Fed Speak – Adriana Kugler says time ripe for normalization

9 Oct 2024 , 12:02 PM

FED OPERATING IN THE UNKNOWN – UNKNOWN SPACE

In the last few years since the pandemic, much of Fed policy decisions have been in the realm of the unknow-unknown. This was the hint given by Fed governor Adriana Kugler while addressing the European Central Bank (ECB) in Germany. One of the important points that Kugler underlined in her speech was that in the last few years, monetary policy practice has been a lot more about bridging precept and practice. That is because, when you are in the realm of the unknown-unknown; you have a situation wherein quite often, the cause is not known and even the outcome of the actions cannot be predicted with any degree of certainty. That is because, there may not be any immediate precedents to such action. For instance, the kind of supply chain driven spike in inflation that the world saw in the aftermath of the pandemic was not only unprecedented, but also unheard of.

As Kugler highlighted in her introductory part of the speech; the economy and the world are continuously subject to new circumstances. Hence precedents from the past are not so easily available nor are there documented experiences and learnings to lean on. Hence, the only plausible solution is to try hard and bridge this divide between precept and practice. Regarding the latest practical challenge faced by the Federal Reserve, Kugler underlined that the task was to reduce inflation while keeping the employment at the maximum level possible. In the US 3.5% unemployment is defined as a condition of full employment. As Kugler highlighted in her speech, the causes of inflation were the same across the globe as the supply chain constraints were making products costlier. It was a supply side story. However, the recovery path followed by major economies has been different.

POST PANDEMIC INFLATION WAS GLOBALLY SIMILAR

To quote Kugler, the inflation experience in the post-pandemic world was largely similar due to the globalization of the pandemic. However, there were some interesting findings, according to Adriana Kugler, about the commonality of inflation globally. Here are some interesting thoughts on the same.

• The reasons for the global spike in inflation were largely similar. For example, the output of goods was severely handicapped due to shortage of raw materials coming from China. In addition, transportation and other aspects of the supply chain got badly hit while the demand for labour in the recovery process far exceeded the supply. All these caused runaway inflation, not only in the US, but across the world.
• During this phase, there were sharp spikes in commodity prices which were eventually exacerbated by Russia’s invasion of Ukraine. It put curbs on the supply chain of crude oil and several important mining and metal inputs. The experience in 26 economies accounting for 60% of world GDP was a level of inflation not seen in 42 years.
• The inflation globally was caused by the post-pandemic recovery. During the pandemic, widespread shutdown of manufacturing plants in different parts of the world had badly disrupted logistic networks, increased shipping costs, and resulted in longer delivery times. However, when the recovery started, the liquidity infusion ensured that demand came back rapidly and with a vengeance, but supply took a long time to normalize.
• There was another reason for the persistent synchronization of inflation. That can be attributed to food and energy prices; that have been largely moving in tandem around the world. This is contrast to core inflation, that tends to be less volatile and more secular in nature. However, much of the spikes in inflation were caused by food and fuel and because these are traded internationally, these effects got transmitted.
• One of the global highlights of the post-pandemic inflation was that even the core inflation showed a sharp spike and also showed a synchronized global cycle. Partly, that was due to the supply chain constraints post the pandemic, which hit all the economies hard. That led to synchronized inflation. Secondly, while food and fuel are volatile, one must understand that both these items contribute largely to core inflation too, either directly or indirectly.

Despite these apparent similarities, the fact is that the economic recovery in the US has been much stronger and more decisive than in other developed economies.

WHY HAS THE US ECONOMIC RECOVERY BEEN STRONGER?

If you look at the GDP growth in the US quarter after quarter, there seems to be strong growth across goods and services. At 3.0% growth in the second quarter of 2024 and a likely growth of 3.2% in the third quarter, the US economy has shown a robustness that is unheard of in rest of the developed world. Most of the European nations and Japan are struggling to hold their heads above water. If you break up the numbers, it is not just that the US GDP has grown faster since 2021. Even the specific components of GDP like consumption and investment have shown better growth in the US as compared to other advanced economies. But, what has this dichotomy happened?

In the words of Adriana Kugler, this faster growth in the US among advanced economies can be attributed to a combination of restrictive monetary policy and convex supply curves. But, more importantly, 3 supply-related factors helped in rapid disinflation in sync with resilient growth. Here is quick dekko at these 3 factors.

• One of the big factors in engineering a rapid recovery in the US was the role of start-ups in the US economy. The US showed a higher rate of new business formation. It is not that all these ventures succeed; in fact, most of them fail. However, the handful of companies that survive, manage to grow rapidly. In the process, they also make significant contributions to aggregate productivity. This trend has been most pronounced in high technology sector, where the impact has had multiplier effects.
• The second factor triggering this higher productivity in the US has been higher and stronger labour productivity growth in the US. Unlike the other advanced economies, the US did not just focus on keeping workers employed in their existing firms. In fact, the unemployment was several times higher at the peak. However, the US did substantially higher levels of sectoral re-allocation of workers compared to the other advanced countries. This not only permitted cross-training, but also made most workers equipped to handle the new skills like artificial intelligence, machine learning, cloud etc.
• Third, the supply of labour in the US has shown a strong growth in the post-pandemic period. Apart from the expansion of the labour force, even the labour force participation rate (LPR) has gone up in this period. This has also been an outcome of higher levels of immigration allowed in this period. Kugler also pointed out that many of the immigrant labourers in the US integrate more seamlessly into the work force, unlike in other advanced economies. That has also been a key factor.

To sum up, the US economic recovery has not just been about the role of chance but about conscious strategy that has led to higher productivity. Today, much of the higher output is coming from productivity gains, which allows the US to justify above median wage growth.

HOW DOES THIS MACRO MIX EXPLAIN MONETARY POLICY STRATEGY?

The US has not just seen a recovery in absolute numbers, but it has been combined with cross training, lateral movement of jobs, and higher labour productivity. This has given the US monetary policy a comparative edge over other advanced economies and has allowed them to be more calibrated about their monetary policy. For instance, the stronger than expected economic performance, combined with falling inflation, has given the Federal Open Markets Committee (FOMC) the luxury and leeway to be patient about the timing of policy rate reduction. The US managed to control inflation much better than other advanced economies while ensuring that the growth levers were not impacted.

The result was that the US Fed could wait long after other central banks had started to cut rats in a show of desperation to revive growth. On the other hand, the US started seriously talking about rate cuts only after the July unemployment data had spiked to 4.3%. That gave the US Fed sufficient time to focus on the inflation story first and ensure that it not only came down, but came down for good. This also explains why the Fed could afford to commence the rate cutting program on an aggressive note with a 50 bps rate cut without worrying about the possible impact on inflation.

How will this shape the US monetary policy in the months ahead? According to Adriana Kugler, the focus of monetary policy will continue to be on bringing inflation to 2% and sustaining that. However, Kugler agrees with the FOMC general view that the current focus of monetary policy must be to shift attention to the maximizing employment and gradually bringing closer to the 3.5% mark, without allowing inflation to go much higher than 2%. According to Kugler, in this unknown-unknown macro situation, it is as undesirable to have high unemployment as it is to have high inflation. Both have a common thread in that they hit the most vulnerable sections the hardest.

In terms of the road ahead, the Fed will focus on pursuing its rate cuts for now and also maintain its appropriate time table of another 50 bps rate cut by December 2024 and another 100 bps rate cut by the end of 2025. That will take the total rate cuts to 200 basis points by the end of 2025. However, Adriana Kugler has also added that the undertone will still be data dependent. Also, the Fed is conscious of the fact that the worsening of the geopolitical situation in West Asia has come in as the new X-factor and needs to be dealt with. Hence, the Fed remains flexible in its approach to future policy moves. What does that really mean?

Kugler has pointed out that some change in circumstances may warrant a change in strategy. For instance, if oil prices shoot up back to $100/bbl due to the crisis in West Asia, then the Fed may have to rethink its rate cuts since it was most likely to spike US energy inflation and also leave its spillover stamp on other inflation baskets. Secondly, Kugler has also underlined that the effects of Hurricane Helene could have a material impact on the economic outlook for the US economy. If downside risks to employment escalate, then the Fed may move policy more quickly to a neutral stance. At this junctures, these are the imponderables, but the moral of the story is that the Fed stands ready to tweak its monetary policy accordingly.