Inflation is 'corrosive', reducing labor market power, San Francisco Fed's Daly says

Federal Reserve Bank of San Francisco on Fourth of July 2022

Takako Hatayama-Phillips/iStock Editorial via Getty Images

San Francisco Fed President Mary Daly emphasized Tuesday that the Federal Reserve is dedicated to both sides of the central bank’s dual mandate of full employment and price stability.

“People need jobs but they also need price stability,” she said in a fireside chat hosted by the Council on Foreign Relations. Inflation is “corrosive” as it erodes wages. “I don’t see real power, if your (real) wages are falling 9%. It hurts the less advantaged more.”

“Inclusive growth goes both ways — it’s jobs and price stability,” she said.

Daly noted, “It’s important to recognize the spectrum of risks. Right now inflation is not a risk, it’s a reality.” For example, she hears people saying it’s like running fast and falling behind.

The labor market is still strong, she added. “Right now the U.S. economy, up until now, we’re north of 300,000 jobs per month,” she said. “We’re running well above the 100K we need. We’re hearing about a smattering of layoffs.”

As to how much of inflation is caused by strong demand and how much comes from supply issues, “there seems to be an emerging span of estimates that about 50% of the excess we have is demand and 50% is supply.” That gives the Fed “a lot of room to work,” since its tools work on demand, she said. The Fed’s tool, primarily raising interest rates, doesn’t help improve supply issues.

The reason businesses didn’t invest in increasing production when demand surged is because they didn’t know it would be transitory, Daly said, citing surveys and conversations the district reserve bank has had with business contacts.

In describing how tricky it is to change from accommodative monetary policy to a tighter approach, she said: “Forward guidance was extraordinarily effective this time around” when the Fed started to pivot to tightening in March. Financial conditions started tightening, mortgage rates rose “expeditiously” once the Fed announced its plans.

Looking back on the lessons learned since the pandemic, she said: “I did not fully appreciate how long it was going to take to beat back COVID. I didn’t realize how geopolitical differences would play out in countries sharing vaccines. China is still implementing lockdowns, affecting supply chains.

She also didn’t expect demand to be as strong as it was. “I didn’t appreciate how unbridled people would be in purchasing things,” Daly said.

Restoring price stability ensures the ability to have sustainable growth. “We don’t have that right now,” she said.

Central bank independence has been “proven again, and again, and again” to be crucial in supporting a “strong and sustainable economy.”

As for quantitative tightening, markets start pricing in the effect soon after the Fed announces its balance sheet plan. She estimates that shrinking the Fed’s balance sheet equates to about “one, maybe two, rate hikes.”

Last week, Fed Vice Chair Lael Brainard reiterated other Fed officials’ statements that policy will stay restrictive “for some time.”