Lessons from the 1990s

Daly reached back to the 1990s to demonstrate that the Federal Reserve is well-equipped to manage monetary policy through the coming transformation, whatever shape it takes. Daly noted that Alan Greenspan, Fed chair at the time, used disaggregated micro data to argue that “the burgeoning computer revolution would spur sustained productivity growth, allowing the economy to grow faster without putting upward pressure on prices”. Thus, the Fed could remain patient with monetary policy even as the economy boomed. Daly did not reference or contextualize the financial chaos that engulfed the late 1990s. The global economy had to survive Russian financial crisis, the Asian financial crisis, the collapse of Long-Term Capital Management, and the ballooning of the tech and dot-com bubble which burst in 2000. Depending on your perspective, monetary policy played alternating roles as savior and villain in these economic calamities.

Going forward, Daly promised that the lessons of the 1990s would inform the foundation of monetary policy’s approach to AI’s impacts on the economy. “The willingness to listen to businesses, hear their ideas, use data and evidence to test them, and invite others to do the same,” Daly recounted as ways to maintain a pulse on AI-driven dynamics.

Daly pointed out that AI can deliver one-time efficiency gains by automating parts of a process. However, that productivity boost does not recur on its own. Sustained productivity growth requires broader reorganization and diffusion across industries. Thus, it is difficult to attribute recent productivity strength to AI or to assume its persistence.

I am particularly intrigued by the notion that the Fed may be slow to respond to a heating economy because of AI-driven productivity enhancements. One of my premises for ongoing sticky inflation includes an economy running hot due to fiscal stimulus and substantial investments in infrastructure and manufacturing. Daly implies that the Fed could be cautious about reacting to inflation that may prove temporary if productivity gains materialize.

Daly noted that AI investment can be inflationary in the near term with the investment required to build out capacity, while the disinflationary channel from productivity may arrive later. Accordingly, timing is central to how the Fed interprets sticky inflation alongside AI.

Thus, developments in AI increase the complexity of interpreting the Fed’s objectives and actions.

Augmentation Not Destruction

While AI could inject disinflationary (or even deflationary) forces into the economy, potential job destruction is top of mind for most workers. Job destruction would present the kind of structural economic force that the Fed typically has minimal ability to influence with monetary policy. Thus, Daly’s optimistic outlook on AI as job augmentation and creation would significantly relieve the Fed of a deeply challenging burden.

Daly’s evidence comes from employers in the San Francisco district. During the fireside chat following the introductory remarks, Daly described her team’s latest findings: “what we’re really seeing is AI replacing tasks, augmenting workers.” Daly and her team are collecting data and anecdotes directly from businesses. According to Daly, “most of those firms are saying, ‘I’m augmenting my workforce’.”

Earlier in the fireside chat, Daly made another call to history to support her optimism: “No technology ever reduces net employment. Not in the history of technologies, but it does change what that employment looks like.” Accordingly, Daly suggested that the same relationships should hold for AI. AI is changing the shape of employment first by replacing tasks within a job and next by augmenting the job itself. For Daly, the next phase for AI and the economy is not wholesale employment destruction but job creation. AI will create new jobs that we cannot imagine in this moment.

Keep Up If You Can

Daly delivered one cautionary message for workers. She warned that workers will need to engage with AI and focus on continuous (and rapid) learning. She referred to the leader of a company who had fired workers who were not able to keep pace. Fortunately, that same leader discovered the need to hire more workers because of the opportunities created by AI.

Daly also used prompt engineering as an example of a job type that emerged and faded quickly because of the changing needs and capability of AI. As a result, Daly advised workers to run as fast as they can:

“work forces need to skill in durable skills…be AI ready, be able to use AI to lift yourself in the educational space. You know, use the technologies that are out there to build your skills up because you can learn a lot fast if you train yourself to look at AI…”

In other words, translate AI into a learning advantage instead of treating AI as a threat.

Conclusion

Overall, Daly struck a positive tone on the current “AI Moment”. While the path forward is uncertain, Daly made the case for a kind of resilience informed by direct experience with AI. Workers need to engage with AI using a growth mindset, looking for opportunities while avoiding threats. In the meantime, the Federal Reserve will remain forward-looking and evidence-driven, monitoring whether AI’s anticipated effects are materializing in productivity, prices, and employment before adjusting policy.

The post San Francisco Fed’s Daly: AI’s Future Is Job Augmentation and Creation, Not Destruction appeared first on Inflation Watch.

Waller’s Case: Tariff-Driven Inflation Is Transitory

Just two days after Federal Reserve Chair Jerome Powell insisted that meaningful inflation is coming, Fed Governor Christopher J. Waller shared a nearly polar opposite narrative. Of course, given Waller may be on the short list of the President’s next pick to head the Federal Reserve, he has a built-in motivation to speak with authority in support of the administration’s claims that tariffs are not a threat to inflation. During a CNBC interview, Waller made the case for transitory and immaterial inflationary impacts from tariffs that would allow the Fed to start cutting rates as early as the July meeting. Waller explained that the Fed had paused for six months fearing inflationary impacts from tariffs that have yet to materialize. He chose to look through the ongoing uncertainty on tariff levels, timing, and frequency of change, as well as the recent Beige Book, which was full of accounts of businesses preparing for or already responding to tariff risks. Moreover, Waller claimed that only about 10% of the price index comes from imports (which made me wonder why there is any fuss over tariffs!). Instead, Waller expressed greater concern about the potential economic weakness caused by tariffs and stated he does not want to wait to cut until “we see a crash.”

Waller also referred to a speech he gave in South Korea in early June that laid out the detailed economic case for looking through tariffs as a one-time price shock. In “The Effects of Tariffs on the Three I’s: Inflation, Inflation Persistence, and Inflation Expectations,” Waller concluded that “the economics behind a tariff increase implies it should have a transitory effect on prices—tariffs raise prices once, but those prices don’t keep going up.” This conclusion holds if tariffs are hiked all at once in a one-and-done fashion. Otherwise, this reassurance reinforces the same argument Treasury Secretary Bessent made at the beginning of the tariff drama, trauma, and noise. Assuming that long-term inflation expectations remain anchored (as they are in market-based measures and professional forecasters, not in consumer-level surveys), Waller concluded “the tariff-induced inflation will be transitory and [the Fed] should look through it when setting policy.”

Powell’s Caution: Don’t Rush the Cuts

When Powell appeared on June 24th in front of the House committee to deliver the semiannual monetary policy report before the House Financial Services Committee, he was, of course, peppered with questions about tariffs and inflation. At one juncture, Powell took the opportunity to agree with Waller with an important condition (emphasis mine): “I do agree that basically if things are a one-time increase, then you don’t respond to them. That’s the whole idea if there’s a shock to prices… generally speaking you don’t respond if you are highly confident that it will just be a one-time shock.” Powell went on to caution that this particular situation is “a complicated one,” and said the Fed must make this decision about the timing of rate cuts “with some care.” He added that the Fed has not yet reached a point of price stability, and these large tariffs “raise kind of more concern” given the economy is just a few years out from a highly inflationary environment.

Powell’s caution appears warranted. Attempts to pattern-match to past history are challenging because of the scale and magnitude of the potential tariffs. The volatile implementation of economic policy means the Fed cannot be sure that tariff hikes will be a one-time episode. So, while a coming price shock may move inflation away from target, there remains some uncertainty about whether the Fed will be able to watch inflation settle back to target.

Bowman and Daly Lend Conditional Support

Vice Chair for Supervision Michelle W. Bowman added commentary on monetary policy in a speech the day before Powell’s testimony: “Assessing the Effectiveness of Monetary Policy During and After the COVID-19 Pandemic,” at a research conference sponsored by the International Journal of Central Banking and the Czech National Bank in Prague, Czech Republic. Bowman positioned herself as supportive of imminent rate cuts, although she did not specifically target July. Instead, she outlined broad conditions supportive of rate cuts: “If inflation remains near its current level or continues to move closer to our target, or if the data show signs of weakening in labor market conditions, it would be appropriate to consider lowering the policy rate, moving it closer to a neutral setting.” Bowman shared Waller’s concerns for the economy and stated that inflation appears on a sustained downward path to the 2% target:

“As we think about the path forward, it is time to consider adjusting the policy rate… we should recognize that inflation appears to be on a sustained path toward 2 percent and that there will likely be only minimal impacts on overall core PCE inflation from changes to trade policy. We should also recognize that downside risks to our employment mandate could soon become more salient, given recent softness in spending and signs of fragility in the labor market.”

Bowman expressed reassurance in the lack of inflationary impact from tariffs to date: “It appears that any upward pressure from higher tariffs on goods prices is being offset by other factors and that the underlying trend in core PCE inflation is moving much closer to our 2 percent target than is currently apparent in the data.” While acknowledging some upside risks for inflation, Bowman emphasized that she is “not yet seeing a major concern, as some retailers seem unwilling to raise prices for essentials due to high price sensitivity among low-income consumers and as supply chains appear to be largely unaffected so far.”

On Bloomberg Surveillance, June 26, Federal Reserve Bank of San Francisco President Mary Daly capped the dovish commentary by leaning toward the third of three timing scenarios for inflation:

1. Delayed, tariffs will have some impact and will be more persistent.
2. Delayed but will be one-off.
3. Does not deliver the punch history suggests will come as businesses absorb costs.

Daly stated that her “modal expectation” had been for some time that the Fed would be ready to cut rates in the fall. Thus her current dovishness is consistent with prior stances. Daly acknowledged tariffs “will potentially raise inflation.” However, since the impact should dissipate over time, it should not build into inflation expectations.

Rate Cuts, Politics, and the Fed’s Legacy

As the Fed’s debate about the impact of tariffs on inflation plays out, I am reminded that there is a larger context that influences how the Fed positions itself. The Federal Reserve was slow to respond to inflation in the throes of the pandemic, assuming that the price shock would be “transitory.” Even though he brought back the term “transitory,” even Waller revealed, “I am willing to admit that, at the time, I underappreciated how the large and sustained fiscal response would combine with highly accommodative monetary policy to overstimulate aggregate demand in an economy that quickly recovered from the early effects of the pandemic.” Waller is full steam ahead on team transitory again, while Powell continues to act like someone who still feels the scars. Powell’s caution makes even more sense in this context.

While Powell insists he is ignoring the political noise about his competence, his unwillingness to follow Presidential orders, and public ruminations about his firing or the looming presence of a shadow Fed Chair, Powell’s adamant stance sure has the appearance of someone trying to prove a point of toughness and independence. Thus, I fully expect Powell to be the “last one” to reluctantly move forward with rate cuts. I even expect his messaging at the time of the first rate cut to place responsibility squarely on the broader Fed… and to include some residual hawkishness of his own.

Overall, I lean toward Powell’s caution for all the reasons he gave to Congress. The environment remains highly uncertain, and the Fed has not yet reached its price target, even as a large price shock looms. Cutting rates in the midst of this swirling dynamic would signal a high degree of confidence in the post-shock equilibrium. Moreover, the Fed may have fundamentally different reads on the economy. For example, Daly insisted that “there are no warning signs that the economy is weakening, although progressing more slowly than before.” So if the Fed is both hampered by lower-quality data (due to federal budget cuts) and divided on the economy’s health, proceeding with rate cuts sooner rather than later seems doubly risky.

Conclusion

I will be highly surprised by a July price cut. Indeed, the CME FedWatch tool shows just a 21% chance of a cut, while September’s meeting has a 96% chance. These high odds essentially lock the Fed into cutting rates at the September meeting in order to avoid shocking the market. The messaging around that rate cut will be critical. Moreover, will the bond market get spooked and send long-term rates higher, just as it did both times the Fed cut rates last year?

The volatility index (VIX) sure looks incredibly low given the potential fireworks ahead. After breaking support from the dawn of the tariff drama, trauma, and noise, the VIX started this week right on top of that line.

Be careful out there!

Full disclosure: no positions

The post Powell vs. Waller: Divided Fed Faces Tariff-Driven Inflation Uncertainty appeared first on Inflation Watch.

Daly’s steadfast perspective is important to remember every time the stock market rallies in anticipation of peak inflation and/or a “Fed pivot.” Indeed, Daly warned that the Fed needs to be prepared for inflation to be more persistent than expected. For context, Daly was one who was unwilling to predict peak inflation ahead of what turned out to be the “CPI shocker” that delivered a surprise of higher core inflation. Part of Daly’s persistence comes from what she and the Fed see as inflation’s greater potential for economic harm than the short-term consequences of normalizing monetary policy. Daly noted that over two years real wages have fallen 9%. She even shared an anecdote of a worker who told her about how he “loses” money when he goes to buy something with his earnings (an anecdote that speaks to nominal wages failing to keep up with nominal increases in prices).

Other interesting nuggets from the interview:

• Rates are probably now around the neutral rate, and the Fed needs to get slightly restrictive.
• The length of time rates stay neutral (or slightly restrictive) is more important than the specific level.
• 50% of today’s inflation is driven by demand (thus justifying the Fed’s desire to get slightly above neutral), 50% from supply.
• Daly refused to take the bait on the question of whether the Fed was purposely trying to induce a recession, trying to force losses on the stock market, or intent on hiking rates until something breaks.
• Daly insisted the Fed is forward-looking and recognizes lagging indicators of inflation.
• Daly pushed back on the notion the Fed needs to coordinate with global central banks. She insisted that the Fed must stick to its domestic dual mandate.

While the signs a few months ago were clear from commodity prices that the Fed’s actions were impacting inflation, the recent strength in oil threatens to rekindle inflation fears from the average person. For example, gas prices look like they are already done declining. The United States Gasoline Fund, LP (UGA) broke out today. UGA looks like it double-bottomed in September.

The recent downtrend in United States Gasoline Fund, LP (UGA) came to an end this week with a powerful breakout above 50 and 200DMA resistance.

Similarly, diversified commodities producer BHP Group (BHP) looks like it is holding a bottom in place since late last year.

BHP Group (BHP) has so far held its lows from a year ago. While upside may be limited, BHP also looks like it is done going down for now.

If these bottoms are indicative of what is ahead, then any soft readings in the near-term inflation numbers could be, well, transitory… (tongue-in-cheek intended!)

Be careful out there!

Full disclosure: long BHP

The post Fed’s Daly: The Market Is Wrong About A Hump in 2023 Fed Rates appeared first on Inflation Watch.

• “The Fed is expeditiously marching towards neutral. It is clear the economy doesn’t need the accommodation that we’re providing” – notice the recognition that current policy is over-stimulative. Maintaining an easy money policy while the economy is strong is not only bad policy, but also doing so increases inflation risks.
• “The neutral rate is about 2.5% by the end of the year” – this statement sets the stage for several 50 basis point rate hikes this year given rates are still at a paltry 0.25%-0.50%.
• “We don’t want to go so quickly or so abruptly that we surprise Americans and make them have to adjust quickly…” – the Fed never likes to create downside surprises, only upside ones. Indeed, Daly observed that tightening financial conditions are already tapping on the economy’s brakes. She pointed to mortgage rates as a prime example; a notable reference given a hot housing market is at the center of the Fed’s concerns.
• Daly insisted that the Fed can pull off a soft-landing.
• Daly cautioned that predicting “peak inflation” is “fraught with peril” given on-going COVID shutdowns in China and Russia’s invasion of Ukraine.
• “High inflation is as bad for workers as not having a job” – in other words, the Fed cannot afford to allow inflation to erode spending power on a sustained basis.
• The Fed funds rate is more precise than and better known for moving monetary policy.

Compare Daly’s comments to this key quote from Powell today:

“It may be that the actual [inflation] peak was in March, but we don’t know that, so we’re not going to count on it…We’re really going to be raising rates and getting expeditiously to levels that are more neutral and then that are actually tight … if that turns out to be appropriate once we get there.”

The Fed is all-aboard the anti-inflation locomotive!

The post SF Fed President Maps the Path Toward Neutral Policy, Not Banking On “Peak Inflation” appeared first on Inflation Watch.