Learnings from JP's speech at Brookings Institute on Economic Outlook

FED chair Powell spoke at the Brookings Institute on economic output on 30 Nov 22'. Here are some crucial points from his speech for us, the emerging economists, to understand and improve our economic comprehension: 

    >>> MOM inflation data are quite volatile and not heavily reliable. Dips in MOM inflation are usually seen with higher inflation numbers in the consequent months, as MOM numbers provide a delusional outlook of improvement while the reality remains anchored

    >>> Though FED is concerned with overall inflation, core inflation is a more accurate indicator of where inflation might be heading

    >>> Forecasting core inflation is very difficult and uncertainty persists going ahead

    >>> FED wants interest rates to be sufficiently restrictive. JP believes significant progress has been made. However, the pivot rate is still unclear

    >>> Interest rates are rising to slow aggregate demand. Slowing demand would aid hindered supply chains to catch up with the demand and stabilize prices

    >>> Rising rates have indeed slowed demand. However, FED wants the dampened demand to sustain for some period

    >>> Despite the slower growth though, inflation has not necessarily come down. To better understand core inflation, JP decomposes core inflation into three sub-components - (1) Core goods inflation (2) Housing services inflation (3) Core inflation (exl. housing)

    >>> Core goods inflation has moved down. Housing services inflation has risen rapidly. Core inflation (exl. housing) has fluctuated without any clear trend

    >>> Core goods inflation had risen post-covid owing to sharp demand recovery meeting pandemic-hampered supply. Over the course of the year, indicators are showing easing supply chain pressures, improving imported energy prices etc. 12-month core goods inflation is still at high levels, however, they have eased significantly since last year

    >>> Housing services inflation measures rental costs including the rental equivalent cost of the owner's self-occupied cost. This inflation has continued to rise over the past 12 months. This inflation, however, lags other inflation "because of the slow rate at which the stock of rental leases turns over". By rental lease, I believe, JP implied a rent agreement. Since rent agreement that provides rental prices are fixed for a time period, for this reason, they would operate in a lag. Only when the rental agreements would be renewed (turnover), that the prices would reset to reflect the changing macro environment. Hence, the market rate on new leases is a leading indicator as to where the housing market will go. The prices in new leases have been falling sharply in recent quarters. The housing inflation has been rising because the existing leases that are expiring are resetting to higher price levels of the new leases. But as new lease prices are falling, over the next year, resets would calm as well, thereby, lowing this component of inflation

    >>> Core services (excl. housing) cover a wide range of services like education, healthcare, haircuts etc. This has the largest weight in the CPI basket. In this sub-category, wages are the most important factor in determining prices. Hence, the labour market holds the key to understanding inflation here. The demand in the labour market far exceeds the supply. Nominal wages in the labour market are exceeding what's consistent with 2% inflation. A large labour shortfall occurred during the pandemic. This shortfall is not expected to close anytime soon due to (a) lower participation rates and (b) slower population growth, 

    (a) Participation dropped sharply during the pandemic due to sickness or precautions. It was expected to bounce back post-pandemic and indeed been for workers in their prime years. However, overall participation is still below the pre-pandemic trend. Recent research shows that the fall in participation has largely been due to excess retirements (accounting for 2 million of 3.5 million shortfall in the labour force). Excess retirements have largely been owing to (i) health effects owing to the pandemic (ii) the high cost of searching for elderly workers who had been laid off during the pandemic (iii) the surge in stock markets post-pandemic increased wealth and allowed early retirements

    (b) Slower population growth owing to slowing immigration and high death rates during the pandemic has also contributed to a labour shortfall

            --- Policies to support labour supply are not in the domain of the FED. Their policies work on the demand side. However, policies (any) that support labour force participation would overall benefit the labour market and the economy in the long run. Having said that, FED's policies would try to calm the labour demand to match with supply (exogenous)

            --- Current job openings are high and unemployment levels are at record lows. Slowing GDP growth, though, has slowed job growth rates, however, it's still in excess of the population growth rates. Since, job creation exceeds population growth, implies, labour market tightness (or labour scarcity). Wage growth is slowing but still way higher than what's consistent with 2% inflation. Wage growth inflation wasn't a primary jerk to the inflation, indeed it was goods inflation that occurred due to supply chain bottlenecks during the pandemic. However, eventually, the inflation spread to this sub-category. FED does want wages to go up but they should be consistent with 2% inflation. JP suggests that the current wage increases are about 2% higher than what's consistent with 2% inflation. These numbers, he mentioned, come by analysing the employment cost index and average hourly earnings index

    >>> Relationship between job openings and unemployment is a flawed one. A typical thinking is that with decrease in job openings, unemployment rises. However, researches have shown that it is very much possible for job openings to decline without unemployment rising significantly. This may be due to outzied levels of job openings. Traditionally FED has used unemployment as an indicator of tightness, however, recent events have shown that it may not be an accurate indicator as job openings are declining but unemployment levels at low rates. The issue, however, is not essentially is not with this framework of using unemployment as the FED's model uses unemployment gap (different between unemployment and natural rate of unemployment). The issue is calculating what the natural rate of unemployment is. It is very tricky to estimate it and in presence of shocks like covid, it may dramatically shift as well. It was estimated at the onset of pandemic that the disruption may have pushed natural rates upwards, i.e., for any given level of unemployment the labour market is tighter (or unemployment level is too low). Fed looked at job openings, quit rates, reservation wages etc in order to realize that the natural rate has moved up

      >>> Inflation forecasts are very difficult. Therefore, fed looks at asset prices, borrowing costs, financial conditions, real rate curve etc to determine where the inflation might be heading alongiwth the projections.