Chair Janet L. Yellen
At the Economic Club of New York, New York, New York
March 29, 2016
The Outlook, Uncertainty, and Monetary Policy
For more than a century, the Economic Club of New York has served as one of the nation's leading nonpartisan forums for discussion of economic policy issues. It is an honor to appear before you today to speak about the Federal Reserve's pursuit of maximum employment and price stability.
In December, the Federal Open Market Committee (FOMC) raised the target range for the federal funds rate, the Federal Reserve's main policy rate, by 1/4 percentage point. This small step marked the end of an extraordinary seven-year period during which the federal funds rate was held near zero to support the recovery from the worst financial crisis and recession since the Great Depression. The Committee's action recognized the considerable progress that the U.S. economy had made in restoring the jobs and incomes of millions of Americans hurt by this downturn. It also reflected an expectation that the economy would continue to strengthen and that inflation, while low, would move up to the FOMC's 2 percent objective as the transitory influences of lower oil prices and a stronger dollar gradually dissipate and as the labor market improves further. In light of this expectation, the Committee stated in December, and reiterated at the two subsequent meetings, that it 'expects that economic conditions will evolve in a manner that will warrant only gradual increases in the federal funds rate.'1
In my remarks today, I will explain why the Committee anticipates that only gradual increases in the federal funds rate are likely to be warranted in coming years, emphasizing that this guidance should be understood as a forecast for the trajectory of policy rates that the Committee anticipates will prove to be appropriate to achieve its objectives, conditional on the outlook for real economic activity and inflation. Importantly, this forecast is not a plan set in stone that will be carried out regardless of economic developments. Instead, monetary policy will, as always, respond to the economy's twists and turns so as to promote, as best as we can in an uncertain economic environment, the employment and inflation goals assigned to us by the Congress.
The proviso that policy will evolve as needed is especially pertinent today in light of global economic and financial developments since December, which at times have included significant changes in oil prices, interest rates, and stock values. So far, these developments have not materially altered the Committee's baseline--or most likely--outlook for economic activity and inflation over the medium term. Specifically, we continue to expect further labor market improvement and a return of inflation to our 2 percent objective over the next two or three years, consistent with data over recent months. But this is not to say that global developments since the turn of the year have been inconsequential. In part, the baseline outlook for real activity and inflation is little changed because investors responded to those developments by marking down their expectations for the future path of the federal funds rate, thereby putting downward pressure on longer-term interest rates and cushioning the adverse effects on economic activity. In addition, global developments have increased the risks associated with that outlook. In light of these considerations, the Committee decided to leave the stance of policy unchanged in both January and March.
I will next describe the Committee's baseline economic outlook and the risks that cloud that outlook, emphasizing the FOMC's commitment to adjust monetary policy as needed to achieve our employment and inflation objectives.
Recent Developments and the Baseline Outlook
Readings on the U.S. economy since the turn of the year have been somewhat mixed. On the one hand, many indicators have been quite favorable. The labor market has added an average of almost 230,000 jobs a month over the past three months. In addition, the unemployment rate has edged down further, more people are joining the workforce as the prospects for finding jobs have improved, and the employment-to-population ratio has increased by almost 1/2 percentage point. Consumer spending appears to be expanding at a moderate pace, driven by solid income gains, improved household balance sheets, and the ongoing effects of the increases in wealth and declines in oil prices over the past few years. The housing market continues its gradual recovery, and fiscal policy at all levels of government is now modestly boosting economic activity after exerting a considerable drag in recent years.
On the other hand, manufacturing and net exports have continued to be hard hit by slow global growth and the significant appreciation of the dollar since 2014. These same global developments have also weighed on business investment by limiting firms' expected sales, thereby reducing their demand for capital goods; partly as a result, recent indicators of capital spending and business sentiment have been lackluster. In addition, business investment has been held down by the collapse in oil prices since late 2014, which is driving an ongoing steep decline in drilling activity. Low oil prices have also resulted in large-scale layoffs in the energy sector and adverse spillovers to output and employment in industries that support energy production.
On balance, overall employment has continued to grow at a solid pace so far this year, in part because domestic household spending has been sufficiently strong to offset the drag coming from abroad. Looking forward however, we have to take into account the potential fallout from recent global economic and financial developments, which have been marked by bouts of turbulence since the turn of the year. For a time, equity prices were down sharply, oil traded at less than $30 per barrel, and many currencies were depreciating against the dollar. Although prices in these markets have since largely returned to where they stood at the start of the year, in other respects economic and financial conditions remain less favorable than they did back at the time of the December FOMC meeting. In particular, foreign economic growth now seems likely to be weaker this year than previously expected, and earnings expectations have declined. By themselves, these developments would tend to restrain U.S. economic activity. But those effects have been at least partially offset by downward revisions to market expectations for the federal funds rate that in turn have put downward pressure on longer-term interest rates, including mortgage rates, thereby helping to support spending. For these reasons, I anticipate that the overall fallout for the U.S. economy from global market developments since the start of the year will most likely be limited, although this assessment is subject to considerable uncertainty.
All told, the Committee continues to expect moderate economic growth over the medium term accompanied by further labor market improvement. Consistent with this assessment, the medians of the individual projections for economic growth, unemployment, and inflation made by all of the FOMC participants for our March meeting are little changed from December.2 A key factor underlying such modest revisions is a judgment that monetary policy remains accommodative and will be adjusted at an appropriately gradual pace to achieve and maintain our dual objectives of maximum employment and 2 percent inflation. Reflecting global economic and financial developments since December, however, the pace of rate increases is now expected to be somewhat slower. For example, the median of FOMC participants' projections for the federal funds rate is now only 0.9 percent for the end of 2016 and 1.9 percent for the end of 2017, both 1/2 percentage point below the December medians.
As has been widely discussed, the level of inflation-adjusted or real interest rates needed to keep the economy near full employment appears to have fallen to a low level in recent years. Although estimates vary both quantitatively and conceptually, the evidence on balance indicates that the economy's 'neutral' real rate--that is, the level of the real federal funds rate that would be neither expansionary nor contractionary if the economy was operating near its potential--is likely now close to zero.3 However, the current real federal funds rate is even lower, at roughly minus 1-1/4 percentage point, when measured using the 12-month change in the core price index for personal consumption expenditures (PCE), which excludes food and energy. Thus, the current stance of monetary policy appears to be consistent with actual economic growth modestly outpacing potential growth and further improvements in the labor market.4
Looking beyond the near term, I anticipate that growth will also be supported by a lessening of some of the headwinds that continue to restrain the U.S. economy, which include weak foreign activity, dollar appreciation, a pace of household formation that has not kept up with population and income growth and so has depressed homebuilding, and productivity growth that has been running at a slow pace by historical standards since the end of the recession. If these headwinds gradually fade as I expect, the neutral federal funds rate will also rise, in which case it will, all else equal, be appropriate to gradually increase the federal funds rate more or less in tandem to achieve our dual objectives. Otherwise, monetary policy would eventually become overly accommodative as the economy strengthened.5
Implicitly, this expectation of fading headwinds and a rising neutral rate is a key reason for the FOMC's assessment that gradual increases in the federal funds rate over time will likely be appropriate. That said, this assessment is only a forecast. The future path of the federal funds rate is necessarily uncertain because economic activity and inflation will likely evolve in unexpected ways. For example, no one can be certain about the pace at which economic headwinds will fade. More generally, the economy will inevitably be buffeted by shocks that cannot be foreseen. What is certain, however, is that the Committee will respond to changes in the outlook as needed to achieve its dual mandate.
Turning to inflation, here too the baseline outlook is little changed. In December, the FOMC anticipated that inflation would remain low in the near term due to the drag from lower prices for energy and imports. But as those transitory effects faded, the Committee expected inflation to move up to 2 percent over the medium term, provided the labor market improves further and inflation expectations are stable. This assessment still seems to me to be broadly correct. PCE prices were up only 1 percent in February relative to a year earlier, held down by earlier declines in the price of oil. In contrast, core PCE inflation, which strips out volatile food and energy components, was up 1.7 percent in February on a 12 month basis, somewhat more than my expectation in December. But it is too early to tell if this recent faster pace will prove durable. Even when measured on a 12-month basis, core inflation can vary substantially from quarter to quarter and earlier dollar appreciation is still expected to weigh on consumer prices in the coming months. For these reasons, I continue to expect that overall PCE inflation for 2016 as a whole will come in well below 2 percent but will then move back to 2 percent over the course of 2017 and 2018, assuming no further swings in energy prices or the dollar. This projection, however, depends critically on expectations for future inflation remaining reasonably well anchored. It is still my judgment that inflation expectations are well anchored, but as I will shortly discuss, continued low readings for some indicators of expected inflation do concern me.
Risks to the Outlook for Real Economic Activity
Although the baseline outlook has changed little on balance since December, global developments pose ongoing risks. These risks appear to have contributed to the financial market volatility witnessed both last summer and in recent months.
One concern pertains to the pace of global growth, which is importantly influenced by developments in China. There is a consensus that China's economy will slow in the coming years as it transitions away from investment toward consumption and from exports toward domestic sources of growth. There is much uncertainty, however, about how smoothly this transition will proceed and about the policy framework in place to manage any financial disruptions that might accompany it. These uncertainties were heightened by market confusion earlier this year over China's exchange rate policy.
A second concern relates to the prospects for commodity prices, particularly oil. For the United States, low oil prices, on net, likely will boost spending and economic activity over the next few years because we are still a major oil importer. But the apparent negative reaction of financial markets to recent declines in oil prices may in part reflect market concern that the price of oil was nearing a financial tipping point for some countries and energy firms. In the case of countries reliant on oil exports, the result might be a sharp cutback in government spending; for energy-related firms, it could entail significant financial strains and increased layoffs. In the event oil prices were to fall again, either development could have adverse spillover effects to the rest of the global economy.
If such downside risks to the outlook were to materialize, they would likely slow U.S. economic activity, at least to some extent, both directly and through financial market channels as investors respond by demanding higher returns to hold risky assets, causing financial conditions to tighten. But at the same time, we should not ignore the welcome possibility that economic conditions could turn out to be more favorable than we now expect. The improvement in the labor market in 2014 and 2015 was considerably faster than expected by either FOMC participants or private forecasters, and that experience could be repeated if, for example, the economic headwinds we face were to abate more quickly than anticipated. For these reasons, the FOMC must watch carefully for signs that the economy may be evolving in unexpected ways, good or bad.
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