Jerome H Powell: Recent economic developments, the productive
potential of the economy, and monetary policy
Speech by Mr Jerome H Powell, Member of the Board of Governors of the Federal Reserve
System, at the Peterson Institute for International Economics, Washington DC, 26 May 2016.
* * *
Original presentation is on the Board of Governors of the Federal Reserve System's website: Slides (PDF).
Thank you for the opportunity to speak here today. I will begin by reviewing recent economic
developments and then turn to supply-side considerations, such as the level of potential
output and the potential growth of our economy. I will conclude with a discussion of monetary
policy. As always, the views I express here today are mine alone.
Recent developments and the state of the economy
The U.S. economy has improved steadily since the recovery began seven years ago. Our
economy is now 10 percent larger than at its previous peak in 2007. Employment has
surpassed its 2008 peak by 5 million workers, and the unemployment rate has fallen from
10 percent to 5 percent, close to the level that many observers associate with full
employment.
Labor market developments remain healthy, with employers adding roughly 200,000 jobs per
month so far this year - a pace similar to that of the past several years (figure 1). Job growth
continues to be substantially faster than the underlying growth of the labor force, so the labor
market continues to tighten. Despite the strong job gains, the unemployment rate has
flattened out at 5 percent over the past six months thanks to a welcome increase in the labor
force participation rate. Meanwhile, there are tentative and encouraging signs of a firming in
wages, seen most clearly in the data on average hourly earnings, which are rising faster than
inflation and productivity. All told, labor market indicators show an economy on solid footing.
Recent spending data have been less positive than the labor market data. Growth of
personal consumption slowed noticeably in the first quarter. Business fixed investment has
fallen for two consecutive quarters, mainly because of a steep decline in energy-related
capital expenditures. As a result, gross domestic product (GDP) growth over the two quarters
ending in March 2016 is estimated to have averaged only 1 percent on an annualized basis.
This estimate may continue to move around as more data come in.1 And there are good
reasons to think that underlying growth is stronger than these recent readings suggest. Labor
market data generally provide a better real-time signal of the underlying pace of economic
activity.2 In addition, retail sales surged in April, as did consumer confidence in May,
suggesting that the pause in consumption may have been transitory. Moreover, stronger
demand would be more consistent with an environment that remains quite supportive of
growth, with low interest rates, low gasoline prices, solid real income gains, a high ratio of
household wealth to income, healthy levels of business and household confidence, and
continuing strong job creation. Indeed, current forecasts for second-quarter GDP growth are
for a rebound to around 2-1/4 percent.3
Inflation remains below the 2 percent target of the Federal Open Market Committee (FOMC),
with total inflation as measured by the price index for personal consumption expenditures at
3/4 percent over the 12 months ending in March and core inflation at 1-1/2 percent, both
slightly higher than a year earlier. Core inflation has been held down by falling import prices,
owing in large part to the rise in the dollar, as well as the indirect effects of lower oil prices on
core prices. As the recent financial market tensions have eased, oil prices have increased
and the dollar has weakened a bit on net. If oil prices and the dollar remain broadly stable,
inflation should move up further over time to our 2 percent objective. Inflation expectations
seem to be under some downward pressure. Some survey-based measures are at the low
end of their recent historical ranges. Market-based measures of longer-term breakevens
have declined significantly since mid-2014 and stand near all-time lows. While I see
expectations as staying reasonably well anchored, it is essential that they remain so and that
inflation return over time to the 2 percent objective.
The easing in global financial conditions since mid-February and the associated waning in
downside risks are welcome, and in part reflect expectations that the FOMC would move
more slowly in removing monetary accommodation. However, underlying risks will likely
remain until global growth is on a stronger footing. Growth and inflation remain stubbornly
low for most of our major trading partners. In China, stimulus measures should support
growth in the near term but may also slow China's necessary transition away from its export-
and investment-led business model. Meanwhile, the ongoing buildup of debt there is notable.
There is also some remaining uncertainty about China's exchange rate policy. Elsewhere,
risks are posed by the upcoming "Brexit" vote, ongoing pressures from refugee flows into
Europe, and challenging conditions for emerging economies such as Brazil, Russia, and
Venezuela.
Despite these downside risks, I see U.S. demand growing at a moderate pace, the labor
market continuing to heal, and inflation returning over time to the FOMC's 2 percent
objective. The economy is on track to attain the Committee's dual mandate of stable prices
and maximum employment.
Supply-side considerations
For several years after the crisis, economic activity remained far below its potential, and the
need for highly accommodative policy seemed clear. As the shortfall of output from potential
has narrowed, supply-side considerations such as the level and growth rate of potential
output naturally begin to matter more for policy. I will turn now to a discussion of these
issues.
The tension between labor market and spending data is not a recent phenomenon.
Throughout the recovery period, forecasters have consistently overestimated both actual and
potential GDP growth while underestimating the rate of job creation and the pace of decline
of the unemployment rate (table 1). For example, in 2007, the average expectation for
longrun GDP growth from the Blue Chip survey of 50 forecasters was 2.9 percent (table 2). After
successive reductions, the estimate now stands at 2.1 percent. Blue Chip forecasters also
underestimated the decline in the unemployment rate. Other well-known forecasts followed
this same pattern, including those of the Congressional Budget Office, the Survey of
Professional Forecasters, and, yes, FOMC participants. The pattern suggests that
forecasters have only gradually taken on board the decline in potential in the wake of the
financial crisis.
Output growth can be decomposed into increases in hours worked and changes in output per
hour, or productivity growth. For the United States, much of the post-crisis decline in
estimates of potential output growth appears to reflect weak labor productivity growth rather
than damage to labor supply. Labor productivity has increased only 1/2 percent per year
since 2010 - the slowest five-year growth rate since World War II and about one-fourth of the
average postwar rate (figure 2). For further perspective, productivity growth averaged
1-1/2 percent during the so-called slow productivity period from 1974 to 1995 and 3 percent
during the tech-boom decade from 1995 to 2005. The slowdown has been worldwide and is
evident even in countries that were little affected by the crisis (figure 3). Given the global
nature of the phenomenon, changes in factors specific to the United States are probably not
the main drivers.
One factor holding back productivity in recent years has been the meager growth in the
business sector's capital stock (figure 4). This weakness is consistent with the weak
recovery in demand.4 Another important factor is the marked decline in total factor
productivity (TFP) growth (figure 5). TFP is that part of productivity that is not explained by
capital investment or labor quality; it is thought to be mainly a function of technological
innovation.5 A broad decline in the dynamism in our economy may also be contributing to
lower TFP.6 There is strong evidence that the slowdown in TFP growth in the United States
preceded the financial crisis, particularly in sectors that produce or use information
technologies.7
The range of opinions on the future path of productivity growth is wide, and the historical
record provides ample grounds for humility.8 A middle-ground position that seems to underlie
many current forecasts is that productivity is probably still being held down by cyclical factors
and lingering effects of the crisis. As those factors dissipate, labor productivity growth should
move up to 1-1/2 percent or so, the lower end of its longer-run range.
In addition to productivity, the other principal factor in potential output is labor supply, which
is determined by the working-age population, the natural rate of unemployment, and the
trend labor force participation rate. Both the natural rate of unemployment and labor force
participation initially appeared to suffer crisis-related damage. But more recent data are a bit
more encouraging.
The natural rate of unemployment reflects the matching of characteristics that employers are
seeking with those of the unemployed. With the dramatic labor market dislocations of the
crisis, it was not surprising to see measures of matching efficiency deteriorate, and many
4
See Eugenio Pinto and Stacey Tevlin (2014), "Perspectives on the Recent Weakness in Investment," FEDS
Notes (Washington: Board of Governors of the Federal Reserve System, November 21). Their analysis
indicates that investment growth over the expansion has been consistent with a model using business output
growth and the user cost of capital. In a second model, they show that the modest increases in the capital
stock are consistent with the increase in labor supply and TFP.
5
Over long periods of time total factor productivity is primarily driven by innovation, knowledge and the
efficiency with which inputs are put to use owing to the evolution of business practices as well as the
influences of public capital stock, government regulations and other factors. Over shorter periods of time TFP
will also capture the variations in the intensity of utilization of inputs, such as capacity utilization and hours per
worker. Disentangling TFP from capital deepening and hours worked can be challenging.
6
See, for example, Ryan Decker, John Haltiwanger, Ron Jarmin, and Javier Miranda (2014), "The Role of
Entrepreneurship in U.S. Job Creation and Economic Dynamism," Journal of Economic Perspectives, vol. 28
(Summer), pp. 3-24.
7
See John Fernald (2014), "Productivity and Potential Output before, during, and after the Great Recession,"
NBER Macroeconomics Annual, vol. 29, no. 1 (Cambridge, Mass.: National Bureau of Economic Research).
Some have argued that part of the TFP slowdown may actually be a measurement problem, owing to the
difficulty in measuring the productivity of health care, information technology, and other services. Others see
the evidence for that claim as weak. For example, a recent paper finds little evidence that the slowdown arises
from growing mismeasurement in information-technology-related goods and services. See David M. Byrne,
John G. Fernald, and Marshall B. Reinsdorf (2016), "Does the United States Have a Productivity Slowdown or
a Measurement Problem?" Brookings Papers on Economic Activity, March 4.
8
On the pessimistic end of the spectrum are analysts such as Robert Gordon; among the optimists are Erik
Brynjolfsson and Andrew McAfee. See Robert J. Gordon (2016), The Rise and Fall of American Growth: The
U.S. Standard of Living since the Civil War (Princeton, N.J.: Princeton University Press); and Erik Brynjolfsson
and Andrew McAfee (2014), The Second Machine Age: Work, Progress, and Prosperity in a Time of Brilliant
Technologies (New York: W.W. Norton).
observers raised their estimates of the natural rate accordingly. But there are other factors,
such as demographic change, that may have led to a decline in the natural rate of
unemployment.9 Blue Chip forecasters' estimate of the natural rate have now returned to
around 5 percent, about the same as before the crisis, suggesting that these factors are
roughly offsetting. Of course, estimates of the natural rate are highly uncertain.10
Trends in labor force participation add another element of uncertainty. Participation has been
declining since about 2000 and is estimated to have a trend rate of decline of 20 to 30 basis
points per year, driven by population aging and other longer-term trends such as the decline
in participation by prime-age males. But the participation rate fell sharply after the crisis,
faster than its apparent trend. It has been important to understand how much of the
postcrisis decline is cyclical, and thus amenable to repair by supportive policies, and how much is
secular, due either to longer-run trends or to irreversible crisis-related damage. It has been a
relief to see the participation rate improve over the past two years relative to estimates of its
trend; indeed, participation is now close to some such estimates.11 Still, despite this relative
improvement, the performance of the U.S. economy on this dimension has been poor relative
to that of most OECD (Organisation for Economic Co-operation and Development) countries.
For example, in the prime-age group of 25 to 54, the United States experienced a
2 percentage point decline in labor force participation from 2007 to 2014, while most OECD
countries saw an increase (figure 6). The United States now stands at the low end of labor
force participation for both men and women in this age group - above Italy, but well below
Germany, France, and Spain.12
Lower potential growth would likely translate into lower estimates of the level of interest rates
necessary to sustain stable prices and full employment. Estimates of the long-run "neutral"
federal funds rate have declined about 100 basis points since the end of the crisis. The real
yield on the 10-year Treasury is currently close to zero, compared with around 2 percent in
the mid-2000s. Some of the decline in longer-term rates is explained by lower estimates of
potential growth, and some by other factors such as very low term premiums.
To sum up so far, estimates of long-run potential growth of the U.S. economy have dropped
from about 3 percent to about 2 percent in the wake of the crisis, with much of the decline a
function of slower productivity growth. The decline in realized productivity growth seems to
be driven both by low capital investment that is well explained by weak demand and by lower
9
For example, older labor force cohorts have lower participation but also lower unemployment rates.
10
Confidence intervals around statistical estimates of the natural rate are routinely estimated to be quite wide,
reflecting both uncertainty about the correct model specification and uncertainty about the parameter
estimates given the model. The canonical paper by Staiger, Stock, and Watson puts the 95 percent
confidence interval at 1-1/2 percentage points on either side of the point estimate. See Douglas Staiger,
James H. Stock, and Mark W. Watson (1997), "How Precise Are Estimates of the Natural Rate of
Unemployment?" in Christina D. Romer and David H. Romer, eds., Reducing Inflation: Motivation and
Strategy (Chicago: University of Chicago Press).
11
For example, a paper by Stephanie Aaronson and others estimates a trend below the current participation
rate, while the Congressional Budget Office's estimate is above the current rate. See Stephanie Aaronson,
Tomaz Cajner, Bruce Fallick, Felix Galbis-Reig, Christopher Smith, and William Wascher (2014), "Labor Force
Participation: Recent Developments and Future Prospects," Brookings Papers on Economic Activity, Fall, pp.
197-275; and Congressional Budget Office (2016), The Budget and Economic Outlook: 2016 to 2026
(Washington: CBO, January 25). For the argument that most of the decline is related to the severity of the
recession and is likely reversible, see Christopher J. Erceg and Andrew T. Levin (2013), "Labor Force
Participation and Monetary Policy in the Wake of the Great Recession (PDF)," IMF Working Paper WP/13/245
(Washington: International Monetary Fund, July).
12
Different countries use slightly different concepts for measuring labor force participation, and therefore
crosscountry comparisons may reflect some measurement issues. However, to the extent that these differences are
constant over time, comparisons of the relative performances will be little affected. Accordingly, it is worth
highlighting that the labor force participation rate in the 25-54 age group has declined somewhat in the U.S.
since 2008, while it has been relatively steady or even increased some in other major advanced economies.
TFP growth. Expectations of lower productivity growth going forward are more a function of
slower gains in TFP. Lower potential output growth would mean that interest rates will remain
below their pre-crisis levels even after the output gap is fully closed and inflation returns to
2 percent.
Over time, our understanding of the relationship between recessions and supply-side factors
has evolved.13 There is a growing body of work suggesting that recessions can leave behind
lasting damage - especially severe recessions associated with a financial crisis. One recent
analysis suggests that about one-third of the time, there is no permanent supply-side
damage; about one-third of the time, there is a reduction in the level of potential output but
not its subsequent growth rate; and about one-third of the time, there is a reduction both in
the level of output and in the growth rate.14 Unfortunately, recent experience suggests that
the United States is at risk of falling in the last category (figure 7).
It goes without saying that economic policymakers should use all available tools to minimize
supply-side damage from the crisis. We need policies that support labor force participation
and the development of skills, business hiring and investment, and productivity growth -
policies that are, for the most part, outside the remit of the Federal Reserve. Monetary policy
can contribute by continuing to support the expansion as long as inflation remains consistent
with our 2 percent objective and inflation expectations remain stable.
Strong labor markets do seem to be averting some of the damage that might otherwise have
become permanent. Improved matching is reducing the natural rate of unemployment.
Potential workers are being pulled into the labor force by rising real wages and the
recognition that jobs are becoming easier to find. Over a longer period, stronger demand
should support increased investment, driving productivity higher. Moreover, as the economy
tightens, firms will have rising incentives to get more out of every dollar of capital and hour of
work.
Real-time estimates of potential output are highly uncertain; forecasts of potential growth
even more so. We can estimate growth of the working-age population reasonably well.
Future levels of labor force participation are less certain. Least certain of all are forecasts of
TFP. If the optimists are right, then there will eventually be another wave of high productivity
growth driven by the truly remarkable evolution of technology. That would mean higher
potential growth, faster increases in living standards, and also a return to higher interest
rates over time.
What if the pessimists are right and productivity growth remains low for another decade, or
indefinitely? The consequences would include lower potential growth and relatively lower
living standards. Our longer-term fiscal challenges would be significantly greater.
Monetary policy
The implications for monetary policy of these supply-side issues have been limited, but they
begin to matter more as we near full employment.
For the near term, my baseline expectation is that our economy will continue on its path of
growth at around 2 percent. To confirm that expectation, it will be important to see a
significant strengthening in growth in the second quarter after the apparent softness of the
past two quarters. To support this growth narrative, I also expect the ongoing healing
process in labor markets to continue, with strong job growth, further reductions in headline
unemployment and other measures of slack, and increases in wage inflation. As the
economy tightens, I expect that inflation will continue to move over time to the Committee's
2 percent objective.
If incoming data continue to support those expectations, I would see it as appropriate to
continue to gradually raise the federal funds rate. Depending on the incoming data and the
evolving risks, another rate increase may be appropriate fairly soon. Several factors suggest
that the pace of rate increases should be gradual, including the asymmetry of risks at the
zero lower bound, downside risks from weak global demand and geopolitical events, a lower
long-run neutral federal funds rate, and the apparently elevated sensitivity of financial
conditions to monetary policy. Uncertainty about the location of supply-side constraints
provides another reason for gradualism.
There are potential concerns with such a gradual approach. It is possible that monetary
policy could push resource utilization too high, and that inflation would move temporarily
above target. In an era of anchored inflation expectations, undershooting the natural rate of
unemployment should result in only a small and temporary increase in the inflation rate.15 But
running the economy above its potential growth rate for an extended period could involve
significant risks even if inflation does not move meaningfully above target. A long period of
very low interest rates could lead to excessive risk-taking and, over time, to unsustainably
high asset prices and credit growth. Macroprudential and other supervisory policies are
designed to reduce both the likelihood of such an outcome and the severity of the
consequences if it does occur. But it is not certain that these tools would prove adequate in a
financial system in which much intermediation takes place outside the regulated banking
sector. Thus, developments along these lines could ultimately present a difficult set of
tradeoffs for monetary policy.16
Conclusion
To wrap up, with the support of monetary accommodation, our economy has made
substantial progress. My view is that a continued gradual return to more normal monetary
policy settings will give us the best chance to continue to make up lost ground.