Former NY Federal Reserve President Dudley offers insight on U.S. economic outlook
At a recent investment conference here in Sydney, former Federal Reserve Bank of New York president, Chief Executive Officer (CEO), and now Bloomberg columnist William C. Dudley, provided a comprehensive overview of the current economic landscape in the U.S., highlighting several key points that shed light on the Federal Reserve’s (Fed) perspective and future policy directions. Dudley’s analysis offers a crucial perspective for understanding the Fed’s current mindset and the potential trajectory of its future policies. All of which, of course, have consequences for investors’ portfolios.
Fed’s current stance and inflation challenges
Dudley emphasised that while the market believes the Fed may have completed its course of action, the reality is more nuanced. The Fed is unsure if it has done enough to tackle inflation. This uncertainty highlights why it avoids sending strong signals that could prematurely ease financial conditions, ignite animal spirits, and make the Fed’s job of reining inflation harder. The biggest policy failure of the Fed would be not doing enough to bring down inflation. Powell doesn’t want to be like Arthur Burns, who didn’t do enough to fight inflation in the 1970s and was replaced by Paul Volker, who had to put the economy through a very painful adjustment in the 1980s.
For his part, Dudley does not believe the U.S. Fed will raise rates in December; however, he also believes inflation is ‘noisy’ and ‘sticky’ and, therefore, the Fed won’t be cutting rates as quickly as the market currently believes.
A key focus of Dudley’s presentation was inflation, particularly whether the current policy is restrictive enough to bring it down effectively. He underscored the labour market is a crucial factor in this equation.
Dudley highlighted the importance of ‘R star’, the rate indicating neutral policy, which he notes is likely moving higher. Factors like spending on the energy transition and defence are boosting the economy more than expected. Additionally, Dudley pointed out that household and business balance sheets are stronger than is typical at this stage of the economic cycle, all of which could mean a longer duration for current elevated rate settings.
Labor market and unemployment rates
The former central bank president stressed the complexity of the labour market, especially in the services sector, where adjusting labour market conditions is more challenging than in the goods sector. He noted that the Fed’s Chair Jerome Powell believes inflation expectations remain well anchored. Still, prolonged high inflation could alter this perception and result in entrenched expectations, so the Fed must remain committed to bringing inflation down further.
Dudley discussed the necessary unemployment rate to moderate wage inflation and achieve economic balance, highlighting that the ideal rate is not well-defined. Unemployment is currently at 3.9 per cent, and it probably needs to rise to between four and five per cent. In the past, an unemployment rate of five per cent was necessary for balance.
Notably, however, a 0.5 per cent increase in unemployment has historically led to a “full-blown” recession.
And that’s a very important point. Since WWII, whenever the unemployment rate rises half a per cent, a serious recession transpires. On all twelve occasions, a recession has followed a jump in unemployment of more than 0.5 per cent.
Fed’s monetary policy and future outlook
On the monetary policy front, Dudley acknowledged the uniqueness of this economic cycle compared to the Global Financial Crisis (GFC). This time, rather than having too much debt, people have lots of money and have locked in low long-term fixed-rate mortgages. It’s the government that now has too much debt, and the situation will worsen with baby boomers retiring and driving up healthcare and social security costs.
Dudley also touched upon the implications of rising bond yields, the potential impact of a U.S. recession on the deficit, and the challenges in the treasury market, especially considering the changing dynamics of international investors. Over the last few years, it has been easy for the treasury to issue bonds and find international buyers who made up 68 per cent of acquirers. Today, however, the U.S. treasury has lost indiscriminate buyers in China, the Middle East, and Japan thanks to international conflicts and fears of sanctions.
Dudley’s insights reflect a cautious and data-driven approach by the Fed. He suggests that the biggest policy failure would be not doing enough to control inflation. The Fed’s actions will be heavily reliant on economic data, particularly regarding inflation, growth, and unemployment.