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OUR DISTRICT SF FED BLOG Watch FOMC Rewind Live, May 2022 – Insights on Fed Policy Announcements May 25, 2022 How is the Federal Reserve working to bring inflation back down? Research Director Sylvain Leduc discusses this and related topics in the latest installment of FOMC Rewind Live, a video series of policy meeting analysis and insights. In this video, Sylvain discusses the Federal Open Market Committee’s policy decision at its May 4, 2022, meeting. He specifically addresses the challenges of high inflation and the Fed’s decision to raise the federal funds target rate a half percentage point. He also sheds light on the Federal Reserve’s balance sheet and the expectations for incremental reductions in its size in the months ahead. In welcoming Sylvain to the stage, Laura Choi, SVP of Public Engagement, also shares some thoughts on the SF Fed’s commitment to being a community-engaged Bank. FOMC Rewind Live videos are expected to recur around four times a year, providing viewers with leading insights on key policy meetings. 25:46 FOMC Rewind Live for May 2022 (video, 25:46 minutes) TRANSCRIPT Opinions expressed in this video do not necessarily reflect the view of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System. Hi, welcome to FOMC Rewind Live, brought to you by the Federal Reserve Bank of San Francisco. I’m Laura Choi, senior vice president of Public Engagement, and it’s a pleasure to welcome all of you today. The San Francisco Fed strives to be a community-engaged organization and that means we actively listen to and learn from the communities we serve. Now, many of you know the Fed is a data-driven institution, but we also know the importance of going below the surface of the aggregate data to understand how the economy is impacting people’s daily lives. To do this, we engage regularly with stakeholders from the public, private, and nonprofit sectors. And one thing we’re hearing loud and clear is that inflation is simply too high. It’s causing real hardship, especially for the families and small businesses that were already struggling financially. So today you’ll hear more about the Fed’s most recent FOMC decision and how policymakers may be thinking about interest rates, the balance sheet, and inflation. To help us make sense of it all, I’m so pleased to introduce Sylvain Leduc, director of Economic Research at the San Francisco Fed. Sylvain, thanks so much for being here today and I’ll hand things over to you. (audience applauds) Thank you, Laura, and good morning, everyone. This is always a pleasure to do this. Before I start delving into the decision that the FOMC made in May, I’m going to discuss questions that we often get when we go around in our communities. And this is, what’s the FOMC and how is it related to the Federal Reserve System? What I’m going to do first is just rewind a little bit further and go back in history to when we created the Federal Reserve System back in 1913. I’ll talk about the structure of the Fed a little bit to think about the FOMC. So when the Federal Reserve Act was passed in 1913, lawmakers were really concerned about concentrating too much power in Washington, DC. And so what they’ve done is decentralized the system, diffused the power across the country by creating 12 regional Federal Reserve Banks, from New York all the way to San Francisco. And at the time, the regional Banks were pretty independent. For instance, they could set the discount rate, which is a tool of monetary policy, at different levels across the different Districts in the country. And so banks that would borrow at the Federal Reserve at the discount rate, and those rates would differ across the country. Now, as the economy became more integrated, there was a need for greater collaboration, greater cooperation across all these entities. And so the Federal Open Market Committee, the FOMC, was established in the 1930s. The way that the FOMC is structured is that it has 12 members. Eight of those members always vote. So the seven governors at the Board in Washington, DC, always have a vote on monetary policy. And the president of the New York Fed always has a vote on the FOMC at every meeting. And after that, there are four remaining members out of those 11 remaining Bank presidents that get a vote, but that vote is for one year on a rotating basis. So we have 19 participants overall, and 12 of those vote on monetary policy. For the other members, they always participate, they always go to DC. They always provide their views about the economy and about the appropriate stance of monetary policy, but only 12 of those members are voting on monetary policy, basically on the federal funds rate. So, as you know, they do that to achieve two mandates that were given to us by Congress and that’s price stability, understood now to be inflation of 2%, and maximum employment. And maximum employment we infer by looking at a whole host of labor market variables. So now, from this, let me jump into the FOMC decision in May. In May, the FOMC decided a few things. It basically announced that it would raise the target range for the federal funds rate by half of a percentage point. It indicated that ongoing increases in the target range would be appropriate going forward. And it also indicated that it would start reducing its balance sheet in early June. Okay, so that’s a whole lot. These are meaningful decisions. So let’s provide a little bit of background to make sense of them. The first thing to note, as Laura mentioned, is that inflation is extremely high at the moment. If you look at the index that we’re trying to target and the inflation rate over time, you see that we’re above 6% right now. As a reminder, we’re trying to target inflation at 2%, so that’s a big gap. And it’s kind of a turn of events. If you look at what happened over the past 20 years, 30 years or so, you see that inflation has tended to hover around 2%. In fact, if you look at the past 10 years, right before the pandemic, inflation had a problem reaching 2%. So each time it reached 2%, it tended to be below. And so we had difficulties reaching our 2% target. Inflation was on average often around 1.6-1.7%. But now we have inflation that’s really high. In fact, it’s so high, you have to go back all the way to the early 1980s to see such high numbers. There are many reasons for this high inflation. Some of it is that consumption is extremely strong, supported by a lot of fiscal support that households received during the pandemic. We all know that there are a lot of supply-side disruptions still around the world. We see this in China right now, in Shanghai, because of new COVID cases. Factories are closing down and this is impacting us here in terms of higher prices. We also know that energy prices are very high because of the war in Ukraine. The same thing for food prices. We’re seeing this when we go to the grocery stores, we see this when we go to put gas in our cars. So the first thing is inflation is much too high. The second thing is that the labor market has been extremely strong also. What I’m showing is the evolution in employment, total employment, compared to where we were pre-pandemic. You look at the change compared to where we were just on the eve of the pandemic. And you see that, as the pandemic hit and we closed down the economy, employment basically collapsed and it declined by about 15% right there. Since then we clawed our way back, and employment started rising slowly again. And now what’s interesting is that we’re back to the level of employment that we had right before the pandemic. The thing to remember is that before the pandemic, we were in the midst of our longest expansion on record. Labor markets were very, very strong at that point, with a lot of employment. And so we’re back at those high employment levels, that’s really important to note. The second thing to note is that this is true for most groups. So if you look at the employment experience for Asians, for Blacks, Hispanics, and whites, we’re either back where we were pre-pandemic or even above. This is true, for instance, for Black, Asian, and Hispanics: their employment level surpasses where we were before the pandemic. And the strength in labor market that I’m showing here in terms of employment is true if you look at a whole host of labor market indicators: wage growth, quit rates, and so on and so forth. So labor markets are very strong. When we put together the high inflation numbers with the strong labor market performance, what it tells you is that the federal funds rate needs to be higher, and this is what the Fed is doing. In the next chart, you see the initial increase in the federal funds rate moving 25 basis points, that is, a quarter of a percentage point in March and half of a percentage point in May. The other thing to note is that if you look at the evolution of the federal funds rate over time, you see that the level we see today is still much lower than the historical experience. This is why the FOMC is indicating that ongoing increases in the federal funds rate will be necessary over time. So this is the background for the decision. And I know this probably triggers a whole lot of questions about the consequences of the policy action, and also just about where we stand in the economy and what we can expect going forward. In fact, when we go out in our communities, we get a whole lot of those questions. So I thought I would take some of those questions, try to answer them to try to provide maybe a little bit more insight about the situation we’re facing. One question that we often get is, “Is the Fed worried that people believe inflation is around for the long run?” So, is this a new normal basically. “Is it too late to get out of that inflationary mindset?” That’s a fair question, an important question. The answer is no, not right now, but it certainly bears watching. And I’m quite definitive about this because we have some data on that. The University of Michigan surveys households every month and asks them, what do you expect inflation to be in the next year, the year ahead, and what do you expect it to be in the longer run, 5-10 years out. So the blue line is inflation over the next year. And you can that inflation is expected to remain high. So clearly households are seeing high inflation numbers and they expect them to last for at least another year. So along that dimension, expectations are very high still. But now switch to the green line. The green line is inflation expectations that households expect over the longer run. And this is what’s kind of striking and interesting. Although we’ve seen upward movement in this index recently, if you look at the historical norm, at what happened over time, you see that it’s fluctuating more or less within normal ranges. So nothing alarming at this point. Clearly it bears watching, but what it tells you is either households are expecting inflation to kind of fade away or that the Federal Reserve will act to bring inflation back down to 2% over the longer run. So at this point, we don’t think that there’s an inflationary mindset being established, that we’re in a new normal at this point. Another question we often get is, “We hear that inflation is really affecting the cost of labor. Are you seeing any impact from that on industries?” And here, the answer is, yes. If you look at labor markets, I said labor markets are very strong at the moment and this is being reflected in very strong wage growth. Nominal wage growth is really strong at the moment. So the way to see this is to look at them doing two things here. I’m looking across industries, I’m looking at wage growth for the total private sector and for one sector in particular, leisure and hospitality, that has been really impacted by the pandemic. And I’m looking at two snapshots in time: the dark blue bars are December 2019, year-on-year growth for that period, and then the same thing more recently in April 2022. So the first thing to look at if you concentrate on the dark blue bar, December 2019, you see that in these two sectors, the total private-sector economy or leisure and hospitality, wages were growing at about the same pace, 3% on average. Kind of solid growth, but no difference across sectors. Now move to April 2022 and you start seeing big differences. First, nominal wage growth has really increased, nearly double for the economy as a whole. So quite noticeable changes in wage growth, but then you move to leisure and hospitality and now we’re growing about 11%. So wages are growing year-on-year about 11%, much stronger than the rest of the economy. And this is a reflection of the pandemic. Clearly, workers were reluctant during the pandemic to take a job in this sector because of COVID exposure, and so they wanted to minimize that. Some of them have switched sectors, have been employed in manufacturing instead, and now it’s difficult to bring them back. So there’s a lot of demand as the sector is reopening. People want to go back to the movie theaters and travel and go to the hotels. It’s difficult to find those workers. Enhanced wage growth is really increasing dramatically in this sector. So the question about wages is, “Are we seeing the impact of strong labor markets on wage growth?” The answer is yes, and we certainly see it in some sectors in particular. Okay, when we talk to people in our districts, what we hear is, “What are we seeing with supply chains and how is that influencing inflation?” So where are we seeing it? We know we’ve been impacted by supply-side disruptions. Like over the past two years, we’ve had problems getting supplies. If you’ve tried to buy bicycles or any goods, it’s been difficult, you had to wait longer to get that. Here I’m showing one index that indicates this, and it’s the time it takes for supply to get delivered. The Institute of Supply Management surveys vendors and asks them about the time it takes to deliver their goods. This is a diffusion index, and the upshot here is that you want to focus on 50; the bottom horizontal line is 50, and above 50 means that it’s slower, it takes more time to get goods delivered. So what you see is, with the pandemic, we had a big jump in the index. Of course, it was difficult to find workers, people were staying home. The time to deliver goods really jumped, and it has stayed really high right now. It’s declining a little bit, but it’s still above 50. So compared to pre-pandemic levels, what we’re seeing is that it takes more time to deliver goods. And so the price of those goods tends to go up because they’re more difficult to get, and that’s feeding into inflation. Now, the issue for the Federal Reserve is that the tools we have—interest rates, monetary policy—really work on the demand side. It doesn’t really work on the supply side. So we cannot repair supply chain disruptions, but we can bring demand more in line with the supply we have. Another question we get is, “Will raising the federal funds rate hinder the labor market?” So this is really on everyone’s mind, clearly. And the way to think about this is that our tools really work on demand, either increase demand or slow down demand. As we raise rates, this would tend to slow down demand, and it would have an impact on the labor market, tend to slow down the pace of job creation, for instance, in the labor market. The thing to remember though is that we have a labor market that is extremely strong, as I mentioned at the beginning, focusing on employment. But you see this also when you look at the ratio of job openings to the number of workers who are looking for jobs. You can see that now we are really at an all-time high compared to where we were, let’s say in the early 2000s. We’re close to two job openings for any worker who’s looking to find one. And so clearly there’s a lot of demand for workers and the supply is not quite right there. And so again, policy can act to bring supply and demand into better balance. Another question that we often get is, “Why did the Fed decide to raise interest rates by half of a percentage point in May, and have they done that before?” It really feels that this is something new, somehow. And it’s true: If you look back in the past 20 years or so, the Federal Reserve, when it raised interest rates, when the FOMC raised interest rates, it tended to do so fairly gradually, by raising rates by a quarter of a percentage point at a time. In fact, you have to go back to 1994 to see increases like that. So when we go back to 1994, we were just coming out of a recession in the early 1990s. The federal funds rate was relatively low, and I’ll explain this chart in a sec, was relatively low, and needed to be adjusted upward. And so between the end of 1993 and early 1995, the federal funds rate went from 3% to 6%. So it doubled basically within a year. And some of the increases that we saw then were 50 basis point increases, basically half of a percentage point, and even three-quarters of a percentage point. So the rate doubled very, very quickly. And so this is kind of an interesting episode because here, I’m showing you the evolution of the unemployment rate. And so you see that the unemployment rate rose following this recession. And then go between this period: 1994 to 1996. What you see is that it started slowing, but it didn’t collapse. So the unemployment rate slowed and basically, after the Federal Reserve raised rates, it tended to stabilize, it just stabilized around here. And then it even continued declining after that. At the time, this became known as the longest expansion on record, and all this policy experience became an example of good policy, of a soft landing, that the Federal Reserve was able to raise rates and the economy continued chugging along at a fairly decent pace, at a more sustainable pace. I mentioned a few things at the beginning—that the Federal Reserve decided to raise rates, anticipated further increases in the federal funds rate to be necessary. And then the last thing is that they indicated they would start reducing the balance sheet in June. So this is always very obscure, this topic. People have a lot of questions about this. The first thing that they ask is, “What’s the Fed balance sheet and what’s the plan for it, and how will it affect the economy?” So let me go through this a little bit. The Federal Reserve, just like any businesses, just like any financial institution, has a balance sheet. The balance sheet is fairly simple. It’s very big, but it’s very simple at the same time. A balance sheet has two sides: assets and liabilities. And these are the key elements that you have to think about, about what’s on the balance sheet. The first thing you think about is assets. There are two things that we have: We’re holding Treasury securities and agency debt. Treasury securities, think about three-month Treasury bills, you could think about 10-year Treasury securities. That’s the type of things we hold. Agency securities, think about debt issued by government-sponsored enterprises, think Fannie Mae or think about other federal agencies that are issuing debt. And we’re mandated by Congress to only hold this type of asset. So it’s not like we can go and buy stocks. We cannot do that. We’re forced to buy only those types. Now the liabilities is interesting also. So the first thing is that one liability to the Federal Reserve is the currency in circulation. We’re supplying as much currency as demanded by the public. And those notes are a liability to the Federal Reserve. The second thing to realize is that we are the bankers to the federal government. So the federal government has an account at the Federal Reserve that it uses to transact. So, for instance, when the federal government receives tax receipts, it puts it in its account with us at the Federal Reserve. And just like any account, just like when you go to a commercial bank, the funds that are from the federal government in this account, these deposits, are a liability to the Federal Reserve. It just works like a commercial bank for you. And the commercial banks also have accounts with us and they can park money with us. And those funds are also just like a form of deposits and, hence, constitute a liability to the Federal Reserve. So, we have the assets, we have the liabilities. The thing is that, over the past 15 years, the size of the balance sheet has really grown. And you can see this very clearly from this chart. I’ll point to two time periods: 2008-2009, and what we’ve experienced more recently with the pandemic. So, you see that over time, the size of the balance sheet really jumped. This is as a ratio to nominal GDP. Before 2008 and 2009, the size of the balance sheet was less than 10% of GDP. And now we’re about 35% of GDP. So, the balance sheet has really exploded in size. Two events, if you think about where we were here, 2008-2009, that’s the Great Recession and the financial crises at the time. What did the Fed do to support the economy? We brought the federal funds rate down to zero. And because we cannot lower it more than that, the Federal Reserve started doing a new policy called quantitative easing. Basically, we bought longer-term assets, longer-term securities from the Treasury. That tended to increase the size of the balance sheet. We were just holding more assets. Move forward to the post-pandemic and the same thing occurred then. You’ll remember in the spring of 2020, the economy collapsed, there was a lot of turbulence in financial markets. The Federal Reserve, again, brought the federal funds rate down to zero and started buying longer-term assets. And the reason it’s doing this is that by buying assets it’s lowering long-term interest rates, and that tends to stimulate economic activity. But the reflection of that is that the size of the balance sheet really increased, and you can see the jump, the very discrete jump right here in 2008-2009 and right here at the start of the pandemic. Now, that’s one reason for the size of the balance sheet increases. The other thing is that the economy grew. And so the demand for currency in circulation has increased. So, that’s another factor why the size has grown over time. And also we’ve changed operating procedures, and now we’re operating in a different system than we were back in the 2000s. We’re operating in a system that’s called ample reserves. So there’s just more reserves in the system. But that’s more technical, not for today. The point I want to make here is that the Federal Reserve has decided to reduce the size, to come back to something a little bit more normal. And I want to indicate that here we’ve been able to do this. After the Great Recession, we indicated that we would reduce the size of the balance sheet. And this has been done in a very gradual manner, operating in the background, not really a tool of monetary policy. And this is what’s going to happen again this time. The Federal Reserve is indicating that it’s going to reduce the balance sheet in a gradual manner, again, operating in the background. But the main tool of monetary policy remains the federal funds rate. So, the year ahead is going to be a challenging one for policymakers, no doubt, but the main goal will be to bring inflation back down towards the 2% target. I think what’s been done so far in terms of raising the target range for the federal funds rate and starting to reduce the balance sheet are really initial steps in this process, and more will be necessary. We’ll stop here. I’m delighted that you could join us, and I’m really hoping that you’ll do so for the next FOMC Rewind Live. Thank you. (gentle music) (audience applauds) You may also be interested in: • Watch FOMC Rewind: What the Fed’s May 2022 Decision Means for You • Watch FOMC Rewind Live—Conversations Breaking Down Fed Policy Announcements for March 2022 • Listen to Learn, Engage to Serve: Becoming a Community-Engaged Bank The views expressed here do not necessarily reflect the views of the management of the Federal Reserve Bank of San Francisco or of the Board of Governors of the Federal Reserve System.
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