William C Dudley: The US economic outlook and implications for
monetary policy
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at the Economic Leadership Forum, Somerset, New Jersey,
15 January 2016.
* * *
It is a pleasure to have the opportunity to join you again at the Economic Leadership Forum. I
would like to thank John McWeeney of the New Jersey Bankers Association and Rutgers
University for the invitation to be here today. Northern New Jersey is a vital part of the New
York Fed's district, and I don't just say that because I live here. My staff and I actively maintain
ties with local community, business and banking leaders, and we always benefit from
opportunities to hear about what is on your mind.
I am particularly delighted to see that community banks are well represented here today. The
Federal Reserve understands the importance of a vibrant community banking sector and the
crucial role community banks play in supporting the activities of local businesses and
households. While protecting the safety and soundness of the financial system is an important
part of the Federal Reserve's mandate, I believe that the regulation of community banks should
be appropriately calibrated to reflect the lower degree of risk they pose to the financial system
relative to larger banks. In other words, community banks should not be subject to the same
set of regulations that are applied to the most systemically important banking organizations.
In my remarks, I will discuss the U.S. economic outlook and the implications for U.S. monetary
policy. I will focus primarily on last month's Federal Open Market Committee (FOMC) "lift-off"
decision - the first increase in the federal funds rate target range in nearly 10 years. I'll explain
what motivated my vote to begin to normalize U.S. monetary policy. I'll also offer a preliminary
assessment of how things are going so far - both with respect to how the U.S. bond market
reacted to lift-off and how well our new tools are working as we begin to push up short-term
interest rates. Both issues are pertinent, as money market rates have spent a very long time
close to zero and we have never attempted to tighten monetary policy with such a large
balance sheet and high level of excess reserves. To summarize my conclusions: Generally so
far, so good on both fronts.
Looking ahead, I'll talk about what comes next. No surprises here - it depends on the data. As
noted in the December FOMC statement, we expect that the normalization of monetary policy
will be quite gradual. But, there is no commitment here. The flow of the data - broadly defined
- will drive our actions as it influences our assessment of the economic outlook and our view
of the stance of monetary policy best suited to achieve our dual mandate objectives of
maximum sustainable employment and price stability. As always, what I have to say reflects
my own views and not necessarily those of the FOMC or the Federal Reserve System.1
In terms of the economic outlook, the situation does not appear to have changed much since
the last FOMC meeting. Some recent activity indicators have been on the softer side, pointing
to a relatively weak fourth quarter for real GDP growth. But this needs to be weighed against
the strength evident in the U.S. labor market. I continue to expect that the economy will expand
at a pace slightly above its long-term trend in 2016. In other words, I anticipate sufficient
economic strength to push the unemployment rate down a bit further and to more fully utilize
the nation's labor resources.
Turning to inflation, we continue to fall short of our 2 percent objective for the personal
consumption expenditure (PCE) deflator. But I take it as a positive sign that the core PCE
inflation rate - that is, excluding food and energy - has been quite stable despite the downward
pressure being exerted by lower energy prices on the prices of non-energy goods and services,
as well as the drop in non-energy import prices from a firmer dollar.
Going into more detail, U.S. economic activity has areas of both strength and weakness. On
the stronger side of the ledger, domestic demand is doing reasonably well. In particular,
consumption and housing activity continue to expand at a moderate pace. Consumer spending
has been supported by solid real disposable income growth, which has been underpinned, in
turn, by sturdy job gains and falling energy prices. Residential investment has been slowly
increasing for several years and that trend seems likely to continue in 2016. Housing starts are
still well below the rate consistent with the nation's population growth rate, and the
fundamentals of housing demand remain positive. Rising employment is likely to boost the
household formation rate and low mortgage interest rates should keep housing relatively
affordable, despite the ongoing recovery in home prices. Last month's passage of a fiscal 2016
budget package should also provide support to economic activity. Not only does this budget
package reduce uncertainty about the budgetary outlook, but its extension of a number of tax
breaks and easing of the caps on domestic and military spending means that fiscal policy in
2016 will likely turn somewhat stimulative.
On the weaker side, the collapse in energy prices continues to pull down domestic investment
in oil and gas drilling projects. Although this adjustment is now well-advanced, I suspect that
there remains a further leg down given the sector's diminished cash flows and the reduced
access to credit. In addition, manufacturing remains very soft - hurt by the drop in
energyrelated investment, an ongoing inventory adjustment and the loss of competitiveness caused
by the persistent strength of the U.S. dollar. Even the one bright spot in manufacturing over
the past year - the auto sector - seems to be close to a cyclical peak. Thus, I suspect
manufacturing will continue to be soft in 2016. Overseas developments, especially with respect
to the emerging market economies, pose a risk to the U.S. economic outlook - potentially
exerting greater restraint on the demand for U.S. exports and contributing to greater turbulence
in global financial markets. Putting these positives and negatives together, the most likely
outlook seems to be more of what we have experienced in this expansion - an economy that
grows at slightly above a 2 percent annual rate this year.
The inflation outlook also has not changed much. Inflation remains well below the Federal
Reserve's 2 percent objective. In my assessment, this is due mainly to weaker energy prices
and the impact of a stronger dollar on non-energy import prices. However, the fact that core
measures of inflation are considerably higher than the headline readings, and have been quite
stable in recent months, suggests to me that we are likely to see inflation rise once energy
prices stop falling and the dollar stops appreciating - clearly neither trend can persist
indefinitely. Of course, this assumes that the U.S. economy grows sufficiently rapidly so that
pressure on available labor and capital resources continues to increase.
With respect to the risks to the inflation outlook, the most concerning is the possibility that
inflation expectations become unanchored to the downside. This would be problematic were it
to occur because inflation expectations are an important driver of actual inflation. If inflation
expectations become unanchored to the downside, it would become much more difficult to
push inflation back up to the central bank's objective. Japan's difficult experience indicates the
importance of avoiding such an outcome.
For this reason, we closely monitor inflation expectations. Inflation measured by the PCE
deflator has been running below the FOMC's objective since May 2012. A concern is whether
these persistent underruns in inflation may be beginning to weigh on inflation expectations.
Some surveys of inflation expectations have softened recently. For example, the University of
Michigan measure of median long-term household inflation expectations - that is, expected
inflation at a five-to ten-year horizon - is currently at 2.6 percent. This is near the very bottom
end of its range over the past two decades.
The New York Fed's Survey of Consumer Expectations also shows softness. The median of
3-year inflation expectations has declined over the past year, falling by 22 basis points to
2.8 percent. While the magnitude of this decline is small, I think it is noteworthy because the
current reading is below where we have been during the survey history. Up until July 2014, the
median largely stayed in the range from 3.2 to 3.4 percent, and from July 2014 to July 2015 it
remained near 3 percent.
While it has a short history, I put more weight on the New York Fed's survey because its
methodology should be more robust in accurately assessing consumer inflation expectations.
Compared to the more widely followed University of Michigan survey, for example, the New
York Fed survey has several advantages. The sample size is larger, most of the people that
are interviewed are the same each month, and the inflation expectations question is posed
differently to focus the respondent's attention on inflation rather than on prices. We believe that
all these factors lead to a more reliable estimate of inflation expectations.
Obviously, I didn't think the degree of weakness we have seen in our survey measure of
inflation expectations was of sufficient concern to defer the start of monetary policy
normalization. And, as long as the economy continues to grow at an above-trend pace, I expect
the increase in resource utilization will be sufficient to push both inflation and inflation
expectations higher over time. That said, should the economy unexpectedly weaken, then this
fall in inflation expectations would become more concerning.
Assuming, as I anticipate, that inflation does move back towards our 2 percent target, I am
often asked how tolerant would I be of an overshoot? In other words, is the 2 percent inflation
target a ceiling or not? I don't think of the 2 percent objective as a ceiling. I would be equally
intolerant of misses relative to 2 percent in both directions, above or below, with my intolerance
growing the further we deviated from our 2 percent objective. We will almost certainly never
be precisely at our 2 percent objective for any length of time given all the forces - many of
which are not under our control - that influence actual inflation outcomes over a business
cycle. Thus, with a neutral monetary policy, my goal would be to spend about the same amount
of time slightly above as slightly below our 2 percent objective.
Turning now to U.S. monetary policy, why did I favor raising the federal funds rate target last
month? Basically, my assessment was that our conditions for lift-off had been met. Recall,
these two conditions were: 1) further improvement in the labor market that we anticipated
would be sustained in 2016, and 2) greater confidence that inflation would begin to move back
towards our 2 percent inflation objective over the medium term.
The timing of policy normalization involves a balancing of risks. I don't disagree with our critics
that there were risks from lifting off in December versus waiting a little longer. First, the
economy might turn out to be more fragile than we anticipate, or economic shocks could push
the economy off-course relative to our expectations. In other words, our economic projections
might be too optimistic. Second, the first tightening move might itself provoke another taper
tantrum characterized by higher bond yields and tighter financial market conditions that could
be sufficiently strong to impede the economic recovery.
My judgment was that these risks were manageable. First, downside forecast errors are
certainly possible, but the U.S. economy appears to be on sufficiently sound footing to
withstand downside shocks better than was the case a few years ago. Second, I felt that the
likelihood of a substantial tightening in financial market conditions due to lift-off was relatively
low, in part, because the rate hike was widely anticipated. Market conditions had adjusted quite
smoothly - except for some strains observed in the high-yield debt market - as market
participants placed higher odds of tightening in the weeks preceding the December FOMC
meeting. This reinforced that conclusion. A large market reaction would have been a surprise
given that this was one of the most anticipated monetary policy events in history. Also, the
policy action needs to be viewed in context. While this decision was the first upward adjustment
to short-term rates in nearly 10 years, the actual move was small - only 25 basis points -
which, by itself, should have only a very mild impact on the overall trajectory of the economy.
As we noted in the FOMC statement and as Chair Yellen pointed out in her December press
conference, even after this rate hike, the stance of monetary policy remains accommodative.
Moreover, it is important to recognize that there are also significant risks from waiting longer
to lift off. Upside forecast errors are also certainly possible. For example, while the pace of
growth has generally been weaker than expected in recent years, the pace of labor market
improvement has generally been stronger. By waiting, we would increase the risk that we
would need to raise rates more aggressively in the future. This could unduly threaten the
economic expansion. In balancing these risks, relatively "early and slow" seems like a better
strategy than "late and fast" - especially when one is uncertain both about the degree of
accommodation being provided by monetary policy and the level of unemployment consistent
with our price stability mandate. Because monetary policy works with a lag, policy
normalization needs to begin before the economy reaches its employment and inflation
objectives. That is, if we are to get to a neutral monetary policy setting before inflation materially
overshoots our 2 percent objective, then we need to get started. Once underway, the pace of
policy tightening can be calibrated to how the economy and financial market conditions are
responding.
A particular risk of late and fast is that the unemployment rate could significantly undershoot
the level consistent with price stability. If this occurred, then inflation would likely rise above
our objective. At that point, history shows it is very difficult to push the unemployment rate back
up just a little bit in order to contain inflation pressures. Looking at the post-war period,
whenever the unemployment rate has increased by more than 0.3 to 0.4 percentage points,
the economy has always ended up in a full-blown recession with the unemployment rate rising
by at least 1.9 percentage points. This is an outcome to avoid, especially given that in an
economic downturn the last to be hired are often the first to be fired. The goal is the maximum
sustainable level of employment - in other words, the most job opportunities for the most
people over the long run.
Some of you may be wondering whether the risk of a recession isn't already quite high? And,
if so, doesn't this imply a need for special care in adjusting monetary policy? After all, the
current economic expansion is more than six years old - a bit long in the tooth by post-war
standards.
Even so, recession risk did not play a major factor in my thinking. Economic expansions don't
simply die of old age. They primarily end either because monetary policy is kept too loose for
too long, thereby necessitating a subsequent sharp tightening in monetary policy to prevent a
significant inflation overshoot, or because some large adverse shock hits the economy that the
central bank cannot easily offset. Mitigating the first risk of being forced to choke off the
expansion argues for getting started with policy normalization now rather than holding off. With
respect to the second risk of unanticipated shocks, this is obviously very difficult for the central
bank to insulate the economy from. Making sure the financial system is robust and resilient is
probably the most important thing the central bank can do in this respect.
I would like to turn now to the issue of how the initial step in normalization is going. The U.S.
bond market response to lift-off has been very mild. There has been no bond market "taper
tantrum" such as what occurred in 2013 when Chairman Bernanke discussed the possibility of
tapering Federal Reserve asset purchases. Normalization is also going very well in the sense
that, even with an extraordinarily large balance sheet, the tools we have developed to raise
the federal funds rate (and other money market rates) have so far worked well. The federal
funds rate is trading close to the middle of the new target range of 25 to 50 basis points and
other money market rates have moved up in tandem.
Why is this noteworthy? To explain, I'll first have to provide some background on how monetary
policy used to work before the crisis and then compare that regime with how it works now.
Before the financial crisis, banks valued reserves - even though the Federal Reserve paid no
interest on them - because the Federal Reserve kept their supply scarce. When the FOMC
wanted to adjust its federal funds rate target - that is, the interest rate banks earn or pay when
lending or borrowing overnight reserves with another bank - it directed the System Open
Market Account (the Desk) manager in New York to alter the supply of reserves within the
banking system (up or down) as needed to match the estimated demand for reserves in order
to keep the federal funds rate very close to the FOMC's target.2 In this setup, the amount of
banking reserves in the system - required and excess - was very small and the Desk typically
conducted open market operations that added or drained no more than a few billion dollars of
reserves from the banking system to ensure that the federal funds rate traded around the
FOMC's target.
In October 2008, after passage of the TARP legislation, the Federal Reserve was authorized
to implement a new tool, the ability to pay interest on required and excess reserves.3 This tool
was significant because it meant that the FOMC would be able to control interest rate policy
even with a much larger balance sheet and a much larger amount of excess reserves in the
banking system. This was important because it gave us more scope to expand the Federal
Reserve's balance sheet to help address the financial crisis and to provide support for the
economic recovery, knowing that later, when the recovery took hold, we could raise interest
rates even with an enlarged balance sheet. The Fed wouldn't necessarily be forced to return
to the much smaller balance sheet we had prior to 2008 before we could begin the monetary
policy normalization process.
When interest is paid on reserves, these reserves retain value even when they are no longer
scarce. Banks may be able to borrow funds at lower interest rates from financial entities such
as money market funds that are not permitted to hold deposits at the Federal Reserve and
place these borrowed funds with the Federal Reserve to earn the higher interest rate paid on
reserve balances.
How well the ability to pay interest on reserves works in practice in raising the entire
constellation of short-term interest rates depends critically on the willingness of banks to
engage in such arbitrage activity. Prior to lift-off, we were uncertain how much friction there
might be that would limit the willingness of banks to expand their balance sheets. These
frictions include limits on bank leverage that can make the use of balance sheet capacity costly,
competitive frictions given the relatively narrow range of banks that are viewed as sufficiently
creditworthy to warrant being recipients of large uncollateralized loans and, for those banks
that accept FDIC insured deposits, insurance premiums that increase when they borrow
reserves and their total liabilities increase.
To help ensure that money market rates would track the federal funds rate regardless of these
frictions, the FOMC developed a second tool - the overnight, fixed-rate, reverse repurchase
facility (overnight RRP). In this facility, a number of financial entities, such as money market
funds, that cannot hold reserves at the Federal Reserve can lend funds overnight to the
Federal Reserve against the Fed's Treasury collateral and receive the overnight RRP rate -
currently 25 basis points. The overnight RRP provides these institutions with an alternative
investment if the interest rate offered by banks is unattractive. Consequently, these financial
entities should be unwilling to lend funds to banks and others at lower rates than the overnight
RRP rate. The overnight RRP rate should act, therefore, as a floor on money market rates.
As I noted earlier, the tools are working as anticipated. Not only is the federal funds rate trading
close to the middle of the new 25 to 50 basis point target range, but the entire complex of
money market rates, such as LIBOR deposits and GCF repo, has also risen as well. Moreover,
apart from a temporary spike in usage around year end, which was expected, the usage of the
overnight, fixed rate reverse repo facility has fallen back to levels similar to what we saw during
the testing phase. In recent days, usage has averaged less than $100 billion per day. Thus,
the facility has been absorbing only a small fraction of the $2.4 trillion of excess reserves in
the banking system. This demonstrates that to firm interest rates, we don't necessarily have to
drain reserves or shrink the size of our balance sheet.
We are very pleased by how well our tools are working, and this has reinforced our confidence
that they will support the policy normalization process going forward. This is what we expected
given our extensive testing, but there are always uncertainties that only can be resolved by
actually getting underway. For example, there was some residual uncertainty about how
important a factor the zero lower bound of interest rates had been in supporting the federal
funds rate and other money market rates. This uncertainty now has been at least partially
resolved. Even as we have moved away from the zero lower bound, the relative yield
relationships we saw before December's federal funds rate hike have persisted.
So what's on the docket for monetary policy in 2016? The answer is that it depends on how
the incoming data weighs on the outlook, and how changes in the outlook influence our views
on the appropriate setting for monetary policy. What I can say is that our expectation at the
December FOMC meeting was for further interest rate hikes in 2016 and beyond. Participants
anticipated that the federal funds rate would likely continue on a gradual upward path. Over
the longer term, FOMC participants expected that the federal funds rate would eventually reach
3 to 4 percent as inflation rose back to our 2 percent objective and the headwinds from the
financial crisis that had been restraining economic activity fully dissipated.
Even though this path is shallow relative to previous tightening cycles, the median federal
funds rate path of FOMC participants in the December Summary of Economic Projections
(SEP) is well above the path implied by the federal funds futures market. Should this be a
concern? Does this imply that there is a significant risk of an abrupt future spike in short- and
long-term interest rates as market rates realign to levels more consistent with the median
FOMC participants' projections?
I don't think so for several reasons. First, the SEP projections are modal forecasts - that is,
what the participants believe is most likely to happen - whereas those embodied in market
prices are a mean - that is, an average across all possible outcomes. One might reasonably
expect these modal forecasts to be above the mean when inflation is low and the economic
outlook is uncertain. Second, the median federal funds rate forecasts for primary dealers and
for buyside participants surveyed just prior to the December FOMC meeting differed only
marginally from the December SEP median projections of FOMC participants. This reinforces
my judgment that the difference between means and modes is the main factor for the gap
between the federal funds futures market and the SEP paths. Third, the differences between
the interest rates implied by futures markets and the SEP have been quite small at
shorterterm time horizons, such as the end of 2016, and grow much larger as the time horizon
lengthens. I think this is noteworthy because the confidence one has at longer horizons should
be much lower than at shorter horizons.
Because I do not know what the federal funds rate target range will be at the end of 2017 or
2018 with any confidence, I am not very concerned if others have a different modal forecast.
Projections will adjust as incoming information changes the economic outlook. I would expect
convergence over time of the SEP and market expectations as new information informs the
outlook.
Let me close with some observations about my current thinking concerning our reinvestment
of maturing Treasury securities and paydowns in our agency MBS holdings. As we noted in
the December FOMC statement, we anticipate that we will continue reinvestment "until
normalization of the federal funds rate is well underway." I think this policy makes sense not
only because the decision to end reinvestment will represent a further tightening of monetary
policy, but also because it is difficult to assess ahead of time the impact of such a decision on
financial market conditions given the lack of historical experience.
I also believe that continuing reinvestment until the federal funds rate reaches a higher level
makes sense. We want to ensure that we have the ability to respond to adverse shocks by
easing monetary policy by lowering the policy rate. Having more "dry powder" in the form of
higher short-term interest rates seems more desirable than less dry powder and a smaller
balance sheet.
Now the words "well underway" in the FOMC statement are vague - what does that mean in
terms of the level of the federal funds rate? Reiterating the disclaimer that I am speaking for
myself, my view is that we should not set a numerical tripwire for ending reinvestment. If the
economy were growing very quickly and the risks of an early return to the zero lower bound
for the federal funds rate were deemed to be low, then I could see ending reinvestment at a
relatively low federal funds rate. In contrast, if the economy lacked forward momentum and the
risks of a return to the zero lower bound were judged to be considerably higher, I would want
to continue reinvestment until the federal funds rate was higher. Consistent with the general
principles I mentioned before, the evolution of the overall monetary policy stance - both interest
rate decisions and balance sheet developments - should be data dependent.
In my view, good monetary policy-making requires ongoing assessment and judgment, not the
adherence to mechanical rules. I know market participants desire certainty, but in the uncertain
world in which we live, that desire is not consistent with the policy that would best achieve our
objectives. We will strive to communicate as clearly as we can so you can think along with us
and alter your expectations just as we do in response to incoming information.
Thank you for kind attention. I would be happy to take a few questions.