What’s Up with the Economy and Monetary Policy?
A speech presented by Charles L. Evans, president and chief executive officer, Federal Reserve Bank of Chicago, on March 24, 2022, at the Detroit Regional Chamber’s 2022 State of the Region event in Detroit, MI.
Thank you, Sandy,1 for the excellent presentation on economic developments in the region and for the invitation to speak to the Detroit Regional Chamber this morning. The Chicago Fed has been very fortunate to have you on our Detroit Branch board of directors since 2017. I’ve been very grateful for your many contributions, among which of course are your keen insights on the Detroit and Michigan economies. These and other information we pick up from business and community leaders—many at events such as this one—are very important inputs into my thinking on monetary policy.
Before I begin my formal remarks, I want to acknowledge the substantial hardships the Ukrainian people are enduring as a result of Russia’s invasion. This is just an awful event. May the people of Ukraine and all who are affected by this crisis remain strong and as safe as possible.
And I should note, too, that the views I share with you today are my own and do not necessarily represent those of my colleagues on the Federal Open Market Committee (FOMC) or others in the Federal Reserve System.
The economy today
Although the Covid-19 virus has taken a horrible toll on the health and livelihoods of so many people, the U.S. economy recovered rapidly in 2021. This progress is remarkable given how dire an event the pandemic has been. Households and businesses showed amazing ingenuity in finding ways to operate safely. The health care sector was able to develop and deploy vaccines extremely rapidly. And fiscal and monetary policymakers provided crucial support through policy actions.
By the second quarter of last year, real gross domestic product (GDP) in the U.S. had surpassed its pre-pandemic level; and despite new waves of infections during the second half, growth for the year was a quite robust 5.6 percent and the economy appears to have entered 2022 with solid momentum. As for the labor market, after peaking near 15 percent early in the pandemic, the unemployment rate declined quickly and now stands at a very healthy 3.8 percent—within shouting distance of the 3.5 percent low we experienced before the Covid crisis.
Here in the Detroit area the contours are similar. In the midst of the shutdowns, the local unemployment rate soared to almost 24 percent in April 2020—much higher than the national average. As the economy reopened and growth picked up, the unemployment rate fell quickly and was 5.1 percent in January 2022. Though still too high—it was 4 percent prior to the pandemic—this improvement is still quite impressive.
If you just look at the national unemployment rate, the labor market appears to have largely recovered from the pandemic. And by a number of other measures, such as unfilled job openings at businesses and the rate at which people quit their jobs for other opportunities, the labor market is downright tight. I know many of you in this room are dealing with the difficulties of hiring and retaining the workers that you need. However, the number of people actually employed is still well below pre-pandemic trends, as many workers who left the labor force during the pandemic have not reentered the labor market. This is especially true of older workers who retired.
In economic statistics, the labor force counts how many people are either employed or actively looking for work—so it’s a measure of the supply of available workers. Today, for a variety of reasons about 600,000 fewer people are in the labor force than before the pandemic. However, given population and labor force participation trends, in the absence of the pandemic we would have expected an increase of about 1.3 million over this time. As the pandemic recedes further, strong labor market conditions will likely draw many of those sitting on the sidelines back into the workforce. This should help alleviate some labor market pressures. But the timing and extent of this return are open questions.
Businesses are adjusting to these labor challenges in a number of ways. One thing that makes this complicated is that the pandemic may have also permanently altered many work arrangements. A wide array of job features is in play. Take, for example, some conversations I recently had with business leaders located in small and medium-sized cities. On the one hand, a number of those running smaller operations talked about the difficulties they were having in retaining back-office staff because these workers are being actively recruited for remote positions with larger employers. On the other hand, an executive at a large manufacturer reported their company had recently hired back a number of high-skilled back-office and digital staff who had left them to take remote positions at West Coast firms, but had not relocated. The executive noted that employees’ desire for a more fulfilling in-person culture and the firm’s decision to increase salaries were important factors in this reversal.
I find these anecdotes fascinating, as they highlight the many different ways we could see the labor market structure evolve over time. As of today, it is highly uncertain how it is all going to play out.
The pandemic set in motion other significant changes as well. Let me give you one example that hits close to home for many of you in Detroit. With people forced to spend more time at home, households shifted their spending from services, such as travel or dining out, toward goods, such as appliances for home improvement projects or consumer electronics. And many of these items contain a large number of sophisticated microprocessors. Well, so do cars. And at the same time, expecting a severe and prolonged recession, automakers substantially scaled back their production plans and ordered fewer microprocessors used in motor vehicles.
As it turned out, the demand for vehicles recovered much more robustly than most expected. But firms manufacturing consumer electronics and other such items had absorbed both chip inventories and new production, leaving fewer chips available for vehicles. As a result of this and other shortages, auto and truck production has been severely curtailed. And with supply curtailed but demand still robust, motor vehicle prices have surged more than 23 percent over the past year.
This is just one story, but in many areas we are seeing producers struggling with such supply bottlenecks. In some cases, lean, just-in-time production processes have come under pressure from multiple directions simultaneously as the flood of demand has put logistics systems under immense strain. The result has been a surge in costs that have been passed through to higher prices for many items.
Market forces should help temper the recent inflation surge
This brings me to inflation. Early last year, as activity began to normalize, prices for goods and services that were especially sensitive to the pandemic adjusted higher. However, as the year progressed, strong demand and continuing supply challenges, including shortages of workers in many sectors, resulted in prices rising across a broader range of goods and services. Inflation for the year was an uncomfortably high 5.8 percent and rose further to 6.1 percent in January.2 For people whose incomes have not kept pace, higher inflation is a real hardship.
It is important to step back and think about the economic factors behind the massive jump in inflation over the past year. After all, in February 2021, inflation was only 1.6 percent—below the FOMC’s objective of inflation averaging 2 percent over time.
We often hear commentary that today’s inflation is the highest we’ve seen since the early 1980s. But our experience today is much different. Back then, overly accommodative monetary policy during the 1960s and ’70s helped fuel a slow but persistent buildup in long-run inflation expectations—that’s economist jargon for the underlying views of wage and price growth that get built into the psychology of households and businesses. Of course, this was the inflation that former Fed Chair Paul Volcker eventually had to address with draconian measures.3 In contrast, the pickup in inflation over the past year occurred rapidly—and did so after more than a decade of sub-2 percent actual inflation and with longer-run inflation remaining quite low.
As I alluded to earlier, today’s surge largely reflects real supply shocks and weakened supply chains and logistics in the face of strong, outsized demand for goods and diminished labor force participation. These have been the strongest forces underlying the past year’s rapid increase.
A broad take-away I get from the data and discussions with business and community leaders is that markets are working to allocate scarce resources to their most critical uses. A shift in demand back toward services, an increase in supply in response to higher relative prices and wages, and adjustments in business models to adapt to the evolving environment will eventually alleviate many of the supply-side pressures we face today. Yet in many cases it is going to be a complicated process.
Adjusting monetary policy
That said, as I noted earlier, since last summer inflation has broadened out to a wide range of goods and services. This is a signal of more general pressure from aggregate demand on today’s impinged supply. If monetary policy did not respond to these broader pressures, we would see higher inflation become embedded in inflation expectations, and we would have even harder work to do to rein it in.
So monetary policy must shift to removing accommodation in a timely fashion, which is what you’ve seen in the latest actions by and communications from the FOMC. Last week, the FOMC announced its decision to raise the federal funds rate target by 25 basis points to a range of 1/4 to 1/2 percent.4 Furthermore, we indicated we will begin reducing the size of our balance sheet at a coming meeting.
The Committee also released its quarterly Summary of Economic Projections (SEP), which presents FOMC participants’ forecasts of key economic variables over the next three years and for the longer run.5 The projections show that including the initial move, the median FOMC participant expects the equivalent of seven 25 basis point increases in the federal funds rate by the end of this year and three more 25 basis point increases in 2023. All told, those increases would put the federal funds rate by the end of 2023 and 2024 at 2-3/4 to 3 percent. This is a bit above the median longer-run estimate of 2.4 percent, and so, it represents a slightly restrictive policy stance.
This is the median projection, and my colleagues hold some range of views as to what exactly constitutes appropriate policy in the current environment. My own viewpoint is in line with the median assessment.
For GDP growth, the median projection for this year is 2.8 percent, with growth moderating to near 2 percent in 2023 and 2024. With the longer-term growth trend for the economy seen at about 1-3/4 percent, these GDP numbers are solid ones. The labor market is expected to remain quite strong as well, with the unemployment rate near 3-1/2 percent from the end of this year through 2024.
This brings me to the big question for today: What about inflation? As we continue to adapt to and better control the virus, as market forces work to reallocate productive resources, and as monetary policy tightens, we should see a reduction in inflationary pressure. At about 4-1/4 percent, the median forecast for inflation this year is still high, but inflation is expected to moderate as we move through the projection period, eventually coming down to 2.3 percent by the end of 2024. I would note that the general contours of these Federal Reserve projections are shared by most private-sector forecasters.
Needless to say, in the current environment all forecasts are subject to a great deal of uncertainty and risks. Of course, two major sources of uncertainty today are the crisis in Ukraine and waves of the virus that currently are hitting abroad. Both of these present upside risks to inflation and downside risks to growth, and we will be monitoring their impact on the economy very closely.
To sum up, economic activity and employment continue to strengthen while inflation remains well above our objective. To steer the economy to our dual mandate goals of full employment and 2 percent average inflation, the Fed has begun to reduce the degree of monetary accommodation. Our recent 25 basis point rate hike was the first of what appears to be many this year.
With all of the uncertainty we face today, policymakers need to be cautious, humble, and nimble as we navigate the course ahead. Monetary policy is not on a preset course: Each meeting’s decision will be based on an assessment of economic and financial conditions at the time, as well as the risks to the outlook. But all of our decision-making will be squarely focused on achieving the Federal Reserve’s mandated policy goals of maximum inclusive employment and inflation that averages 2 percent over time.
1 Sandy K. Baruah is the president and chief executive officer of the Detroit Regional Chamber.
2 Our preferred measure of inflation is the Price Index for Personal Consumption Expenditures (PCE).
4 Federal Open Market Committee (2022b).
5 Federal Open Market Committee (2022a).
Federal Open Market Committee, 2022a, Summary of Economic Projections, Washington, DC, March 16, available online.
Federal Open Market Committee, 2022b, “Federal Reserve issues FOMC statement,” press release, Washington, DC, March 16, available online.