By Raphael Bostic, President and Chief Executive Officer
June 21, 2023
Inflation remains too high, and the Federal Open Market Committee (FOMC) is firmly committed to bringing it down to our 2 percent objective.
But the pursuit of price stability, never easy, has become even more complicated by turmoil in the banking system earlier this year. A few high-profile bank failures and difficulties at certain other institutions raised fears that liquidity concerns could spread throughout the banking system and create financial instability. In response to those concerns and slowing economic activity, many lending institutions have tightened credit standards—they've become choosier in deciding whether to lend money to prospective borrowers.
It is important to note that widespread credit tightening does not constitute financial instability. Instability in the financial system means markets are shutting down, bank runs are ongoing, and capital is not flowing where it is needed to fuel economic activity. We are not at that precarious place. The contagion we feared might emanate from the turmoil that surfaced in March has so far not materialized. The banking system has not been shaken and institutions in our district by and large report solid liquidity and capital positions.
Should conditions worsen and financial instability concerns increase, the Federal Reserve maintains tools, including the Bank Term Funding Program, to blunt the likelihood of bank runs and ensure that households and businesses can get the financial support they need from their banks.
Tighter bank lending standards, in fact, are a byproduct of restrictive monetary policy. This is how it's supposed to work. The financial system that distributes capital to businesses and households is the primary means through which Fed policy affects the real economy. Economists call this the "policy transmission channel." Basically, the Committee raises the federal funds rate, which is the rate banks charge one another for overnight loans from their reserves held at the Fed. In turn, that higher rate filters through to higher rates on consumer and business loans, eventually slowing economic activity to bring down inflation.
So, tougher bank lending standards are a powerful mechanism that can bring supply and demand across the macroeconomy into balance by cooling demand. Narrowing the gap between (low) supply and (higher) demand is the fundamental factor that reduces inflation.
A look at what we've done
The FOMC has already done plenty. Since March 2022, the Committee has increased the federal funds rate by a total of 5 percentage points, from a range of 0 to 0.25 percent to a range of 5 to 5.25 percent. That is a rapid pace of policy tightening, and it was frontloaded. That is, we started with bigger increases of 75 basis points before shifting to smaller hikes, an appropriate course given the surge in inflation that began in the spring of 2021 and proved more persistent than the Committee first expected.
Here, let me clarify that the first several rate hikes did not move policy into truly restrictive territory. The policy rate had been at zero for about two years, which is the equivalent of flooring the gas pedal such that our policy gave the maximum push to the economy. So you can think of the first several rate increases as the Fed taking its foot off the gas. More recent hikes have made policy restrictive—here the Committee is applying the brakes. I like to separate the hikes and think about the first 325 to 350 basis points of increases as removing accommodation and then the subsequent 150 to 175 basis points as moving policy into restrictive territory.
That means policy has been restrictive for only eight to nine months. Therefore, the real economic effects of tighter monetary policy are only just beginning to take hold. We know that with a fair degree of certainty. What we don't know is exactly how responsive our brakes are, how quickly policy will bite more deeply and in turn how quickly inflation will fall. I expect it will continue to come down gradually, with bumps along the way.
How do we know policy tightening is at least starting to take hold? Though the labor market remains strong, hiring and the number of job vacancies have declined from supercharged levels. Housing markets and manufacturing have shown signs of slowing. As noted, banks are toughening lending standards. Most importantly, inflation continues its steady decline, from around 4 percent, as measured by the Fed's preferred gauge, the Personal Consumption Expenditures price index. Importantly, the breadth of price increases has narrowed. The latest Consumer Price Index reports show that less than half of all prices rose more than 5 percent, well off the peak when nearly 80 percent of the index climbed that much. Finally, business contacts in the Sixth District tell me their power to raise prices is eroding.
Still, inflation is roughly double the FOMC objective of 2 percent, so there is still a ways to go.
The current and future stance of monetary policy
As always, the task of policy is to manage risks. That is especially true amid risks that cut in various directions—a possible rise in unemployment and a severe economic slowdown, further stresses on banks, unforeseen geopolitical events, and the chance that inflation takes longer than we'd like to decline to 2 percent.
In terms of an appropriate policy stance in this environment, I see three viewpoints to choose from.
- One could take the view that the Fed must actively do more to bring down elevated inflation. Therefore, the Committee should keep tightening policy lest we replay the 15-year-long "Great Inflation" of the 1970s and '80s.
- One could argue that policy may now be sufficiently restrictive, but we have not yet seen its full effects on the macroeconomy. So, let's pause and give policy time to work and assess how rapidly it is gripping the real economy. Under this view, the bar to justify further rate hikes is higher than it was a few months ago.
- One could decide to take a play-it-by-ear approach. In this view, the Committee should continue to evaluate conditions and simply approach policy decisions on a meeting-by-meeting basis.
There are reasonable arguments for each approach. For now, though, I am in the second camp.
I think we are in a place where we should let the hard work the Committee has already done work its way through the economy and see if it continues to bring inflation closer to our goal. Letting restrictive policy work for a while is prudent because the policy has been truly restrictive for less than a year, and it takes time for monetary policy changes to meaningfully influence economic activity. We have good reasons to expect our policy tightening will be increasingly effective in coming months, which would accelerate progress to that end.
I continue to believe we can subdue inflation without severe economic dislocation. In part, that's because the labor market remains strong. The job market has cooled, moving nearer to a place consistent with lower inflation, mainly because of a reduction in the number of job openings without a meaningful rise in the unemployment rate. If we simply press on with additional rate hikes, we could needlessly drain too much momentum from the economy.
Also, I must emphasize that waiting is not the same thing as inaction. If inflation continues to fall in coming months, our current policy stance effectively becomes tighter, as the real interest rate—which is the difference between our rate and the rate of inflation—will increase. I think of this dynamic as "passive tightening," and it should help us continue on the path to our target if recent inflation trends persist.
The clearest risk in pausing is that we give inflation a chance to rekindle, even as the economy might slow and labor markets deteriorate. That is not my baseline forecast. But we cannot forecast with certainty, so if down the road we find our twin mandates of maximum employment and price stability in conflict, then the discussion necessarily turns to our policy framework and underlying principles. As of now, price stability clearly remains the pressing priority, and that seems unlikely to change soon.
To be sure, some further slowing in the labor market will probably be necessary to reach the 2 percent inflation objective. Yet even if we see an uptick in unemployment, the case for staying resolute in pursuit of price stability is compelling. History shows that if we recede from the inflation battle prematurely and allow price increases to go unchecked, that will threaten inclusive prosperity for many years to come.
Bottom line: We will bring inflation down to 2 percent. Price stability is a necessary precondition for sustained maximum employment and long-run, inclusive economic expansion. The monetary policy work goes on, and we will continue to pursue it in service to the American public.