William C Dudley: The 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, before the New York Association for Business Economics, New
York City, 20 May 2014.
* * *
Thank you for inviting me to speak here today. It always is a special pleasure to address my
fellow economists. In my remarks today, I am going to focus on the economic outlook and
the implications of that outlook for monetary policy.
My views on the economy have not changed much since last fall. Although economic growth
stalled in the first quarter, some slowing was expected and unseasonably harsh winter
weather appears to have done the rest. The fundamental supports for a strengthening
economy remain in place, and recent data seem to confirm that forecast. On the price front, I
expect inflation to drift higher over the remainder of the year as the effects of some
temporary factors that have been holding inflation down dissipate and the labor market
continues to tighten.
If my forecast is correct, as growth strengthens and inflation drifts higher, the focus will turn
to monetary policy. In particular, what will be the timing of lift-off? And when lift-off occurs,
how quickly will the Federal Open Market Committee (FOMC) raise rates and to what level?
Also, with an exceptionally large balance sheet there will be considerable attention on the
methods that the FOMC will likely use in order to exert control over the level of short-term
rates. I can't tell you yet how we will do it, but I am fully confident that we have the necessary
tools to control the level of short-term rates and the credit creation process, and I will share
with you some of my own thoughts on the subject. As always, what I have to say here today
reflects my own views and not necessarily those of the FOMC or the Federal Reserve
System.
Turning first to economic activity, the trajectory of economic growth continues to disappoint.
Since the downturn ended in mid-2009, real GDP growth has averaged only 2.2 percent per
year despite a very accommodative monetary policy. This performance reflects three major
factors - the significant headwinds resulting from the bursting of the housing bubble, the shift
of fiscal policy from expansion toward restraint, especially in 2012 and 2013, and a series of
shocks from abroad - most notably the European crisis.
The good news is that all three of these factors have abated. With respect to the headwinds
resulting from the financial crisis, they are gradually becoming less severe. In particular, the
sharp decline in household wealth due to the decline in housing prices and the weakness in
equity prices has been largely reversed. As housing prices have climbed, the number of
homes moving into the foreclosure process and the number of households with mortgages
underwater have fallen sharply. Moreover, households have deleveraged their balance
sheets. Debt levels have declined and lower interest rates have cut financing costs. As a
result, the financial obligation ratio, which measures the debt servicing cost of households,
has declined from a peak of 18.1 percent of disposable income in the fourth quarter of 2007
to 15.4 percent in the fourth quarter of 2013. This is a level not seen since the early 1980s.
On the fiscal side, the amount of restraint has diminished sharply. For 2014, the projected
drag is about 1⁄2 percent of GDP, roughly half the level of 2013. Moreover, much of this
restraint was frontloaded into the beginning of the year, with the cessation of long-term
unemployment compensation, the expiration of the bonus depreciation provisions and the
higher tax rates that applied to final tax settlements for the 2013 tax year. For the remainder
of this year and next, the degree of fiscal restraint should be very modest.
In terms of the outlook abroad, the circumstances are more mixed. Although Europe is doing
better, Japan is digesting the large hike in consumption taxes that was implemented on
April 1, Chinese growth is slowing and some other emerging market economies are coping
with structural imbalances that are anticipated to lead to slower growth this year. One
obvious wildcard is the situation in Ukraine and relations with Russia. How this will evolve is
difficult to predict. The big risk is that conditions deteriorate and the ultimate outcome is a
disruption to energy supplies from Russia. When all these cross-currents are considered, the
impetus to growth from abroad appears little changed from last year.
Now a reasonable question would be: If the outlook is improving, then how does one explain
the sharp slowdown in growth in the first quarter? My own view is that the principal factors
behind the slowdown were transitory so we should not be overly concerned at this point.
Some slowing in the first quarter was nearly inevitable. Foreign trade and inventories
provided unsustainably large contributions to growth over the second half of last year and
payback for those large gains was expected in the first quarter of this year. Also, the
expiration of extended unemployment compensation benefits and bonus depreciation at the
end of the year was likely to take some of the starch out of consumer spending and business
fixed investment. Beyond these anticipated factors, we had unusually harsh winter weather,
which likely depressed housing activity, manufacturing production and some aspects of
household spending such as motor vehicle purchases.
With the fundamentals of the economy improving and fiscal drag abating, I expect the
economy to get back on to a roughly 3 percent growth trajectory over the remainder of this
year, with some further strengthening likely in 2015. But, there remains considerable
uncertainty about that forecast and, given the persistent over-optimism about the growth
outlook by Federal Reserve officials and others in recent years, we shouldn't count our
chickens before they hatch.
Business fixed investment and housing are two key areas where activity has been
disappointing. They need to kick in more forcefully for the economy to grow at an above
trend rate for a sustained period.
With respect to capital spending, the recent trajectory has been very soft relative to the
apparent strong underlying fundamentals. Corporate cash flows have been strong, profit
margins are high, balance sheets are healthy and financing generally appears readily
available at low interest rates. Moreover, the absolute level of capital outlays is low so that
the capital stock is expanding only slowly. Despite these positive fundamentals, real
business spending on equipment and software has risen only 3.2 percent over the past four
quarters and contracted in the first quarter. This is a bit of a puzzle to me. But, I expect it to
be resolved by a pickup in capital spending. Recent trends in durable goods orders and
conversations I have had with businesses in my district suggest that such a pickup may
finally be occurring.
On the housing side, residential investment has stalled out over the past few quarters.
Although I expected some slowing due to the rise in mortgage rates in the middle of 2013,
the extent of the slowdown has surprised me given that the recent pace of housing starts -
roughly 1 million per year - is far below what is consistent with the economy's underlying
demographic trends.
I think housing has been weaker than anticipated because several significant headwinds
persist for this sector. First, mortgage credit is still not readily available to households with
lower credit scores. Second, some people are coping with higher student loan debt burdens
that have delayed their entry into the housing market as first-time homebuyers. This, in turn,
makes it more difficult for existing homeowners to sell and trade-up. Third, there may be
some ongoing difficulties increasing housing supply. The housing downturn was very deep
and protracted. It takes time to shift resources back into this area. Also, in some markets
house prices still appear to be below the cost of building a new home. Thus, in those
markets, it remains uneconomic to undertake new home construction. Although I expect that
the housing recovery will resume, the pace will likely be slow, especially relative to past
economic recoveries.
With respect to the outlook for prices, I think that inflation will drift upwards over the next
year, getting closer to the FOMC's 2 percent objective for the personal consumption
expenditure (PCE) deflator. Some of the factors holding down inflation - such as the cut in
Medicare reimbursement rates last April - were one-offs and are now dropping out of the
year-over-year figures. In some other areas, such as owners' equivalent rent, price pressures
look likely to firm somewhat.
That said, I see little prospect of inflation climbing sharply over the next year or two. There
still are considerable margins of excess capacity available in the economy - especially in the
labor market - that should moderate price pressures. Most notably, the trend of labor
compensation is running at only about a 2 percent annualized pace. This is far below the
roughly 31⁄2 percent pace that would be consistent with trend productivity growth of 1 to
11⁄2 percent and the FOMC's 2 percent inflation objective.
Recently, some economists have argued that the amount of slack in the labor market may be
smaller than suggested by the official unemployment rate of 6.3 percent. They focus on the
level of short-term unemployment - those workers unemployed for less than 27 weeks -
which has returned close to its average long-term level - and argue that it is the short-term
unemployed that are critical in driving compensation trends.
My own reading of this research suggests that one should not jump to such a conclusion.
Instead, I conclude:
• The relative impact of each type of unemployment on wages depends on whether
long-term unemployment reflects primarily structural or cyclical forces. If individuals
have remained unemployed for a prolonged period due to the absence of
appropriate job skills so there is a mismatch between labor demand and supply - a
structural imbalance in labor markets, then this is very different than if individuals
lost their jobs during a deep recession that has been followed by a still tepid
recovery - a cyclical problem in labor markets. In the first case, the long-term
unemployed may be less well-attached to the labor market in terms of exerting
downward pressure on compensation, while in the second case they were
particularly unlucky - they are long-term unemployed because of bad timing. I
suspect that a much greater proportion of those who are currently long-term
unemployed have simply been very unlucky compared to historical averages. This
blunts somewhat the distinction between being short- versus long-term unemployed.
• If the long-term unemployed are simply unlucky as opposed to not having the
appropriate skills, then their impact on wages presumably depends on whether or
not there is an excess supply of short-term unemployed. If there are plentiful
shortterm unemployed, they may get the best job opportunities first. In part, this reflects
employer bias against the long-term unemployed when they compete with those
who have been unemployed for shorter periods. But, once the short-term
unemployed pool is depleted, then the long-term unemployed will become more
relevant to the labor market supply, so their impact on wages and the labor market
will likely increase as the labor market tightens.
To sum up, this isn't likely to be a case of black (only total unemployment matters) or white
(only short-term unemployment matters) with respect to compensation cost trends. I suspect
that the degree of attachment falls on average as one is unemployed for longer periods of
time. But, I don't believe that this pattern of attachment is stable. It is affected by the nature
of the business cycle and how and why people have become long-term unemployed.
Before I turn to the implications of the economic outlook for monetary policy, let me leave you
with a final thought on inflation and our inflation objective. I think there is some confusion as
to whether the FOMC's 2 percent inflation objective is a ceiling or not. My own view is that
2 percent is definitely not a ceiling. Once we reach 2 percent, I would expect that we would
spend as much time slightly above 2 percent as below it, recognizing that we will hardly ever
be exactly at 2 percent because of the inherent volatility in prices. If inflation were to drift
above 2 percent, all else equal, then we would tend to resist such a rise. But, if inflation were
slightly above 2 percent even as unemployment remained far above levels consistent with
maximum employment, then the unemployment consideration would dominate because we
would be further from the unemployment objective than we are from the inflation objective.
This should not surprise anyone. This is what our "balanced approach" implies.
Given my outlook for above-trend growth and inflation gradually drifting higher, the inevitable
question is what this means for the monetary policy outlook. Over the near-term, if
circumstances evolve relatively close to my forecast, I would continue to favor gradually
reducing the pace of asset purchases by staying on the same glide path of a $10 billion
reduction in the monthly purchase pace following each FOMC meeting.
Assuming asset purchases end sometime this fall, the focus will shift to the timing of lift-off,
the pace of tightening once lift-off occurs and where short-term rates are ultimately headed
over the longer-term. The issue of how the Fed will manage its balance sheet will also be
relevant, as well as how monetary policy will be conducted during a period when the amount
of excess reserves in the banking system is unusually large. I will give you some of my early
thinking on each of these issues in the remainder of my remarks.
Turning first to the timing of lift-off, how the outlook evolves matters. We currently anticipate
that a considerable period of time will elapse between the end of asset purchases and lift-off,
but precisely how long is difficult to say given the inherent uncertainties surrounding the
outlook. If the economy is stronger than expected, causing the excess slack in the labor
market to be absorbed sooner and inflation to rise more quickly than forecasted, then lift-off
is likely to be pulled forward in time. If, instead, economic growth disappoints, inflation stays
unusually low and the labor market continues to exhibit evidence of considerable excess
slack, then lift-off will likely be pushed back in time.1
With respect to the trajectory of rates after lift-off, this also is highly dependent on how the
economy evolves. My current thinking is that the pace of tightening will probably be relatively
slow. This depends, however, in large part, not only on the economy's performance, but also
on how financial conditions respond to tightening. After all, monetary policy works through
financial conditions to affect aggregate demand and supply. If the response of financial
conditions to tightening is very mild - say similar to how the bond and equity markets have
responded to the tapering of asset purchases since last December - this might encourage a
somewhat faster pace. In contrast, if bond yields were to move sharply higher, as was the
case last spring, then a more cautious approach might be warranted.
In terms of the level of rates over the longer-term, I would expect them to be lower than
historical averages for three reasons. First, economic headwinds seem likely to persist for
several more years. While the wealth loss following the financial crisis has largely been
reversed, the Great Recession has scarred households and businesses - this is likely to lead
to greater precautionary saving and less investment for a long time. Also, as noted earlier,
headwinds in the housing area seem likely to dissipate only slowly.
Second, slower growth of the labor force due to the aging of the population and moderate
productivity growth imply a lower potential real GDP growth rate as compared to the 1990s
and 2000s. Because the level of real equilibrium interest rates appears to be positively
related to potential real GDP growth, this slower trend implies lower real equilibrium interest
rates even after all the current headwinds fully dissipate.
Third, changes in bank regulation may also imply a somewhat lower long-term equilibrium
rate. Consider that, all else equal, higher capital requirements for banks imply somewhat
wider intermediation margins. While higher capital requirements are essential in order to
make the financial system more robust, this is likely to push down the long-term equilibrium
federal funds rate somewhat.
Putting all these factors together, I expect that the level of the federal funds rate consistent
with 2 percent PCE inflation over the long run is likely to be well below the 41⁄4 percent
average level that has applied historically when inflation was around 2 percent. Precisely
how much lower is difficult to say at this point in time.
The fact that the equilibrium real federal funds rate is likely to be lower for a long time
underscores the need for caution in applying the benchmark Taylor Rule as a guide to the
appropriate stance of monetary policy. As typically applied, the Taylor Rule assumes an
equilibrium real rate of interest of 2 percent. This seems much too high in the current
economic environment in which headwinds persist, and somewhat too high even when these
headwinds fully dissipate.
The next question I wish to consider is how the Fed will likely manage its balance sheet as
the taper process is completed and lift-off eventually occurs. Unlike previous normalizations
of monetary policy, which only involved the level of short-term rates, this prospective
tightening cycle also involves considerations with respect to the size and composition of our
balance sheet. The Committee stated in its June 2011 exit principles that changes in
shortterm rates will be the primary means for adjusting monetary policy post-liftoff, not
discretionary shifts in the balance sheet. In other words, the balance sheet will be set on
automatic pilot. I believe this approach still very much applies.
However, the language in the June 2011 exit principles concerning agency mortgage-backed
securities (MBS) sales no longer applies. As Chairman Bernanke noted in the press
conference following the June 2013 FOMC meeting: "While participants continue to think that
in the long run the Federal Reserve's portfolio should consist predominantly of Treasury
securities, a strong majority now expects that the Committee will not sell agency
mortgagebacked securities during the process of normalizing monetary policy." The balance sheet
would shrink post-lift-off as Treasury securities matured and mortgages were prepaid, but
outright agency MBS sales are no longer contemplated during the process of monetary
policy normalization.
Also, I think that the language in the June 2011 exit principles with respect to reinvestment
needs to be revisited. The exit principles state: "To begin the process of policy normalization,
the Committee will likely first cease reinvesting some or all payments of principal on the
securities holdings in the SOMA." There are two considerations that suggest to me that
ending the reinvestments prior to lift-off may not be the best strategy. First, such a decision
might complicate our communications regarding the process of normalization. Ending
reinvestments as an initial step risks inadvertently bringing forward any tightening of financial
conditions as this might foreshadow the impending lift-off date for rates in a manner
inconsistent with the Committee's intention.
Second, when conditions permit, it would be desirable to get off the zero lower bound in
order to regain some monetary policy flexibility. This goal would argue for lift-off occurring
first followed by the end of reinvestment, rather than vice versa. Delaying the end of
reinvestment puts the emphasis where it needs to be - getting off the zero lower bound for
interest rates. In my opinion, this is far more important than the consequences of the balance
sheet being a little larger for a little longer.
With respect to the issue of how the FOMC will control money market rates with an enlarged
balance sheet, the Federal Reserve already has the necessary tool - the ability to pay
interest on excess reserves. However, the degree of control could be further buttressed.
Enhancing confidence in the Fed's ability to control money market rates, and hence, inflation,
might also help keep inflation expectations well anchored.
One method the Fed has been testing is an overnight, fixed rate, reverse repo (RRP) facility.
The Federal Reserve posts a fixed interest rate and accepts cash from counterparties, which
include some banks, dealers, money market funds, and government sponsored enterprises,
on an overnight basis in return for a security. The repo facility is "reverse" because the
direction in which the funds and securities move - participants are lending funds to the Fed
rather than vice versa. Users of the facility are making the economic equivalent of an
overnight collateralized loan of cash to the Federal Reserve.
If implemented, the facility could be set up as "full allotment," which means that there is no
cap on the amount of funds accepted from any of its counterparties at the posted overnight
interest rate. Or, caps could be imposed on either an aggregate or per counterparty basis in
order to limit total usage.
The amount of funds invested in the facility is likely to be sensitive to the spread between the
posted interest rate and comparable money market rates and the level of caps placed on
usage. The narrower the spread to comparable money market rates, the greater the
participation is likely to be. In our ongoing tests with this facility, the New York Desk has
varied the RRP rate from 1 to 5 basis points and the cap on usage by counterparty has
gradually been increased to its current level of $10 billion. As expected, narrower spreads to
comparable money market rates and larger caps have led to greater usage.
Although the testing process is still ongoing, early results suggest that the overnight RRP
facility will set a floor under money market rates. Treasury repo rates have generally traded
no more than a basis point or two below the overnight RRP rate.2 2 Thus, the early evidence
suggests that this facility would help strengthen our control over money market rates.
Two issues with the overnight reverse repo rate warrant careful consideration. The first is
how big a footprint the facility should have in terms of volume. To the extent that the
overnight RRP rate were set very close or equal to the interest rate on excess reserves
(IOER) without caps, then this might result in a large amount of disintermediation out of
banks through money market funds and other financial intermediaries into the facility. This
could encourage further development of the shadow banking system. If this were deemed
undesirable, this would argue for a wider spread between the overnight RRP and the IOER in
order to reduce the volume of flows into the facility.
The second issue is the facility's potential impact on financial stability. In particular, would
such a facility make financial instability less likely? And, when financial stress did occur,
would such a facility amplify or dampen financial strains?
On the first point, it seems that such a facility would tend to make financial instability less
likely. The overnight RRP facility allows us to make a short-term safe asset more widely
available to a broad range of financial market participants. The provision of short-term safe
assets by the official sector might crowd out the private creation of runnable money-like liquid
assets. This might enhance financial stability by reducing the likelihood of a financial crisis.
However, if a financial crisis were to occur, the existence of a full allotment, overnight, RRP
facility might exacerbate instability by encouraging runs out of more risky assets into the
facility. That is because the supply of a full allotment facility would be completely elastic at
the given fixed rate. Money market mutual funds and other providers of short-term financing
could rapidly shift funds into the facility away from assets such as commercial paper that
support the private sector. In contrast, in the current regime, when financial crises lead to
flows into less risky assets, their interest rates fall, limiting the appetite for these less risky
assets. Consequently, under a full allotment setup, runs could be larger and these runs could
exacerbate the fall in the prices of riskier assets. Note that the risk here is how quickly
financial flows could reverse from one day to the next, not the average level of take-up of the
facility over time.
Fortunately, this risk seems relatively easy to address. One could design the facility to
prevent rapid inflows during times of financial stress. This could be done by building in circuit
breakers such as caps on overall usage of the facility. The circuit breakers would not affect
the amount of take-up during normal times or prevent take-up from rising at moderate rates.
Instead, they would be in place to limit the pace and magnitude of inflows during times of
stress.
A second option to improve the Fed's control over short-term rates is to drain reserves by
offering banks term deposit accounts in which to invest funds for longer terms than overnight.
There are two issues that might make this option somewhat less attractive. First, to
strengthen monetary policy control significantly through this course, it might be necessary to
drain most of the $3 trillion of reserves. This could be done of course with effort, but is the
effort worth it?
Second, the Fed would undoubtedly have to "pay up" to induce banks to hold term deposit
accounts relative to keeping their monies in reserves at the excess reserves interest rate.
This would likely result in higher Fed interest expenses relative to relying on an overnight
RRP facility to set a floor on money market rates.
The choices here are important and I expect that considerable testing, analysis and
discussion will be necessary to reach firm conclusions about the appropriate course. My goal
would be to clarify our intentions later this year, long before we begin to contemplate raising
short-term rates.
I also think that the choices are about how to conduct monetary policy during the transitional
phase, not about the long-term monetary policy framework. Longer term, the issue will be
whether to return to the type of corridor system that was in place prior to the crisis or to
instead to stay with the type of floor system that will likely be the type of regime that is in
place as the balance sheet gradually normalizes. I expect that the choices made over the
near-term can be implemented in a way so as not to forestall either a corridor or a floor
system over the longer term. The experience we gain with operating monetary policy
effectively with a very large balance sheet will undoubtedly inform that choice.
But, that topic is putting the cart far before the horse. First, we need an economy that is
strong enough to more fully utilize the nation's labor resources and to begin to push inflation
back towards the Federal Reserve's long-term objective. Only then can the monetary policy
normalization process proceed. Although we are making progress towards our goals, we still
have a considerable way to go.
Thank you for your kind attention. I would be happy to take a few questions.