Thank you for the invitation to speak today. I am a year-and-a-half into my appointment as president of the Federal Reserve Bank of Kansas City after spending most of my professional life in banking. As a banker, I always appreciated the way that the Fed interacted with my bank and engaged in my community, but over the past 18 months, my appreciation for the Fed’s unique regional structure and how it benefits our nation has only grown.
A cornerstone of the Federal Reserve System’s design is that it engages the whole country in the discussion around monetary policy. The 12 independent regional banks and the Board of Governors in Washington, D.C., were established around the idea that our nation is best served by a central bank that is directly engaged in communities across the United States rather than one that is isolated in New York City or Washington, D.C. Our understanding of current and developing economic conditions is informed by direct, local engagement with the industries and geographies that make up the American economy. Events like this one today play an important role in the process, and I look forward to our discussion this morning.
Over the past week we have witnessed significant volatility in financial markets, both in the United States and around the world. After a prolonged run up in equity prices, we have seen a notable repricing in recent days, in part reflecting a rapidly changing economic outlook. Today, I will discuss how recent developments have affected my outlook for the economy and monetary policy. In addition to the near-term, I will offer a few thoughts on some long-run factors affecting policy.
Setting the Stage
Turning to the outlook, I would like to start with some good news. We are entering a challenging period from a position of strength. The economy has shown a lot of momentum and has repeatedly brushed off periodic recession fears in recent years. Over the past two years, GDP growth has averaged just under 3 percent, almost ½ percentage point faster than in the decade before the pandemic. Recent productivity growth, a measure of how much can be produced with an hour of work and a key measure of economic health, has also picked up. And perhaps most encouragingly, the labor market has remained robust. Last week’s report for March showed continued strength in hiring and an unemployment rate of 4.2 percent, not far off from historic lows and close to what many observers believe is the full employment rate.
The strength of the economy over this period reflects many factors. One important element has been that a healthy labor market creates a self-reinforcing dynamic: More jobs lead to more disposable income, which in turn leads to more spending and supports further hiring.
Another important factor has been the economy-wide health of household balance sheets. Fiscal support to households and businesses during the pandemic was effective in bolstering household balance sheets and supporting spending, even as the public balance sheet mechanically deteriorated by a similar amount. Even now, household balance sheets are still historically well positioned to buffer many households and support continued spending. Of course, it should be noted that while this appears to be true in the aggregate, it is certainly the case that not all households are equally well positioned. There are many reports, including from contacts in my region, of lower-income households coming under increasing financial strain. This is of course concerning and something that I will be following closely as we move forward.
Overall, helped by an aggressive policy response, both fiscal and monetary, the economy has emerged from the Covid period in relatively good shape. The Covid recession turned out to be short-lived and likely holds the distinction of being the only recession where most households and businesses emerged in better financial shape than they entered. In addition, the recovery in the U.S. has also compared favorably internationally. Compared to the end of 2019, real price adjusted output is 12 percent higher in the United States, while the euro area has grown 5 percent, Japan 4 percent, and the UK 3 percent over the same period. Overall, few countries came out of the pandemic in as good an economic position as the United States.
Of course, the strength of demand growth in the United States did have the side effect of contributing to the elevated inflation that we have experienced in recent years. As demand momentum ran into pandemic-related supply constraints, prices increased, and inflation picked up to a multi-decade high.
The Fed reacted to the increase in inflation aggressively, raising its policy interest rate 5¼ percentage points and beginning the process of shrinking its balance sheet. As supply recovered from pandemic-related disruptions and demand eased, partly on account of tighter monetary policy, inflation has fallen back towards the Fed’s 2 percent objective. In February inflation ran at a 2½ percent pace. The Fed’s policy goals are mandated by Congress and include price stability and full employment. The most recent data suggest that we are pretty close to meeting our mandate.
The Outlook
However, the current policy and economic environment has become considerably more complicated. The recent tariff announcements have elevated economic uncertainty and have coincided with a decline in consumer sentiment and increases in near-term inflation expectations. Relative to earlier this year, and in line with conversations I have had with contacts in my district, it appears as though we have seen a marked increase in the upside risks around inflation along with elevated downside risks to the outlook for employment and growth. Based on what I have heard from our business contacts, there is a growing possibility that in setting policy the Fed will have to balance inflation risks against growth and employment concerns.
As I said in a speech earlier this year, when contemplating this balance, I intend to keep my eye squarely focused on the outlook for inflation. While in theory, tariffs may have only temporary effects on inflation (although persistent effects on the level of prices) I would be hesitant to take too much solace from theory in this environment. Given the recent experience with high inflation, I am concerned that any further jump in prices could further push up inflation expectations. One enduring lesson of the high inflation period of the 1970s and early 1980s was that once inflation is embedded in expectations, it becomes much more difficult to contain. So far, through the spike and subsequent decline in inflation over the past few years, the Fed’s actions have been effective in keeping longer-term inflation expectations well anchored. Now, with renewed price pressures likely, I am not willing to take any chances when it comes to maintaining the Fed’s credibility on inflation.
Longer-Term Considerations
Though it can be hard to look through the daily gyrations of markets, I would like to offer some thoughts on the longer-term outlook for policy as we consider the possibility of structural shifts in the nature of the U.S. economy. Following up on a speech I gave last fall, I would like to focus on two offsetting factors influencing the outlook for interest rates in the longer run.
First, demographic transition in the United States is likely to weigh on interest rates going forward. Evidence suggests that countries with faster population growth and younger populations tend to have higher levels of capital investment and a greater desire to borrow, both of which work to push up interest rates. In contrast, older, slower growing economies borrow and invest less, pushing down interest rates.
The United States is currently in the midst of a demographic transition that will likely push down interest rates. We are getting older. The dependency ratio, or the ratio of retirees per working age adult, has been creeping up for decades, but has accelerated in recent years as the Baby Boom generation moves into retirement.
This change in the dependency ratio reflects not only an increase in the number of retirees but a flattening out in the number of workers. From 1980 to now, the U.S. workforce population has grown by 66 million, a large increase that has supported the overall growth of the economy. Over the next 45 years, the U.S. Census Bureau projects that the working age population will increase by only 2 million individuals, a considerable downshift that has important implications for growth and the long-run level of interest rates.
With almost no increase in the number of workers projected over the coming decades, all growth going forward will rely on workers becoming more productive. Hence, productivity growth will drive economic growth from now on.
The second factor, and an argument for higher rates in the long term, relates to the supply and demand for U.S. assets and, importantly, U.S. government debt. When the supply of such assets is low relative to the demand to hold those assets, investors require less compensation, and interest rates will be low. In contrast, if the supply of government debt expands faster than growth in the demand to hold that debt, or demand eases, interest rates will be pushed up.
High demand for U.S. government debt on the part of investors, particularly from overseas, was thought to be an important contributor to the low level of long-term rates experienced over much of the century so far. A growing global economy demanded a safe asset to facilitate financial transactions and to store wealth, and U.S. government debt was deemed the safest of the available assets.
However, the widening of the U.S. government deficit has increased the available supply of government debt that needs to be absorbed, while at the same time changes in the pattern of foreign demand suggest that there could be a diminished demand for U.S. debt. Growing supply, in tandem with shrinking demand, is a recipe for higher interest rates in the longer-term.
In summary, there are reasons that rates could stay high in the long-run and reasons why they might decline. The ultimate trajectory will be determined by the balance between these forces.
The views expressed by the author are his own and do not necessarily reflect those of the Federal Reserve System, its governors, officers or representatives.