Monetary Policy in a Lower Interest Rate Environment
Thank you, Jeff, for that kind introduction. It is a great pleasure to be here. The past ten years have been a challenging environment for the global economy. In the years since the financial crisis and the deep recession that followed, economic growth around the globe has been modest and the stance of monetary policy remains highly accommodative.
That is certainly true in the U.S. As you know, in response to the enormous challenges posed by the financial crisis, the Federal Open Market Committee (FOMC) reduced its short-term policy interest rate - the federal funds rate - all the way to its zero lower bound (ZLB) in December 2008. The Committee took a first step toward policy normalization last December, increasing the target range for the federal funds rate by 25 basis points to 1/4 to 1/2 percent. However, for a variety of reasons, the FOMC has refrained from further increases since then. This may well be changing soon, as the policy statement after our most recent meeting in mid-September noted that "the Committee judges that the case for an increase in the federal funds rate has strengthened but decided, for the time being, to wait for further evidence of continued progress toward its objectives." 1
In my remarks today, I will discuss my outlook for the U.S. economy and share my views on U.S. monetary policy. I will not be addressing the narrow question of exactly when our next policy move is going to be. Instead, I will talk about some broader issues that influence the entire path for policy renormalization, which I see as much more important than the particular date at which we make our next 25 basis point move. In that regard, another feature of Fed communications in September that gained a good deal of attention was the fact that FOMC participants once again reduced the number of rate hikes they expected over the next several years and also slightly lowered their views about the longer-run level of the fed funds rate. 2 Such downward adjustments to the path for our policy rate have been a familiar refrain in recent years.
Now, before I proceed, let me lay out my main points:
- I expect to see sound economic growth and further reductions in labor market slack.
- My inflation outlook is less sanguine. Inflation is too low, has been too low for too long, and I don't expect a quick and easy return to our 2 percent target.
- With regard to monetary policy, an important structural feature to keep in mind when calibrating the future path for policy is that the "equilibrium level of interest rates" — a key concept I'll cover in detail later on - is likely a good deal lower than it has been in the past.
- I think policy can improve the inflation outlook by better linking future moves to indicators that inflation is moving up in a sustained fashion to the 2 percent target.
Moreover, I think to achieve our symmetric 2 percent inflation target, appropriate policy needs to be accommodative enough to generate a reasonable likelihood that future inflation could exceed 2 percent.
Naturally, the views I express today are my own and do not necessarily reflect the views of my colleagues on the FOMC or those in the Federal Reserve System.
Let me start by briefly sharing my outlook for the U.S. economy. After a weak first half of 2016, during which real gross domestic product (GDP) growth averaged only about 1 percent, I expect growth to move up in the second half and to average just over 2 percent over the next three years.
The U.S. consumer is the linchpin of this forecast. The most important factor supporting household spending is the substantially improved labor market in the U.S. Over the past two years, the unemployment rate has fallen below 5 percent (half its 2009 peak) and job growth has averaged around 220,000 per month. These gains have raised incomes and buoyed confidence over future job prospects. Lower energy prices and accommodative monetary policy have provided additional support to the spending wherewithal of households. All of these factors should continue to generate solid increases in consumer spending - particularly given my assumption that interest rates will stay quite low for some time.
I also expect stronger performance from two sectors of the economy that held growth back in the first half of the year - inventory investment and business capital spending. Inventory investment subtracted 3/4 of a percentage point from growth in the first half of the year; firms even liquidated inventory stocks in the second quarter. Without evidence of overhangs, I think just a return to the trend pace of stock-building will add a lot to growth.
Business fixed investment has been weak: It's declined two of the past three quarters. There are good reasons for this low level of business investment: The rising value of the U.S. dollar against many foreign currencies has been an obstacle to manufacturers with an international presence; low oil prices have held back energy exploration and drilling; and, early in the year, increased risk spreads in financial markets raised borrowing costs. However, even after accounting for these factors, recent capital spending has been weak. Fortunately, incoming indicators are pointing to some recovery in spending. But this doesn't mean we're expecting a robust rebound. Notably, my business contacts say their capacity is right-sized to their sales expectations, and they remain very cautious about spending money on even moderately risky new opportunities.
Adding everything up, I see growth in the U.S. recovering from the tepid first half of 2016 and averaging in the range of 2 to 2-1/4 percent for the next two to three years. For reference, this pace is modestly stronger than my assessment of the underlying growth trend and should, therefore, support continued reduction in labor market slack.
In particular, I expect the unemployment rate to decline further over the next three years, to reach 4-1/4 percent by the end of 2019. My current estimate of the natural rate of unemployment is 4.7 percent; 3 I think demographic factors will steadily lower this natural rate to about 4-1/2 percent by 2020. Therefore, under appropriate monetary policy, I expect the unemployment rate to reach its natural rate by the end of next year and to undershoot it a bit after that. As I will discuss later, I think undershooting the unemployment goal is a necessary feature of appropriate monetary policy that raises inflation to our 2 percent target in a reasonably timely and sustainable fashion.
There are, however, risks to my growth outlook. On the upside, the solid labor market and continued low energy prices could lead to stronger household spending than expected - with attendant spillovers to other components of domestic demand. That said, I see more downside risks. My biggest growth concern on the domestic front is that business caution will hold back capital spending more than I expect and may even impinge on hiring. Furthermore, according to most economic forecasters as well as my business contacts, the U.S. is the bright spot in the global economy. While the International Monetary Fund (IMF) expects the U.S. economy to expand at a 2.4 percent rate over the next two years, its growth forecast for the euro area is only 1-1/2 percent, and the UK and Japanese economies are predicted to grow at even more meager rates. Even the relatively faster-growing emerging market economies are projected to grow at a 4.7 percent rate - a noticeably slower pace than five years ago. 4
To be clear, I do not want to be seen as a "glass half-empty" kind of forecaster - the type who sees gloom and doom everywhere. I have reasonable confidence in my forecast for U.S. GDP growth running a bit above potential and for further improvements in labor markets. It's just that one needs to be cognizant of the risks.
Inflation Outlook and Risks
I am less optimistic about the inflation outlook. In January 2012, the FOMC set 2 percent inflation - measured by the annual change in the Price Index for Personal Consumption Expenditures (PCE) - as the explicit inflation target consistent with our price stability mandate. 5 However, over the past eight years, PCE inflation has averaged only 1-1/2 percent. To get a sense of where total inflation is likely to be headed over the next year or so, it's useful to strip out the volatile food and energy components and look at so-called core inflation. And here we see core PCE inflation also has averaged about 1-1/2 percent since the crisis. 6 Although we did see core inflation move up some at the beginning of this year, it appeared to have stalled at 1.6 percent in August; it then edged up to 1.7 percent. Further ahead, I see both core and total inflation moving up very gradually to approach, but not quite reach, our 2 percent inflation target over the next three years. This path reflects the dissipating effects on consumer prices of earlier declines in energy prices and the appreciation in the dollar; the influence of further improvements in labor markets and growth in economic activity; and the support of an accommodative path for monetary policy.
However, as with growth, I see downside risks to the outlook for inflation. The U.S. and other advanced economies have experienced below-target inflation rates for several years. Given the disinflationary forces across the globe and the growth challenges faced by many countries, international developments may result in further declines in energy prices or additional appreciation of the dollar.
Most worrisome to me is the possibility that inflation expectations in the U.S. might be drifting lower. The compensation for prospective inflation one can glean from a number of financial asset prices has fallen considerably over the past three years. Some survey-based measures of inflation expectations also have moved down to historically low levels. True, financial market inflation compensation and some survey measures of inflation expectations have stabilized in recent months, but they still remain quite low. For instance, investors see the risk-priced probability of total Consumer Price Index (CPI) inflation over the next ten years being below 1 percent at about 38 percent, while they are pricing in only 19 percent odds that inflation will be above 3 percent. 7 I don't hear any talk of inflationary pressures or pricing power from my business contacts either. Notably, despite the solid improvements in labor markets over the past several years, most contacts report only modest, if any, increases in the wages they have to pay to attract and retain qualified workers. These are certainly not the kinds of increases we would expect to see in a 2 percent inflation environment. If we were going to see a quick return to 2 percent inflation, I would have expected to have already heard hints bubbling up from among my contacts.
These incipient signs that businesses and households may be entrenched in a "low inflation" psychology are disconcerting. The Bank of Japan's experience over the past two decades is a reminder of how difficult it is to raise actual inflation and inflation expectations once such a psychology takes hold. Unless there is a more dramatic and sustained increase in aggregate demand or something else supporting an upward movement in inflation expectations, I don't see this low-inflation psychology changing quickly.
In sum, as conditions currently stand, my forecast for a gradual and modest increase in inflation is still just a forecast. It relies on historical relationships holding true in today's somewhat different environment, rather than on a solid trend in recent economic data.
I would note that my forecast of moderate expansion in economic activity and further improvements in labor markets is broadly consistent with the median forecast from the September Survey of Economic Projections (SEPs). 8 However, my colleagues are a bit more optimistic about inflation than I am, with the median participant expecting core PCE inflation to reach 2 percent by the end of 2018.
A Longer-Run Perspective: Lower Growth Potential, Lower Interest Rates
Given the major developments of the past ten years and their implications for future growth prospects, it is important to put my outlook in a longer-run context. It is my view that we will be in a low-growth, low-interest-rate environment for some time.
Let me sketch out why.
Let's start with a thought experiment. Think about a world in which the economy is at full employment; output is growing along its long-run trend path; and inflation and inflationary expectations are well anchored at the FOMC's 2 percent inflation target. Economists call the real interest rate consistent with this economic environment, which subtracts out the inflation target, the "equilibrium real rate of interest." 9 What determines this rate?
A crucial element is long-run trend output growth. The greater this growth rate, the greater the real returns are to business and household capital investment - and the greater the returns are to the financial instruments funding that investment. These higher returns, in turn, imply a higher equilibrium real interest rate.
Looking ahead, I see there is a distinct possibility that there has been a reduction in the long-run trend in economic growth. My colleagues on the FOMC and I have spoken extensively about a number of reasons underlying this slowdown: the retiring of the baby boomers; lower labor force participation trends among the working-age population; a plateauing in educational achievement; smaller increases in capital per worker; and slower growth of total factor productivity (TFP). 10
Beyond the potential slowdown in the long-run trend of economic growth, there are other factors that will likely keep market interest rates low for quite a while in the U.S. and other advanced economies. High on this list is the enormous worldwide demand for safe assets. In their well-known "conundrum" and "global savings glut" speeches, former Fed chairs Alan Greenspan and Ben Bernanke both pointed to such growing demand as an important factor reducing interest rates on long-term safe assets in the U.S. 11 Greenspan's "conundrum" commentary explicitly cited this demand as leading to a flattening of the Treasury yield curve. 12
Note that I didn't mention monetary policy as a primary element in determining the equilibrium real interest rate. This is because the effects of monetary policy on the long-run growth potential of the economy or the saving preferences of economic players are small and indirect. True, the Fed would still be setting the federal funds rate in this hypothetical situation, but with the economy at full employment and inflation at target, the Fed's job simply would be to guide the target fed funds rate to the equilibrium determined by these nonmonetary factors.
Now, monetary policy does have a direct influence on the equilibrium nominal interest rate, which is the sum of the equilibrium real rate and expected inflation. This influence depends on the central bank's choice of an inflation target and its success at achieving that target over time. As long as the public believes that policy authorities are committed to symmetrically achieving that target, expected inflation should equal the central bank's inflation objective over the long run.
A lot is made of the Federal Reserve's role in engineering today's low nominal interest rate environment. Certainly, following the Great Recession, in order to provide the accommodation necessary to get economic activity back up to its potential and bring inflation back up to target, we have attempted to steer interest rates below their equilibrium levels. However, to a great degree, the current low levels of nominal interest rates likely also reflect changes in the equilibrium real rate of interest that are largely beyond the scope of monetary policy. Importantly, the factors currently weighing on equilibrium real rates could be quite persistent. In such a case, low real and (given our 2 percent inflation target) nominal interest rates could be with us for some time - even after policy rates return to a neutral setting.
It is also worth noting that other countries also are likely to confront lower potential growth rates and lower interest rates. For instance, the International Monetary Fund (2015) estimates that underlying structural trends will lower the average rate of potential growth in advanced economies from 2-1/4 percent during the 2001-07 pre-crisis period to 1.6 percent over the 2015-20 period. Similarly, Rachel and Smith (2015) estimate that global structural factors could result in the average of ten-year real interest rates in the G7 countries (excluding Italy) being about 1 percent in the medium and long term - well below their trends in the past.
For the U.S., most analysts now expect that both short-run money rates and longer-term interest rates will be lower over the long run than they had expected just a few years ago. For instance, in March 2010, the Blue Chip consensus - an average of about 50 private sector economic forecasters - expected the three-month Treasury rate would average 4-1/4 percent over the long run. By March 2016, that number had fallen to just 3 percent. Over the same time period, their outlook for long-term interest rates had come down as well (falling by over 1-1/2 percentage points). 13
Beyond just economists' consensus forecasts, the lower-for-longer interest rate scenario appears to be built into business plans. I recently had a meeting with a number of executives from the life insurance industry, whose business models rely on investing funds to cover anticipated long-term liabilities. They talked about the challenges posed by the low interest rate environment to their business models and their bottom lines. But they also discussed how they and other real money investors - such as investment managers for pension funds - are reassessing the yield curve environment. They are increasingly coming around to the view that persistently slow output growth in the U.S. and abroad may keep real interest rates low for a long time - longer than they likely thought one, two or certainly three years ago. As a result, these long-horizon investors are developing strategies to manage their business operations based, at least in part, on the low yields that are currently achievable on longer-term fixed-income instruments.
Let me be very clear on why this is important. We often hear of rates on long-term safe assets being reduced by a temporary flight to quality - that is, by investors running away from riskier investments until the threats recede. And many statistical asset-pricing models estimate that temporary declines in term premia - as opposed to outright permanent declines in expected real rates - have been a major contributor to low long-term interest rates. As a technical matter, these models' conclusions often turn importantly on the assumption that the level factor is stationary - that is, it will revert to its historical average over time - and, unless otherwise augmented, cannot robustly allow for secular changes in the level of interest rates. The commentary from the life insurance executives and others I just referred to differs from what such stationary models tell us. Their business decisions suggest that an important part of the decline in long-term market rates reflects expectations of lower short-term interest rates over the long run. This is quite different from attributing nearly all of the decline to transitory movements in difficult-to-explain term premia.
Implications for Monetary Policy
Now, how does this all inform U.S. monetary policy?
For one, there has been a notable decline in FOMC participants' views of where the federal funds rate will converge to over the long run. Their median forecast fell from 4-1/4 percent in 2012 to 2.9 percent most recently. 14
Moreover, as indicated in their public commentary and FOMC communications, many FOMC participants estimate that the neutral level of the federal funds rate today is lower than its eventual long-run level due to various headwinds to growth. 15 By some estimates, the equilibrium real rate is currently near zero. Judged against this benchmark, the median forecast of a 50 to 75 basis point range for the nominal fed funds rate at the end of 2016 is not terribly far below neutral and, hence, not as accommodative as it would have been in the past. Moreover, in recent years, as the data on economic activity and inflation came in and as the FOMC participants' views of neutral policy have shifted downward, so has the median path for appropriate policy. In the September projections, the median participant expects one rate hike this year, followed by eight additional increases of 25 basis points each over the course of the following three years as appropriate. Such a path would bring the federal funds rate to 2.6 percent at the end of 2019 - still somewhat below its longer-run level.
Clearly, the pace of policy tightening envisioned in these forecasts is much slower than in previous tightening cycles. I think a very shallow funds rate path, such as the one envisioned by the median FOMC participant, is appropriate and needed to support my forecasts for growth and inflation. Indeed, I think the pace of policy normalization necessary to bring inflation back up to 2 percent in a timely manner has to be shallow enough to result in the unemployment rate falling below its natural level. I should note, too, that achieving a symmetric target means having enough accommodation in place to generate a reasonable likelihood that inflation in the future could moderately exceed 2 percent. 16 If you eliminate all chance of inflation rising above target, then you are effectively making your inflation target a ceiling. A very shallow path for policy normalization is likely needed to deliver these results.
Furthermore, I believe the communications underlying our policy path are key to the execution of appropriate policy.
Much attention has been placed on exactly when the next increase in the federal funds rate might be. I am less concerned about the timing of the next increase than I am about the path over the next three years. If core inflation was clearly on its way to 2 percent, then I would see a readjustment of monetary policy toward its long-run neutral level as an appropriate and easy decision. However, I have yet to see clear and convincing evidence in the data that inflation is headed up to 2 percent.
What would convince me that inflation is clearly on its way to 2 percent?
First, I'm looking for core inflation moving closer to 2 percent. Given the potentially significant shifts in underlying economic fundamentals and the global disinflationary forces, I would prefer to see solid evidence that inflation is actually moving up in a sustained fashion rather than rely solely on historical forecasting relationships to make the call.
Second, I would like to see further reductions in unemployment and other indicators of labor market slack. Such reductions should help foster tighter labor market conditions and boost wages and inflation.
Third, I would like to have more confidence that inflation expectations are solidly and symmetrically aligned with our 2 percent inflation objective. Sustained increases in the various measures of inflation compensation and surveys of inflation expectations would help me in this regard.
Indeed, I would prefer that at the time we make our next move, FOMC communications would also indicate that subsequent increases will depend on seeing such changes in inflation indicators. I believe this would help assure the public that the Committee is seeking economic and financial conditions to support attaining our 2 percent inflation target sustainably, symmetrically and sooner rather than later.
I also view risk-management issues to be of great importance today. Given that the fed funds rate is still barely above its effective lower bound and given the downside risks to my outlook, policy is much better positioned to counter unexpected strength than to address downside shocks. So I still judge that risk-management arguments continue to favor providing more accommodation than usual to deliver an extra boost to aggregate demand. Such a boost would provide a buffer against possible future downside shocks that might otherwise drive us back to the effective lower bound.
To conclude, there are many challenges for policymakers in judging long-run growth prospects and discerning the appropriate path of monetary policy. I see good arguments that we are in for a protracted period of low equilibrium real interest rates. In such an environment, it is all the more critical that we demonstrate our commitment to a symmetric inflation target with our policy actions and our policy communications.
1 Federal Open Market Committee (2016b).
2 Federal Open Market Committee (2016a).
3 The natural rate of unemployment is the unemployment rate that would prevail in an economy making full use of its productive resources. Consequently, it is the rate of unemployment that would predominate over the longer run in the absence of shocks to the economy.
4 International Monetary Fund (2016, 2013).
5 Federal Open Market Committee (2012a); for the most recent statement of the longer-run goals, which reaffirmed this inflation target, see Federal Open Market Committee (2016c).
6 Specifically, except for a brief period at the beginning of 2012, core PCE inflation has been below 2 percent since the third quarter of 2008.
7 Board of Governors of the Federal Reserve System staff calculations based on prices on inflation derivatives, as discussed in Kitsul and Wright (2013).
8 Four times a year, the FOMC releases its Summary of Economic Projections, which presents FOMC participants’ forecasts of key economic variables over the next three years and for the longer run. Real GDP growth in the September SEPs is expected to increase from 1.8 percent this year to around 2 percent over the next two years — a bit higher than the longer-run estimate of growth. The median FOMC participant expects the unemployment rate to decline from 4.8 percent at the end of this year — which is the median forecast for the longer-run rate of unemployment — to 4.6 percent by the end of next year and to remain at about that level through the end of 2019. See Federal Open Market Committee (2016a).
9 The equilibrium interest rate is sometimes called the “natural” or “neutral” interest rate.
10 See, for instance, Yellen (2016a, 2016b), Evans (2016) and Powell (2016). TFP refers to the technologies and operational systems that businesses use to combine various inputs into outputs. In other words, TFP captures the residual growth in total output of the national economy that cannot be explained by the accumulation of measured inputs, such as labor and capital.
11 Greenspan (2005) and Bernanke (2005).
12 A yield curve is the line plotting the yields or interest rates of assets of the same credit quality but with differing maturity dates at a certain point in time. These assets, such as U.S. Treasury securities, typically yield incrementally more at longer maturities.
13 See the March 10, 2010, and March 10, 2016, issues of the Blue Chip Economic Indicators.
14 Federal Open Market Committee (2012b, 2016a).
15 The neutral, or equilibrium, federal funds rate is the funds rate associated with a neutral monetary policy (policy that is neither expansionary nor contractionary).
16 This is not as heretical as it might first appear. After all, it is a simple consequence of having a symmetric inflation target: It is difficult to average 2 percent inflation over the medium term if there is little chance of inflation ever running above 2 percent. If policy preempts this possibility, the public could begin to mistakenly believe that 2 percent inflation is a ceiling — and not a symmetric target.
Bernanke, Ben, 2005, “The global saving glut and the U.S. current account deficit,” remarks of Federal Reserve Governor at the Sandridge Lecture, Virginia Association of Economists, Richmond, VA, March 10.
Evans, Charles L., 2016, “Reflections on the current monetary policy environment,” speech by Chicago Fed president at Global Interdependence Center, London, June 3.
Federal Open Market Committee, 2016a, Summary of Economic Projections, Washington, DC, September 21.
Federal Open Market Committee, 2016b, press release, Washington, DC, September 21.
Federal Open Market Committee, 2016c, “Statement on longer-run goals and monetary policy strategy,” Washington, DC, as amended effective January 26.
Federal Open Market Committee, 2012a, press release, Washington, DC, January 25.
Federal Open Market Committee, 2012b, Summary of Economic Projections, Washington, DC, January 25.
Greenspan, Alan, 2005, testimony of the Federal Reserve Chairman before the U.S. Senate, Committee on Banking, Housing and Urban Affairs, Washington, DC, February 16.
International Monetary Fund, 2016, “Uncertainty in the aftermath of the U.K. referendum,” World Economic Outlook Update, Washington, DC, July 19.
International Monetary Fund, 2015, “Where are we headed? Perspectives on potential output,” in World Economic Outlook: Uneven Growth — Short- and Long-Term Factors, Washington, DC, April, pp. 69–110.
International Monetary Fund, 2013, “Growing pains,” World Economic Outlook Update, Washington, DC, July 9.
Kitsul, Yuriy, and Jonathan H. Wright, 2013, “The economics of options-implied inflation probability density functions,” Journal of Financial Economics, Vol. 110, No. 3, December, pp. 696–711.
Powell, Jerome H., 2016, “Recent economic developments, monetary policy considerations and longer-term prospects,” remarks of Federal Reserve Governor at the Chicago Council on Global Affairs, Chicago, June 28.
Rachel, Lukasz, and Thomas D. Smith, 2015, “Secular drivers of the global real interest rate,” Bank of England, staff working paper, No. 571, December.
Yellen, Janet, 2016a, transcript of Federal Reserve Chair press conference, Washington, DC, June 15.
Yellen, Janet, 2016b, speech by Federal Reserve Chair at the World Affairs Council of Philadelphia, Philadelphia, June 6.