to 2 percent over time; we are not confident that we have achieved such a stance. We know that ongoing progress toward our 2 percent goal is not assured: Inflation has given us a few head fakes. If it becomes appropriate to tighten policy further, we will not hesitate to do so.”

So, while the latest inflation report is good news, it’s still too early to know whether inflation is on a stable path to return to the Fed’s 2 percent target. (It’s worth noting that the Fed uses inflation as measured by the personal consumption expenditure (PCE) price index rather than as measured by the CPI when evaluating whether it has achieved its 2 percent target.)

A Review of Recent Macro Data

Some interesting macro data were released during the past two weeks. On the key issues, the data indicate that inflation continues to run in the range of 3.0 percent to 3.5 percent, although depending on which series you focus on, you could conclude that inflation has dropped to a bit below 3 percent or that it is still in vicinity of 4 percent. On balance, output and employment data seem to be indicating that the economy may be cooling in response to the contractionary monetary policy that the Federal Open Market Committee began implementing in March 2022.

We can summarize the key data releases.

Employment, Unemployment, and Wages

On Friday morning, the Bureau of Labor Statistics (BLS) released its Employment Situation report. (The full report can be found here.) Economists and policymakers—notably including the members of the Federal Reserve’s Federal Open Market Committee (FOMC)—typically focus on the change in total nonfarm payroll employment as recorded in the establishment, or payroll, survey. That number gives what is generally considered to be the best indicator of the current state of the labor market.

The previous month’s report included a surprisingly strong net increase of 336,000 jobs during September. Economists surveyed by the Wall Street Journal last week forecast that the net increase in jobs in October would decline to 170,000. The number came in at 150,000, slightly below that estimate. In addition, the BLS revised down the initial estimates of employment growth in August and September by a 101,000 jobs. The figure below shows the net gain in jobs for each month of 2023.

Although there are substantial fluctuations, employment increases have slowed in the second half of the year. The average increase in employment from January to June was 256,667. From July to October the average increase declined to 212,000. In the household survey, the unemployment rate ticked up from 3.8 percent in September to 3.9 percent in October. The unemployment rate has now increased by 0.5 percentage points from its low of 3.4 percent in April of this year.

Finally, data in the employment report provides some evidence of a slowing in wage growth. The following figure shows wage inflation as measured by the percentage increase in average hourly earnings (AHE) from the same month in the previous year. The increase in October was 4.1 percent, continuing a generally downward trend since March 2022, although still somewhat above wage inflation during the pre-2020 period.

As the following figure shows, September growth in average hourly earnings measured as a compound annual growth rate was 2.5 percent, which—if sustained—would be consistent with a rate of price inflation in the range of the Fed’s 2 percent target. (The figure shows only the months since January 2021 to avoid obscuring the values for recent months by including the very large monthly increases and decreases during 2020.)

Job Openings and Labor Turnover Survey (JOLTS)

On November 1, the BLS released its Job Openings and Labor Turnover Survey (JOLTS) report for September 2023. (The full report can be found here.) The report indicated that the number of unfilled job openings was 9.5 million, well below the peak of 11.8 million job openings in December 2021 but—as shown in the following figure—well above prepandemic levels.

The following figure shows the ratio of the number of job opening to the number of unemployed people. The figure shows that, after peaking at 2.0 job openings per unemployed person in in March 2022, the ratio has decline to 1.5 job opening per unemployed person in September 2022. While high, that ratio was much closer to the ratio of 1.2 that prevailed during the year before the pandemic. In other words, while the labor market still appears to be strong, it has weakened somewhat in recent months.

Employment Cost Index

As we note in this blog post, the employment cost index (ECI), published quarterly by the BLS, measures the cost to employers per employee hour worked and can be a better measure than AHE of the labor costs employers face. The BLS released its most recent report on October 31. (The report can be found here.) The first figure shows the percentage change in ECI from the same quarter in the previous year. The second figure shows the compound annual growth rate of the ECI. Both measures show a general downward trend in the growth of labor costs, although compound annual rate of change shows an uptick in the third quarter of 2023. (We look at wages and salaries rather than total compensation because non-wage and salary compensation can be subject to fluctuations unrelated to underlying trends in labor costs.)

The Federal Open Market Committee’s October 31-November 1 Meeting

As was widely expected from indications in recent statements by committee members, the Federal Open Market Committee voted at its most recent meeting to hold constant its targe range for the federal funds rate at 5.25 percent to 5.50 percent. (The FOMC’s statement can be found here.)

At a press conference following the meeting, Fed Chair Jerome Powell remarks made it seem unlikely that the FOMC would raise its target for the federal funds rate at its December 14-15 meeting—the last meeting of 2023. But Powell also noted that the committee was unlikely to reduce its target for the federal funds rate in the near future (as some economists and financial jounalists had speculated): “The fact is the Committee is not thinking about rate cuts right now at all. We’re not talking about rate cuts, we’re still very focused on the first question, which is: have we achieved a stance of monetary policy that’s sufficiently restrictive to bring inflation down to 2 percent over time, sustainably?” (The transcript of Powell’s press conference can be found here.)

Investors in the bond market reacted to Powell’s press conference by pushing down the interest rate on the 10-year Treasury note, as shown in the following figure. (Note that the figure gives daily values with the gaps representing days on which the bond market was closed) The interest rate on the Treasury note reflects investors expectations of future short-term interest rates (as well as other factors). Investors interpreted Powell’s remarks as indicating that short-term rates may be somewhat lower than they had previously expected.

Real GDP and the Atlanta Fed’s Real GDPNow Estimate for the Fourth Quarter

On October 26, the Bureau of Economic Analysis (BEA) released its advance estimate of real GDP for the third quarter of 2023. (The full report can be found here.) We discussed the report in this recent blog post. Although, as we note in that post, the estimated increase in real GDP of 4.9 percent is quite strong, there are indications that real GDP may be growing significantly more slowly during the current (fourth) quarter.

The Federal Reserve Bank of Atlanta compiles a forecast of real GDP called GDPNow. The GDPNow forecast uses data that are released monthly on 13 components of GDP. This method allows economists at the Atlanta Fed to issue forecasts of real GDP well in advance of the BEA’s estimates. On November 1, the GDPNow forecast was that real GDP in the fourth quarter of 2023 would increase at a slow rate of 1.2 percent. If this preliminary estimate proves to be accurate, the growth rate of the U.S. economy will have sharply declined from the third to the fourth quarter.

Fed Chair Powell has indicated that economic growth will likely need to slow if the inflation rate is to fall back to the target rate of 2 percent. The hope, of course, is that contractionary monetary policy doesn’t cause aggregate demand growth to slow to the point that the economy slips into a recession.