Forecasting Beyond Today’s Data

Thank you for that kind introduction. I thought today I could share my perspective on where the economy stands and where it may be headed. Before I jump in, let me share two notes of caution.

First, nearly three months ago, I spoke on the state of the economy at the Economic Club of D.C. When I walked off the stage, someone showed me her phone. The stock market was surging. My first thought was, “Oh no, what’d I say?” Happily, it wasn’t me. While I’d been speaking, the reciprocal tariffs had been delayed. So, suffice it to say, what I share today only reflects what I know as of 8 a.m. this morning.

Second, as always, the views I share today are mine alone and not necessarily those of anyone else on the Federal Open Market Committee (FOMC) or in the Federal Reserve System.

Reconciling Solid Data With Poor Sentiment
Let’s turn to the economy. You have all seen the data, which remains pretty solid. Twelve-month headline PCE hit 2.1 percent in April, and May’s CPI was encouraging. Job growth continues at a healthy pace, averaging 135,000 over the last three months, in line with its 12-month average. Unemployment has been stable around its current low level of 4.2 percent. Consumer spending is holding steady, as is business investment, recognizing some of the strength we saw in the first quarter was pull forward pre-tariffs.

But, while the data has been good, it’s fair to say the mood has not. The University of Michigan consumer sentiment survey probed historic lows this spring. On the business side, the exuberance we saw postelection in small business and CFO surveys, including our own, has subsided.

The issue has been uncertainty. Since late March, I’ve been saying, “Driving is really hard when it’s foggy.” Businesses don’t want to press on the gas; they don’t know what lies around the next curve. They also don’t want to slam on their brakes; someone could run into them. So, they see no better option than pulling over, turning on their hazards and waiting it out.

It’s been three months, and that’s still what I am hearing from business leaders. They’re on pause, choosing to “wait and see.” They’re not cutting back, but they’re also not hiring nor leaning into new investments. The fog hasn’t lifted. Tariff uncertainty remains pronounced. Who here can confidently predict the level of tariffs on, say, the EU six months from now? The budget outlook is still unclear, affecting government contractors, nonprofits, health care organizations and universities, among others. This is a big deal in my district, which includes the Washington, D.C., metro area. Recent developments in the Middle East only add to all the uncertainty.

What does this all mean for the path of the economy? It’s hard to see the horizon while in dense fog, but I will give you my best sense. I should warn you of the old joke that economic forecasting was invented to make weather forecasting look good.

Watching for Price Pressure
I do believe we will see pressure on prices. Based on current policy, average tariff rates have increased from roughly 2.5 percent to over 15 percent. Even with some substitution effects, customs collections suggest these costs have increased significantly. Businesses tell me (and have sent letters to their customers saying) they intend to pass those input costs on, either directly or through price increases for non-tariffed goods. I even hear non-tariffed businesses discussing price increases under the cover of what they perceive to be a more inflationary context.

To date, these increases have had only modest effects on measured inflation, but I anticipate more pressure is coming. A large retailer told me that the lack of much increase in his May prices reflected the lack of much increase in his input costs when he purchased those products in February, under the then prevailing lower tariff levels. It takes months for his goods to move through inventory to his customers. To see the impact of the big tariff increases in April and May, he suggested we wait and see July and August prices.

That said, I don’t expect the impact on inflation to be anywhere near as significant as what we just experienced. Why not? This isn’t 2022. For one, the Fed’s policy stance is more restrictive today, leaning against inflation. But beyond that, remember that back then, consumers felt flush because of stimulus payments, COVID-era savings, higher wages, and a frothy market. They accepted higher prices. In contrast, today’s consumer is already frustrated by higher price levels and is choosing to trade down and defer discretionary spending. Their choices are already helping to bring inflation down. Businesses that attempt to raise prices further should meet active resistance.

Tracking Pressure on Employment
This resistance implies there could also be pressure on unemployment. If businesses lose volume when they raise prices, they will need to reduce costs. If they lose margin because they are unable to raise prices, they too will need to reduce costs. Either way, cost reduction would likely mean headcount reduction, suggesting that the current low hiring, low firing environment might come under threat.

That said, again there are mitigants. By all accounts, immigration has dropped precipitously, meaning the potential workforce has dropped — by some estimates — over two million from its prior trend. Fewer workers in the labor force should reduce the pressure on the unemployment rate. I should also note that economic policies can change, and I expect severe effects on the economy would be addressed once identified.

So, my weather forecast isn’t calm and sunny, but it’s not particularly stormy either — unless the Middle East conflict somehow results in a big oil price spike.

Looking to the Long Term
My bigger worry isn’t tomorrow’s weather, but instead, the longer-term business climate. Markets and outside commentators seem to be tracking a passing squall that will settle by late summer. I see it differently.

I expect tariffs will continue to be applied and renegotiated, and policy changes will continue. Higher geopolitical tension looks likely to persist. In such a world, volatility would continue to quiet hiring and investment, as would elevated long rates. At some point, businesses would conclude that they can only idle for so long. When they do, they are likely to move beyond responding to near-term volume or margin pressure and focus on taking out costs more broadly — the part of the business they perceive they control. Artificial intelligence offers them a ready tool. This of course would affect employment.

On the other side of our mandate, the timing of anticipated inflation pressure from tariffs (and potentially oil prices) could also prove problematic. If I were to torture the weather metaphor, we haven’t fully finished the cleanup from the last storm. Twelve-month inflation hasn’t met our 2 percent target for over four years now, during which time it has averaged about 4 percent. It shouldn’t be surprising that, despite actual inflation continuing to come down, near-term inflation expectations have moved up significantly more recently than they did in the tariff episode of 2018-2019. I am keeping a close eye on the cumulative impact of elevated actual inflation on inflation expectations.

So, there are risks on the employment side and risks on the inflation side. There are challenges in the short term and challenges in the longer term. But to offer a positive note, I’d point to the strength of the American consumer. Consumer spending makes up nearly 70 percent of GDP and has been remarkably stable year after year. Consumers have helped us weather many a storm. We learned that again over the past few years; despite rising prices, sour sentiment, and higher interest rates, consumers continued to spend, supported by low unemployment, real wage growth, and strong asset valuations. All three of these factors remain supportive today.

Let me close with a brief note on monetary policy. At our last meeting, the FOMC held the federal funds rate steady. The fog is dense for us too, and there is little upside in heading too quickly in any one direction. Given the strength in today’s economy, we have time to track developments patiently and allow the visibility to improve. When it does, we are well positioned to address whatever the economy will require.