Fed Speak: Vice Chair Jefferson on US outlook and policy transmission

10 Oct 2023 , 11:31 AM

Fed speak has been one of the major means of communication by the Fed. Apart from the Fed statement, the long term surveys and the minutes of the Fed meeting, the Fed communication also comprises of regular speeches given by the members. It is not just the Fed chair, Jerome Powell, but even others like the Fed Vice Chair and the governors of the other regional Feds deliver speeches from time to time. The Fed ensures that the message that goes out in these speeches is broadly in sync as far as the rates trajectory is concerned

It is in this context that the latest speech delivered by vice chair, Phillip Jefferson becomes important. Jefferson recently spoke at the National Association of Business Economics in Texas on the US economic outlook and the process of monetary policy transmission. Here are some of the key takeaways from what Jefferson said in the speech.

Key takeaways from the speech by Fed vice chair, Phillips Jefferson

In his speech, Jefferson not only spoke about the outlook for the US economy and the outlook for inflation, but also touched upon other critical topics like the labour market, aggregate economic activity and the risks facing the US economy.

1. Inflation data has been encouraging in recent months, but it is still far from the Fed target of 2%. In fact, in the 12 months to August, PCE inflation was up 3.5%, while the core PCE inflation for the same period rose by 3.9%. it is critical to understand why inflation in the US still hovers so much above the long term target after nearly 20 months of explicit hawkishness. 

    

2. There is good news and there is also news that is relatively disconcerting. On the positive side, the core goods inflation has slowed remarkably, as supply chain pressures eased to a great extent. Housing services price inflation has also slowed down in sync with the slowing of increases in rents for new tenants. However, the core non-housing services have remained sticky. That is a problem because this sticky segment accounts for mor than 50% of core PCE inflation. Labour markets need to soften more.

    

3. Let us now turn to the labour market. There is still evidence, even in the latest data about an imbalance between labour demand and labour supply; although it is narrowing. Labour supply is improving and labour demand is cooling, but the rate unemployment in the range of 3.8% to 4.0% is still fairly close to full employment. Hence the labour market continues to be tight.

    

4. Even though, the job openings declined by 1 million since the end of January, the job openings are still about 30% above their pre-pandemic level. At the same time, layoffs have remained very low, and the pace of payroll employment gains remains strong. The unemployment level of 3.8% is very near to its historic lows. In the past, rate tightening cycles were associated with substantial increase in unemployment. However, this time around, that has not happened and that has slowed the inflation impact as rising wages are largely neutralizing the rate hike impact.

    

5. However, this is one area that promises to show positive traction for the US economy and is crucial to inflation control. Improvements in labour supply are contributing to rebalancing the labour markets. Apart from improvement in labour participation rate, immigration has also picked up. On the one hand, restrictive monetary policy continues to slow labour demand without causing an abrupt increase in layoffs or the unemployment rate. On the other hand, labour supply is increasing. Inflation may be still away from the target, but it is on the right track.

    

6. Let us turn to the economy growth story of the US economy. The first two quarters have left the US economy with hopes of annual GDP growth of 2.1% to 2.2%. Data points are already pointing to smart economic growth in the third quarter too, which should help the full year GDP to veer closer to the 2.2% mark. Consumer spending was strong in both July and August, while the housing starts are rebounding after a slowdown amidst rising higher interest rates. 

    

7. This issue of economic growth assumes importance since the goal of the Fed all along was to ensure a soft landing. That means inflation gets controlled by higher rates, but the higher rates do not impact economic growth in a significant manner. That was always considered to be impossible, but now it seems like a likely outcome. Thanks to strong labour market and rising wages, the consumer demand did not get impaired by the higher rates. This ensured that GDP growth remained buoyant. But then there are also risks to this assumption of soft landing.

    

8. Let us turn to the risks to a possible soft landing for the US economy. According to Jefferson, while the US economy has been resilient and inflation has been subsiding, the outlook for growth still remains uncertain and analysts and economists must now lose sight of the risks, according to Jefferson. The biggest risk to growth stems from the upside risks to inflation. This could be an outcome of too much labour tightness or too much of a spike in global commodities like oil, which significantly impact inflation. The experience in the last few months has been that lower inflation can often be deceptive as it shows signs of staying higher for a longer period of time.

    

9. Apart from the upside risks to inflation impacting growth, there are also other downside risks at play. A classic downside risk factor is the possible slowdown in foreign economic growth, especially China. The Chinese economy has lost its erstwhile momentum and real estate activity appears to be the nucleus of pressure. Retail sales, consumer demand and economic activity are slowing in China, even as household debt is rising to alarming levels. Even in developed Europe, the manufacturing and services PMIs are both in contraction mode. 

    

10. Let us turn to the transmission of monetary policy, which is critical to the success of monetary policy in controlling inflation. Typically, monetary policy is transmitted to the rest of the economy through market interest rates. However, even as higher rates contain inflation, they also raise the cost of funds for households and businesses. This impacts their spending power and capital investment power in a big way. To an extent, that is inevitable but the challenge lies in ensuring that it does not end up in a slowdown or recession, which is a potent risk. Hence transmission has to happen without impacting the demand factors too much. 

     

11. The other downside risk of transmission of interest rates is that it impacts asset prices. The reasons are not too hard to understand. Higher interest rates lead investors to discount cash flows associated with longer-term investments at higher rates. This reduces the present value of the stock market assets. While transmission is important, one of the big challenges for the Fed is to ensure that tighter monetary policy does not reduce the willingness of investors to bear risk. This would only increase yield spreads and reduce the prices for a range of asset classes.

     

12. However, Jefferson admits that transmission may still be elusive as you normally get to understand transmission only when bulk of the loans come up for refinancing. For example, while the tightening started in March 2022, the bulk of corporate debt issued by large firms has not yet had to be refinanced since the FOMC started to tighten monetary policy. That is when a clear picture of the extent of rate transmission and its impact on corporate solvency will be apparent.

Final word: Key considerations for monetary policy

In the last part of his address, vice chair Jefferson dwelt at length on the monetary policy considerations going ahead. Jefferson has also underlined the hawkish undertone of the Fed that more rate hikes and more tightness may be needed. However, he also adds that after raising rates by 525 bps in 20 months, the Fed has the relative luxury of proceeding carefully in assessing the extent of additional policy firming required. The Fed has reached as stage where the choices are not discrete: to hike or not hike. The choices are a lot more complex now as any move can have a magnifying impacting on risk and the performance of the economy. The Fed is still trying to find an answer to How much is too much and how much is too little, when it comes to monetary policy tightness. That is why, holding the policy rate constant for the time being, may be the best choice.

One of the reality checks that the Fed regularly does is to keep a tab on the bond yields on the benchmark 10 year and 30 year bonds. The real long-term Treasury yields have risen recently with the 10-year bond yields touching a 17-year high of 4.8%. According to Jefferson, the higher bond yields may reflect investor assessment that the underlying momentum of the economy is stronger than previously recognized. As a result, the restrictive stance of the monetary policy may be needed for longer than previously thought to return inflation to 2%. One thing is clear; the Fed is not taking any stance either ways. They would prefer to deal with data as it flows in. In volatile times, that is perhaps the best thing to do.