Fed Speak – Christopher Waller on a Plan-B for macro exigencies

22 Oct 2024 , 10:21 AM

HANDLING CONTRASTING MACRO DATA FLOWS

Addressing the prestigious Hoover Institution at the Stanford University, Fed governor, Christopher Waller said something very interesting. According to Waller, the challenge to the Fed today was not just about inflation or growth or jobs. The challenge was about the rapid inflow of data, which were many times contrasting. As late as in August and September 2024, the general view was that the US economy was slowing and a hard landing was almost a reality. There were several supportive data points. GDP growth had slowed in the first quarter, unemployment had spiked and the problems with core inflation were again surfacing. In a little over a month, the entire colour of the US data has changed. The US grew at 2.2% in the first half of 2024 and promises to grow at a faster clip in H2. Despite oil supplies playing truant, the US has seen inflation trending lower in recent months.

There are 4 things that we can decipher from these data flows. Firstly, the data flows are coming in rapidly. You almost have data flows relevant to jobs, GDP growth, and inflation coming in on a daily basis. Secondly, the undertone of data changes at very short notice. A classic example was the way the colour of the jobs and growth data changed in the last two months. Thirdly, predictive models are becoming more sophisticated and hence projections are becoming a lot more accurate. This is evident in the way the CME Fedwatch (a market based statistical input) predicted the trajectory of Fed rates much better. Lastly, unlike in the past, monetary divergence is a reality today. Central banks are becoming increasingly insular and inward looking in their approaching to monetary policy.

WHAT CHRISTOPHER WALLER SAID ABOUT THE US ECONOMY

According to Waller the macro data in recent months has been relatively uneven. Here are some key numbers that Waller has crunched on the US economy.

1) The broad theme of the US economy, according to Waller, is that it remains on a very solid and strong footing. For instance, if you look at the two core objectives of the US monetary policy i.e. full employment and 2% inflation; the US economy appears to be on the right track. The level of employment is very closer to the maximum employment objective of the Federal Open Markets Committee (FOMC). At the same time, even if you factor in recent spurts in parts of the inflation basket, the overall headline PCE inflation is in the vicinity of the 2% Fed target. Let us turn to the growth story.

2) According to Christopher Waller, the real GDP grew at an annualized rate of 2.2% for the first half of 2024. Based on the inputs coming from the predictive Atlanta Fed GDP estimates, this is likely to pick up further in the second half of 2024. For now, it looks like the third and fourth quarter of 2024 could see real growth in the vicinity of 3.2% to 3.4%. That would mean overall growth for the year 2024 could inch closer to the 3% mark. Recent upwards revisions of Q1GDP and downward revisions of the third and fourth quarter of 2023, makes the trend a lot more secular.

3) In the earlier part of our note, we had spoken about how the undertone of the economic message changes at short notice. A classic example is the relationship between the GDP and the GDI (gross domestic income). There were concerns that H1-2024 GDP may be overstating the strength of the economy, since the GDI was pegged to have grown at just 1.3%. That hinted at a downward revision of GDP. However, the revisions have revised GDI growth substantially higher to 3.2%. This resulted in a 200 bps spike in the savings rate. In other words, the household resources for future consumption are actually in good shape, although some anecdotal evidence has suggested that the lower-income vulnerable groups are facing a lot of stress. That does not seem to be the case.

4) Another proxy or, rather a trigger, for GDP growth is the consumer spending, which continues to be strong and robust. The data suggests that despite the PCE inflation inching towards 2% mark, there is enough pent-up demand for durable goods, home improvements, and other big-ticket items. With rates starting to come down, credit would get cheaper and a lot of the pent-up demand will be unleased. Also, if one were to look at business spending, the pressure is only in manufacturing while the service sector continues to earn, spend and invest.

5) What did Christopher Waller read from the labour market data? Just two months back, the rate of unemployment had spiked to 4.3%, hinting at growth pressures. However, since then, the unemployment has fallen back to 4.1% and the non-farm payroll additions are back to previous levels. For example, in September 2024, the job creation was strong at 254K; sharply higher than the previous two months. When it comes to the job market, it is not just the unemployment ratio, but even the wages growth matters a lot. Let us quickly turn to the wage story.

6) Recent evidence has suggested that supply and demand for labour has come into balance. For the last 3 years, too many jobs were chasing too few jobs. That had led to a sharp spike in wages, something that was disrupting inflation control. However, that is more in balance now. The ratio of vacancies to unemployed is at 1.2X, which is about the level in 2019 (pre-pandemic). The same is also hinted by the quits ratio.

One of the key things that Waller did mention was the volatility in data. For example, the October jobs data that would be announced in the first week of November is likely to show a marked deterioration. There are likely to be sizable loss of temporary jobs from the two recent hurricanes and the ongoing strike at Boeing Co. This could impact the jobs growth meaningfully.

TAYLOR RULES AND MONETARY POLICY MAKING

For a central bank like the Fed, considering its history and its influence, it has to go by data, but it has to also go by certain set rules. That is what makes a central bank predictable, and the Fed is fully conscious of that. One such popular set of rules refers to the Taylor Rules. What exactly are Taylor Rules. The Taylor Rules correlate the level of the policy interest rate to a limited number of other economic variables. Here we will broadly look at two types of such rules viz. Inertial Rule and Non-Inertial Rules. Here is a quick dekko at what they are.

• In a typical inertial rule, the policy rate changes gradually over time. It is more of a traditional approach that captures the reaction function of a policymaker in a stable economy. In this case, the focus is on the forces that would tend to change the economy and policy build over time. The inertial rules suggest that when change occurs, a gradual response will give the policymakers sufficient time to assess the true state of the economy and the possible impact of their decision. Let us turn to non-inertial rules.
• Non-inertial rules, are more dynamic and call for relatively quick adjustments to policy. The guidance from these rules is more useful when there is a turning point in the economy, and policymakers need to stay ahead of events. The front ending of rate hikes in early 2022 and the front-ending of the rate cuts in September 2024 were both examples of non-inertial rules. Non-inertial rules are more attuned to the modern global economy where the interrelationships are substantial and there are a series of shocks to be dealt with in between.

At the end of the day; these rules (be it inertial or non-inertial), provide a simple, elegant, and reliable guide to policy. This is more relevant when there are data dichotomies and guides policy making in such uncertain times, amidst volatile data flows. However, as any central banker would tell you; there is only so far that rules can take you. However much your macroeconomic models may become sophisticated, there is also the room and the necessity to use and apply discretion. On such areas where discretion is needed is in creating Plan-B for different likely macroeconomic scenarios.

WALLER TALKS OF PLAN-B FOR 3 LIKELY SCENARIOS

Turning to my view for the path for policy, let me discuss three scenarios that I have had in mind to manage the risks of upcoming decisions in the medium term. Christopher Waller concluded his address by talking abut the 3 diverse but possible scenarios and how the Fed is ready with a Plan-B in each of these cases. Here is how.

• The first scenario is also the most likely and also the most preferred scenario for the policymakers. According to Cristopher Waller, the first scenario is one where the overall strong economic growth continues, with inflation nearing the FOMC’s target and the unemployment rate moving up marginally. This is what the US Federal Reserve would call a, “Best Case Scenario” from a policy perspective. In this kind of a scenario, the Fed would proceed with moving policy toward a neutral stance at a very measured pace. However, this path would be based on the judgment that the risks to both sides of the Fed dual mandate (2% inflation and full employment) are in a state of balance. What is the Plan-B in this case? Not much of Plan-B is required since the focus of the US Fed will be to keep inflation near the 2% mark, without allowing the economy to slow down.
• The second scenario outlined by Christopher Waller envisages a situation that is technically possible but less likely to happen. This scenario envisages a situation where the PCE (personal consumption expenditure), inflation falls sharply and meaningfully below the 2% mark and stays put for a reasonably long period of time. The other condition could be that the labour market deteriorates substantially in this case. This would imply that the consumption and investment demand in the US economy was falling and the US Fed was way behind the curve. In terms of the Plan-B for the Fed, it should focus on how soon the Fed can move towards a neutral rate by front-loading rate cuts. The only risk factor here, is that it could push monetary policy to a point of no-return.
• The third scenario applies if inflation unexpectedly spikes either because of stronger-than-expected consumer demand or wage pressure. In the volatile geopolitics of the Middle East and West Asia, it is also possible that there could be supply shocks which could push up inflation. The recovery from the pandemic recession, was a classic example of the demand being stronger than expected, while supply chains struggled to cope up. These imbalances could likely trigger supply shocks; calling for a pause on rate cuts till the time the labour market became robust. Rate cuts could resume later.

Let us finally turn to the outlook for rates and rate action as painted by Christopher Waller.

RATE CUTS WILL REMAIN THE THEME OF FED POLICY

The base line view of Christopher Waller still is that the time is ripe for reducing the policy rates gradually over the next year. This is irrespective of vagaries in data flows. The median estimate of Fed rates put out by the FOMC members is pegged at 3.4% by the end of 2025. That broadly corresponds with the view expressed by the CME Fedwatch on 100 bps rate cut by end of 2024 and another 100 bps rate cut by end of 2025. However, as Waller himself admits, the final destination is still not too clear. That should hopefully evolve and manifest itself over the next few months.