William C Dudley: The recovery and monetary policy
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York and Chairman of the Committee on the Global Financial System
(CGFS), at the National Association for Business Economics Annual Meeting, New York City,
15 October 2012.
* * *
Good morning. It is a pleasure to have the opportunity to speak at this NABE (National
Association for Business Economics) conference today. Having spent more than 20 years as
a business economist working in the private sector before joining the Federal Reserve Bank
of New York in 2007, I feel right at home here today.
My remarks will focus on the economic outlook. I do this with some trepidation, of course. In
the private sector there are two adages about forecasting that underscore the need to be
humble in this endeavor: First, forecast often. Second, specify a level or a time horizon, but
never specify both, together.
But more seriously, despite the difficulties in making accurate forecasts, we still need to
understand as best we can why the economy is performing the way it is, what that implies
about the economic outlook, and, how policymakers can respond to generate better
outcomes. We live in a highly complex and uncertain world, but we need to make as much
sense out of it as possible. As always, what I have to say reflects my own views and not
necessarily those of the FOMC (Federal Open Market Committee) or the Federal Reserve
System.
My attention today will be on three important questions:
• Why has the U.S. recovery been so sluggish and consistently weaker than
expected?
• What should we, as monetary policymakers, do it about it?
• What other policy actions are needed to help ensure a timely transition to strong and
sustainable growth?
The disappointing recovery
Turning to the first question, U.S. economic growth has been quite sluggish in recent years.
For example, annualized real GDP (gross domestic product) growth has averaged only about
2.2 percent since the end of the recession in 2009. As a consequence, we have seen only
modest improvement in the U.S. labor market.
Not only has growth been slow, it has also been disappointing relative to the forecasters'
expectations. For example, the Blue Chip Consensus have been persistently too optimistic in
recent years. This is illustrated in Exhibit 1 which shows how private sector forecasts for
2008 through 2013 have evolved over time.
Two aspects of this exhibit are noteworthy. First, forecasters have consistently expected the
U.S. economy to gather momentum over time. Second, with only one exception, the growth
forecasts for each year have been revised downward over time, as the expected
strengthening did not materialize.
In contrast, as shown in Exhibit 2, there has been no notable pattern of forecast misses for
inflation. Sometimes, inflation has been a bit higher than expected, other times a bit lower.
On balance, inflation has been very close to our 2 percent longer-run objective.
Although I have focused on the private forecasting record here, the FOMC participants'
forecasts show a similar pattern. It is on the growth side where there have been chronic,
systematic misses.
In my view, the primary reason for the poor performance of the U.S. economy over this
period has been inadequate aggregate demand. There are several explanations for this.
Although some were well-known earlier, others have only become more obvious as the
recovery has unfolded.
One reason is the nature of economic recoveries following financial crises. On that basis, the
poor performance of the U.S. economy is not unusual - historical experience shows clearly
that recoveries following financial crises typically are very slow and difficult.1
During the credit boom, finance is available on easy terms and the economy builds up
excesses in terms of leverage and risk-taking. When the bust arrives, credit availability drops
sharply and financial deleveraging occurs. Wealth falls sharply, precautionary liquidity
demands increase, desired leverage drops further. In the U.S. case, there were some
idiosyncratic elements, such as subprime lending and collateralized debt obligations. But, in
the end, the U.S. experience included the major elements of most booms: Too much
leverage, too little understanding of risk, too easy credit terms, and then a very sharp
reversal.
When the bust arrives, over-indebted households and businesses want to increase their
saving and liquidity buffers, and financial intermediaries want to raise credit standards. Both
responses restrain demand and make a cyclical rebound more difficult. In the U.S. case,
because the bust was concentrated in housing, the scope for a strong cyclical recovery was
particularly constrained because the interest-rate sensitive sector that would typically lead
such a rebound could not recover until the overhang of unsold homes and the impairment of
housing finances was corrected.
The U.S. recovery has also been subpar because it has been taking place in the context of a
weak global economy. Historically, after a country experienced a financial crisis, growing
foreign demand and currency depreciation have often led to a sharp improvement in the
trade account that has put a floor under economic activity. In such circumstances, rising
exports substitute for domestic consumption in supporting aggregate demand. This demand,
in turn, encourages businesses to hire and invest. In contrast, this time the shock generated
by the U.S. housing bust had global consequences, exposing economic vulnerabilities
outside of the United States, especially in Europe. Under these circumstances, the scope for
trade as a support for U.S. growth, while positive, has been very limited.
These two factors - the dynamics following financial crises and the weakness of foreign
demand - help explain why U.S. growth has been weak, but I don't think these factors
explain why it has been consistently weaker than expected.
After all, on the other side of the ledger, the policy response following the crisis has been
much more aggressive than is typical. On the monetary policy side, the Federal Reserve cut
short-term interest rates close to zero, communicated that short-term rates were likely to stay
exceptionally low far into the future, and undertook a series of large-scale asset purchases in
order to ease financial conditions further.
On the fiscal side, in 2009 the Congress and Administration enacted the largest fiscal
stimulus program in history and some of these fiscal actions were renewed (e.g., extended
unemployment compensation benefits) and new initiatives undertaken (e.g., the payroll tax
holiday) once it became clear that the recovery was faltering. Also, there were significant
policy actions taken to strengthen the banking system, including forcing banks to recapitalize
so that they would have the capacity to sustain their lending.
So why has the recovery disappointed?
One possibility is that the negative dynamics of a post-bubble environment are even more
potent than had been appreciated. Feedback loops may be more powerful and frictions may
be larger. In the U.S. case, this is particularly germane with respect to housing and mortgage
finance. For example, we have found significant shortcomings in those institutional structures
available to support the workout of the overhang of mortgage debt in an efficient and timely
manner.
A second reason may be the series of additional negative shocks experienced since the
initial phase of the financial crisis. The largest of these relate to the crisis in the eurozone.
But one could also add the periodic commodity price shocks, the disruptive impact of the
tragic Japanese earthquake and tsunami on global trade and production, and the effect of
the uncertainties around the impending fiscal cliff on hiring and investing.
That said, the shocks since the acute phase of the crisis in the United States were not
uniformly negative. Take, for example, the sharp increase in U.S. oil and natural gas
production stemming, in part, from the innovations in drilling and extraction technologies. Not
only does this rising production directly boost real GDP, but also the large drop in natural gas
prices has significantly improved the industrial competitiveness of U.S.-based businesses.
A third reason for the weaker than expected recovery likely lies in the interplay between
secular and cyclical factors. In particular, I believe that demographic factors have played a
role in restraining the recovery. The developed world's populations are aging rapidly. In the
United States, for example, the baby boom generation, which is a particularly large cohort, is
now beginning to retire. As the population ages, this has two consequences. First, the
spending decisions of the older age cohorts are less likely to be easily stimulated by
monetary policy. That is because such age groups tend to spend less of their incomes on
consumer durables and housing. Second, as the population ages and the number of retirees
climbs, the costs associated with Social Security, government pensions, and healthcare
retirement benefits increase. This creates budgetary pressure and leads to a choice of
raising revenue to fund these costs, cutting other government programs, or cutting benefits.
Now if this all had been fully anticipated by retirees and near-retirees, then this would already
be factored into their spending and saving decisions. But, I doubt that this has been the case.
I suspect that many have been surprised by the swift change in economic circumstances as
the housing boom went bust. I doubt that many fully anticipated the budget crunch and the
prospect that their future retiree and healthcare benefits would likely be curbed or their taxes
would have to rise in the future. When households begin to anticipate this, they reduce their
assessment of their sustainable living standards. This downward reassessment then feeds
back to current spending and saving decisions.
A fourth reason why the recovery has been slower than expected may be that we
overestimated the capacity for fiscal policy to continue to provide support to growth until a
vigorous recovery was achieved. On the fiscal side, the authorities can cut taxes or increase
spending to support income and demand during the deleveraging phase that follows the
financial crisis. But the ability of such stimulus to continue to support economic activity
ultimately encounters budgetary limits. For example, the need to keep the long-term fiscal
trajectory on a sustainable path limits the size and duration of federal fiscal stimulus
measures. For state and local governments, the statutory requirements for balanced budgets
meant that fiscal policies turned restrictive relatively quickly once budget surpluses and rainy
day funds were exhausted, and this was only temporarily mitigated by federal transfers to the
states as part of the initial fiscal stimulus program. Fiscal policy is now a drag rather than a
support to growth in the United States, and this will likely continue.
Monetary policy
I would give each of these four explanations some weight for why the recovery has been
consistently weaker than expected. But I would add a fifth, monetary policy, while highly
accommodative by historic standards, may still not have been sufficiently accommodative
given the economic circumstances.
Now let me be clear. I believe the evidence overwhelmingly indicates that our monetary
policy has been effective in easing financial conditions and supporting economic activity.
After reducing the traditional policy tool, the target for the overnight federal funds rate, to
close to zero, the Fed has aggressively employed two complementary types of
non-traditional tools - asset purchases and forward guidance on the policy rate - to provide
additional stimulus through their effects on long term rates and various risk premia.
Effective forward guidance on interest rates causes market participants to lower their
expectations and uncertainty about future path of interest rates and to anticipate that easier
financial conditions will persist well in to the future. This pushes down the yield curve and
leads to easier financial conditions.
Federal Reserve asset purchases also make financial conditions more accommodative. Such
purchases, by taking duration out of private hands, push down term premia and lead to lower
long-term rates than would otherwise be the case for any given economic outlook. Agency
MBS (mortgage-backed securities) purchases absorb prepayment risk and reduce secondary
and primary mortgage rates, stimulating demand for housing and increasing purchasing
power through refinancing. Lower long-term rates support the prices of equities and housing,
boosting wealth and easing balance sheet constraints, while an accommodative monetary
policy stance reduces downside risks for the economy and this leads to lower default risk
premia on corporate debt.
Our two tools work in a complementary manner. Asset purchases strengthen the credibility of
the forward guidance on interest rates, while forward guidance provides information about
how long the FOMC is likely to hold on to the assets it purchases.
My conclusion is that the easing of financial conditions resulting from non-traditional policy
actions has had a material effect on both nominal and real growth and has demonstrably
reduced the risk of particularly adverse outcomes. Nevertheless, I also conclude that, with
the benefit of hindsight, monetary policy needed to be still more aggressive. Consequently, it
was appropriate to recalibrate our policy stance, which is what happened at the last FOMC
meeting.
As I argued in a recent speech, simple policy rules, including the most popular versions of
the Taylor Rule, understate the degree of monetary support that may be required to achieve
a given set of economic objectives in a post-financial crisis world. That is because such rules
typically do not adjust for factors such as a time-varying neutral real interest rate, elevated
risk spreads, or impaired transmission channels that can undercut the power of monetary
policy.2
One reason that monetary policy may have been less powerful than normal is that one of the
primary channels through which monetary policy influences the real economy - housing
finance - has been partially impaired. This has both quantity and price dimensions. Credit
availability to households with lower-rated credit scores remains limited and households with
homes that have fallen sharply in value have lost most or all of their home equity and this
makes it very difficult for them to refinance these mortgages.
Federal Reserve MBS purchases have succeeded in driving down mortgage rates to
historically low levels. But these purchases would have had still more effect on the economy
if pass-through rates from the secondary market to the primary market had been higher. As
can be seen in Exhibit 3, the Federal Reserve's purchases significantly narrowed the spread
between agency MBS and Treasury yields, with the latest round of purchases notably
effective in this regard. But, as shown in Exhibit 4 the spread between primary mortgage
rates and agency MBS yields3 has widened and this has limited the drop in primary mortgage
rates.
The incomplete pass-through from agency MBS yields into primary mortgage rates is due to
several factors - including a concentration of mortgage origination volumes at a few key
financial institutions and mortgage rep and warranty requirements that discourage lending for
home purchases and make financial institutions reluctant to refinance mortgages that have
been originated elsewhere. On a related note, higher guarantee fees charges by Fannie Mae
and Freddie Mac have increased the fixed cost of originating loans and this has also
increased the spread between primary and secondary mortgage rates. Factors limiting
pass-through warrant ongoing attention from policymakers.
Another reason why monetary policy has become less effective in stimulating the economy is
because the impetus from a given level of monetary accommodation likely has become
attenuated - that is, less powerful - over time. Historically, attenuation has not been
important because monetary policy typically has not stayed exceptionally easy for long
periods of time. But this time is different and that difference may be important.
So how might the monetary policy impulse on economic activity have become attenuated
over time? I would suggest two potential channels.
The first channel is that monetary policy works, in part, by changing the timing of purchase
decisions. If interest rates decline, the drop in financing costs may induce some households
to buy a motor vehicle or purchase a home now rather than in the future. Of course, if the car
or home is purchased today, this will borrow at least a portion of those sales from the future.
There is a limit to how many cars and homes most people will want to buy, given their budget
constraints. In this case, as the stimulus from the policy stays in place, the impulse on
economic growth will gradually "wear off" as there are fewer and fewer households who can
be induced to pull their future planned purchases forward to the present. The same argument
applies to mortgage refinancing activity. The stimulus comes from the refinancing activity,
which increases the amount of income that borrowers have available for other expenditures.
The impetus to growth wears off unless mortgage rates keep dropping, stimulating additional
rounds of refinancing activity.
The second channel is that low interest rates will gradually reduce the interest income of
savers and this could eventually affect their consumption. Household interest income has
fallen considerably over the past few years.
This effect is likely to work quite slowly. The fact that interest rates are low for six months or
a year probably does not have much impact on households' expectations of their long-term
interest income and thus, does not have much of an impact on consumer spending. But, as
low interest rates are sustained, this could eventually lead to a downward adjustment in
households' assessments of their interest income over time and influence their spending.
One way to look at this is through the prism of forward real interest rates. If interest rate
expectations many years forward have fallen, then expectations about the permanent level of
interest income should have declined as well. As shown in Exhibit 5, forward real rates
five years ahead have declined notably over the past few years. This could be a reasonable
proxy for savers' expectations. Note that the decline in Exhibit 5 has not been precipitous, it
has occurred very gradually over time.
However, policymaking is about making choices between available alternatives. In the long
run, even savers would be better off in a world in which aggressive monetary policy
generates a strengthening recovery that eventually permits the normalization of interest
rates, than they would be compared to a circumstance in which the United States allowed
itself to fall into a Japan-style trap of low growth and low rates for decades. So I do not view
the effect of low rates on savers as a reason to be less accommodative.
Rather, in my view, the potential for the monetary policy impulse to be attenuated over time,
is an additional reason to be aggressive in terms of the policy response. A more front-loaded
program would avoid greater attenuation compared with a policy that started out less
aggressive but added stimulus gradually over time. This has two benefits. First, it would likely
be more successful in generating the desired recovery more quickly. Second, relative to a
more back-loaded program, less would ultimately need to be done to achieve the desired set
of outcomes.
The fact that there are asymmetric payoffs from an economy that is weaker than expected
versus one that is stronger than expected, given that we are at the zero lower bound
reinforces this conclusion. In particular, if the economy were to continue to underperform,
and experienced a severe shock, there would be some risk of getting stuck in a deflationary
situation in which monetary policy would be even less effective.
At the present time there is no conflict between our employment objective and our inflation
objective, as I expect inflation to be at or below our 2 percent longer-run objective over the
coming years. But shouldn't we also consider the costs associated with a more aggressive
monetary policy of the kind adopted at the last FOMC meeting, especially when we are using
non-traditional monetary policy tools?
Absolutely. We have carefully evaluated three potential sets of costs and will continue to
review them.
The first set of costs stems from the risk that the current monetary policy regime could distort
asset allocations and lead to renewed financial asset bubbles. We look at this issue on an
ongoing basis. To date, there is little evidence of problems or excesses, but this could
change as the recovery proceeds. If these costs were to rise, we would need to examine
what steps could be taken on the macro-prudential front in response. Also, such
developments would need to be incorporated into the monetary policy decision-making
process.
The second set of costs stems from the risk that exit from this regime could prove difficult. In
particular, some observers worry that the expansion of the Federal Reserve's balance sheet
could ultimately prove inflationary. If that were the case, then I would regard the costs as
exceptionally high.
Fortunately, I am confident that such fears are misplaced. That is because we now have the
ability to pay interest on excess reserves (IOER). This means we can keep inflation in check
regardless the size of our balance sheet. If the recovery got underway in earnest and credit
demand surged, we could slow down the rate of credit creation by raising the interest rate we
pay on excess reserves. Banks wouldn't lend out funds at lower rates than what they can
earn from holding reserves with us. As a result, a hike in the IOER would raise the level of
interest rates throughout the economy and this would dampen any expansion of credit. Our
ability to pay interest on excess reserves is an essential tool that we can use to avoid future
inflation problems.4
We are mindful of the fact that there could still be confusion about how exit will take place.
This could increase financial market volatility. To reduce this risk, the FOMC has published a
set of exit principles. These principles lay out a roadmap about how exit is likely to occur:
First, the end of reinvestment of maturing securities; second, an increase in short-term
interest rates, and, third, the gradual sale of mortgage backed securities to shrink the
magnitude of excess reserves in the system and ultimately to restore the Fed's balance
sheet to a predominately all-Treasury portfolio.
A degree of humility is appropriate given the lack of experience as to how markets will
respond when economic conditions eventually cause investors to anticipate exit. When asset
purchases are anticipated to end or when asset sales begin to be anticipated, this will affect
term premia in ways that cannot be precisely predicted in advance. That said, I do expect the
repricing will prove manageable. We will seek to communicate so as to avoid generating
sharp shifts in term premia and in long-term interest rates. Also, we will play close attention
to ensure that financial institutions are managing their interest rate risks appropriately.
The third set of costs is the impact of higher short-term rates on the Federal Reserve's
earnings and balance sheet when exit occurs. When we ultimately raise short-term interest
rates, this will squeeze the Fed's net interest margin. Also, when the Fed sells long-term
assets, there is some prospect for losses on these sales depending on the level of long-term
interest rates at the time when such sales occur. This means that the Fed's earning could fall
sharply or even turn negative in a given year. We look at this issue very closely to
understand the risks here. The good news is that a very large proportion of our liabilities -
those associated with currency outstanding - has no interest cost. This mitigates the risk of a
sharp net interest margin squeeze. Moreover, our analysis shows that the cumulative income
generated over the period in which the balance sheet has been unusually large is likely to
exceed normal levels under a wide range of scenarios.
In my view, while the costs are real and need to be carefully evaluated, they pale relative to
the costs of not achieving a sustainable economic recovery. A failure in that regard would
lead to widespread chronic unemployment. Not only would that be tragic for millions of
people, but it also would generate chronic shortfalls in the nation's potential output and fiscal
capacity. Relative to the costs outlined above, the benefits from avoiding such an outcome
seem overwhelming.
Cyclical and structural policy
Although I favor an aggressive monetary policy in the current situation, I also recognize that
monetary policy is not a panacea. We all know that in the long run money is neutral - that is,
that while monetary policy can help the economy return to full employment following a shock,
the full employment level of output, employment and real income depends on factors outside
of monetary policy. Also, we must recognize that the strength of the current cyclical recovery
will depend importantly on non-monetary policy choices.
Other steps are needed to secure the best available economic outcome. In particular,
attention should be paid to what could be done to capitalize on the recent stabilization in
house prices to improve access to mortgage credit and to foster competition in mortgage
origination to ensure a more complete pass-through of low secondary mortgage rates to
households. Indeed, if balance sheet dynamics are more important and frictions around
housing more powerful than we initially understood, then there should be strong payoff to
policies that ease them.
At the same time, Congress and the White House should take steps that reduce the
short-term and long-term uncertainty over fiscal policy. Currently, households and
businesses face elevated short-term uncertainty as to what will happen to tax and spending
policies in 2013 and how this will affect the economic outlook. I believe this is restraining
hiring and investment today.
But families and businesses also face long-term uncertainty about how the country's fiscal
challenges will be addressed. Providing greater clarity about the scope and terms of Social
Security and Medicare must be helpful, especially in correcting those expectations that are
unduly pessimistic. On this score, Social Security is particularly noteworthy. According to a
2011 Pew Research Center poll, more than 40 percent of people aged 18 - 30 believe they
will receive no retirement income from Social Security, even though Social Security receipts
are estimated to equal about 75 percent of benefits on a sustainable basis under the current
regime.5
Congress and the White House should enact a fiscal program that starts with mild restraint,
but credibly builds that restraint over time so as to put the nation's debt burden on a clearly
sustainable course. Ideally, the program would have broad bipartisan support and provide
clarity not just on the near-term outlook, but also about how the major entitlement programs
would be adjusted.
Also, steps could be taken to increase the productive capacity of the economy over time.
Such actions are desirable because a more productive economy will generate higher living
standards and have greater fiscal capacity.
Let me briefly mention a few steps that could be taken to increase the economy's potential
over time - immigration policies that attract workers with scarce skills to the United States;
education policies and job retraining programs that build and replenish human capital;
spending on infrastructure to remove bottlenecks; tax simplification and the elimination of tax
policies that distort investment and saving decisions; regulatory policies that are attentive to
costs and benefits and that emphasize getting the incentives right.
Counter-cyclical policies and structural policies are not substitutes, they are complements.
We need both. The strength of demand today is importantly influenced by expectations about
future living standards. The lower the expected path of national income, the less favorable
the distribution of that income is expected to be, and the greater the uncertainty over the mix
of tax rates and benefits a person or business expects to pay and receive, the less they will
spend or invest today. Thus, policies that improve the long-run outlook make a cyclical
recovery easier to achieve today.
Conversely, a monetary policy that promotes a cyclical recovery supports the economy's
long-run prospects. Left for too long, long term unemployment will eventually lead to
permanent atrophying of skills that will restrain the economy's growth potential. This is also
true for the cohort of young workers who are stuck in jobs for which they are overqualified
and who are having trouble securing the professional experience that would make them
increasingly productive over time.
Although the outlook for the U.S. economy remains somewhat cloudy as we look into 2013, I
remain a long-run optimist about where we are headed. The long term prospects of the US
economy are excellent. The United States leads the world in higher education, technology
and innovation and has recently acquired new comparative advantages in energy. We have
an exceptionally dynamic labor market, high rates of entrepreneurialism, competitive product
markets, and a well-capitalized financial system that relentlessly reallocates capital from one
sector to the next in search of higher returns.
Even over the next few years, while there are significant downside risks relating to the fiscal
cliff and the eurozone, it is possible that the recovery could turn out stronger than expected.
The underlying process of balance sheet repair is considerably advanced, housing is
recovering and, as that occurs, our newly recalibrated monetary policy could gain additional
traction. Thus, if uncertainties about the U.S. fiscal path and the future of the eurozone were
resolved in a constructive manner, growth could pick up more vigorously than anticipated.
This would be a wonderful outcome. The September FOMC statement noted: the Committee
expects "that a highly accommodative stance of monetary policy will remain appropriate for a
considerable time after the recovery strengthens". Consistent with this, if we were to see
some good news on growth I would not expect us to respond in a hasty manner. Only as we
became confident that the recovery was securely established, would I expect our monetary
policy stance to evolve to ensure that it remained appropriate to achievement of our
objective: maximum sustainable employment in the context of price stability.
Thank you for your kind attention. I would welcome a few questions.
10 BIS central bankers' speeches
BIS central bankers' speeches 11
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