For release on delivery
10:00 a.m. EDT (8:00 a.m. MDT)
August 24, 2018
Monetary Policy in a Changing Economy
Remarks by
Jerome H. Powell
Chairman
Board of Governors of the Federal Reserve System
at
"Changing Market Structure and Implications for Monetary Policy," a symposium
sponsored by the Federal Reserve Bank of Kansas City
Jackson Hole, Wyoming
August 24, 2018
Thank you for the opportunity to speak here today. Fifteen years ago, during the
period now referred to as the Great Moderation, the topic of this symposium was
"Adapting to a Changing Economy." In opening the proceedings,
then-Chairman Alan
Greenspan famously declared that "uncertainty is not just an important feature of the
monetary policy landscape; it is the defining characteristic of that landscape."1
On the
doorstep of the period now referred to as the Global Financial Crisis, surely few, if any,
at that symposium would have imagined how shockingly different the next 15 years
would be from the 15 years that preceded it.
Over the course of a long recovery, the U.S. economy has strengthened
substantially. The unemployment rate has declined steadily for almost nine years and, at
3.9 percent, is now near a 20-year low. Most people who want jobs can find
Committee's
them. Inflation has moved up and is now near the Federal Open Market
(FOMC) objective of 2 percent after running generally below that level for six
years. With solid household and business confidence, healthy levels of job creation,
rising incomes, and fiscal stimulus arriving, there is good reason to expect that this strong
performance will continue.
As the economy has strengthened, the FOMC has gradually raised the federal
funds rate from its crisis-era low near zero toward more normal levels. We are also
allowing our securities holdings--assets acquired to support the economy during the deep
I
recession and the long recovery--to decline gradually as these securities are paid off.
will explain today why the Committee's consensus view is that this gradual process of
normalization remains appropriate. As always, there are risk factors abroad and at home
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that, in time, could demand a different policy response, but today I will step back from
these.
In keeping with the spirit of this year's symposium
topic--the changing structures
of the economy--I would also note briefly that the U.S. economy faces a number of
longer-term structural challenges that are mostly beyond the reach of monetary
policy. For example, real wages, particularly for medium- and low-income workers, have
grown quite slowly in recent decades. Economic mobility in the United States has
declined and is now lower than in most other advanced economies.2 Addressing the
federal budget deficit, which has long been on an unsustainable path, becomes
increasingly important as a larger share of the population retires. Finally, it is difficult to
say when or whether the economy will break out of its low-productivity mode of the past
decade or more, as it must if incomes are to rise meaningfully over time.
My FOMC colleagues and I believe that we can best support progress on these
issues by pursuing the Federal Reserve's mandate and supporting continued
longer-term
economic growth, a strong labor market, and inflation near 2 percent. The topic of
managing uncertainty in policymaking remains particularly salient. I will focus today on
one of the many facets of uncertainty discussed at the 2003 symposium--uncertainty
around the location of important macroeconomic variables such as the natural rate of
unemployment. A good place to start is with two opposing questions that regularly arise
in discussions of monetary policy both inside and outside the Fed:
- 3 -
1. With the unemployment rate well below estimates of its longer-term normal
why isn't the FOMC tightening monetary policy more sharply to head off
level,
overheating and inflation?
2. With no clear sign of an inflation problem, why is the FOMC tightening policy
at all, at the risk of choking off job growth and continued expansion?
These questions strike me as representing the two errors that the Committee is
always seeking to avoid as expansions continue--moving too fast and needlessly
shortening the expansion, versus moving too slowly and risking a destabilizing
overheating. As I will discuss, the job of avoiding these errors is made challenging today
because the economy has been changing in ways that are difficult to detect and measure
in real time. I will first lay out a standard view of a handful of basic relationships that are
thought to reflect key aspects of the underlying structure of the economy. I will then use
that framework to explain the role that structural change plays in our current policy
deliberations, focusing on how that role has been shaped by two historical episodes.
Conventional Views of Macroeconomic Structure
In conventional models of the economy, major economic quantities such as
inflation, unemployment, and the growth rate of gross domestic product (GDP) fluctuate
"normal," or or The
around values that are considered "natural," "desired." FOMC has
chosen a 2 percent inflation objective as one of these desired values. The other values are
not directly observed, nor can they be chosen by anyone. Instead, these values result
from myriad interactions throughout the economy. In the FOMC's quarterly Summary of
Economic Projections (SEP), participants state their individual views on the longer-run
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normal values for the growth rate of GDP, the unemployment rate, and the federal funds
rate.
These fundamental structural features of the economy are also known by more
familiar names such as the "natural rate of unemployment" and "potential output
growth." The inflation is the "neutral real
longer-run federal funds rate minus long-run
interest rate." At the Fed and elsewhere, analysts talk about these values so often that
u* (pronounced
they have acquired shorthand names. For example, "u star") is the
rate of unemployment, r* π*
natural ("r star") is the neutral real rate of interest, and ("pi
star") is the inflation objective. According to the conventional thinking, policymakers
should navigate by these stars.3 In that sense, they are very much akin to celestial stars.
For example, the famous Taylor rule calls for setting the federal funds rate based
on where inflation and unemployment stand in relation to the stars.4 If inflation is higher
than π*, raise the real federal funds rate relative to r*. The higher real interest rate will,
through various channels, tend to moderate spending by businesses and households,
which will reduce upward pressure on prices and wages as the economy cools off. In
contrast, if the unemployment rate is above u*, lower the real federal funds rate relative
to r*, which will stimulate spending and raise employment.
Navigating by the stars can sound straightforward. Guiding policy by the stars in
practice, however, has been quite challenging of late because our best assessments of the
location of the stars have been changing significantly.
- 5 -
Shifting Stars during Normalization
In December 2013, the FOMC began winding down the final crisis-era asset
purchase program. Asset purchases declined to zero over 2014, and in December 2015,
the FOMC began the gradual normalization of interest rates that continues to this day. As
normalization has proceeded, FOMC participants and many other private- and public-
sector analysts regularly adjusted their assessments of the stars (figure 1). Many
projections of the natural rate of unemployment fell roughly 1 full percentage point, as
did assessments of the neutral interest rate. Estimates of the potential growth rate of GDP
slipped about 1/2 percentage point.
These changing assessments have big implications. For example, the 1
percentage point fall in the neutral interest rate implies that the federal funds rate was
considerably closer to its longer-run normal and, hence, that policy was less
accommodative than thought at the beginning of normalization. The 1 percentage point
fall in the natural rate of unemployment implies at present that about 1.6 million more
people would have jobs when unemployment is at its longer-run level. These shifts in the
stars generally reflect analysts' attempts to square their estimates with arriving
macroeconomic data. For example, as the unemployment rate fell toward, and then
below, estimates of its natural rate, many expected inflation to move up. When inflation
instead moved sideways, a reasonable inference was that the natural rate was lower than
previously thought. Further, over this period, GDP growth was slower than one might
have expected based on the rapid decline in unemployment and the well-known
relationship between output and unemployment known as Okun's law. Put another way,
labor productivity growth consistently disappointed, which raised the question of whether
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that shortfall was temporary--perhaps due to headwinds from the crisis--or was part of a
new normal.
These assessments of the values of the stars are imprecise and subject to further
revision. To return to the nautical metaphor, the FOMC has been navigating between the
shoals of overheating and premature tightening with only a hazy view of what seem to be
shifting navigational guides. Our approach to this challenge has been shaped by two
much discussed historical episodes--the Great Inflation of the 1960s and 1970s and the
"new economy" period of the late 1990s.
Shifting Stars and the Great Inflation
While the crisis and its aftermath have been extraordinary in many ways, the
shifting of the stars is not one of them. Figure 2 illustrates the Congressional Budget
Office's (CBO) current estimate of movements in the natural rate of unemployment and
potential GDP growth from 1960 to 2000.5 Viewed against the ups and downs observed
over these four decades, the recent shifts in longer-run values are not all that dramatic.
Of course, these CBO estimates benefit from many years of hindsight, whereas monetary
policy must be based on assessments made in real time. The Great Inflation period
vividly illustrates the difficulties this difference raises.
Around 1965, the United States entered a period of high and volatile inflation that
ended with inflation in double digits in the early 1980s. Multiple factors, including
monetary policy errors, contributed to the Great Inflation. Many researchers have
concluded that a key mistake was that monetary policymakers placed too much emphasis
- 7 -
on imprecise--and, as it turns out, overly optimistic--real-time estimates of the natural
rate of unemployment.6
the CBO's
Figure 3 compares current view of the natural rate of unemployment in
that era with an estimate by Athanasios Orphanides and John Williams of the rate as
policymakers perceived it in real time. From 1965 to the early 1980s, this real-time
estimate of u* was well below where hindsight now places it. The unemployment rate
over this period was generally well above the real-time natural rate, and contemporary
documents reveal that policymakers were wary of pushing the unemployment rate even
further above u* (figure 4, top panel).7 With the benefit of hindsight, we now think that,
except for a few years in the mid-1970s, the labor market was tight and contributing to
inflation's rise (figure 4, lower panel).
It is now clear that the FOMC had placed too much emphasis on its imprecise
estimates of u* and too little emphasis on evidence of rising inflation expectations. The
an "expectations revolution" in macroeconomic
Great Inflation did, however, prompt
thinking, with one overwhelmingly important lesson for monetary policymakers:
Anchoring longer-term inflation expectations is a vital precondition for reaching all other
monetary policy goals.8
When longer-term inflation expectations are anchored, unanticipated
developments may push inflation up or down, but people expect that inflation will return
fairly promptly to the desired value. This is the key insight at the heart of the widespread
- 8 -
adoption of inflation targeting by central banks in the wake of the Great Inflation.
Anchored expectations give a central bank greater flexibility to stabilize both
unemployment and inflation. When a central bank acts to stimulate the economy to bring
down unemployment, inflation might push above the bank's inflation target. With
expectations anchored, people expect the central bank to pursue policies that bring
inflation back down, and longer-term inflation expectations do not rise. Thus, policy can
be a bit more accommodative than if policymakers had to offset a rise in longer-term
expectations.
Shifting Stars and the "New Economy" of the Late 1990s
The second half of the 1990s confronted policymakers with a situation that was in
some ways the flipside of that in the Great Inflation. In mid-1996, the unemployment
rate was below the natural rate as perceived in real time, and many FOMC participants
and others were forecasting growth above the economy's potential.
Sentiment was
building on the FOMC to raise the federal funds rate to head off the risk of rising
inflation.9 But Chairman Greenspan had a hunch that the United States was experiencing
the wonders of a "new economy" in which improved productivity growth would allow
faster output growth and lower unemployment, without serious inflation risks.
Greenspan argued that the FOMC should hold off on rate increases.
Over the next two years, thanks to his considerable fortitude, Greenspan
prevailed, and the FOMC raised the federal funds rate only once from mid-1996 through
- 9 -
late 1998.10 Starting in 1996, the economy boomed and the unemployment rate fell, but,
contrary to conventional wisdom at the time, inflation fell.11
Once again, shifting stars help explain the performance of inflation, which many
had seen as a puzzle. Whereas during the Great Inflation period the real-time natural rate
of unemployment had been well below our current-day assessment, in the new-economy
period, this relation was reversed (figure 3). The labor market looked to be tight and
getting tighter in real time, but in retrospect, we estimate that there was slack in the labor
market in 1996 and early 1997, and the labor market only tightened appreciably through
1998 (figure 4). Greenspan was also right that the potential growth rate had shifted up.
With hindsight, we recognize today that higher potential growth could accommodate the
very strong growth that actually materialized, let alone the moderate growth
policymakers were forecasting.12
The FOMC thus avoided the Great-Inflation-era mistake of overemphasizing
Under Chairman Greenspan's leadership, the Committee
imprecise estimates of the stars.
converged on a risk-management strategy that can be distilled into a simple request:
Let's wait one more meeting; if there are clearer signs of inflation, we will commence
tightening.13 Meeting after meeting, the Committee held off on rate increases while
10
In the second half of 1998, a Russian debt default and other ongoing financial instability in Asia
intervened, and the FOMC rapidly lowered the federal funds rate 3/4 percentage point.
11
By current data, over the eight quarters starting in 1996:Q3, core PCE (personal consumption
expenditures) inflation fell from 1.8 percent to 1.3 percent.
12
forecasts each July as part of the Fed's
During this period, FOMC participants submitted six-quarter
Monetary Policy Report to the Congress.
semiannual Each July from 1996 through 1998, the FOMC
forecast growth very close to or above the real-time estimates of potential growth. The forecast growth is
well below current estimates of potential output growth. For the forecasts, see Board of Governors (1996,
1997, 1998).
13
For a more complete discussion of the greatly distilled account here, see the sources in note 9.
believing that signs of rising inflation would soon appear. And meeting after meeting,
inflation gradually declined.
it may seem odd that it took great fortitude to defend "let's
In retrospect, wait one
more meeting," given that inflation was low and falling. Conventional wisdom at the
time, however, still urged policymakers to respond preemptively to inflation risk--even
when that risk was gleaned mainly from hazy, real-time assessments of the stars. With
the experience in the new-economy period, policymakers were beginning to appreciate
that, with inflation expectations much better anchored than before, there was a smaller
risk that an inflation uptick under Greenspan's "wait and see" approach would become a
significant problem.
Risk Management in the Face of Shifting Stars
Given what the economy has shown us over the past 15 years, the need for the
sort of risk-management approach that originated in the new-economy era is clearer than
ever before. That approach continues to evolve based on experience and the growing
literature on monetary policy and structural uncertainty.
Experience has revealed two realities about the relation between inflation and
unemployment, and these bear directly on the two questions I started with. First, the stars
are sometimes far from where we perceive them to be. In particular, we now know that
the level of the unemployment rate relative to our real-time estimate of u* will sometimes
be a misleading indicator of the state of the economy or of future inflation. Second, the
reverse also seems to be true: Inflation may no longer be the first or best indicator of a
tight labor market and rising pressures on resource utilization. Part of the reason inflation
sends a weaker signal is undoubtedly the achievement of anchored inflation expectations
and the related flattening of the Phillips curve.14 Whatever the cause, in the run-up to the
past two recessions, destabilizing excesses appeared mainly in financial markets rather
than in inflation. Thus, risk management suggests looking beyond inflation for signs of
excesses.
These two realities present challenges. The literature on uncertainty reviewed at
the 2003 symposium--and much refined since then--provides important advice for how
policy should respond, although not yet, in my view, an explicit recipe or rule that a
prudent central bank should follow.15 The literature on robust rules, such as so-called
difference rules, for example, supports the idea of putting less emphasis on the level of
The FOMC's practice of
unemployment relative to u*.16 looking at a broad range of
indicators when assessing the state of the labor market has explicitly been part of the
FOMC's
Statement on Longer-Run Goals and Monetary Policy Strategy since its
inception in 2012.17 We have greatly expanded the scope of our surveillance for signs of
labor market tightness and of destabilizing excesses more generally.
The risks from misperceiving the stars also now play a prominent role in the
FOMC's deliberations. A paper by Federal Reserve Board staff is a recent example of a
range of research that helps FOMC participants visualize and manage these risks.18 The
research reports simulations of the economic outcomes that might result under various
14
Kiley (2015) reviews the literature on this point.
15
The literature was reviewed by Walsh at the 2003 symposium; see Walsh (2003). Also from the same
symposium, see, for example, Greenspan (2003), Feldstein (2003), Fischer (2003), and Yellen (2003). For
a more recent perspective, see Wilkins (2017).
16
See Taylor and Williams (2011). Note that the robust rules literature does not suggest ignoring the
general notion of labor market tightness or of resource utilization more generally. Indeed, robust rules
often reflect tightness through the change in the unemployment rate. Instead, the issue is about how best to
take account of labor market tightness when the best estimates of u* are very imprecise. See also Erceg
and others (2018).
17
See Board of Governors (2018).
18
See Erceg and others (2018).
policy rules and policymaker misperceptions about the economy. One general finding is
that no single, simple approach to monetary policy is likely to be appropriate across a
broad range of plausible scenarios.19 More concretely, simulations like these inform our
risk management by assessing the likelihood that misperception would lead to adverse
outcomes, such as inflation falling below zero or rising above 5 percent.
Finally, the literature on structural uncertainty suggests some broader insights.
This literature started with the work of William Brainard and the well-known Brainard
principle, which recommends that when you are uncertain about the effects of your
actions, you should move conservatively.20 In other words, when unsure of the potency
of a medicine, start with a somewhat smaller dose. As Brainard made clear, this is not a
universal truth, and recent research highlights two particularly important cases in which
doing too little comes with higher costs than doing too much. The first case is when
attempting to avoid severely adverse events such as a financial crisis or an extended
period with interest rates at the effective lower bound.21 In such situations, the famous
words "We will do whatever it takes" will likely be more effective than "We will take
cautious steps toward doing whatever it takes." The second case is when inflation
expectations threaten to become unanchored. If expectations were to begin to drift, the
reality or expectation of a weak initial response could exacerbate the problem.22 I am
confident that the FOMC would resolutely "do whatever it takes" should inflation
expectations drift materially up or down or should crisis again threaten. In addition, a
decade of regulatory reforms and private-sector advances have greatly increased the
strength and resilience of the financial system, with the aim of reducing the likelihood
that the inevitable financial shocks will become crises.
The Current Situation
Let me conclude by returning to the matter of navigating between the two risks I
identified--moving too fast and needlessly shortening the expansion, versus moving too
slowly and risking a destabilizing overheating. Readers of the minutes of FOMC
meetings and other communications will know that our discussions focus keenly on the
relative salience of these risks. The diversity of views on the FOMC is one of the great
virtues of our system. Despite differing views on these questions and others, we have a
long institutional tradition of finding common ground in coalescing around a policy
stance.
as the FOMC's
I see the current path of gradually raising interest rates approach
to taking seriously both of these risks. While the unemployment rate is below the
Committee's estimate of the
longer-run natural rate, estimates of this rate are quite
uncertain. The same is true of estimates of the neutral interest rate. We therefore refer to
many indicators when judging the degree of slack in the economy or the degree of
accommodation in the current policy stance. We are also aware that, over time, inflation
has become much less responsive to changes in resource utilization.
While inflation has recently moved up near 2 percent, we have seen no clear sign
of an acceleration above 2 percent, and there does not seem to be an elevated risk of
overheating. This is good news, and we believe that this good news results in part from
the ongoing normalization process, which has moved the stance of policy gradually
closer to the FOMC's rough assessment of neutral as the expansion has continued. As
the most recent FOMC statement indicates, if the strong growth in income and jobs
continues, further gradual increases in the target range for the federal funds rate will
likely be appropriate.
The economy is strong. Inflation is near our 2 percent objective, and most people
who want a job are finding one. My colleagues and I are carefully monitoring incoming
data, and we are setting policy to do what monetary policy can do to support continued
growth, a strong labor market, and inflation near 2 percent.
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Monetary Policy
In a Changing Economy
Jerome H. Powell
Chairman
Board of Governors of the Federal Reserve System
Federal Reserve Bank of Kansas City Economic Symposium
Jackson Hole, Wyoming
For release at 10:00 a.m. EDT (8:00 a.m. MDT)
August 24, 2018
Figure 1. Real-Time Projections of Longer-Run
Normal Values
FOMC Blue Chip CBO
Neutral Real Rate of Interest Real GDP Growth Unemployment Rate
Percent Percent
Percent
2.25
5.75
2.50
2.00
5.50
1.75
2.25
5.25
1.50
2.00
1.25
5.00
1.00
1.75
4.75
0.75
4.50
0.50 1.50
2012 2013 2014 2015 2016 2017 2018 2012 2013 2014 2015 2016 2017 2018 2012 2013 2014 2015 2016 2017 2018
Note: Federal Open Market Committee (FOMC) data are quarterly and extend through June 2018; Blue Chip data are biannual and extend through June 2018;
Congressional Budget Office (CBO) data are biannual and extend through August 2018. GDP is gross domestic product.
Source: For FOMC, Summary of Economic Projections, available on the Board's website at https://www.federalreserve.gov/monetarypolicy/
fomccalendars.htm; for Blue Chip, Wolters Kluwer, Blue Chip Economic Indicators and Blue Chip Financial Forecasts; for CBO, Congressional Budget Office (The
Budget and Economic Outlook) and Federal Reserve Bank of St. Louis (ALFRED).
Figure 2. Current CBO Estimate of the Natural Rate of
Unemployment and the Potential Growth Rate of GDP
Percent Percent
7 6.5
Potential growth (left scale)
Natural rate of unemployment (r