Fed Speak: Chris Waller looks back at 19 months of Fed rate hikes

19 Oct 2023 , 02:01 PM

There has been a lot of ink spent on the US economy and the outlook for monetary policy. However, central banks like the Federal Reserve operate on likely outcomes, the probability of such outcomes and the consequent plan of action. It is in this light that recent speech by Governor Christopher Waller of the US Federal Reserve becomes relevant. Addressing the audience at the European Economic and Financial Centre (EEFC), Governor Waller underlined how monetary policy options may be a lot more complicated for the Fed than they seem today. According to Waller, most analysts and economists are still look at 2 discrete scenarios of inflation going up and inflation not going up. However, the reality may be a lot more complex and hence solutions may have to be more flexible. What exactly does that mean?

US Economy: Perhaps, too good to be true!

Waller pointed out that it was already a full 19 months since the Fed embarked on rate hikes in March 2022 to rein in inflation. However, as Waller pointed out, despite the substantial progress made, uncertainties remain. These uncertainties pertain to the forces that will shape the economic outlook in coming months as well as whether monetary policy has reached a level that is sufficiently restrictive to support sustained progress toward the 2% inflation target of the FOMC (Federal Open Market Committee). According to Waller, it is here that the dichotomy arises because the goals of the Fed are not just inflation control but also maximum employment and reasonable growth momentum. 

Here is how the economic situation in the US reads, according to Chris Waller. On the positive side, the economic activity and the labour markets have been stronger than expected. The growth in GDP, as seen in the last couple of quarters, has been much better than expected; even inducing the FOMC to raise its full year growth projections. In addition, the level of unemployment is close to a 50-year low. Apart from these two salutary factors, the sustained Fed action has also led to gradual progress in lowering inflation and towards that end, the tightness has also resulted in moderation of wages. Waller feels that the situation is just too good to be true. And as the old piece of economic wisdom goes, “If something is too good to be true, then it is probably not true.” 

That leaves two possible scenarios

As Waller puts it eloquently, the emerging economic situation in the US can be bucked into two distinct likely scenarios. 

1. The first scenario conceived by Waller is that, the real side of the economy actually slows. These concerns were expressed in the long term projections accompanying the Fed September statement. This is possibly the simpler scenario. The slowdown in real GDP growth would lead to easing of consumer demand help bring the economy into better balance with supply. That also nudges inflation gradually towards 2% mark. In such a scenario, it would be possible for the Fed to hold the rates steady and let the macro forces do the rest of the job of containing inflation.

    

2. The second scenario, as envisaged by Waller, could be a little more complex. There could be well be a situation wherein the demand and economic activity continue at their recent pace, and that could exert persistent upward pressure on inflation. This would not only nip the progress on price stability, but also offset some of the advantages built by the US economy in terms of price stability. According to Waller, such a scenario would call for more rate hikes (hard to say how much), so as to obviate the risk of the Fed failing to act and that in turn impacting the inflation expectations.

Why has this debate about these two scenarios arisen? That is largely because the recent market reaction in terms of the spike in bond yields in the US and the spike in the dollar index; have been at cross purposes with the general view on inflation and interest rates. It means that; either the markets are overacting (as is likely) or the markets know something that the regulators have overlooked (which is equally likely).

 What Waller will be watching on GDP and labour data?

With the growth coming in stronger than expected, and unemployment still very low by historical standards; here are some key points that would be looked at.

• Irrespective of which way the Fed rats move, the key trigger to watch would be the 10-year benchmark bond yields. That not only gives a picture of the cost of funds for the corporates, but also indicate whether consumer credit will continue to drive personal consumption or not.

   

• After GDP grew in the range of 2% to 2.2% in the first two quarters of 2023, the first indication of the third quarter GDP will be out when the Bureau of Economic Analysis (BEA) publishes the first advance estimate of US Q3 GDP in the last week of October. However, the survey of business forecasters indicates Q3 GDP growth over 3.5% while the GDPNow model of Atlanta Fed pegs it even higher. In a nutshell, the GDP growth in Q3 is likely to surprise on the upside. 

   

• However, Waller also indicated that they would be wary of the Flash in the Pan syndrome wherein one quarter may flatter only to get back to normal growth. However, if such robust growth also sustains in the fourth quarter of 2023, then the Fed will need to do a serious rethink. In that case, just  wait and watch approach may not work. The Fed may have to take the rates to much higher than what they are now. For now, the odds are stacked in favour of a strong fourth quarter too. That is because, consumer spending which represents 70% of US GDP, has been quite strong thus far in 2023. 

   

• Much of the wisdom will be available in the confluence of the GDP and labour data. For instance, strong spending in the face of tightened monetary policy suggests consumption is likely supported by strong household balance sheets. In addition, there is also the confidence in future labour income. The core of whether GDP can sustain at higher levels will largely predicate on the spending data. In the last 6 months since the start of the banking crisis in the US, credit conditions had tightened, but the impact on consumption engine has been limited.

   

• What would Waller be watching in the labour market data? In September alone, the US economy had created 336,000 jobs; which is much higher than what the forecasters had expected. Earlier soft job reports have also been revised to show more robust job data. The bottom line is that the job growth is still exceptionally strong and hasn’t slowed much this year. However, the tightening has had an impact on jobs in the sense that, the number of job openings per person has moderated, although it remains above 1.50.

To sum it up, GDP growth in2023 so far has been 100 bps better than expected. In addition, the third and fourth quarter are likely to be even more robust. While the labour market is showing signs of loosening, it is still unusually tight. 

What Chris Waller will be watching on the Inflation front?

The good news is that there has been progress on containing inflation. However, the question is whether the progress is sufficient to move the US economy towards 2% inflation on a sustained basis. For instance, the annualized inflation in the 12 through September stood at 3.7%, which is sharply lower than 8.2% last year. Even core inflation has fallen from 6.7% to 4.3% in the interim period. In addition, there are other factors that are likely to exert downward pressure on inflation. Monetary policy is restrictive. Households are spending the excess saving accumulated during the pandemic and have growing levels of debt, which are likely to moderate spending growth. In addition, the sharp spike in medium and longer-term interest rates in recent weeks should weigh on household and business.

However, the experience in the recent past has been that a string of good inflation reports has simply evaporated; not once but multiple times. A lot will be depending on the real economy starting to cool off and that is the one factor that could trigger lowering of inflation in the US economy.

This perspective has critical implications for monetary policy. According to Waller, this is the time to wait, watch, and see how the economy evolves before making definitive moves on the path of the policy rate. So, there could be a longer pause, but Waller is clear that it would be premature to call this the end of the rate hike program. However, if the real economy continues showing underlying strength and inflation appears to stabilize or reaccelerate, more policy tightening by the Fed may be the order of the day. It may eventually boil down to the direction of the core inflation metrics.