Richmond Fed CEO: Inflation headed in right direction as economy reaches a crossroads

Richmond Fed CEO: Inflation headed in right direction as economy reaches a crossroads

October 19th, 2023

At the Currituck Chamber of Commerce’s annual Coastal Economic Summit last week, Richmond Federal Reserve Bank President and CEO Thomas Barkin said he feels steps taken on interest rates have had the desired effect of bringing down inflation, while noting a soft recession is still possible.

Presented by Twiddy and Company, the summit was attended by several dozen members of the Greater Outer Banks business community, and also featured presentations on tourism and transportation issues in northeastern North Carolina.

Barkin has led the Federal Reserve’s Fifth District since 2018, and also serves on the Chief Monetary Policy Body, the Federal Open Market Committee and is responsible for bank supervision and the Fed’s technology organization.

Thomas Barkin, President and Chief Executive Officer Federal Reserve Bank of Richmond, speaks at the Currituck Chamber of Commerce Coastal Economic Summit presented by Twiddy & Co. on Oct. 13, 2023. [Sam Walker photo]
During his opening remarks, Barkin reviewed the steps taken by the Federal Reserve Board to address inflation, raising the key interest rate by 500 basis points to about 5.3 percent.

“If we learned anything, over the last two years, it’s that we hate inflation,” Barkin said. “I think everybody hates inflation, because it creates uncertainty, it’s hard to know where to put your money, it’s hard to know when to spend or when to save. It’s exhausting.”

“It’s exhausting to try to shop around if somebody tries to charge you more money, or it’s exhausting to try to go to your customers and try to pass on higher costs. And it just feels unfair,” Barkin said.

“If you’re a worker, and you’ve just gotten a pay increase, you think that’s because you’re actually getting more value than then you have to give it away at the gas pump,” Barkin said.

But Barkin noted that doing something about inflation is not easy, and that raising interest rates is “a pretty blunt tool”.

“When you raise rates, people who spend in interest sensitive sectors like housing or automotive or manufacturing, a pullback on borrowing becomes more costly, banks get a little tighter with credit, capital investment slows consumer spending weekends,” Barkin said. “The reduced demand then reduces the rate of inflation over time.”

Barkin’s speech at the Currituck Extension Center in Maple came one day after new numbers were released showing cost percentage index inflation was 3.7%, while core inflation was 4.1%. The Fed’s target inflation rate is two percent.

“That’s down from a peak of over 9% in June of 2022,” Barkin said. “If you analyze the last three months we’re at three percent, So we’re not there yet, but we’re heading in the right direction.”

He noted much of this round of inflation has been driven by supply chain issues, as well as fuel prices driven in part by the war in Ukraine, but that those two factors have started to ease recently.

“I’d say there’s a plausible story here, that weakening demand is already bringing down inflation,” Barkin said. “And that means we could get to normal inflation levels with a minimum of pain.”

“Demands is weakening in part because rate increases work with a lag,” Barkin said. “And so it just takes time to have a full effect demands weakening part because credit conditions have tightened coming after the Silicon Valley Bank situation.”

He also said demand is weakening because post-pandemic spending was spurred by “fiscal stimulus or excess savings or revenge spending, and that’s thinning.”

Barkin offered that the data they see at the Federal Reserve is “actually pretty confused”, and that attending summits like the one held in Currituck was a way to better learn what is happening on the ground.

“The data will tell you that demand is not softening at all, but rather just a few pieces,” Barkin said.

“GDP grew two percent in the second quarter that’s a little higher than normal,” Barkin said. “Most forecasters have GDP growing four to five percent in the third quarter.

“That’s largely due to the consumer, who’s still spending down their pandemic-era savings, benefiting from higher wages and higher stock prices,” Barkin said.

“Despite the slowdown in housing activity, home prices have started going up again, which is just a testament to continued demand and tight supply,” Barkin said. “Business investment is growing as well up 7.4% in the second quarter.”

“The data will say the job markets not solved, we got a jobs report last Friday, unemployment at 3.8%,” Barkin said. “That’s historically very low number. Job growth continues 336,000 In September, that’s three times the replacement rate.”

“Wage growth is elevated vacancies are higher than pre pandemic levels. initial jobless claims are still at all time lows. So if you believe the data, you’ve got really strong demand and a really strong job market,” Barkin said.

And if you believe that data, something’s got to give, you can’t have inflation come down to target with demand that’s this strong,” Barkin said.

“I don’t like depending just on the data. It comes in late. It’s revised three times. It’s adjusted by seasonal factors that are distorted by the pandemic,” Barkin said.

He shared what he had heard at other similar gatherings, including that demand truly is softening, especially in interest rate-sensitive sectors like housing, manufacturing and deal making, that business that sell to lower income customers say those consumers are stretched thing and reprioritizing their spending, and that middle income consumers are trending down.

“I’m hearing that banks are feeling the margin pressure in a step back for riskier sectors, newer customers and less profitable loans,” Barkin said. “I’m hearing that construction backlogs are being worked down. I’m also hearing that the labor market is still tight, but it’s coming back into better balance.”

“I’d say the one exception I’m hearing in the labor market is skilled trades, construction, plumbers, carpenters, nurses, veterinary assistants do people have to get some degree get to work, those…are still a very tight market,” Barkin said.

He even noted that there’s been some deflation in the price of goods, such as used cars, apparel, and other similar sectors as inventories and demand come back into better balance.

“So I see an economy that’s a lot closer than normalization, that most of the data would tell you,” Barkin said. “And that’s why on the rate side, I was comfortable in our last meeting with pausing (interest rate hikes) and not doing any more.”

“I think we’ve got time to see if we’ve done enough, or if there’s more than we need to do,” Barkin said.

Recession threat not over, economy at a crossroads

Barkin warned that there are a wide variety of potential paths the U.S. economy could take in the near future.

“You can describe a resurgence story like the one that data is telling you, you can describe the recession story where the cliff is just around the corner and we’re about to run off, or you can describe the return to a pre-COVID trend,” Barkin said.

But he said that is a “thin line to walk”.

“If we do too little, we run the risk of inflation coming back,” Barkin said. “Even worse, if we do too much, we run the risk of driving the economy south unnecessarily.

“And even the best policy can be interrupted by some outside event,” Barkin cautioned. “Don’t forget the last three recessions were driven by the pandemic, a financial crisis, and 9/11.”

Barkin said that when you think recession, you “think of something big and violent, deep and long”, but that on the current path it would likely be an easier decline than previous downturns.

“I will say that if the economy softens or weakened somewhat, that we all have to acknowledge that we have PTSD from the financial crisis,” Barkin said.

He said there are several factors in the current state of the economy that if a recession happens, it’s going to be a much softer fall.

He noted that major layoff announcements over the last year have been mostly in professional services, rather than the trades and manufacturing as was seen in 2008.

“I’ve talked to (companies) courting workers and saying they can’t afford to take the chance that I lay somebody off, and then I can’t rehire them,” Barkin said.

He said that the housing and automotive markets are hiding some pent up spending.

“Housing sales are down, but not because there’s no demand, it’s because there’s no houses,” Barkin said. “If you did get more houses on the market, if you did get more cars on the market, I think there’s latent demand out there that hasn’t been met.”

And he said the sheer mention of a possible recession for the last 18 months has had an effect.

“If you spend time talking about recessions, and planning for recession, than the average business has already taken some steps to cut back on spending, be a little more conservative on hiring, be a little more conservative on capital expenditures, or inventories,” Lakrin said.

“And so were we to have a downturn, I just think you’re gonna find people less out over their skis than perhaps what we’re used to,” Barkin said.

“So that’s why I’m saying the economy, the demand is very strong, but I don’t think it’s quite as good as what you read. The labor markets still tight, but it’s getting better inflation is down, when we’ve still got a ways to go,” Barkin said.

Attendees at the summit during a small group discussion about tourism. [Sam Walker photo]

Questions from Outer Banks business professionals

Q: “Do you think that 2% is still a good goal for inflation? Or do you think it should be higher at this point in time?”

A: “So every central bank around the world has 2% as its target, there’s nothing magical to 2%. It was designed with a theory that if you if your target was zero, that the risk was you get deflation too often.

And when things can be cheaper tomorrow than today is something you want to avoid, because it really does constrain and the economy hasn’t settled. And so they wouldn’t have a little bit of a cushion. There’s also a measurement error.

If you think about encyclopedias, we used to buy encyclopedias. The price of an encyclopedia now is absolute zero, because you got it in your phone. But it’s not measured, it just leaves the database.

And so there’s some reasons to have it not be zero. I think the challenge with changing the target is that you haven’t hit that target.

If the Fed has any weapon, its credibility, and if we go out and say, “Yeah, you know, might be easier if we just set a target for 3%”, then who’s gonna believe 3%? And so it’s just a prescription to have inflation go ratchet up even further.

I’ll also say it’s not like 2%, some magical unicorn and nobody’s ever had, we hit it for the 30 years before, two years ago. So as I said, the last three months were 3%. 3% doesn’t feel very far from 2%. I don’t think it’s that big of a journey.

And so I think, what you can’t really change target midstream. I think you just destroyed all credibility in your new target.”

Q: “We did hear a lot about the 2% inflation target. And as somebody who’s old enough to remember the late 70s and early 80s when rates were 15, 16, 17%, there’s a whole generation who has been used to the 2% interest rate. What do you see, is there a target interest rate once inflation goes down?

A: ” So there was interesting chart I saw the other day, when the US debt first came on the market when Alexander Hamilton and everybody else created the first central bank back in late 1700s, that the average interest rate since that time has been what the interest rate is today.

So we finally, after all these increases, finally gotten the 10-year treasury to the level of the average of the last 235 years.

Which is to make the point that they’ve been 16%, 8%, 0%, now they’re a little less than 5%. That’s normal. That’s average for 10-year or a 30-year.

The economists do a lot of work to try to sort through where do we get a return to everything’s back and okay. And there’s a phrase that I use called the “neutral rate of interest”.

And I’m now talking about the overnight rate is more like 2.5% to 3%, than it is like today, 5 or 5.25%. That would then bring the 10-year bill down a little bit, but that’s what they think.

It’s more of an academic exercise than a practical exercise. To me, it’s when you’re no longer stimulating and no longer restricting the economy.

I do believe today, we are restricting the economy…I do not think that it’s back to where we were in 2013, when when you had overnight rates at zero.

And what I just say is, is that a whole bunch of factors over the last 30 years, that have been tailwinds to our ability to control inflation.

Things like globalization, things like demographics, things like fracking, things like access to offshore labor pools, things like Ecommerce, which has allowed inflation to stay low.

It’s a lot easier to envision today headwinds to control inflation, globalization, energy transition, the shrinking of the working age, population, high fiscal spending, and debt, all of which are working against that.

And so that implies have a somewhat higher interest rate over the next several years than you perhaps did over the last 10 years. But we’ll we’ll see.”

Q: “Given the global situation right now with two wars going on, how do you see that affecting our economy? In the next 6 months, 8 months, 12 months, a year, two years?”

A: “It’s really hard to know. I’m completely unqualified to answer what’s going to happen geopolitically in these wars. So I’m not going to let that stop me. Who knows whether these turn into ‘boulders’ or not?

But there just a couple of historical reminders. It’s been 50 years since we had a war in Israel. And when that happened, the Arab countries bonded together and weaponized OPEC, and our oil prices started to spike. So is that going to happen now? I hope not.

But if oil prices started to spike, that’s a serious issue for our economy, both on the demand side, and on the pricing side.

When Russia went into Ukraine…food prices spiked and so did oil prices. And again, that was bad for the economy.

So disruptions in global supply chains are bad for us. And were these things to turn, that creates both price pressure through the oil prices, but also a demand reduction, because higher oil prices are really the clearest thing out there, that leads to recessionary tendencies.

Because people who are living on the edge, if gas prices go up, have to cut back somewhere else. And that reduces. And its the same for companies.

But is that what’s going to happen? It’s just hard to know. And I think, on the Russian side, and again, this is I just want to triple warn you guys, I know nothing about what I’m about to say.

But on the Ukraine-Russian side, they’ve been in a stalemate for a year. I feel like political support for Ukraine is at least in enough question that maybe they’ll end up in some conversations. That feels somewhat more stable than the Middle Eastern one, which could go 100 different directions.

I think the biggest risk is commodity prices in both cases. So that’s that’s the thing to watch.”

Q: “In my conversations with realtors here, cash purchases are still are very much driving the business. And so two questions, where’s that cash coming from? And how long will it last?”

A: “The big picture on housing is we overbuilt housing for the 10 years after the Great Recession nationally.

That wasn’t a huge issue, because a whole generation of millennials decided that they really did feel the need to own a house and a lot of the story that we all grew up with, which is, you know, you borrow as much as you can to buy your house because it will appreciate the value. and that’s how you make, you know, create wealth kind of disappeared after the Great Recession.

So COVID hits. And what happened?

First of all, people spend 24 hours a day in their house. And if you spent 24 hours a day in your house, the number one thing you learned is you don’t like your house.

And so, you know, people started buying second houses, people started trying to move out of their houses demand for housing, and then remote work, which means you you’re going to be working for a better office, you might want a better deck.

So demand for housing just started to blossom. Millennials got to the age where they wanted to buy.

At the same time, you know, those people who usually would have sold their house and moved into an assisted living facility or whatever, they weren’t going to do that during COVID.

And so the supply of housing strong. So you have huge demand for houses big drop. Price of houses shoot up, right? And that’s the world we’re living in.

You had all this craziness, where you had houses going for $25,000 over list, all that stuff.

We’ve raised rates…that has definitely quieted the froth around housing, and there are fewer bids.

On the other hand, there’s a lot of people with a 3% mortgage who don’t want to sell their house and buy another house at an 8% mortgage.

I should make this public service announcement for the realtors as well here and just say, if you’re waiting to buy a house, because you think rates are going to come down, go ahead and buy a house because when rates come down, you can just refinance your mortgage.

And so a disproportion is being bought by cash buyers now, where’s the cash coming from?

The reason I asked that the second home is there are a lot of people who have decided to move out of Connecticut or whatever other relatively dense place, they’re in into a place that they want to live.

And I sell their house for a lot of money, and they buy another house for that same money. So that’s one source of cash.

And house prices are up 40 plus percent since before COVID. So if you sell your house, that is a very real source of cash.

The second is equities, because the equity market is also up 35% or so from before COVID. And so the people who have liquid assets and equities also are pretty high on cash.

The third source is there are a set of people who didn’t spend as much as they thought that we have spent during COVID locked in their house didn’t go out to eat, didn’t go on vacation.

And so the stock of savings in this country, which normally runs at about 6% ranted about 13% for a year and a half. So that 7% off of the national debt that’s a lot of money.

Now, some of that’s being spent on Taylor Swift tickets or on or on international travel. It’s being spent down but there’s still probably a trillion dollars in excess savings that are around that were before COVID.

Q: What about the corporations that are buying up large amounts of housing in densely populated areas, what can be done on the federal level? And the current state of the housing market and interest rates what can be done for the first-time homebuyer?

A: There’s this whole business now, that is corporations that buy houses…but they’re being turned into rentals is effectively how it works.

The big thing that drives value for them, is the cost of ownership versus the cost of rent. And they’re going to be in the rental business until the rental income doesn’t match up with what you get on the house. So they’re constantly evaluating that formula.

And when the rate between ownership and renting moves to a certain level, they’ll start selling, because they’ll make more money that way. Or if it goes the other way, they’ll buy even more.

There’s no question that the combination of higher house prices and higher construction costs has meant that a first time homebuyer has a much harder time buying a house, that in higher interest rates, buying a house.

I’m doing a speech and a couple of weeks that we’re doing some research on, but I think wages have gone up about 16%, new home prices have gone up 42%, construction costs have gone up, I think it’s 26%. And so people are just priced out of the market.

Now, there’s nothing in our world that we do that changes that. But I do think this is a serious issue for communities who don’t want to do it. You don’t want to have this problem where first time homebuyers, like nurses or teachers or childcare workers can’t find the place to live. And so you’ve got to solve it.

The place to start and solving it is the community actually needs to want to solve it, that not just being cheap when I say that, there are many communities that actually like it just the way it is and don’t want any more houses.

You can’t solve it through subsidies to homebuyers, because that just creates demand. You have to solve it through supply, you have to create more supply of housing that has a piece of that zoning, there’s a huge piece of it.

I tried to look when I’m driving in. It looked like there was been a reasonable amount of new construction here over the last period of time. I’d say I’d say that’s true in most of eastern North Carolina, eastern North Carolina. I was in Clayton and Smithfield and Wilson and Rocky Mount a couple of months ago. And I saw tons and tons and tons and tons of houses being built.

That would be more in the greater Raleigh area, you know, people living an hour hour and a quarter outside of Raleigh. Maybe they’re only coming into the office three days a week. So the commute is less painful.

I think that land is a huge piece of it. Another huge piece of it is not allowing the properties to go off the market. And what I mean by that is dilapidation. If you’re losing housing stock, because it’s not being kept up.

There are a lot of organizations out there, one I was with on the Northern Neck of Virginia this week, that are working to actually try to rehab houses as they get older so that they don’t leave the stock. We have to build something and actually keep it under repair, especially for senior citizens.

And there’s some creative things being done by employers. I was at The Tides (Resort) on the Northern Neck. They’re actually building residences for their employees who can’t otherwise get them.

Some other interesting thing is to try to create buildable home sites. For developers. We’re going to invest in that. There’s a ton of excess land in this country that could be used for housing. That’s not. And we’ve got to get that going to get that done.

Smaller houses are another thing if construction costs are going up. The size of the average house in this country has increased…maybe that’s part of the answer all these things.

I think it’s a systemic issue, every community I go to has a housing challenge, especially those that are growing. And so that’s what we’ve got higher housing prices, if you try to solve by lowering housing prices for them make another set of people unhappy.

You get higher construction costs, and you’ve got a bunch of infrastructure spending that’s not coming down. Quickly, higher interest rates will come down in time, but we’ve got to find a way to get more housing.”

Q: “Over the six months to a year, the federal infrastructure dollars are finally filtering down through local governments. And so there’ll be a lot of reinvestment into infrastructure: schools, wastewater, water, roads in the coming two to three years. What do you see is that being the long term impact as far as jobs, wages and the the demand to have these materials on hand?”

A: “It’s a complicated question. There’s a ton of need for investment in infrastructure. In this country, a lot of its repair, bridges, highways, a lot of its water and sewer cleanliness, broadband. So I think there’s bipartisan agreement that we’ve got to do something infrastructure.

Is it good for the federal government to be spending all that money? Well, if it’s one time maybe. But if it’s long term, no.

So think about how you fund that infrastructure. That is a challenge and a gap.

And if we’re running big deficits, and you can’t afford to keep running, big deficits, eventually your creditors are going to charge you more money for your money if you run out of steps. So that’s another thing I think is one of the big challenges.

So in the short term, we have a lot of construction needs. It could be infrastructure, that could be houses.

But we don’t have a lot of construction workers. And I’ve written an essay on that, we need to work on the infrastructure, not just the physical, but also human infrastructure.

And when you have that much more demand for construction workers, when you don’t have any construction workers, it creates pressure on house costs, and housing prices and all the rest of it.

In this situation, we don’t have enough skilled trades for the skilled trade work that we need to do. And that’s a challenge.

And I like to think there was a way to get some amount of the resources towards building our capacity and the supply side, so that the supply side would work together on this demand side, I think that’s where we’ve got a squeeze in the near term. And it’s quite noticeable.

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