Dennis Lockhart: Considerations on the path to policy normalization
Speech by Mr Dennis Lockhart, President and Chief Executive Officer of the Federal
Reserve Bank of Atlanta, at the Southwest Florida Business Leaders Luncheon, Naples,
Florida, 6 February 2015.
* * *
• Atlanta Fed President and CEO Dennis Lockhart, in a February 6, 2015, speech to
the Southwest Florida Business Leaders, shares his thoughts on the monetary
policy "liftoff" decision ahead.
• Lockhart says the linchpin in a decision to make a significant policy change is
confidence in the economic forecast.
• Lockhart's baseline outlook for 2015 and 2016 assumes growth at around 3 percent
per annum.
• In Lockhart's view, this outlook, combined with the improvement of economic
conditions to date, indicates the economy is on a path to a satisfactory and desirable
state of health.
• Lockhart says that the weakness of inflation and wages is a concern, and that
firming of inflation readings will give him confidence that the outlook on which
monetary policy decisions will swing remains realistic.
• From a Main Street perspective, Lockhart says, the important point for business
planning is that monetary policy is likely to shift sometime this year, and that
decision should be a signal that the FOMC is confident that the economy is on track
to achieve its objectives.
I want to begin by expressing thanks to Gary Tice for his service on the Federal Reserve
Bank of Atlanta's Miami board. Gary follows Gay Rebel Thompson from this community, who
earlier served as a board member and chair of the Atlanta Fed's board for South Florida.
This year - 2015 - is widely expected to be the year the Federal Reserve initiates
normalization of monetary policy. This prospect has generated a lot of interest and buzz.
If you follow the Fed-watching industry, as I do, you are well aware that a top-of-mind
question regarding policy is: At what meeting will the Fed decide to lift off? At what meeting
will the Federal Open Market Committee (FOMC) raise the policy rate target above its
current near-zero range?
If you are an investor in fixed-income or interest-paying assets, a lot of money may ride on
the precise answer to that question.
In contrast, if you are a business person operating in the nonfinancial real economy, you may
be less concerned about the precise timing of the first policy adjustment. You are likely to be
more concerned about what a change in the interest-rate environment means for the outlook
for overall demand conditions and the general direction of the economy.
Today I will orient my remarks mostly to the concerns of Main Street. This keeps the focus
where, in my opinion, it ultimately should be - that is, on the health, resilience, and
momentum of the broad economy.
With this perspective in mind, I want to share my thought process, as one policymaker, on
the decisions ahead and the economic context in which they may be made.
When a Reserve Bank president speaks publicly, he or she is expressing individual views,
not an official message of the Fed or the FOMC. That is the case today. My colleagues may
not agree with my views.
Economic progress and outlook
The national economy has improved greatly from the recession's trough in 2009. Much has
been accomplished.
The Great Recession was a particularly severe episode. The economy lost quite a lot of
ground. We lost nearly 7 million jobs - more jobs than in the prior three recessions
combined. During the recovery, we have regained that ground, and nonfarm payroll jobs are
now about 2 million jobs above where they were at the onset of the recession.
In terms of total output, the economy is now almost 14 percent larger than at its nadir at the
bottom of the recession.
It has taken a while - the recovery is five-and-a-half years old - and the job is not finished, in
my opinion. But, as I said, much has been accomplished.
I believe the economy has sufficient traction for the expansion to be extended through the
medium term.
My baseline outlook for 2015 and 2016 assumes growth at around 3 percent per annum. I
expect employment to continue to grow and both unemployment and underemployment to
continue to decline. This morning, we received the Bureau of Labor Statistics' employment
situation report for January. Payroll jobs grew by 257,000 on net. And over the past three
months, job gains have averaged 336,000.
As a general statement, the improvement of economic conditions to date, in combination with
the outlook I just outlined, leads me to the view that the economy is on a path to a
satisfactory and desirable state of health.
The Fed's statutory objectives contained in the so-called dual mandate help define what is
satisfactory and desirable. Our policy objectives are maximum employment and low and
stable inflation. The Committee has put a clear definition on the inflation objective. The
Committee has defined it as a rate of 2 percent annual inflation over the longer run as
measured by a particular index called the personal consumption expenditures price index.
Importantly, inflation is targeted on a total or headline basis including the highly variable
components of food and energy prices. In practice, most Fed officials monitor a collection of
inflation indicators in an attempt to discern the underlying trend. There are worrisome
aspects of the current inflation picture, and reading underlying trends is problematic at
present. Hold that thought. I'll emphasize the centrality of inflation concerns a little later.
Maximum, or full, employment is less explicitly defined. Most economists assume that what
constitutes full employment changes over time. Structural shifts in the economy cause the
natural rate of unemployment to move around. For a good part of the recovery period, a
number of Fed policymakers, me included, have estimated the unemployment level
consistent with full employment as between 5 1/4 and 5 1/2 percent or a little higher. Today's
report has the headline unemployment rate at 5.7 percent. So, on that basis, we would seem
to be approaching an acceptable steady-state level of employment.
It's a fair question, then, why the FOMC has not already started to normalize interest-rate
policy. My answer is the recovery has been sluggish for much of its five-and-a-half years. To
accomplish what we have, the recovery has required the support of extraordinary policy
measures - measures such as a policy rate set effectively at zero and three rounds of
quantitative easing. Furthermore, the economy has endured periodic headwinds that
threatened to dilute or reverse progress. And although the economy is growing, its strength
has sometimes seemed tentative and fragile.
A moment ago, I said the job is not finished. Some gaps remain.
Employment progress, for instance, may be less than meets the eye. Many of us have held
that the conventional measure of unemployment probably overstates actual progress. There
are still almost 7 million workers counted as employed who say they are working part-time
involuntarily. As a point of reference, 7 million is about 4 1/2 percent of a labor force of
157 million. There are always people in this involuntary part-time category, but the number is
still elevated compared to historical levels. Over the last few years, there has been a
worrisome outflow of prime-age workers - especially men - from the labor force. I believe
some of these people will be enticed back into formal work arrangements if the economy
improves further.
The distance between current conditions and our goals doesn't have to be completely closed
for the FOMC to start moving interest rates higher. Monetary policy is, of necessity, forward
looking. If, as we look forward, it seems likely we will achieve our policy objectives, then we
can consider beginning to adjust policy.
From a Main Street perspective, it is the overall direction and extent of normalization that
should matter most, rather than the exact date of liftoff. Liftoff will be a momentous event
when it happens, but it is the evolution of the interest-rate environment over the next few
years that will most influence real business activity.
Confidence as linchpin
The linchpin in a decision to make a significant policy change is confidence. By that, I mean
confidence in a forecast - an outlook narrative, if you will - that has the economy on track to
achieve the FOMC's policy objectives in a reasonable timeframe. I think a reasonable time
horizon is one to two years.
I really want to emphasize this point. The Committee has repeatedly stressed that the first
and subsequent policy moves will be data-dependent. It is confidence based on clear
evidence in the data that will trigger the start of normalization.
One hundred percent confidence is never attainable. The test is one of sufficiency - that is,
sufficient confidence that, in a defined period of time, the broad economy will reach
conditions consistent with sustainable full employment and stable prices.
At this particular moment, I don't quite have sufficient confidence. There are factors at work
at the moment whose effects I consider to be transient. Key among these factors is inflation.
Inflation, by almost every measure, has been running considerably below the FOMC's target
of 2 percent. This was the case well before the recent drop in energy prices. Because of the
sharp falloff of energy prices - especially gasoline prices - headline or total inflation has
gone negative in the most recent readings. Core inflation - the measure that excludes the
direct impact of energy and food prices - has recently been running below 1 percent.
In my baseline forecast, I have inflation getting past this period of broad disinflation and
resuming a gradual rise to 2 percent. It's important, in my opinion, to be confident that this
will occur, and certainly that the trend in overall prices is not continuing to move away from
the FOMC's target.
Just as current readings of inflation give some pause, broad wage trends seem to suggest
we are not yet on the cusp of full employment. The quite modest growth of wages across the
economy does not seem normal given the solid growth numbers we've seen in recent
quarters.
Inflation and wages ought to be telling indicators that the gaps are closing. Their weakness is
a concern.
A noisy first half
The first half of 2015 will present challenges in evaluating the validity of economic
assumptions.
I've mentioned oil prices. After seven months of decline, prices firmed in trading sessions last
week, then fell again. Financial market participants interpreted the firming as a positive
development. A number of oil and gas sector analysts forecast that global petroleum supplies
will exceed demand through the first half of the year.
The dollar has appreciated by 13 percent on a trade-weighted basis since last June. Exports
in the fourth quarter seem to have been negatively affected by the dollar's rise. I will avoid
predicting exchange rates, but suffice to say that the impact of the dollar on exports, as well
as imported consumer goods prices, is part of the current swirl of variables making the state
of the economy harder to assess.
The direction of the dollar is an aspect of the larger context of slow global growth with risk of
spillover to the U.S. economy. Some of the influence of soft economic conditions abroad is
incorporated into my baseline outlook. In contrast, more extreme scenarios are not.
I should also comment on inflation compensation in inflation-protected securities.
Compensation for inflation in these securities (so-called TIPS) has moved sharply lower
since last summer. This decline may reflect transitory influences like falling energy costs. A
less benign possibility is that investors are lowering their outlook for inflation. This could be
either because their confidence is waning that the Fed will achieve its 2 percent inflation
target, or because they see growing risks to the continued strength of the broad economy.
Since mid-January, some inflation-compensation measures have shown signs of reversing. A
firming in the inflation compensation data from their year-end lows is an example of the kind
of encouraging development that will bolster my confidence in the medium-term outlook.
To put an exclamation point on the proviso that the first half of 2015 may be noisy and hard
to read, I'll just catalog a few of the obvious things that might confuse true underlying
conditions: oil prices, the dollar, the effects of both oil prices and exchange rates on headline
inflation, their possible impact on core inflation, slow-to-improve wages, the ups and downs
of quarter-to-quarter growth, and mixed messages from measures of inflation expectations.
What am I looking for?
So, if the linchpin in a policy decision, for me, is confidence, what am I looking for?
For starters, as I said earlier, key indicators of economic conditions should not be moving
away from my basic outlook. Assuming no substantial softening of GDP and employment
growth, my attention will likely be on the path of inflation.
I'd like to see some evidence that what we believe to be transient factors driving recent weak
inflation readings are, in fact, passing. I would like to see firming of inflation readings. This
will give me confidence that the outlook on which important decisions will swing remains
realistic and likely to play out.
Inflation is appropriately a focal point because its firming will reduce concerns that the
economy is somehow stalling, that prophesies of long-term stagnation have any basis, and
that chances of accomplishing the FOMC's policy goals are receding.
As of today, I remain comfortable with the assumption that circumstances will come together
around mid-year, or a little later, that will deliver sufficient confidence to begin normalization
with the liftoff decision. I won't be more definitive than that. I think all possibilities from June
on should remain open. I don't at this juncture have a prediction or preference. Timing will
depend on what the data tell us.
From a Main Street perspective, the important point for business planning is that monetary
policy is likely to shift sometime this year, and a higher interest-rate environment will ensue.
The decision to begin normalization should be a signal that the FOMC is confident the
economy is on track to achieve its objectives and that the economy should have sufficient
strength and momentum to handle higher rates. The start of the process of normalization
should itself instill confidence on Main Street.