This article is the speech given by John C. Williams, the President of the Federal Reserve Bank of New York, at the conference on “Exploring Central Bank Innovation” co-hosted by the New York Federal Reserve Bank and the Bretton Woods Committee. The speech focuses on the current economic situation in the United States, including the monetary policy actions being taken and the outlook for the economy. Before I proceed further, I need to provide the standard Federal Reserve disclaimer that the views I express today are my own and do not necessarily reflect the views of the Federal Open Market Committee (FOMC) or other members of the Federal Reserve System.
The Federal Reserve System has a dual mandate set by Congress, which is to achieve maximum employment and price stability. We have been performing well in terms of our employment mandate. The unemployment rate has been below 4% for the past 21 months, which is the longest period since the 1960s. It aligns with my estimate that the unemployment rate is expected to remain around 3-3/4% for a longer period.
However, the persistent supply-demand imbalances since the start of the pandemic have led to unacceptable high inflation. According to the Personal Consumption Expenditures (PCE) price index, inflation rate surged to over 7% last June, the highest in 40 years. Since then, we have seen inflation decline to 3%, which is a significant and welcome decrease. However, inflation still remains elevated.
Price stability is the foundation of our economic prosperity and a key to achieving maximum employment in the long run. The FOMC is committed to restoring inflation to our 2% long-term target on a sustained basis.
To understand why inflation has risen so much and why it is currently easing, I have been using the analogy of an onion over the past year. Each layer represents a different sector of the economy.
The outer layer of the inflation onion represents commodity prices in global trade. Inflation soared due to a surge in demand for commodities early in the pandemic and rose again during the Russian invasion of Ukraine. By the end of last June, food price inflation had risen to over 10%, while energy price inflation skyrocketed to over 40%.
Over the past year, global supply and demand have balanced better due to the tightening monetary policies implemented by central banks around the world. Commodity price inflation has significantly declined. Food price inflation has dropped to around 2.5%, even making Thanksgiving dinner cheaper than a year ago. Energy prices have been declining over the past year, dragging down overall inflation instead of pushing it up.
The second layer of the onion consists of core goods, which excludes food and energy. Here, we also see the effects of supply-demand rebalancing. Supply chain bottlenecks triggered significant shortages of goods during the pandemic, which have now largely been resolved. According to the New York Federal Reserve Bank’s Global Supply Chain Pressure Index, which measures the degree of supply chain disruptions, the index reached its most favorable level in October since 1998.
With supply-demand rebalancing and the easing of supply chain bottlenecks, core goods inflation is now around 0.25%. Moreover, it seems to be returning to pre-pandemic levels.
While the outer layers of our onion have improved the most and the fastest, the inner layers are also making progress. Core services inflation, which reached a peak of around 5.75% earlier this year, is now around 4.5%, and recent readings suggest further moderation in this category of inflation.
One major driver of the surge in core services inflation has been the significant increase in housing prices. Strong demand and limited supply have driven inflation in housing prices during and after the pandemic. Recently, rents for newly signed leases have been increasing at a pace close to pre-pandemic levels. As this data is incorporated into official statistics, housing inflation should continue to decline. Inflation for services other than housing and energy is also starting to move in the right direction. In the past six months, inflation in this category has slowed to around 4%, significantly lower than the peak of 5.25% we saw in December 2021.
This summarizes the situation for each layer of the onion. But what does it mean for the future trajectory of inflation?
Inflation expectations are an important indicator of future inflation. Long-term inflation expectations are at levels consistent with the FOMC’s 2% target. According to the New York Federal Reserve Bank’s monthly Survey of Consumer Expectations, medium-term expectations have risen between 2021 and 2022 and have now fully recovered to pre-pandemic levels.
Meanwhile, one-year ahead inflation expectations have decreased significantly since reaching a peak of nearly 7% last June. It is now only slightly above the average level between 2014 and 2019.
Another useful indicator of inflation trends is the New York Federal Reserve Bank’s Underlying Inflation Gauge (UIG). After reaching close to 5.5% last June, the UIG stood at 2.9% as of September. Other measures of underlying inflation show a similarly significant decline since last year.
Now let me turn to the other side of our dual mandate: employment.
The labor market has been exceptionally hot since the recovery from the pandemic downturn. Demand has far outstripped supply, leading to wage growth and rising inflation.
Numerous indicators show a gradual rebalancing. Job vacancies have continued to decline. Quit and hire rates have returned to pre-pandemic levels. The perception of job opportunities and the ability to fill positions have also improved. While still relatively elevated, wage growth has slowed significantly.
We have made significant progress on the supply side of the labor market. Labor force participation has increased significantly, and immigration rates have returned to pre-pandemic levels. But there are constraints on the increase in supply, and further reduction in demand is needed to fully restore balance in the labor market.
The FOMC has reached a tightening monetary policy stance. This helps balance demand and supply and restore inflation to our 2% long-term target. Earlier this month, the FOMC kept the federal funds rate target range unchanged at 5.25 to 5.5%.
In addition to our tightening policy actions, financial conditions have tightened, in part due to the increase in long-term Treasury yields since the summer. While statistical models of Treasury yields often attribute much of the increase to a rise in term premiums, market participants have expressed a range of views without a clear consensus on any single explanation. The rise in yields and increased volatility likely reflect increased uncertainty about economic prospects and future interest rates.
Taking into account the tightening of financial and credit conditions, I anticipate that GDP growth will slow to around 1.25% next year, and the unemployment rate will rise to around 4.25%.
I expect inflation to continue to decline toward our 2% long-term target. As I mentioned earlier, the moderation in inflation should help pull down inflation. Moreover, based on research from the New York Federal Reserve Bank, which shows a strong relationship between the Global Supply Chain Pressure Index and commodity price inflation, I anticipate additional inflationary pressures to ease at this level. My forecast is that the overall PCE inflation rate will be around 3% in 2023, then decline to around 2.25% next year, and approach 2% by 2025.
However, the future remains highly uncertain, and our decisions will continue to be data-dependent. The risks are two-sided, with the possibility of persistent stubborn inflation conflicting with the risks of economic and employment weakness.
Balancing these risks, based on what I know now, my assessment is that we may have reached or are close to the peak level of the federal funds rate target range. Based on model estimates of the long-run neutral rate of interest considered in the current quarter’s forecast, the stance of monetary policy is quite tight; in fact, it is estimated to be the tightest in 25 years. I expect to maintain an appropriately tight stance going forward to fully restore balance and bring inflation back to our 2% long-term target on a sustained basis.
I will continue to closely monitor 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 tightening may be necessary.
Before I conclude, let me briefly touch on our balance sheet. At our last meeting, the FOMC indicated that it will continue to reduce its holdings of Treasury, agency debt, and agency mortgage-backed securities in line with the framework announced in 2022. We have reduced our securities holdings by over $1 trillion, with no signs of adverse effects on market functioning.
Since I started peeling the inflation onion a year ago, we have made significant progress in reducing inflation and restoring economic balance.
But our work is far from done. I am committed to achieving our 2% long-term inflation target and laying a solid foundation for the future of our economy.