Federal Reserve Vice Chair Philip N. Jefferson spoke on the challenges of responding to unpredictable economic shocks in remarks at Stanford University on July 16.
Jefferson, in remarks to the Stanford Institute for Economic Policy Research, talked about how the Federal Open Market Committee takes into account events that are difficult to predict, such as pandemics, wars, or major technological advances. The aim is still to meet the dual mandate of maximum employment and price stability.
He outlined a simple framework that distinguishes demand shocks that affect spending by households, businesses and government from supply shocks that change the economy’s productive capacity. The output gap compares actual output to potential output. This is used to determine if there is excess demand or excess supply in the economy.
If a shock moves inflation and the output gap in the same direction, the policy decision is relatively straightforward. But a positive output gap with high inflation usually calls for higher interest rates. Rates should be lower as inflation is low and the gap is negative. Hard cases occur when the two sides of the mandate pull in opposite directions, requiring policymakers to balance the costs and risks to each goal, relative to the other.
Jefferson said the conflict in the Middle East and the proliferation of artificial intelligence are two current developments that demonstrate these challenges.
“The situation in the Middle East has been part supply shock. Stress in global oil and energy-related supply chains helped to push up oil prices, which lowered real incomes and tightened financial conditions. Oil prices have retreated from recent highs, but uncertainty remains in the region. The blow to U.S. demand should be limited, Jefferson said, pointing out that the U.S. is now a net oil exporter. Its economy is less oil-intensive than it was in past decades.
This energy shock follows inflation that has been above the Fed’s 2 percent target for some time and an unemployment rate that is near levels consistent with maximum employment. What results is a delicate balancing act. Policymakers must contend with inflationary pressures while keeping an eye on the possibility that employment might fall below its sustainable maximum. More recently, changes in trade policy have added another layer of complexity, affecting output and prices in the short-term, and possibly productive capacity.
Jefferson pointed out the danger that successive shocks could embed inflation or elevate longer-term inflation expectations.
He turned to artificial intelligence, which he described as a development likely to have lasting effects on both supply and demand. On the supply side, AI is expected to automate some tasks and improve others, generating productivity gains that raise the growth rate of potential output. On the demand side, optimism about the technology is already driving investment and consumption. Companies are pouring money into data centers, computing equipment, and AI features.
The relative timing of these effects is what matters for inflation. If demand is stronger before productivity improvements arrive, then prices could rise. If productivity improves faster, cutting costs, that may ease price pressures. AI may also affect the longer-run neutral interest rate, or r-star. Faster productivity growth could increase investment demand and decrease household saving, exerting upward pressure on the neutral rate. But an increase in inequality is more likely to push in the other direction, by increasing aggregate saving.
Jefferson reiterated his pledge to bring inflation back down to 2 percent. The committee decided to keep the federal funds rate target range unchanged at 3-1/2 to 3-3/4 percent at its June FOMC meeting. That stance should be supportive for the labor market, he said, as earlier tariff and energy price effects fade and inflation resumes its decline. If inflation does not come down soon, he said, it could be appropriate to rethink the current policy stance.
“I am strongly committed to bringing inflation back to our 2 percent target consistent with our dual-mandate goals of price stability and maximum employment handed to us by Congress,” Jefferson said.
He rounded out by emphasizing the importance of well-anchored inflation expectations. When the public expects the Fed to bring inflation back to target, policymakers have more room to respond to the full spectrum of shocks the economy may face.
