Takako Hatayama-Phillips
Before the COVID-19 pandemic, the Federal Reserve was struggling to bring inflation to its 2% target. All of that changed with the virus, as the economy nearly came to a standstill. months after the economy restarted, inflation rose as demand increased amid part shortages and production constraints. In addition, the prices of raw materials rose.
To reduce demand, and with it inflation, the Fed increased the cost of borrowing, raising its benchmark interest rate by 420 basis points by the end of 2022 and an additional 25 bp in February. Inflation has slowed from its peak of almost 7% in June to 5.4% in January 2023, but is still well above the 2% target.
“The disinflation boost we need is far from certain,” said Mary Daly, president of the Federal Reserve Bank of San Francisco. Several factors will be key in determining what kind of economic outlook the central bank will navigate in the coming months. In any case, it does not end with its tightening.
“To put this episode of high inflation behind us, more policy tightening will probably be needed, sustained for a longer time,” he said in a prepared speech at the Princeton University economic symposium on Saturday. He did not specify how much higher he thinks the policy rate will go.
Four factors that could offset past deflationary trends are: lessening global price competition; continuing domestic labor shortages; investments in renewable energy and energy efficient technologies; and a change in inflation expectations.
If “pre-pandemic trends re-emerge as the dominant structural forces, then our efforts to reduce inflation will be reinforced by the natural characteristics of the economy,” Daly said. “But if the old dynamics are overshadowed by other, newer influences and inflation pressures start to push up rather than down, then policy may need to do more.”
As for what’s next, he said: “We’ll work in the economy we have and prepare for the economy that’s coming. That’s what this moment calls for.”
1:40 p.m. Eastern Time: “There is excessive turnover for the Fed to do more than we can legally or effectively do,” Daly said. The Federal Reserve primarily has one tool: interest rates. “Our tools only work on demand, not on supply.”
1:35 p.m. Eastern Time: Addressing the tight labor market, “I don’t see a recovery in the labor supply that we have seen in previous expansions. Much of the loss of workers is in the 55 and older (age) group.”
Update at 1:33 p.m. ET: More communication from the Fed is helping to reduce some of the lag in the effect policy has on the economy, he said during the question-and-answer session. Still, it still takes longer for the effects that the policy has on some parts of the economy. “There is still a long and variable backlog,” she said.
With the labor market so tight, there is still more work to be done to adjust it, he said.
Please check back for updates.
On Friday, Richmond Fed President Tom Barkin stressed that it will take time to bring inflation to the Fed’s 2% target.