Driving through Economic Fog

Thank you for having me today. I am honored to be a part of the H. Parker Willis Lecture series. As you likely know, Willis was instrumental in drafting the Federal Reserve Act, which created the Federal Reserve System as we know it. I think it’s fair to say we all owe him a great deal. I, for example, owe him my job.

To keep that job, let me note before I begin that 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.

Over the years, you’ve hosted an impressive slate of Federal Reserve leaders as part of this series, including two other Richmond Fed presidents. My background is a bit atypical for a member of the FOMC. I am not a Ph.D. economist. I spent 30 years at McKinsey and Co, helping firms make decisions on growth and restructuring, compensation and pricing. I served as CFO and ran our offices in the South, meaning I made a lot of those same decisions myself. So, I approach my role as a practitioner rather than a researcher.

As a practitioner, as well as a policymaker, I’ve seen that the beliefs and outlook of consumers and businesses help drive the economy; what they believe influences when they hire, fire, switch jobs, make major investments or purchases and raise wages or prices. All of these decisions are sensitive to expectations about the future. I want to spend my time today focusing on how these beliefs and expectations, which I’ll refer to as “sentiment,” are affecting today’s economic outlook.

Let’s start at the end of 2024. At that time, conditions looked rosy. GDP had grown 2.5 percent in 2024, a healthy level. Unemployment was at 4.1 percent, near most estimates of its natural rate. And the 12-month Personal Consumption Expenditures Price Index had come down considerably, to 2.6 percent from its peak of 7.2 percent in June 2022.

Businesses were overwhelmingly optimistic. Small business optimism, for example, saw its biggest jump in 40 years in November and then increased further in December. Election uncertainty had moved into the rearview mirror. The supply side had healed. Business-friendly policies seemed likely. Consumers too — with unemployment low, real wages up and the stock market soaring — were feeling confident, as evidenced by strong holiday spending. Put simply, sentiment was good.

That seems like a long time ago. Since then, federal government policy has taken center stage. One can debate the pros and cons of these policies over the medium term, but, in the near term, the pace of change seems to have created a sense of instability. Business optimism has dropped. Consumer sentiment has fallen. The March edition of the Fed’s Beige Book, which summarizes each Reserve Bank’s outreach on economic conditions, literally broke the record for mentions of “uncertainty.” 

The feeling of uncertainty is undeniable, but I thought it might be helpful to go through what we do know. After all, we do have some certainty. We know we likely are headed toward more tariffs, lower net migration, an extension of the 2017 tax cuts, deregulation, lower growth in government spending and more efforts to promote traditional energy sources. We also know what typically happens when you move policy in each of those directions. What we don’t know is how far these efforts will go, how they will net out and when they will land with enough clarity for participants in the economy to act.

Take tariffs. In 2018, average tariffs rose by about 3 percentage points, with most studies assessing they had only a modest impact on growth and raised prices about 0.3 percent. This time around, if we assume an eventual 20 percent tariff on China and a 25 percent tariff on Mexico, Canada and aluminum and steel products, the average tariff rate rises almost four times more than in 2018. In the context of recent high inflation, one could imagine more of an impact on prices, but no one knows where the tariff rates will finally settle or how affected countries, businesses and consumers will respond.

Take immigration. Forecasters expect lower net migration to lead to slower workforce growth in years to come — roughly about half the growth we saw in the 2010s and a third of what we saw at the peak during the Biden administration. Slower workforce growth could put downward pressure on economic growth and upward pressure on wages. But these stats are based on assumptions; no one knows what immigration will be in fact.

Take fiscal policy more broadly. Proposed tax cuts have the potential to raise growth and put upward pressure on inflation. Proposed cuts in government spending could push the other way. Deregulatory efforts could boost productivity, enabling growth and lowering inflation. How they play out is still to be negotiated. I should acknowledge the impact of government spending cuts will be outsized in my district; federal employment is 2 percent of the national workforce but a fourth of D.C.’s.

Finally, take energy. Traditional energy sources are being promoted, OPEC+ has announced plans to boost supply, and global demand seems likely to weaken as a result of trade developments. Presumably energy will thus be disinflationary, but we know that situation can change abruptly.

So, we have a lot we know. But in the minds of consumers and businesses, that knowledge is being swamped by what they don’t know and by uncertainty around when they’ll finally have more certainty on the path forward.

The shift in sentiment is exacerbated by the relentless pace of change in today’s always-on media environment. You can’t miss the headlines. We constantly surf the news on our phones. Business media is even on the seatbacks when you fly. As a result, sentiment seems to be shifting faster than ever, and the shifts are magnified. It happened during the pandemic. It happened with inflation. And it seems to be happening now.

With all this change, a dense fog has fallen. It’s not an everyday “forecasting is hard” type of fog. It’s a “zero visibility, pull over and turn on your hazards” type of fog.

And that’s what businesses seem to be experiencing. Even those that believe the sun is still lurking behind the fog aren’t willing to take many risks today. They for the most part aren’t pulling back, but they’re not pushing forward either. They’re “on pause,” “on hold,” “frozen” or “paralyzed” until the fog lifts. Those are their words. Nonprofits, hospitals, universities and other organizations downstream of possible federal spending changes express the most trepidation. Manufacturers with supply chains in tariffed countries express the most uncertainty. We’ve been in a low-hiring, low-firing environment. With all this confusion, it’s hard to imagine a break toward hiring.

We are also seeing signs of caution from consumers. A number of large firms, including airlines and retailers, have raised flagging consumer confidence in recent weeks while warning about weaker demand. That would be rational. Wage growth expectations are normalizing at the same time as tariff talk is pushing up near-term inflation expectations. The net is that expected real wages are dropping. At the same time, equity markets have been volatile. Both would signal less strength in consumer spending.

Sentiment matters. For consumers and businesses to spend and invest, they need to have a certain level of confidence. For credit and equity markets to finance those investments, they need stability. And, for now, an uncertainty-driven drop in sentiment looks like it could quiet demand. The outlook once the fog lifts will in part depend on how long it lasts.

What does all this mean for monetary policy? We face the same fog as businesses and consumers. How does one drive in fog? Carefully and slowly, and if there’s a safe place to pull over, you do so to avoid getting in trouble. That’s where we are. At our last meeting, the FOMC held the federal funds rate steady. With the labor market still solid and inflation still above target, our moderately restrictive stance is a good place to be. If conditions start to shift, we are well positioned to adjust. Until then, like businesses and consumers, we are waiting for the fog to clear.