Multi-Chamber Economic Outlook Luncheon and Expo

It was a strong year for the real side of the economy in 2023—much better than had been feared at the end of 2022. In addition, activity remains solid coming into 2024. This doesn’t have to mean new inflationary pressure, though. Looking at the economy as a whole, this doesn’t look like a traditional, broad-based overheating of demand.

• The labor market is coming more into balance by standard measures, such as the ratio of unemployed workers to job vacancies or the voluntary quit rate, and the growth rate of wages is robust and coming back into equilibrium.
• There has been robust immigration, raising the population growth rate faster than expected. Labor force participation has been strong as well. So aggregate measures like payroll job creation or gross domestic product (GDP) growth can be larger without overheating the economy.
• There are, however, some cautionary signs on the real side, such as rising consumer delinquencies, which have historically predicted business cycle downturns.
• Finally, in the last year productivity growth has rebounded much more than we expected and even exceeded the pre-Covid trend. If this continues, both GDP and wages can grow faster without generating higher inflation—similar to the experience during the late 1990s.

This brings us to the matter of inflation. It’s important to view inflation over a longer arc. We saw sizable reductions in inflation over the past nine months that have brought us closer to the Federal Reserve’s 2 percent inflation target. In 2023, we hit what I was calling the “golden path.” It was one of the largest drops in inflation on record, and it didn’t come with the usual serious recession. That progress, while obvious at a longer timeframe, has come with bumps. That’s to be expected.

• The last two months of inflation data were one such bump. I don’t think we can write them off as purely noise because the elevated readings from January continued into February. So I will be watching developments closely. But February’s readings were better than January’s, and as I noted, there does not seem to be a broad-based overheating of demand. So my overall assessment is that these two months should not knock us off the path back to target if we start to see progress in the areas I will mention in a moment.
• Let’s not forget that with the federal funds rate range at 5-1/4 to 5-1/2 percent, our policy stance is restrictive. Real interest rates are high by historical standards. So we need to be mindful of how long we want to stay in that posture if, as expected, we see continued progress getting inflation down.
• With the improvements in inflation we’ve seen over the past nine months, I see the risks to our inflation and employment mandates having moved into better balance. If we stay restrictive for too long, we will likely see the employment side of the mandate begin to deteriorate. That’s why it’s worth paying especially close attention to the leading indicators from the labor market for signs of deterioration.
• When gauging progress in returning inflation to target, I find it useful to examine the underlying components of core inflation (that is, inflation not including volatile food and energy prices). The big three are core goods, core services excluding housing, and then housing services.
• First, recognize that before Covid we had overall inflation at 2 percent or even below, but that didn’t mean that every component had inflation of 2 percent. Housing inflation was around 3.5 percent, core services excluding housing about 2.5 percent, and core goods around –1 percent. That combined for about 2 percent overall.
• Much of the improvement in inflation last year came from positive supply developments. This was especially apparent in the rapid fall in goods inflation. After a very challenging few years, supply chains largely got fixed. And goods inflation returned to something like normal. To some, that means further improvement is unlikely because the supply chain won’t improve as much as it did then.
• Another major positive supply development was that labor supply expanded with unexpectedly large increases in labor force participation and immigration. Favorable labor supply developments tend to work with a lag, so I think they will likely continue to work their way through the economy. And that will probably be a rather direct benefit for core services inflation.
• Indeed, after rising to high levels in 2021 and 2022, inflation in core services excluding housing improved a good deal in 2023. It is still higher than its pre-Covid level, but it has come down more than expected and is not that far away.
• This leaves the biggest danger to the inflation picture in my view as the continued high inflation in housing services. Although it has come down some from quite elevated levels, it continues to run much higher than it was before the pandemic. Based on market data on rents for new leases, I have been expecting it to come down more quickly than it has. If it does not come down, we will have a very difficult time getting overall inflation back to the 2% target. Housing inflation remains my most valuable indicator for the immediate future.