In Conversation: Mary C. Daly at the American Enterprise Institute

Michael Strain:

Thanks especially to Mary Daly, president of the Federal Reserve Bank of San Francisco for being here. I will introduce President Daly in just a moment, though, of course she needs no introduction.

The run of show here is quite straightforward. President Daly and I will discuss economic and policy issues for about half an hour, and then we’ll turn to your questions. You are welcome to submit questions via email to my colleague John Towey at John.Towey@aei.org. You can find the spelling of his email address on the web page for this event. You are also welcome to submit questions via Twitter using the #AskAEIEcon.

I will now introduce President Daly. Mary Daly became president and CEO of the Federal Reserve Bank of San Francisco in October of 2018. She began her career at the bank in 1996. As an economist specializing in labor market dynamics, and economic inequality. She went on to become the San Francisco fed Executive Vice President and Director of Research. She has also held multiple leadership positions at the San Francisco Fed and within the Federal Reserve System. More broadly, she has served on numerous advisory boards, including for the Congressional Budget Office, the Social Security Administration, the Office of rehabilitation research and training, the Institute of Medicine and the Library of Congress. As an economist, she has been published widely on topics such as wage growth income inequality, disability insurance, disability, program policy, and on indices of happiness. She has held visiting research positions at a number of distinguished organizations. Mary is a native of Ballwin, Missouri. I am a native of Overland Park, Kansas, which I think makes us roughly speaking, from the same hometown President Daly. Thank you so much for being here. It’s an honor to be with you again.

Mary Daly:

I’m delighted to be here. Thank you so much for having me.

Michael Strain:

So let’s just dive right in and why don’t why don’t we open this by giving you the opportunity to just briefly tell us, how do you think things are going with the economy right now?

Mary Daly:

I really think of it as a yes and situation. And what I mean by that is, yes, the economy has good momentum. Yes, the economy looks like monetary policy is starting to have an effect. We see some slowing in interest-sensitive sectors, we see that we feel a slowdown coming in a way that would be predicted by us raising interest rates. And we still have a long way to go because even though two months of CPI data have come in with some good news. We are far away from our price stability goal. And why that’s so important is one it’s our commitment. Congress gave us a dual mandate. Price stability is one of those mandates, but also inflation takes a tremendous toll on people. It’s a regressive tax. It’s a tax on everybody, but it hurts low- and moderate-income families the most. And so, we are committed resolute united and focused on bringing inflation down and getting back to 2% inflation on average.

Michael Strain:

Let’s talk more about inflation. And in the Federal Reserve Open Market Committee meeting that just ended, the median inflation projection from the Fed rose pretty significantly relative to the previous meeting. Median inflation projection rose to 3.5% in 2023 2.5%, in 2024, that represents an increase over previous projections of about four tenths of a percentage point for next year. So, a pretty sizable increase. I think people have thought that those projections were made prior to the release of the November consumer price index data that showed another good month of slowing. But Chairman Powell made clear in the press conference that that wasn’t the case.

Can you explain your thinking about this? Why has your concern about the longevity of inflation gotten worse over the last several months despite two good months of CPI data?

Mary Daly:

Sure. That’s a terrific question and let me unpack the answer so that it’s crystal clear how I think about it. We can break inflation, overall inflation, into—let’s take core because that is a good indication of underlying inflation and takes out those sectors that are volatile like food and energy. Let’s go with core and you can separate core into three components: goods price inflation, which is you know, goods that supply chains were most disruptive for; housing price inflation, shelter price inflation, which includes both homes that people own and live in and also rental prices; and then core services as we call them, excluding housing. So when you go to goods, you see the data coming in on the last two reports. Well, it’s coming in with goods price inflation falling, this is what we’ve been hoping for expecting. We all knew I think there was a general consensus among all people who do forecasts that this was going to happen. We just didn’t know when so we’re finally getting the healing of supply chains we were looking for and goods price inflation is coming down. That’s good news. It takes usually about a year for that to fully come down to its historical values. That’s what history would tell us. So we’re looking at that coming down gradually over the course of next year but being a drag on the high inflation numbers we have seen. The same can be said of housing—house price inflation is coming down; it is yet to filter completely into rental price inflation that traditionally takes about a year as well. So once house prices start coming down, you start seeing new leases formed, they’re coming down. But that takes about a year to fully make its way into all rental prices and see full relief on that sector.

But then there’s core services excluding housing and that’s for things ranging from haircuts to restaurants to, you know, just the basic retail that you do—any services you can think of. And those numbers are still quite elevated relative to their historical values. And that’s where we know that it usually takes quite a bit longer for that kind of inflation to come down. A lot of that inflation is related to the labor market, and the labor market remains quite out of balance. We have too many jobs and too few workers. So that means that wage inflation is going to be above its long run sustainable average and we’re going to have that passing through to prices and that’s what we’re working on right now. That’s why my projection has gone up. It’s really coming out of that core services and relates fundamentally to this the ongoing strength in the labor market.

Michael Strain:

Let me ask you more about that because I think that kind of breakdown of inflation into those three components is very helpful. But it also highlights a concern I have about the challenge facing the Fed. So I completely agree with you. We’re on a great trajectory for housing price inflation. We’ve already seen that we’re actually having negative growth month over month in core goods. Inflation core services looks a little more troubling—that’s the sector of the economy that’s most exposed to the labor market, most exposed to wages. Tell me what you think about this, my concern is that it will be relatively straightforward to get inflation to come down from you know, say 7% to 4% and then a lot of that work can be done through those first two sectors we talked about. But when consumer price inflation really starts to bump into wage inflation, right, average wages have been growing at about 5%.

And we have you know, 1-1.5% productivity growth and so when the primary driver of inflation is wage inflation, I worry that it will be much harder for the Fed to get from four to two than it would be to get from seven to four. And that in order to get from four to two that will require substantially larger increases in interest rates that will require the unemployment rate to go higher than the Fed released in his projections after the last meeting. Do you share my concern, how do you think about breaking it up into those two parts getting from seven down to four or five and then getting from four or five down to down to two?

Mary Daly:

Let me say that I use that same framework. And so I agree that getting from seven to four is dependent on sectors like goods and housing that we already know how they react. We know that supply chains were the barriers in goods and with some excess demand but a lot of it was supply chain and then housing is very interest sensitive. It reacts strongly to changes in interest rates. The way I’ve said it to some who have asked me is that it becomes exponentially more challenging to get each percentage point decline after you get those two things out of there because it is more about inflation expectations. It’s more about the fact that you have wage inflation in part goes up because the labor market is so strong.

I’d like to start instead of going with how much pain will we have to go through. I start this way, I say if we have to get from four to two and a lot of that is core services. Why is core services rising? And I go back to not inflation but to the real economy. The labor market is out of balance. If you want a job, it’s easy to find one. If you want a worker, it’s hard to find one. And that’s causing, of course, employers to bid up wages. But the striking fact and I don’t think everybody—we don’t regularly pay attention to this but it’s really important to pay attention to is despite nominal wage growth rising rapidly, real wages have been flat and, in some cases, falling depending on which group you’re looking at.

For the average person out there working they’re saying, “Well, I’m not even keeping up. I’m on a treadmill that just keeps making me fall behind even though I’m getting good nominal wage gains.” And so the way to get those two things back in balance is to bring the labor market back in balance. You’ll see in the projections for the SEP that the unemployment rate for 2023 and 2024 went up—the projections went up. And you know, some would push back on us and say we can just reduce vacancies in the labor market, and we can get there with less pain, less costly, but I just don’t think so. My own projection is very similar to the SEP median that we’re going to have to go into the mid fours or even been slightly higher on unemployment to get the sort of relief in the labor market we need to bring things back in balance.

And the final thing I’ll say about that is wage growth right now is four and a half to five depending on which series you’re looking at and what sector you’re looking at, and really we need it to be three and a half to four, if we’re going to be in that sustainable place. But the wage growth itself is not the problem. The problem is the labor market is out of balance. And that’s causing the effects we see just like it caused, you know, things out of balance, caused price inflation in the goods sector or the housing sector.

Michael Strain:

Let me ask you to kind of follow ups about that. I think that prior to the pandemic, a number of economists questioned whether or not wage inflation actually fed through to price inflation anymore, and the argument was that price inflation was really largely determined by inflation expectations and inflation expectations were very well anchored. And that even though wages knocked up and down, businesses didn’t take that into account, at least not as much as they did say in the 1970s. How do you think about the relationship between wage and price inflation now? I feel like now, people are talking quite a bit about the relationship between wages and prices without really explaining that shift in the way economists think about that relationship.

Mary Daly:

Even when we were back in the time when people were talking about this flat Phillips Curve and the basic fundamental relationship between wages and prices had broken, you know, I would always say this. Let’s forget about being an economist and let’s just use common sense or business sense, right? If your input costs rise, you try to pass those on through your prices. But then there are factors that prohibit you from doing that. And I’ve called those wedges. There’s a relationship between wages and prices that’s fundamental. And to employers, wages are like another input cost. It’s the largest input cost that most employers face—the labor compensation. They want to pass it through, but there were all kinds of things interrupting that process and one of those things was strictly just global competition driving down the ability to pass things on because you’d be beaten out by a competitor. So the gains were all coming out of efficiency and other things like that. So that was a period when it was pretty fierce and you didn’t see much pass through.

Now because of a variety of things, most importantly, the pandemic but also the war in Ukraine, you have supply constraints, input costs are rising all over and importantly, there’s not that kind of competition to get things down. All employers and all firms are trying to scramble for workers and you’re seeing that translate into wage growth.

The interesting thing you compared it to the 1970s is that in the 70s, it was one for one—prices went up, wages went up, then prices went up, wages went up. So it was almost, the correlation there was like something close to 80% correlation between wage growth and price growth. Now you don’t see that one for one because the labor market—that’s why real wages are falling because inflation has been rising so rapidly that wages haven’t been keeping up with it. And it’s partly because of these other wedges as well that you know, it’s really hard for firms. They’re trying hard to find workers, compensate them in these conditions, and factor out what how much is persistent versus temporary. Those are challenging things.

On the worker side, you’re getting great wage increases and you’re falling behind. That’s why inflation is such a toxic thing in an economy, it permeates everybody’s decision making and everybody’s well-being and you know, if you want to ask why is the Fed paying so much attention to inflation? Well one, it’s our job—we’ve committed to do it. But the second one is because inflation is toxic, and we need to get it back down to 2% on average, in order for the things that we’re used to permeate.

Michael Strain:

Let me ask you more about the labor market. I think the labor market is interesting in the sense that we don’t really have a problem of excess employment right now. Employment is kind of roughly where it was prior to the pandemic, lower than were would have been under the pre pandemic trend. Labor force participation rates are lower than they were prior to the pandemic. The employment rate is lower than it was prior to the pandemic. The employment rate for the demographic slice of workers who are too old to be in school, but generally speaking, too young to be retired, has, you know, kind of roughly been in the same place than it was but it’s not significantly higher than it was. And yet, we’re talking a lot about the labor market being overheated, which I which I agree that it is. Chairman Powell talked a little about missing workers in the press conference. Can you say a little more about the supply and demand dynamics in the labor market and a little more about where the workers have gone?

Mary Daly:

Sure. So it is, you know, this is something we have to pay a lot of attention to where the supply of workers is. The labor market is just like any other market. And so there’s demand for workers, but the supply has been relatively sluggish to respond. And so the question is why? Well, there are many things you can point to and there’s not one that’s driving it all but let me go through the things that are really important.

The first one is I’m going to start with older workers who were probably going to retire. So when COVID hit they were probably within five years of retiring, five to seven years of retiring. They just retired in droves. So they said that they would pull their retirements forward and they just retired during the pandemic. And you know, when you ask these workers, why did you do that? And surveys or when I have my meetings across—I’ve nine states in the United States and so I spend a lot of time traveling through those states asking people, why did you leave the workforce? I mean, you could get a good wage now if you went in, they say, well you know, I was afraid for my health. Now I’m helping with the grandkids. I’ve moved back to where my children live, so I can be helpful. And even though schools are fully back in session and things are working, there’s still a lot of out of school days that we didn’t have before because now when your kid’s sick, that kid stays home, and so that’s disruptive for working parents. So that’s one of the things going on with older workers.

And then it’s, you know, coming back into the labor market, you’re factoring in several things—you’re factoring in, how much wage growth am I getting? Well, real wages have been flat to falling depending on who you are so that’s not a big incentive. And then of course, you have these other things that are keeping you out. So that’s one big group that were missing, in terms of they just didn’t come back at the level that they had pre pandemic. Then on the prime age, what we often call prime age, although I dislike that term more and more the further I get from that group, which is usually considered 25 to 54. So every year I inch past that I’m like, I don’t like that naming convention. But seriously, that’s the group where the bulk of your work life before you start to see retirements is in that age range. And so we see that coming back to almost pre-pandemic levels, but not quite. And you would have thought that it would be growing more rapidly, but that’s where we’ve had a challenge for at least a decade is the prime age labor force participation in the United States has been behind other industrialized nations, other industrialized competitors, and that goes to a lot of things, but something that’s really been salient in the current recovery and expansion is childcare. With childcare access because there’s just fewer people providing it that is just lower than it was prior to the pandemic. And now it’s much more costly. So think of yourself, if you’re a lower moderate wage earner and you have two earners and now you’ve got real wages flat, maybe slightly rising, slightly falling depending on where you are. So that’s not going to really be the incentive. You have structural challenges with getting childcare or it’s really, really expensive. And then of course, transportation costs have gone up to get to work. So at the rate of return on that extra work isn’t what it used to be. And that’s a factor holding the labor force, the labor supply back as well.

So, you know, what, come all the way back to that, what do I say? How do I think about it as a labor economist? I say that if we can get inflation down, which is the job, then the real wage starts to be the incentive for people to come back in, transportation costs start to fall, childcare costs start to fall, but in the United States, we have a more challenging problem that the Fed can’t do anything about. We don’t have any of these levers, and that is we need more childcare if we’re going to have people fluidly go back and forth into the labor force and that’s something we just don’t have. We had a shortage before the pandemic and now we have a severe shortage.

Michael Strain:

Let me ask you a little more about the outlook. There’s been a discrepancy, I think between what the Fed thinks the outlook looks like and what bond investors think the outlook looks like. Bond investors, for example, are expecting much lower inflation than in the Fed’s recent projections. Why do you think that discrepancy exists? How do you think about the outlook among investors?

Mary Daly:

Well, to be honest with you, I don’t quite know why markets are so optimistic about inflation, but you know, I speak of them as priced for perfection. If the goods price inflation goes down exactly as we can project, if the housing price or shelter price inflation goes down exactly as we think, and core services excluding housing is purely cyclical, there’s nothing persistent in there and it goes down as the economy slows, then you could achieve what the markets have priced in. But policymakers, in particular, we don’t have the luxury of pricing for perfection, because we have a price stability mandate. And so we have to imagine what the risks to inflation are. And to me they still are on the upside, for the reason we talked about just a moment ago. You know, the core services excluding housing is largely a reflection of the labor market strength, and right now the labor market is strong, and I don’t see a dramatic slowing in the labor market starting to take place. So that means that wage growth will be above its long-run sustainable average of three and a half to four. And we’re going to find that that passes through to price inflation.

For me, I want to tell the American people this—that we are resolute in bringing inflation down not just getting to that level where you said it’s easy to get to, four for instance. … We’re going to go until the job is well and truly done, which is 2% on average inflation. That means that I have a tighter path of policy, a higher terminal rate or a higher peak rate for the funds rate. I have it held longer than some of the bond investors would have predicted. But that’s what I think we’re going to need to do at this point right now in order to bring price stability back to where we give that back to the American people. If the data come out better, then of course policy will do as it’s always done, adjust. But it is really important for us to continue to say that we don’t see anything right now but hope in the inflation data, and I get confidence out of evidence, not hope. So I’m hopeful we’re in a good track, but I am I won’t be confident until I see repeated evidence that inflation is truly back on a path for 2% in the coming couple of years.

Michael Strain:

That’s a good segue into more explicit discussion of monetary policy and less about the economic outlook. Let me begin with kind of a 30,000-foot question. We’re doing this interview right now. It’ll be covered in the media when other Federal Reserve Bank presidents or members of the Board of Governors give interviews that’s covered in the media, the media has this kind of hawk and dove categorization. And I wonder, you know, where do you where do you think you fit? Do you think those categories are outmoded? Do you think of yourself as a hawk or a dove?

Mary Daly:

Well, so I guess let me start this way. We have 19, you know, participants on the FOMC. And we have two labels. So how likely is that going to be to be a good description of anyone really? So I think that’s a starting point that just doesn’t make logical sense that we would be we’d be able to sort people into a couple of camps.

I also don’t really love labels. Frankly, I’ve been labeled my whole life. You know, first it’s, I’m a high school dropout. And then I’m a labor economist, my gosh, how can I do monetary policy? You know, there’s a sense where we say labels and then we think we know what people are going to do.

Michael Strain:

Your predecessor Janet Yellen was a labor economist.

Mary Daly:

Yeah, I know so that gave me a lot of hope, and here I am.

But seriously, I think with labels the reason we don’t want to use them is because they have grave shortcomings that mean that we’re simplifying things beyond what is really important if we’re going to get the information out. So when I think of it, if you looked at the media coverage, for instance, before the FOMC, you would have thought that nobody agreed on anything and that we were in these two opposing camps. And then you get the Summary of Economic Projections and you find out that all of us have individually come up with a policy path that has a pretty tight range. You know, if you really just look at it, it’s 4.75 to 5.25, and then 5.1 is the middle and then you think, oh okay, well, what are they going to do in terms of cutting and everybody has rates holding for 23. And the reason for that is we’re all committed to the same thing, achieving our goals: price stability, full employment. Right now it’s clear that full employment is being met. Where we’re really off is price stability. And so there, we’re taking policy remedies that restore the part of our mandate where we’re missing. So I guess what I would say to this is that really people like to do that type of thing but it is not actually a good description of anyone.

And the final thing I’ll say there is the only we only use hawk / dove in this very narrow set of what I call Fed followers. In America, the average people I talk to, the people out there that community every day, my business contacts, that’s not how they think of it. They say only one thing right now, when are you going to get inflation down? And how hard is it going to be? And so that’s where my focus is.

Michael Strain:

Let me remind our audience please to send in questions to John.Towey@aei.org. You can find that email address on the webpage for the event. Or to tweet them using the #AskAEIEcon. More on monetary policy, I saw a column written by Peter Orszag, the Obama administration official, former CBO director. And he when talking about monetary policy, he said the following: he said with antibiotics, it’s better to take all your medicine even if you’re already feeling better after a couple of days. With steroids when used in moderation, they can reduce inflammation and control reactions but take too much for too long and you can risk the whole immune system. Do you think that interest rate increases are more like antibiotics or more like steroids? Is there a real risk that that one extra dose of tightening can cause huge problems or instead should we think about monetary policy interest rate increases as something that just kind of gradually affects the economy and it takes a while to really understand what the effects are?

Mary Daly:

Well I have a rule in my head to never use analogies about medical things because I’m not a doctor of medicine, I’m a doctor of economics. So I’m going to step outside of the medical metaphor and I’m going to go to how I think about that question, which is a really good question, right? How I think about monetary policy is there’s a risk always of doing too little and doing too much. So what are the costs of doing too little? Well the cost of doing too little is that inflation embeds itself in psychology and you end up in a situation where now inflation is high and it’s very challenging to get it down. We’ve experienced such an episode and have done so in my lifetime. And then we had to have the Volcker disinflation, which was the necessary reaction to that embedded psychology. We do not want to repeat that. I saw the cost personally that it took on people who went from having high inflation, which made it hard to afford anything, to [having] no jobs, which made it hard to buy any anything either. And so that’s something we absolutely want to avoid. Right now we don’t have inflation embedded in the psychology, so we want to make sure that that does not happen. The costs of doing too much, of course, are also real. Those costs are you can throw the labor market—if you overreact to the high inflation and you do too much—you can throw the economy into a troubling and deep recession, and then that’s hard to come back from. But the policy we’ve taken today in my judgment, what we’ve done so far, is not achieving either one of those things. It’s not doing too much. It’s not doing too little. So far what we’ve done, and I would call this our first phase of tightening, we have simply taken the accommodation we had offered during the pandemic out of the economy and got rates into modestly restrictive territory. This next phase of tightening, phase two, is more challenging. We have to then figure out—and we’ll do that meeting by meeting with data dependence and looking at the risks—what is the peak rate that would be sufficiently restrictive to bring price stability back? And then we’ll be in that third phase of tightening, which is how long should we hold it? And all of those things together are how I think about doing monetary policy. It’s really a stage-to-stage piece. We finished phase one, we’re now in phase two. Eventually we’ll get to phase three and 2023. And in all of those, I’m weighing the cost of doing too little against the cost of doing too much.

I guess I want to end this answer with this: When we talk about the cost of doing too much, we always talk about inflation expectations in psychology because those are real, but something I’m hearing a lot lately from my contacts, whether they’re small businesses, community members, workers, is there are real costs to high inflation right now. It is not a pain-free situation. Americans everywhere are paying a tax with high inflation, and those least able to bear it are paying an exceedingly large tax. So it’s about reducing that pain while we don’t do unnecessary pain to the labor market. But we don’t see really close to that right now. Right now, we have a labor market that’s strong, and inflation that’s too high.

Michael Strain:

So how do you know when to stop? Do you stop or do you wait for the unemployment rate to hit a certain level and that tells you to stop? Or do you think to yourself you know, we’ve done a lot of tightening, and we need to sit back and see whether the unemployment rate hits a level that we deem too high.

Mary Daly:

Here’s how I think about it. I think about it as we have to, we put this in our FOMC statement in the November meeting and we still have it still in there in December, because this is how it works, right? We already have done a lot of tightening, cumulative tightening of monetary policy. So that’s already in the pipeline, and we have more planned so that’s in the pipeline, then we understand that monetary policy acts with a lag. We don’t know how long those lags are, which is why the third part of that statement is so important that we put out, which is we will continue to watch the evolution of the economic and financial data. So we know there are lags, which means we can’t wait until inflation gets to 2% before we stop tightening and stop raising rates and that would be the kind of unforced error that causes overtightening. We have to account for the lags, but we don’t know what they are, looking ahead. We have to watch the data to see where they are. So it’s really an experiential learning and looking at the whole dashboard of indicators. The ones I look at are not just the headline numbers for unemployment and inflation, but what’s going on in the labor market. What do quits look like? What does job finding look like? What happens to vacancies? Are there help wanted signs if you go out in your communities? Are the help wanted signs coming down? And when you go to your favorite store, they have the normal hours you expect because they have full amounts of workers. That’s a labor market sign. On the inflation side, you know, do I see sales starting to reemerge at retail outlets? Do I see the price of thing—you know there’s a particular place I go for services for my haircut, they just keep crossing out the prices and writing in new ones. And when I see that stop happening, I’m like okay we’re starting to get some relief on inflation.

So there’s a lot of published data we can look at. But this is where we’re talking to people being out there—it’s really where the 12 Reserve Banks, the regional Feds. People often say, why do we have those? Well, here’s a really important reason we have them: We have people all over the nation in these 12 Reserve Banks talking to people who run businesses, who have nonprofits, who are workers in unions and asking them, what is it like out there? How’s it going? What’s happening and that gives us the forward-looking information we need to ensure that we do our best at not over tightening or under tightening. That’s how I make my decision.

Michael Strain:

Let me ask you about one of those one of those indicators. I’ve been really surprised by the durability of consumer spending. My expectation was that following so I think there’s a lot to be said for this and revenge spending way of thinking about this and I thought there would be a lot of revenge travel over the summer. I’m going on that trip. I don’t care what the price of the airline ticket is or I don’t care how expensive the hotels are. I’ve been cooped up in my house for years. But then I expected in the fall going into the winter that consumer spending would soften considerably. And you know, maybe it did last month, retail sales that just came out yesterday looked softer than were expected. But on the whole, I’ve been surprised by how consumer spending has held up. This of course has a direct implication for consumer price inflation because when demand is growing faster than supply, you see prices go up. Have you also been surprised about consumer spending? What do you think accounts for its strength and durability? And how long do you expect this to last?

Mary Daly:

The resiliency of the American consumer, all of us would be part of that has been surprising to me. And here’s the things that were have surprised me. Well, here’s the things that I think relate to it and you know, I understand that term revenge spending and things, but I really think of it this way. We have published data that says or survey data that says people aren’t very optimistic or sentiment is down, but you don’t see it in actions. You see in actions that people are buying things. They’re doing the things in their lives and it really makes sense to me. I mean, we were hunkered down for a long time. And it’s not just frustrating. You can’t do what you want. It actually takes you away from the things that make meaning in your life like seeing family or going on trips and seeing places and I see that momentum still there. You know, Las Vegas right now, which is in my district and I recently visited, it’s booming. People want to see each other. People are coming from all over the country to meet up, they go and do these things. That is just a sign to me that people really want to be with each other. They want to partake in services, they want to do things. So you can’t do them though if you don’t have money. And so there I really say it’s a tale of two pandemics still. We’re starting to see the people in the lower part of the income scale, really feel the tax of inflation and so the spending is going to slow, but for people above the median, there’s really a lot of excess savings still available of people who didn’t spend during the pandemic and now have excess money to spend freely on things and showing great interest in doing so. So that is a strength that you know, it kind of surprised me how long the momentum would last when a slowing economy is clearly ahead and how much excess savings people had accumulated. And we have some information about that, but it’s not particularly great. And we’re starting to get more but that’s something that’s really surprised me on the strength.

The other thing is not surprising is if you just do a simple calculation on the strength of the labor market, it would predict the consumer spending would remain strong because one of the main things that would bridle consumer spending is a slowing labor market and we haven’t seen that yet. So as we start to see the labor market slowdown and get more imbalanced, I would expect then that to filter through to consumer spending, especially when there’s not that excess savings buffer being so high to kind of propel and even when a slower labor market comes about. So I’m looking for a slower slowdown in this in 2023 as the labor market comes into balance, but you know, I also recognize we’ve been waiting for that to happen for a while. It hasn’t happened yet so my confidence will rise when I see the evidence that it’s occurring.

Michael Strain:

Let me ask you a question that came in from Chris Rugaber at the Associated Press. He writes, your colleague John Williams at the New York Fed says that the Fed’s benchmark rate needs to rise higher than the rate of inflation, in order to get inflation under control. Do you agree? And in what timeframe do you think that needs to happen?

Mary Daly:

I think that that’s an easy thing to agree with. So the question is not that really, it’s about what how do we calculate that, right? Because people use different calculations. So if you look at the SEP, let me just direct attention back to the Summary of Economic Projections. If you haven’t already looked at it, it’s very scintillating. It’s available on the website of the Board of Governors. And what you’ll find is that the peak funds rate is about 5.1 for the median SEP, and the inflation rate at the end of 23, which is at the same time, is 3.5. So that means that the rate is above inflation, and that’s what restrictive policy looks like. You have a restrictive policy because the real rate of interest is above zero. It’s restraining the economy and the SEP confirms that that’s what the median SEP participant sees.

Michael Strain:

Let me let me ask you a little bit about the interaction of fiscal and monetary policy. I guess the first question I would ask is: Does the new Congress matter to the Fed—the Congress that was just elected that will take office in January?

Mary Daly:

We say this a lot, but I want to unpack it a little bit that the Fed is a is an independent central bank. And that independence is predicated on us being apolitical. We are not reactive to whatever party the elected officials come from, because those are different kinds of decisions, Congress gave us our mandates, gave us our responsibilities, and then we execute them for the American people. That’s the job that Congress expects of us, and that’s the job we’re up to. So the answer to your question is, you know, it isn’t relevant for policymaking, for monetary policymaking, what the elected officials are going to do [or] who is in office at that point in time. We of course, watch how fiscal policy is moving forward because it affects the economy, and that will help us understand how to adjust monetary policy to achieve our dual mandate goals. But which party is in in power in Congress or whether Congress is transitioning isn’t really relevant for our policymaking because Congress depends on us to do our jobs for the American people with the goals that they gave us: full employment price stability.

Michael Strain:

A question from Rich Miller at Bloomberg: Chair Powell has said it’s likely that restoring price stability will require policy and a restrictive level “for some time.” Over the last five interest rate cycles, the average hold at peak rate was 11 months. Is that a good way of thinking about what is meant by “for some time?”

Mary Daly:

That’s a reasonable starting point. We maybe have to do a little more because of the how long we’ve been here—for two years. Remember, we even been in a situation like this a long time. And so I would say you could start with that. And I think that’s pretty consistent with what you see in the SEP, the Summary Of Economic Projections, for the median: We raise the rate in in 2023, and then hold it throughout 2023. We hit that peak rate and hold it—there’s no rate cuts projected in that median forecast. And that would be a reasonable starting point, but the data will determine how we actually do it. That’s the important thing to know is that these are projections sitting right where we are today. But we’ve repeatedly as a group—and Chair Powell reiterated this; I will reiterate from my own point of view—that we have to be data dependent. We can project, but then we have to watch, and if the data come in stronger than we’ve penciled in, we’ll have to respond more strongly. If the data come in, you know, if inflation falls back much more quickly than we’ve anticipated, then we will respond. That’s what nimble policy looks like. But right now I sit here and I think 11 months as a starting point is a reasonable starting point, but I’m prepared to do more if more is required.

Michael Strain:

So I’m expecting a recession next year. I wouldn’t be shocked if we didn’t have one, but my baseline expectation is that there will be one. The Fed does not expect there to be a recession but does expect there to be considerable slowdown in economic growth. My guess is that if we were to have a recession next year or a significant slowdown, that given the composition of the Congress we won’t have a big stimulus package. What are the implications of that for the Fed? You mentioned that the Fed keeps an eye on fiscal policy because that affects the economy. If we have a slowdown, Congress doesn’t do anything, fiscal policy doesn’t do anything, does that have implications for how long the Fed holds the funds rate at a high level?

Mary Daly:

Well, I guess let me if I can, I’ll unpack that a little bit so I can give an answer to each part of that. The first piece is that, you know, I’m very much aligned with the median for the Summary of Economic Projections, the SEP. I expect a slowdown, for growth to be well below our trend rate. That’s going to feel like slow growth to people. We’re going to feel like we’re in a sluggish economy. And sO I absolutely anticipate that. But when you think about how the things in our economy respond that support people through these slower times, a lot of that is already built in. It’s these automatic stabilizers that we have in place. So when people lose their job, they get unemployment insurance, and that doesn’t take a new act of Congress. That’s just something built into the system. And so it gives an automatic stabilization to people who become unemployed as the labor market slows. And then the important thing is getting inflation down quickly enough that we can be back on the path of trend growth, so that those jobs come back rapidly. The other automatic stabilizers are things like the support systems, you know, food stamps and other things that kick in when people fall below a certain income. Those things are all there without Congress passing any new legislation, and I think that’s a recognition that there’s going to be what we call you know, normal kinds of slowdowns—ups and downs in the economy. And hopefully, very few of them will be like something we just experienced with the Great Recession. That’s a very unusual event. We haven’t had anything that deep since the Great Depression. Those are rare and deep events as opposed to the more typical recessions, which last, you know, less than a year, a little over a year, and these automatic stabilizers help people through them. But all this comes back to policy will be nimble. We will adjust to the economy we have. But what is top priority right now is bringing inflation back down to 2% on average, because it’s our goal, of course, and price stability is so important, but also because it’s already extracting a tax from Americans, and I’ll say it again because it’s so important, especially those who are the least able to bear it.

Michael Strain:

Chairman Powell said that the FOMC will only cut the funds rate when it’s confident that inflation is moving down in a sustained way. What do you think would constitute inflation moving down in a sustained way?

Mary Daly:

So I’ll just let me speak for myself here and in no way the committee, but what I’m looking for is continued progress on goods inflation. And, as you and I talked about, goods inflation, once it starts—barring any additional disruption in supply chains—you’d expect this to just come down gradually but completely. Then there’s the housing price inflation, again, with a tighter interest rate environment, you would expect that to go as it is. So I’m really looking for movement in core services excluding housing, which to me means that the first thing I would see is the labor market coming back into balance—jobs available, workers who want jobs are coming back in in alignment. Then I’d like to see that show through to core services excluding housing, and that will be the third piece of this inflation puzzle. But what I really do need to see is that because that’s how we’re going to get back to 2%. If we simply had goods, price inflation and housing price inflation return to historical norms, but services exclusing housing were still high, we wouldn’t get back to 2%. So we’ve got to see progress there to be confident that we can start reducing the policy rate. I think, if I may, Michael, it’s really important to remind people too, that as inflation comes down, a given policy rate is more restrictive in real terms, right? Because, you know, the real rate of restrictiveness is the nominal rate minus inflation. So as inflation falls, policy becomes more restrictive, so we have to balance that as well.

Michael Strain:

Let me ask you a final question that doesn’t get a lot of attention, but that I think is very important, certainly over the over the longer term. FOMC participants are asked for all sorts of things, and they come out with the dot plots and all the things we’ve been talking about. One of those is the long run neutral rate. And the median rate was unchanged in the projections from the last meeting, but three participants raised their estimate of the longer run neutral rate. This this rate has all sorts of implications for whether the economy will return “to normal” after the pandemic and the kind of surge of fiscal and monetary policy support and all the issues that have affected supply chains and economic supply. Will the world look the same on the other side of that as it did in 2019? That rate is influenced by massive global forces related to demographics, related to economic growth in developing nations, related to the balance between global savings and global investment opportunities. How do you think about the long run the long run neutral rate?

Mary Daly:

Well, first, I think of that as one of the top questions we have to grapple with in the coming year, because you know, as we come out of the pandemic, we’re back to thinking about the longer run, we call them the star variables, right? The fundamental factors that guide how we think about the economy. And you know, the piece that you said in your list is really how I think of it. There’s a global savings supply and a global investment opportunity demand. And those things come together to determine the neutral rate of interest that thing that clears that market. We have to go back in and ask ourselves, do the factors that affected that and pushed the neutral rate of interest down after the Great Recession—it was all in train: population growth, as you said, demographics, slower productivity growth all over—that really had this factor going down. So our R-star moved to something like .5 off of its historical norm of closer to 2. So you kind of have to go back and ask yourself: are those factors still there and what kind of force are they putting on global savings and demand for investments? And the answer is not known right now. I mean, I’ve seen studies here and there, but we have to do a full court press for researchers, policymakers, etc. really asking those questions again, and I’m going to remain open-minded to whether it’s gone up or gone down. The reason I haven’t moved mine is that we’re at a point now where there’s so many cyclical forces, that it’s hard to separate the cyclical forces from the more persistent ones that will ultimately determine global savings and global demand for investment. But I think that’s the 2023 issue. We should come out of next year having a much more clear understanding of whether the pandemic changed things more than just temporarily, and I’m sure it did; the question at hand is by how much?

Michael Strain:

Let me thank everyone for tuning in for this conversation. Let me thank everyone who will watch the video of this later on. And let me thank especially Mary Daly. Thank you so much for being with us today, thank you for your leadership, and thank you for your service during such an important time in national and global economic affairs. Thank you so much.

Mary Daly:

Thank you always a pleasure Michael to be here with you. Great discussion. I appreciate it.