New York Fed President: How does the onion theory of U.S. inflation guide future policy?

Written by:John C. Williams, President and CEO of the Federal Reserve Bank of New York

Compiled by: GaryMa, Wu ShuoBlockchain

This article was published on November 30, some data may be lagging behind

Preface

good morning everyone. Welcome to the Federal Reserve Bank of New York. We are pleased to co-host this workshop with the Bretton Woods Commission.

My remarks today will focus on the U.S. economic situation, including the monetary policy actions we are taking and my outlook for the economy. Before I speak further, I need to provide the standard Federal Reserve disclaimer that the views I express today are mine alone and do not necessarily reflect the views of the Federal Open Market Committee (FOMC) or other Federal Reserve System members.

double responsibility

The Federal Reserve System is mandated by Congress with the dual responsibility of achieving maximum employment and price stability. We perform well in responsible employment. The unemployment rate has been below 4% for the past 21 months. This is the longest period since the 1960s. It's consistent with my estimate of the unemployment rate, which I estimate is expected to remain at 3-3/4% over the longer term.

But the supply-demand imbalance that has persisted since the start of the pandemic has led to unacceptably high inflation. Inflation surged to a 40-year high of over 7% last June, according to the Personal Consumption Expenditures (PCE) price index. We have since seen inflation fall to 3%. This is a significant and welcome drop. Still, inflation remains too high.

Price stability is the cornerstone of our economic prosperity and key to ensuring maximum employment in the long term. The FOMC is committed to returning inflation to its long-run objective of 2 percent on an ongoing basis.

Inflation "onion"

To understand why inflation has risen so much and why it is easing, I have been using an onion analogy over the past year. Each layer represents a different sector of the economy.

The outermost layer of the currency onion represents globally traded commodities. Inflation soared as demand for commodities surged early in the pandemic, then rose again when Russia invaded Ukraine. By the end of June last year, food price inflation had risen to more than 10%, and energy price inflation had soared to more than 40%.

Over the past year, global demand and supply have become better balanced due to tight monetary policies implemented by central banks around the world. Commodity price inflation has fallen significantly. Food price inflation has fallen to about 2.5%, and even Thanksgiving dinner costs less than it did a year ago. Energy prices have been falling over the past year, pulling down headline inflation rather than pushing it up.

The second layer of the onion is made up of core commodities excluding food and energy. Here, too, we see the impact of the rebalancing of supply and demand. Global supply chain bottlenecks that triggered massive shortages of goods during the pandemic are now largely a thing of the past. According to the New York Fed's Global Supply Chain Stress Index, which measures the extent of supply chain disruptions, it reached its most favorable level on record in October, based on data going back to 1998.

Core commodity inflation is now around 0.25% due to the rebalancing of supply and demand and the easing of supply chain bottlenecks. And it appears to be returning to pre-pandemic levels.

Although the outer layers of our onions improve the fastest and most, the inner layers are also making progress. After peaking at around 5-3/4% earlier this year, core services inflation is now around 4-1/2%, with recent readings suggesting inflation in this category has slowed further.

A key driver of the surge in core services inflation has been the sharp increase in housing prices. Strong demand and limited supply have driven housing price inflation during the pandemic and much of its aftermath. Recently, rents for newly signed leases have been rising at nearly pre-pandemic rates. As these figures are incorporated into official statistics, housing inflation should continue to fall. Inflation in services other than housing and energy is also starting to move in the right direction. Inflation in this category has slowed to about 4% over the past six months, well below the 5-1/4% peak we saw in December 2021.

future indicators

This sums up what’s going on with the layers of the onion. But what does it mean for the future direction of inflation?

Inflation expectations are an important indicator of future inflation. Moreover, long-term inflation expectations are at levels consistent with the FOMC's 2% target. According to the New York Federal Reserve's monthly consumer expectations survey, medium-term expectations rose between 2021 and 2022 and are now fully back to pre-pandemic levels.

Meanwhile, inflation expectations one year out have fallen sharply since a peak of nearly 7% last June. It is now only about three percent higher than the average between 2014 and 2019.

Another useful measure of inflation trends is the New York Fed’s Multiple Core Trend (MCT) Inflation. As of September, the MCT was at 2.9%, after being close to 5-1/2% last June. Other measures of underlying inflation also show significant declines since last year.

labour market

Let me now turn to the other aspect of our dual responsibilities: employment.

The labor market has become extremely hot in the wake of the recovery from the pandemic recession. Demand far exceeds supply. This imbalance leads to higher wage growth and inflation.

Numerous indicators point to a gradual return to equilibrium. Job vacancies continue to decline. Resignation and hiring rates are back to pre-pandemic levels. The same goes for perceptions of employment opportunities and the ability to fill positions. Although still relatively high, wage growth has slowed significantly.

We have made significant progress on the labor market supply side. Labor force participation rates have increased significantly. Immigration rates have returned to pre-pandemic levels. But there are limits to the increase in supply capacity, and some further reductions in demand are needed to fully restore balance in the labor market.

Tightening stance of monetary policy

The FOMC has settled into a tight monetary policy stance. This helps balance demand with supply and return inflation to our long-term goal of 2%. Earlier this month, the FOMC left its target range for the federal funds rate unchanged at 5-1/4 to 5-1/2 percent.

In addition to our tightening policy actions, financial conditions have tightened, in part due to increases in long-term Treasury yields since the summer. While statistical models of Treasury yields typically attribute much of the rise to rising term premiums, financial market participants have expressed a variety of views on any single explanation and there is no clear belief in any one explanation. Rising yields and higher volatility likely reflect increased uncertainty about the economic outlook and future interest rates.

Given tighter financial and credit conditions, I expect GDP growth to decelerate to about 1-1/4% next year and unemployment to rise to about 4-1/4%.

I expect inflation to continue falling toward our long-term goal of 2%. As I mentioned before, the slowdown in inflation should help bring inflation down. And, based on research from the Federal Reserve Bank of New York that shows a strong relationship between the Global Supply Chain Stress Index and commodity price inflation, I expect to see additional deflationary pressures at this level. My forecast is that overall PCE inflation will be about 3% in 2023, then drop to about 2-1/4% next year, and then approach 2% in 2025.

Nonetheless, the future remains highly uncertain and our decisions will continue to rely on data. Risks are two-way, inflation remainsXiaobai NavigationThe possibility of continued stubbornness is weighed against the risks of economic and employment weakness.

In weighing these risks, my assessment, based on what I know now, is that we are probably at or near the peak of the federal funds rate target range. According to model estimates that take into account the long-term neutral rate forecast for the current quarter, the stance of monetary policy is quite tight; in fact, according to estimates, it is considered the tightest in 25 years. I expect it will be appropriate to maintain a tightening stance in the future to fully restore balance and return inflation to our long-term goal of 2% on a sustained basis.

I will continue to carefully watch all data to assess whether the current policy stance is sufficient to achieve our inflation objectives. If price pressures and imbalances persist beyond my expectations, further policy strengthening may be needed.

Before I wrap up, a quick word about our balance sheet. At our last meeting, the FOMC indicated that it would continue to reduce its holdings of Treasury securities, agency debt, and agency mortgage-backed securities consistent with the framework announced in 2022. We have reduced our securities holdings by more than $1 trillion with no indication of adverse effects on market functioning.

Committed to our goals

Since I began peeling back the inflation onion a year ago, we have made significant progress in lowering inflation and restoring balance to the economy.

But our work is far from done. I am committed to achieving our long-term inflation goal of 2 percent and laying a solid foundation for our economy's future.

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