I was happy to host Federal Reserve governor Christopher Waller for remarks and discussion at AEI this morning. Here’s some press coverage of the event:
Federal Reserve policymakers look increasingly comfortable closing out the year with interest rates on hold and the clock ticking on the timing of the U.S. central bank’s first cut as they try to engineer a “soft landing” for the economy.
“Inflation rates are moving along pretty much like I thought,” Fed Governor Christopher Waller, a hawkish and influential voice at the central bank, told the American Enterprise Institute think tank on Tuesday.
“I am increasingly confident that policy is currently well positioned to slow the economy and get inflation back to 2%,” he said, and also “reasonably confident” of doing so without a sharp rise in the unemployment rate, now at 3.9%.
If the decline in inflation continues “for several more months . . . three months, four months, five months . . . we could start lowering the policy rate just because inflation is lower,” he said. “It has nothing to do with trying to save the economy. It is consistent with every policy rule. There is no reason to say we will keep it really high.”
You can watch the event here, and you can read Governor Waller’s speech here.
Below is an edited and condensed version of our discussion. We talk about the likelihood of a recession vs. a “soft landing,” the potential for the commercial real-estate sector and consumer debt to derail the expansion, the odds of the economy reaccelerating and inflation getting stuck above the Fed’s target, the implications of the federal budget deficit for monetary policy, the “longer-term neutral rate of interest,” when the policy rate might be lowered, and whether the post-pandemic “new normal” will look like the pre-pandemic world. Also, Taylor Swift and Bruce Springsteen.
Michael R. Strain: Let me begin by offering some of my reflections on the soft-landing scenario, and get your reaction to those. I agree with you that we’re seeing a softening in aggregate demand. That seems clear in terms of business investment, consumer spending, and the labor market. So if that were to continue, then we could tip into recession, or we could have a soft landing, or we could reaccelerate. Those seem like three mutually exclusive and collectively exhaustive possibilities.
There seems to be a lot of hope around the soft landing. Conceptualizing the soft landing in terms of the labor market, the scenario would be that we go from, say, a 150,000 job-per-month economy down to a, say, 40,000 job-per-month economy — something above zero, but below the pace needed to keep up with population growth. And then we stay there for four months, five months, six months, something like that — a length of time sufficient to bring inflation back down to target — and then we reaccelerate, and we go back to a 150-per-month, 200-per-month economy.
That scenario seems to have captivated the imaginations of economists and journalists. It seems to me to be a little too neat and tidy. If you look at post–World War II economic history, you don’t see that happening. What you see is that when the unemployment rate goes up a little, it tends to go up a lot. When you look at employment growth, when year-over-year payroll growth dips below 1.5 percent, it goes on to go negative.
On the other hand, we are in, I think, the most unusual period of economic history since the demobilization from World War II. A lot of things that weren’t supposed to happen have happened, and a lot of the laws of economics seem to have been suspended. Maybe this time will be different, and we’ll get the soft landing.
So my question to you: Am I unduly pessimistic about this? Or do you think that a soft landing could happen, but my general assessment of its likelihood seems reasonable?
Christopher J. Waller: Well, I’m an optimist. So back in May ’22, I gave a speech outlining what I thought a soft landing would be, and how we could actually achieve it. And it was largely the fact that we had so many vacancies to workers that I thought our efforts in raising the policy rate could put downward pressure on labor demand, not through really getting rid of workers, which there seemed to be a big shortage of, but just reducing the number of vacancies. Now inevitably, there’s going to be some increase in unemployment, but through some analysis I did at the Board of Governors, we said that, look, in unemployment, if there aren’t massive layoffs, if you just keep the involuntary job-separation rate stable, you can get vacancies down, get labor demand down, and unemployment would only go up to maybe 4.3 percent or 4.4 percent.
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There was a lot of controversy around that argument, but so far, it seems to have played out fairly closely. Unemployment is 3.9 percent, we still haven’t quite got everything down to where it was in 2019, and so I think that is where people are starting to say, yeah, maybe this is going to look like that. But if you go back in U.S. history, when you think about a recession, it’s always caused by some major shock. That could happen again. There could be another major shock, and this whole soft landing disappears. But shocks are shocks. We can’t really forecast it. And when I think about the last 18 months, we saw a Russian invasion of Ukraine, we saw the Silicon Valley shock, banking stresses, the recent events in the Middle East, and these things have all been what normally we think would be a big shock that could tip the economy into recession, but so far they haven’t done it.
So that’s why I think just looking at past recessions isn’t going to be necessarily a good guide in this case. And so that’s why in unemployment, when it goes up, it goes up fast. It doesn’t kind of just gradually go up, and then flatten out. But as long as we don’t get any big shocks, I am reasonably confident that we can pull off this soft landing. And you know, unemployment will probably go up a little bit more, but if we can get inflation to come down, GDP growth to soften but not go negative into a full recession, there’s no reason we can’t pull it off. But there’s always some shock sitting in the background that may happen, and blow the whole thing up.
Strain: So let’s stick with that for a minute. When the soft-landing arguments began to be made, I was more optimistic as well for exactly the reason that you mentioned, which is that labor-market tightness looked to me to be driven more by excessive labor demand than by excessive employment. Labor demand is normalizing. The job-worker gap is shrinking, and we still have inflation that is well above the Fed’s target, and there’s still the risk of inflation getting stuck well above the Fed’s target. And that normalization of labor demand without an accompanying clear path back down to 2 percent for price inflation has increased my level of pessimism regarding the soft-landing possibility.
With regard to the shocks, how concerned are you about commercial real estate? How concerned are you about private-sector data that show an increase in credit-card delinquencies? How concerned are you about the data that can be gleaned from earnings calls that talk about concern for weak demand, a weak holiday season? How concerned are you about businesses not gearing up for the holidays with October hiring? How concerned are you about corporate earnings? And yes, we’ve seen a loosening of financial conditions due to appreciation of stock prices, but that’s seven stocks out of the 500 in the S&P 500.
Does that kind of constellation make you concerned both about a specific shock — maybe it’s commercial real estate, maybe it’s credit-card delinquencies — and make you concerned that the economy is actually kind of folding faster than the headline statistics suggest?
Waller: On the labor-market side, one thing that has also happened is we’ve seen a very strong comeback in labor-force participation, mainly among prime-age workers from 25 to 54. In women in particular, the return to labor force has been astounding. We’ve seen immigration levels coming back to what they were pre-pandemic in terms of trend, so we’ve also gotten a lot of help on the supply side of the labor market to help with this reducing demand, but not having unemployment go up dramatically.
On commercial real estate, everybody knows there’s going to be repricing in commercial real estate. When repricing occurs, somebody wins, somebody loses. But we all know when that refinancing and repricing is going to happen. It’s not a shock, it’s well anticipated, and everybody sees it coming. So that’s why I’m not as concerned about somehow we’re going to wake up one morning and be surprised that commercial real estate is repriced. We all know it’s going to do that. That’s not a shock. And it’s going to happen over a couple of years. It’s not going to happen one morning, every commercial real estate prop in the U.S. has to be refinanced and repriced. So that’s why I’m not as concerned about commercial real estate being a shock that throws it into a recession. Is it going to be painful? Yeah, some people are going to lose money when these things have to be refinanced and repriced. But that’s just the way markets work, so I’m not too concerned about the commercial real estate.
On the other elements, remember, we are trying to slow down demand. We are trying to slow down the economy. That’s going to have an effect on delinquencies. It’s going to have an effect on earnings calls. These are things we need to get the economy to slow down, and also get inflation down. So what we don’t want is it to go so bad that, you know, the economy goes tanking into a recession, but these are all signs of showing we’re getting the moderation in demand that we want to help us get the economy back on stable footing in terms of inflation, without tossing us into a recession.
Strain: So it sounds to me like of the three scenarios I outlined, you’re less concerned about the economy reaccelerating than about either a soft landing or a recession.
Waller: I was in the third quarter. I was stunned by this third-quarter number. I think everybody was. It was like, where is this coming from? We were at 2 percent, 2 percent, 2 percent, 2 percent, 2 percent, and then almost 5 percent. But now, what I said is all the forecasts I’m seeing, all the preliminary data that’s coming in, it’s going to be probably 1 percent to 2 percent in the fourth quarter, depending on which one you’re looking at. So that clearly is in moderation.
The things you mentioned, these are all things that are telling you, look, this 5 percent growth isn’t going to continue for a couple of quarters. So, something happened in the third quarter, I don’t know . . . lots of Taylor Swift concerts? I don’t know what it was, but something blew up the third quarter, and it’s not likely to continue going forward.
So that’s why I’m less concerned. Once I saw the last couple of weeks of data, I felt more confident that this seemed to be a one-off. And as I stress, inventory investment was a big factor, and that can be some evidence, just pulling forward investment from the fourth quarter, which means fourth quarter will be even lower. So that’s why I’m thinking that, you know, whatever we get for third quarter, it was a bit of an anomaly, and it’s not going to continue.
Strain: How much of the moderation in the fourth quarter would you attribute to Bruce Springsteen having to pull off the tour due to that peptic ulcer?
Strain: It seems to me that an elephant in the room for the Fed is the fiscal situation. And of course, fiscal and monetary policy are independent, but the fiscal situation affects monetary policy in a couple of important ways. High deficits boost aggregate demand at a time when the Fed is trying to cool aggregate demand. That in turn boosts the neutral rate of interest, which means that the policy rate needs to be relatively higher to be contractionary. In addition, high defects require that the Treasury sell large amounts of longer-term debt. That boosts yields; it could boost the term premium. The Fed, I think, can’t just recognize that higher rates are going up because these two different effects have different implications. A higher neutral rate implies a higher policy rate; a higher term premium implies a lower policy rate.
How do you think about that? How do you think about the fiscal situation as it affects the FOMC? How do you think about those competing effects of extremely large structural deficits?
Waller: Yeah, so I mean the way we’ve always kind of thought about fiscal policy and monetary policy is, look, there’s lots of exogenous external factors that are not under our control. We just take them as given, and we do the best we can in response. The same is true with the exchange rate, you know, foreign-government monetary policies, all sorts of trade rules that get put in. Our job is to take that as given, and do the best job that we can. We can’t change those things because they’re not under our control.
So with fiscal policy, you know, that’s Congress’s job, to do whatever they think they need to do in the administration. My job is to say, okay, whatever it is, that’s how I have to respond. Sometimes it might make my job harder, sometimes it might make my job easier. But that’s just the way that monetary policy works. You know, on the fiscal side, it’s just . . . you know, we typically don’t comment, but just as a former academic economist, you know, running budget deficits of 7 percent, 6 percent of GDP in peacetime at full employment just doesn’t sound sustainable. It doesn’t mean there’s going to be a financial crisis around the corner, but longer term, something probably has to be done to address it.
Strain: What is your outlook for the longer-term neutral rate?
Waller: I have a whole speech on this at some point. There’s so much chatter about the long-run neutral rate, and my just general comment is if you look at the real return on safe liquid government debt, that thing has been falling for 40 years. Just go plot it out; it is just a long, long, long downward trend. The rate of return to capital, due to some work by one of my colleagues at the St. Louis Fed, B. Ravikumar, if you look at the real return, or the average real return to capital over the last 40 years, it’s constant. It’s very volatile, but there’s no secular downward trend. So there’s something unique about safe liquid government debt, treasuries in particular, that is driving this long-term decline. So whenever people tell me it’s going to bounce back up, I always kind of ask, it’s been declining for 40 years, what is it that you suddenly think is now driving it up?
I mean, just a couple of weeks ago we heard it’s all the 10-year treasuries going up because R-star [the longer-term neutral rate] is higher. Well, now it’s fallen back six-tenths. Is R-star coming back down in three weeks? I mean, these just sound like . . . they’re just really not plausible stories. You’ve got to do a lot more work in thinking about, and estimating, and understanding the causes of why it would suddenly start going back up.
Strain: I know you want to stay focused on the economic outlook, but I want to ask you about the Basel Endgame capital-requirement proposal, and your vote on that, and kind of how you’re thinking about how you might further engage with that.
Waller: The Basel Endgame is out for comment. We had an open board meeting, we all made our official statements. I voted against it. I thought it was excessive in terms of what it was doing, particularly on one element, which was this operational-risk bucket, which is mainly due to, like, lawsuits, cyberfraud. Those are things that don’t typically occur at the same time as a financial meltdown due to a macroeconomic shock, so they’re not correlated with market risk, trading risk, all the other things that might bring a bank down. So I just argue that because it’s not really a threat to this, you don’t need a separate bucket for this. You can use operational risk paid for out of your standard capital bucket.
So that was my argument. And I think when I looked at the numbers, operational risk is something like over 50 percent of the increase in capital. So, you know, if there’s some willingness to move on operational risk and some other things, there is a possibility that this could be put forward in a revamped way that would be acceptable.
Strain: Okay, let’s take questions.
Nick Timiraos: Hi, Nick Timiraos, with the Wall Street Journal. Governor Waller, I want to ask you about something you said at the beginning of the year. At the beginning of the year, there was a disconnect between what you and your colleagues were saying about the path of policy for this year, and what the markets were pricing at. And the markets were pricing in a lower policy rate by the end of this year, and you had said, you had kind of characterized this as a miraculous melting away of inflation that the market expected, that you didn’t see. Since June, we’ve now seen, with this week’s reading, perhaps five months of better-behaved core PCE inflation could be annualized around 2.5 percent. And so I’m wondering if that continues, if that would count in your book as this miraculous melting away of inflation.
I guess the question I’m building up to is, at what point would you say maybe policy rates could be lowered, that a 5 3/8 percent policy rate wouldn’t be appropriate if inflation could be sustained at 2.5 percent core inflation? Thank you.
Waller: Yeah, so back in January, yeah, as Nick pointed out, there’s been a couple of disconnects between us and the markets over the last 18 months. And in January, I was saying this was just due to forecast. We just had different forecasts. It wasn’t like somebody was right or wrong; we just had different forecasts of what was going to happen.
The market, I argued, as Nick said, you know, I viewed the market was thinking inflation was going to be at 2.5 percent by the summer. I didn’t think it was going to go down that far. Where we’re looking at being for the 12 months at the end of the year is about what I thought it would be back in January, somewhere between 3 percent to 3.5 percent. That’s kind of what I had in mind back in early January. So it’s kind of played out that way, but it’s been bumpy, you know? There have been months where it was much better, and looked like it was going to be a miraculous disinflation, and then it popped back up, like in September. So I think it’s heading . . . the inflation rate’s moving along pretty much like I thought.
Now, if you think about in central banking, we talk about a Taylor rule, or various types of Taylor rules to kind of give us a rule of thumb about how we think we should set policy, and every one of those things would say if inflation is coming down, you don’t need to keep . . . you know, once you get rates or inflation down low enough, you don’t necessarily have to keep rates up at those levels. So there are certainly good economic arguments from any kind of standard Taylor rule that would tell you if we see this inflation continuing for several more months, I don’t know how long that might be — three months, four months, five months — that we feel confident that inflation is really down, and on its way, that you could then start lowering the policy rate just because inflation is lower. It has nothing to do with trying to save the economy, or recession; it’s just consistent with every policy rule I know from my academic life, and as a policy-maker. If inflation goes down, you would lower the policy rate.
So yeah, there’s just no reason to say you would keep it really high, and inflation’s back at target, for example.
Strain: Before the pandemic, we were worried about low real interest rates, we were worried about below-target inflation. We were asking: How can we get inflation back to target? We were worried about the possibility of declining inflation expectations. And as you say, over the decades prior to the pandemic, we just saw real rates go down and down and down. This is driven, in my view and the view of many economists, by slow-moving structural factors: demographics, the supply of savings and the demand for investment, technological change that affects the way people enter the workforce. And then we had the pandemic, and we had extraordinary fiscal and monetary support, we had substantial supply-chain challenges. And now we’re kind of unwinding all of that.
The big question: Does the world after this business cycle look like it did in 2017, 2018, 2019? Or are we in a world of permanently higher interest rates? Are we in a world where the challenge is not to get inflation up to 2 percent; it’s to get inflation down to 2 percent? It seems to me that if you believe that the 2017, 2018, and 2019 world was created by these sorts of slow-moving structural factors, you would conclude that the world after this business cycle will look an awful lot like it did before the pandemic. Is that your view? If not, where are we differing?
Waller: So again, this is back to what I was saying about estimates of the neutral rate of interest. When people say declining low real rates, they’re talking about real rates on government debt. I’m telling you, go look at the work my colleague B. Ravikumar at St. Louis Fed did, and other academics that have done it since then. The real return to capital has no secular downward trend in it. It’s bouncing around, but it’s roughly 7 percent in real terms. So technology, productivity growth, these are all things that should be affecting that as well. The fact that real returns on government debt have fallen for 40 years and the average return to capital hasn’t changed says there’s a different process driving Treasury returns and driving returns to private capital.
So there’s something unique about government debt, and you want to sort these two things out. What would be things that would not affect the real return to capital, but would affect the real return on safe liquid government debt? U.S. Treasuries are special objects. They’re very special financial instruments. So just looking at that, and making broad statements about the economy, can kind of lead you off in the wrong direction.
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