Lael Brainard: The economic outlook and implications for monetary
policy
Speech by Ms Lael Brainard, Member of the Board of Governors of the Federal Reserve
System, at the Council on Foreign Relations, Washington DC, 3 June 2016.
* * *
These remarks represent my own views, which do not necessarily represent those of the Federal Reserve Board
or the Federal Open Market Committee
In recent months, financial conditions have eased, and there are encouraging signs that
consumption has regained momentum. On the other hand, there are tentative signs of slowing
in the labor market and risks remain. We cannot take the resilience of our recovery for granted.
Recent developments
As we consider the appropriate posture of policy going forward, the most immediate question
is whether the data provide confidence that domestic economic activity has strengthened
notably following two disappointing quarters. This is critical for making progress on the
Committee's dual mandate objectives of full employment and 2 percent inflation. The data in
today's labor market report on balance suggest that the labor market has slowed. Nonfarm
payroll employment increased at an average monthly pace of 116,000 over the last three
months - well below the 220,000 per month average pace over the preceding twelve months.
The unemployment rate moved lower, reaching 4.7 percent, a new low in the current recovery,
but involuntary part-time employment increased and the labor force participation rate declined.
Even so, there are reasons to expect that the labor supply still has room to respond if labor
demand increases. Importantly, the employment to population ratio for prime-age workers still
remains 1-3/4 percentage points below pre-crisis levels. The recent data on wage inflation
suggest a similar conclusion. Although there have been some signs of increasing wage growth
recently, the step-up has been modest, and growth in the broad measures of wages remains
quite low. For example, the average change over the past year across the three most
commonly cited wage measures was about 2-1/2 percent, compared with an average change
from the end of 2009 to the end of 2014 of 2 percent.1
The recent news on inflation - the second leg of our dual mandate - has also been mixed. The
price of oil has rebounded significantly from the lows reached earlier in the year on
expectations that supply and demand are likely to come into better alignment. Over the same
period, the dollar has receded a bit, on net, from its peak in January, though it is still about
15 percent above the level in mid-2014 in inflation-adjusted trade-weighted terms. As a result,
non-oil import prices look likely to stabilize this quarter after a year and a half of declines. Still,
it should be noted that these developments coincided with the easing in financial conditions
since mid-February and are likely due, at least in part, to expectations of more gradual U.S.
monetary policy tightening. If those expectations were to shift materially, the conditions
supporting higher inflation could diminish.
While there are thus signs that inflation will move higher over the medium term, measures of
core inflation have yet to convincingly exceed the low levels that have prevailed over much of
the recovery. The 12-month change in core personal consumption expenditure (PCE) prices,
a reasonable proxy for the underlying trend in inflation, was only 1.6 percent in April. This is
still noticeably below our target and is roughly equal to the average change in core and total
PCE inflation from the end of 2009 to the end of 2014.
We cannot rule out that stubbornly low inflation may be having an effect on inflation
expectations. Market-based measures of inflation compensation - which reflect inflation risk
and liquidity premiums, as well as inflation expectations - remain extremely low. For example,
inflation compensation at the five-year, five-year-ahead horizon is currently around 1.5 percent,
1-1/4 percentage points below levels prevailing prior to mid-2014. Some survey-based
measures of inflation expectations are also somewhat below historical norms. Median 5- to
10-year inflation expectations in the University of Michigan Surveys of Consumers, for
example, over the past year have been on average about 1/4 percentage point below the
average over the 10 years from 2005 to 2014.
Thus, although some signs point to a firming of inflation going forward, I view the persistently
low level of inflation during the recovery together with some signs of a deterioration in inflation
expectations as suggesting that the risks to the return of inflation to our 2 percent target over
the medium term are weighted to the downside.
Progress toward our goals of full employment and 2 percent inflation will depend importantly
on solid growth in aggregate demand. Following disappointing gross domestic product (GDP)
growth in the fourth quarter of last year and the first quarter of this year that averaged only
1.1 percent, I have been very attentive to incoming data, especially on consumption, which
point to a pick-up in growth this quarter.2 In particular, consumer expenditures rose a strong
0.6 percent in April, and auto sales edged higher in May. These are encouraging signs, but the
data relevant for second-quarter growth are still relatively sparse.
In general, demand growth in recent quarters has benefited from a relatively strong household
sector - buoyed by a recovering labor market, reduced oil prices, and low interest rates - and
has been pulled down by weak business investment and net exports. Indeed, consumption
and housing investment can more than account for the 2 percent increase in GDP over the
past four quarters. By contrast, business investment and net exports together subtracted
1⁄4 percentage point. The rise in the dollar and decline in foreign growth reduced demand for
American exports, as well as profits and investment at U.S. firms, which were also adversely
affected by declines in the price of oil. Over the twelve months ending in April, manufacturing
output increased only 0.4 percent, while total industrial production, which also includes the
drilling for, and extraction of, oil and gas, fell 1.1 percent. Although the most recent indicators
suggest that weakness in investment and net exports has persisted into the current quarter, if
the easing in financial conditions since mid-February and the recent firmness in oil prices were
to continue, along with stabilization of the dollar, business investment and exporters would
benefit.
Risks to the outlook
Of course, there are risks to the projection that future GDP growth will be strong enough to
deliver progress on inflation and employment. Most immediately, there is important uncertainty
surrounding the United Kingdom's June 23 "Brexit" referendum on whether to leave the
European Union (EU). The International Monetary Fund has noted that a vote in favor of Brexit
could unsettle financial markets and create a period of uncertainty while the relationship
between the United Kingdom and the EU is renegotiated. Although the economic effects of this
uncertainty and the costs of adjusting to altered trade and financial ties are difficult to quantify,
we cannot rule out a significant adverse reaction to such an outcome in the near term, such as
a substantial jump in financial risk premiums. Because international financial markets are
tightly linked, an adverse reaction in European financial markets could affect U.S. financial
markets, and, through them, real activity in the United States.
In addition, we should not dismiss the possible reemergence of risks surrounding China and
emerging market economies (EMEs) more broadly. In recent months, capital outflows in China
have moderated as pressures on the exchange rate have eased. Should exchange rate
pressures reemerge, we cannot rule out a recurrence of financial stress, which would affect
not only China but also other emerging markets that are linked to China via supply chains or
commodity exports and, ultimately, conditions here. China is making a challenging transition
from export- to domestic demand-led growth, and the cost of reallocating resources from
excess capacity sectors to more dynamic sectors could further impair growth in the near term.
While China has taken policy steps to limit the extent of the slowdown, there is an evident
tension in policy between reform and stimulus, and the effect of the stimulus may already be
waning. Vulnerabilities - such as excess capacity, elevated corporate debt, and risks in the
shadow banking sector - appear to be building, and could pose continued risks over the
medium term.
The fragility of the global economic environment is unlikely to resolve any time soon. Growth
in the advanced economies remains dependent on extraordinary unconventional monetary
policy accommodation, while conventional policy continues to be constrained by the zero lower
bound. Conventional policy, whose efficacy is more tested and better understood than
unconventional policies, can respond readily to upside surprises to demand, but presently
would be constrained in adjusting to downside surprises. This asymmetry in the capability of
policy effectively skews risks to the outlook to the downside.
It also may amplify the sensitivity of exchange rates. Indeed, the evidence suggests that over
the past year, dollar exchange rate movements have become considerably greater in response
to U.S. monetary policy surprises than previously.3 The evidence that the sensitivity of
exchange rate movements has been elevated lately is consistent with recent research
suggesting that cross border financial transmission is likely to be amplified at near-zero interest
rates where the ability to provide additional support through domestic channels in response to
negative shocks may be viewed as limited.4
In this environment, markets have become quite sensitive to the possibility of a prolonged
period of low growth, low inflation, and economic underperformance. One possible example of
this sensitivity is the current negative term premium for 10-year Treasury notes, or the
difference between the yield on the 10-year Treasury and expected risk-free short rates over
the next 10 years. Prior to the Great Recession, the term premium was positive, as bond
investors seem to have been most concerned about the risk that inflation would be higher than
expected. But since the Great Recession, the term premium has been persistently negative,
suggesting that investors have instead been focused on the risk of prolonged
lower-thanexpected inflation in the context of low growth and underperformance.5
Thus, while the easing in financial conditions since mid-February is very welcome, it is
important to recognize that some of the conditions underlying recent bouts of turmoil largely
remain in place, and an important reason for the fading of this turbulence was the expectation
of more gradual U.S. monetary policy tightening.6 Should an event trigger renewed fears about
global growth or a reassessment of the policy reaction function in the United States, turbulence
could well return.
Policy implications
On balance, recent developments have signaled continued progress toward our goals. While
signs of weakness in business investment and global demand remain, consumption and
residential investment have held firm, and the labor market has moved closer to full
employment. At the same time, the relative stabilization in the dollar and oil prices in recent
months has boosted somewhat the likelihood of a return to 2 percent inflation over the medium
term. However, the data on progress toward our inflation objective are equivocal. Measures of
underlying inflation have yet to convincingly signal a move back to 2 percent, and inflation
expectations appear low, as I noted earlier.
I want to emphasize that monetary policy is data dependent and is not on a preset course. In
this regard, I look forward to hearing the deliberations of the Committee. Recognizing the data
we have on hand for the second quarter is quite mixed and still limited, and there is important
near-term uncertainty, there would appear to be an advantage to waiting until developments
provide greater confidence. Prudent risk-management would suggest the risks from waiting
until the totality of the data provides greater confidence in a rebound in domestic activity, and
there is greater certainty regarding the "Brexit" vote, seem lower than the risks associated with
moving ahead of these developments. This is especially true since the feedback loop through
exchange rate and financial market channels appears to be elevated. In light of this amplified
feedback loop, when conditions are appropriate for a policy move, it will be important that it be
understood that any subsequent moves would be conditioned on further evidence confirming
continued progress toward our objectives and not as inevitable steps on a preset course.
Indeed, several factors suggest that the appropriate path to return monetary policy to a neutral
stance could turn out to be quite shallow and gradual in the medium term. In particular, it
appears likely that the medium-term neutral rate, or the real federal funds rate consistent with
the economy remaining at full employment and 2 percent inflation, may be quite low. With
productivity running very low, substantial overcapacity and disinflationary pressures abroad,
and less favorable demographics, the neutral rate may be lower and today's federal funds rate
closer to neutral than previously anticipated. Although we cannot observe the neutral rate
directly, a variety of models suggests that it is currently very low relative to historical norms.
Earlier in the recovery it seemed likely that the low level of the neutral rate was largely due to
temporary factors, such as tight credit, weak consumer confidence, and the loss in household
wealth following the crisis. However, with the recovery well into its seventh full year, credit in
many markets is widely available, while consumer confidence and household net worth are at
high levels. As a result, it appears more likely that much of the decline in the neutral rate is
likely to prove persistent, consistent with a variety of estimates.7
One likely explanation for this persistence is the sharp drop-off in potential output growth since
the Great Recession. From 1953 to 2003, potential output growth varied between 3 and
4-1/2 percent, with one brief exception, according to the Congressional Budget Office. Over
the recovery, it has averaged only 1-1/4 percent. One contributor to this decline has been a
reduction in the labor force participation rate due to population aging. Another has been a
marked slowing in productivity growth. Over the six years from the end of 2009 to the end of
2015, productivity grew only a little over 1/2 percent per year, compared with average growth
of 2-1/4 percent over the 50 years prior to the Great Recession.8
The reasons for such a dramatic slowing in productivity growth are not clear. Possible
explanations include the fading of a one-time boost to productivity from information technology
in the late 1990s and early 2000s; the reduced movement of resources from the least
productive to the most productive firms, including new businesses, perhaps due to greater
financial constraints for new and small businesses; and a delay between the introduction of
new technologies, such as robotics, genetic sequencing, and artificial intelligence, and their
effect on new production processes and products.9
To conclude, recent economic developments have been mixed, and important downside risks
remain. In this environment, prudent risk management implies there is a benefit to waiting for
additional data to provide confidence that domestic activity has rebounded strongly and
reassurance that near-term international events will not derail progress toward our goals. In
addition, because the depressed level of the neutral rate of interest reflects forces that are
likely to persist, the appropriate path of policy is likely to remain shallow for several years.
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