Tom Barkin

Thank you for that kind introduction and for having me with you. You may know that the last time the Fed tackled high inflation, in the ’80s, homebuilders sent Paul Volcker two-by-fours inscribed with the message: Lower interest rates. I look forward to hearing from you today but am hoping you checked your lumber at the door.

To set up our discussion, I thought I might share how I am seeing the economy. Let me caution these are my thoughts alone and not necessarily those of anyone else in the Federal Reserve System.

As you well know, the Fed has moved aggressively against inflation that was way too high. We have raised rates 525 basis points in just a year and a half. Hopefully you agree we needed to take action because, if there is one thing we have relearned over the past two years, it is that everyone hates inflation. High inflation creates uncertainty. As prices rise unevenly, it becomes unclear when to spend, when to save or where to invest. Inflation is exhausting. It takes effort to shop around for better prices or to handle complaints from unhappy customers. And inflation feels unfair — the wage increase you earned feels arbitrarily taken away at the gas pump.

We are the folks mandated to tackle inflation, but we only have one primary tool: raising interest rates. It’s a powerful tool, as you know, but a blunt one. As we raise rates, borrowing becomes more costly, banks pull back, capital investment slows and consumer spending weakens, particularly in interest-sensitive sectors like real estate, autos, manufacturing and deal-making. Reduced demand lessens the rate of inflation in time.

But this tool doesn’t hit all sectors evenly. And, of course, I recognize our rate hikes hit your industry early and disproportionately.

I hope you agree we are making progress on inflation. Our inflation target is 2 percent. In September, 12-month headline CPI inflation was 3.7 percent, down considerably from its peak of 9.1 percent in June 2022. Core was 4.1 percent, and in the last three months has been 3.1 percent annualized. We aren’t there yet, but we’re headed in the right direction.

We’ve had some help. Supply chains have largely opened up. Labor force participation has rebounded. And gas prices have fallen from last year’s highs.

Now there’s a story — a plausible story — that weakening demand is already working to bring inflation down to 2 percent. Demand is weakening because rate increases work with a lag, and many models estimate their impact really starts to hit around now. Demand is weakening as long-term rates rise. Demand is weakening because credit conditions tightened following the bank turmoil earlier this year. And demand is weakening because the pandemic economy continues to fade. Savings are being spent down. Fiscal stimulus has waned. As demand settles, that reduces its imbalance with supply and brings inflation back to target.

It's a plausible story but — if I can borrow from my time as a Boy Scout — this isn’t our first campfire. We have all told ourselves a number of stories about inflation over the last two years. They each seemed compelling at the time, but none have yet seen a happy ending. At first, inflation seemed transitory, as fiscal stimulus faded and the economy fully reopened. Then supply chain remediation and lower commodity prices looked likely to feed through to prices. Then, when we raised rates and shrunk our balance sheet so aggressively last year, you might have thought inflation would have come back in line quickly. But inflation remained elevated.

So, I am still looking to be convinced, both that demand is settling and that any weakness is feeding through to inflation. These are particularly hard questions to answer today because there is somewhat of a disconnect between the data and what I hear on the ground.

The data will tell you that demand is not weak. GDP remains solid, growing 2.1 percent in the second quarter. S&P Global forecasts a remarkable 5.2 percent in the third quarter. That growth has been in no small part due to the consumer who has continued to spend down pandemic-era savings and benefit from higher wages and rising stock prices. Despite a slowdown in housing activity, home prices have renewed their upward climb this year — a testament to continued demand amid tight supply. And after slowing last year, business investment has rebounded, reaching 7.4 percent annualized growth in the second quarter.

The data will also tell you that the labor market is not weak. Unemployment remains low at 3.8 percent. Job growth came in at 336,000 in September, triple the breakeven pace. It has averaged 266,000 over the last three months. Vacancies remain higher than pre-pandemic levels. Wage growth is still elevated. Initial jobless claims in the last four weeks were below 2019 levels.

So, if you believe the data, something’s got to give. Demand that strong isn’t the fix for inflation.

But I don’t like depending solely on data. It comes in a month late. Then it is revised multiple times. And it is adjusted by seasonal factors distorted by the pandemic. That’s why I’ve made it my priority to be on the ground every week talking to groups like this in the hopes of understanding the economy better. I’m hearing a different message on the ground.

I’m hearing demand is softening. Interest-sensitive sectors like yours are of course feeling the impact of higher rates. Businesses that sell to lower-income consumers tell me those consumers are stretched thin and reprioritizing their spend. Middle-income consumers are trading down. Banks are feeling margin pressure and have stepped back from riskier sectors, newer customers and less profitable loans. Construction backlogs are being worked down.

I’m also hearing that parts of the labor market are coming into better balance. It’s easier to find workers, especially professionals. Turnover is down. Wage pressure still exists but has moderated from last year’s extreme levels. An exception, to be sure, is skilled trades, which remain quite tight.

The question is how much of this softening is feeding through to inflation. Goods deflation is back, as inventories and demand come into better balance. Rental vacancies are increasing, which should mitigate inflation in that key sector. But while most businesses acknowledge that the period of major pricing power is behind them, I’m still talking to a number that want and feel they need to push price where they can.

So, I see an economy that is much further along the path to demand normalization than much of the data would tell you. But the path for inflation isn’t yet clear. That’s why I supported our decision at our last meeting to keep rates steady and wait for more information, both from data and conversations on the ground. We have time to see if we have done enough, or whether there’s more work to do.

But I recognize there are a wide range of potential paths going forward — from resurgence to recession to return to the pre-COVID-19 normal. And we are walking a fine line. If we undercorrect, inflation re-emerges. If we overcorrect, we do unnecessary damage to the economy. And even the best policy has the potential to be waylaid by external events, as we’ve been reminded with the recent news from the Middle East.

I will say that if we do see the economy weaken, it’s worth remembering that not all recessions are created equally. We’ve been scarred by our memories of the Great Recession and the Volcker Recession, but they were particularly long and deep. As I talk to firms, I hear reasons to believe that any downturn this time might be less severe.

First, it could cause less dislocation in the labor market. When you think of a slowdown, you naturally think of 2008 when manufacturing workers were sidelined across the Rust Belt and those last into the workforce bore a disproportionate burden. But those are the workers I hear are most in demand today, as manufacturing plants, hotels, construction sites and restaurants remain short of workers. Large company layoff announcements this year have primarily targeted administrative functions, not front-line workers. These professionals may have a lower propensity to file for unemployment, be unemployed for shorter periods and often can leverage backup savings to bridge their consumption. Unemployment for those with a college degree is just 2.1 percent.

Second, a spending slowdown could be mitigated by latent demand. Houses and cars became expensive and hard to find. But should supply open up in a weakening economy, I suspect we would find a number of buyers who have deferred purchases over the last few years and are ready to buy.

And, finally, the prolonged recession preamble could reduce the cost. This has been called the most predicted recession ever. Businesses have been planning for a downturn for 18 months. They have slowed hiring, streamlined costs, managed inventory levels and deferred investment. Banks have cut back on marginal loans. Many consumers have tightened their belts. So, if a recession does come, the economy should find itself less vulnerable. And if it doesn’t come, today’s conservatism can fuel tomorrow’s revival. You might even argue that the recent strength in the economy is being supported in part by businesses, consumers and governments that have outperformed their recessionary forecasts.

So, that’s how I’m seeing the economy. I’m interested in your insights. Let me open it up now for questions and input.