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This edition was written by Sarah Ahmad, Alex Conner, Georgia Nabors, and David Wessel.
Simon Smith of the Federal Reserve Board of Governors, Allan Timmerman of University of California, San Diego, and Jonathan Wright of Johns Hopkins estimate the relationship from 1980 to 2022 between labor market tightness and inflation, known as the Phillips Curve. First, they show that the relationship depends on labor market tightness: When the unemployment rate falls below 5%, the marginal impact of unemployment on inflation almost doubles. Second, the authors identify a regime shift in Phillips Curve dynamics around the year 2000. Before 2000, the “flat” section of the Phillips Curve (that is, where unemployment is higher than 5%) was about 50% more sensitive to unemployment than it is now. The “steep” section of the Phillips Curve (unemployment below 5%) appears similar over the entire sample. The authors conclude, “Monetary policymakers face a fundamentally different inflation-unemployment tradeoff in tight labor markets compared with in loose labor markets and should account for this when setting policy.”
Using machine learning, Stefania Albanesi of the University of Miami and Domonkos F. Vamossy of the University of Pittsburgh develop a measure of consumer credit worthiness that performs better than conventional credit scores in predicting defaults, particularly for young, low-income, and minority borrowers. The model places more weight on credit amount and less weight on the length of credit history, credit mix, and incidence of new credit relative to conventional credit scores. They find that traditional credit scores incorrectly classify 41% of consumers, assigning them to a risk category that does not reflect their true likelihood of defaulting. This result is more pronounced for borrowers with low scores. Some 47% of borrowers deemed subprime by conventional credit scores are misclassified. Approximately 33% would have higher credit ratings according to the authors’ model, and only 15% would be considered deep subprime. The authors conclude that improved credit scoring practices can improve access to credit for low earners, minorities, and young people.
“I do not expect this first [interest-rate] cut to be the last. With inflation and employment near our longer-run goals and the labor market moderating, it is likely that a series of reductions will be appropriate. I believe there is sufficient room to cut the policy rate and still remain somewhat restrictive to ensure inflation continues on the path to our 2% target," says Christopher J. Waller, member of the Federal Reserve Board of Governors.
"Determining the appropriate pace at which to reduce policy restrictiveness will be challenging. Choosing a slower pace of rate cuts gives time to gradually assess whether the neutral rate has in fact risen, but at the risk of moving too slowly and putting the labor market at risk. Cutting the policy rate at a faster pace means a greater likelihood of achieving a soft landing but at the risk of overshooting on rate cuts if the neutral rate has in fact risen above its pre-pandemic level. This would cause an undesired loosening of monetary policy.
Determining the pace of rate cuts and ultimately the total reduction in the policy rate are decisions that lie in the future. As of today, I believe it is important to start the rate cutting process at our next meeting. If subsequent data show a significant deterioration in the labor market, the FOMC can act quickly and forcefully to adjust monetary policy…”
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