Ben S Bernanke: The economic outlook and monetary policy
Remarks by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve
System, at the Bond Market Association Annual Meeting, New York, 22 April 2004.
The references for the speech can be found on the Board of Governors of the Federal Reserve System's website.
* * *
I am pleased to have the opportunity to address the members of the Bond Market Association. I know
that you have a keen interest in the likely future course of the economy and of monetary policy, so I
will use my time today to comment on both topics. I will begin with the economic outlook, discussing
prospects for economic growth, the labor market, and inflation, and conclude by drawing some
implications for monetary policy. As always, my views are my responsibility alone and are not to be
ascribed to my colleagues in the Federal Reserve System.1
The prospects for economic growth
Broadly, the economy has shown substantially increased vitality since the middle of last year, and with
the passage of time the economic recovery has shown increasing signs of becoming self-sustaining.
Judging from the most recent data, growth in domestic spending appears consistent with growth in
real gross domestic product (GDP) in the range of 4-1/2 to 5 percent for the first quarter and at a rate
of 4 percent or higher for 2004 as a whole. One reason for increased confidence that the recovery is
becoming self-sustaining is that the expansion of aggregate demand has become more broad-based,
with households, firms, and government all making contributions to spending growth.
Household spending, which has not slackened significantly at any point in the past three years, has
continued its advance, supported by positive wealth effects and tax cuts. Except for a modest decline
in auto sales (relative to the strong pace of the previous quarter), consumer expenditures on most
major categories of goods and services were well sustained in the first quarter, as recent data on retail
sales testify. Household spending is likely to continue to grow at a solid pace for the remainder of this
year, especially if the job market improves as expected.
A question that many have asked is whether household spending, including spending on new homes,
will remain strong if interest rates rise. I think that consumers are not badly positioned for a normal
cyclical increase in interest rates. The balance sheets of most households are in good shape: Perhaps
most important, the ratio of household net worth to income is relatively high, not far below its
pre-recession level. Also, households took advantage of low long-term rates during the last cycle to
reduce their exposure to short-term and high-interest debt. Although household debt burdens have
risen, most household debt today is in the form of mortgage debt, of which some 85 to 90 percent is at
fixed rates and thus insulated from interest-rate increases.
The decision to purchase a home is probably the most interest-sensitive decision made by
households. Private housing starts rebounded in March from a possibly weather-related dip in
February, and sales of new and existing homes during the first quarter remained close to record
levels. I expect residential investment to continue strong this year. Mortgage rates have risen in the
past month but remain low relative to historical experience, while new household formation, improved
job prospects, and income growth should ensure a continued healthy demand for housing. However,
residential investment is unlikely to rise much further from current high levels and thus its contribution
to GDP growth over the next year or two can be expected to decline.
Energy price increases have reduced households' real disposable personal income by about
$30 billion since December. This development will probably shave a tenth or two from the growth in
personal consumption expenditures in 2004 but thus far, at least, the rise in energy prices does not
materially affect the outlook.
A key factor in the economic turnaround in the third quarter of 2003 was the resurgence in business
fixed investment, particularly in equipment and software. That component of spending seems set to
continue to expand as output grows, profits improve, and firms become more confident in the durability
of the recovery. Double-digit growth in real spending on equipment and software seems quite possible
this year, in part because the expiration of partial expensing allowances at the end of 2004 will lead
some firms to move forward investment they otherwise would have made in 2005. Given the very low
inventory stocks currently held by businesses, inventory investment should also support growth. In
contrast, nonresidential investment remains weak, reflecting low capacity utilization rates in factories
and high vacancy rates in office buildings, and the improvement in that sector seems likely to be
gradual.
The Federal government's budget deficit is expected to peak this year at something between
$450 billion and $500 billion. Both increased government expenditures and reduced taxes will support
growth in aggregate demand in 2004, though fiscal policy will provide somewhat less impetus and may
even be slightly restrictive in 2005. U.S. exports are likely to continue their recent rise, because of a
weaker dollar and economic recovery among our trading partners. However, rising U.S. incomes will
spur imports as well. On net, the external sector will probably continue to be a slight drag on U.S.
growth, and little if any progress is likely to be made in closing the current account deficit this year.
The state of the labor market
As you know, the recovery in labor markets has not kept pace with the recovery in output, an issue
that has been central in recent debates about economic policy. As has been widely noted, the leading
explanation for the slow recovery in the labor market has been the remarkable ability of employers and
workers to increase labor productivity. Over the four quarters of 2003, output per hour in the nonfarm
business sector is estimated to have risen 5.4 percent, up from an already robust 4.3 percent gain the
previous year. Output per hour probably grew at a rate exceeding 4 percent in the first quarter of this
year, accounting for the lion's share of growth during the quarter. Although these productivity
increases are unalloyed good news for the U.S. economy in the longer term, in the short run they have
allowed firms to expand production rapidly while adding fewer workers than would be normal in a
cyclical expansion. I and many others have argued that this situation cannot persist: As managers
exhaust the possibilities for outsized productivity gains and become convinced of the durability of the
expansion, they should become increasingly more willing to add employees (Bernanke, 2003b).
Unfortunately, the pace of productivity gains and hence of employment growth has proved difficult to
forecast.
If we look past the erratic month-to-month changes in payrolls, the labor market does appear to be
gradually improving. On average, private nonfarm payrolls grew by 161,000 per month in the first
quarter, up from 58,000 per month in the fourth quarter of 2003. Recent employment gains have not
been confined to a few industries. For example, in March the one-month employment diffusion index,
which measures the proportion of industries with expanding employment relative to the share of
industries with contracting employment, reached its highest value since July 2000. Initial claims for
unemployment insurance have also been falling and are now at pre-recession levels. The decline in
initial claims is consistent with other data that suggest that the pace of layoffs has slackened
considerably. The rate of new hiring has been exceptionally sluggish for the past several years,
however, and the available evidence suggests modest improvement at best in hiring rates so far this
year.
Although the labor market appears to be sitting up and taking fluids, it has not hopped out of bed and
begun a round of jumping jacks. Despite the strong payroll gains in March, nonfarm payrolls remain
343,000 below their level of November 2001, the official trough of the recession, and private nonfarm
payrolls are more than half a million below the trough level. The average workweek of production and
nonsupervisory workers declined slightly in March; at 33.7 hours, the workweek is low on an absolute
basis and barely above the 33.6 hours average attained during the third quarter of last year, the lowest
quarterly figure in 2003.
The data I have cited thus far come from reports provided by employers, through what is known as the
payroll survey. Much has been made of the differences between the results of the payroll survey and
those from the household survey, which is based on the responses from a random sample of
households.2 When its coverage is adjusted to be comparable to that of the payroll survey, the
household survey shows a net gain of about 1.7 million jobs since the November 2001 trough,
compared with the already noted loss of more than 300,000 jobs reported by the payroll survey. Since
June of last year, when the pace of output growth picked up significantly, employment as measured by
the household survey (on a comparable payroll basis) has risen by 1.42 million jobs, more than double
the increase of 689,000 jobs reported by the payroll survey. Recent revisions of both surveys - in the
case of the household survey, to take into account the likelihood that immigration to the United States
since 2003 has been below earlier estimates - have only modestly reduced the gap in estimated job
creation.3
Although resolving the differences between the two surveys is important, my own assessment of the
labor market does not change markedly even if substantial credence is given to the data drawn from
the household survey. For example, although the unemployment rate (measured by the household
survey) has fallen to 5.7 percent from its peak of 6.3 percent last June, that rate remains high relative
to recent experience and in comparison to most plausible recent estimates of the sustainable rate of
unemployment. The evidence suggests, moreover, that the official unemployment rate of 5.7 percent
understates to some extent the true amount of slack in the labor market. Notably, to a greater degree
than in past cycles, discouraged job seekers have been withdrawing from the labor market rather than
reporting themselves as unemployed. According to the household survey, the labor force participation
rate has actually declined significantly since the official trough of the cycle, from 66.7 percent of the
working-age population in November 2001 to 65.9 percent in March 2004.4 From its peak last June,
the unemployment rate has fallen by 0.6 percentage point, from 6.3 percent to 5.7 percent. However,
during the same period, the labor force participation rate also fell by 0.6 percentage point, from
66.5 percent to its current value of 65.9 percent. The net result is that the employment-to-population
ratio has barely changed since the middle of last year. Thus even the household survey, its relatively
more encouraging job-creation numbers notwithstanding, paints a picture of ongoing softness in the
labor market. So long as the labor market is weak, the economic recovery will be incomplete. Indeed,
by reducing confidence and spending, a failure of the labor market to improve could conceivably
threaten the sustainability of the expansion.
One way to see the extent of the slack in the labor market, as measured even by the household
survey, is to ask how much job creation would be needed to bring the unemployment rate down
further. Underlying the household survey's employment calculations is an estimate that the adult
non-institutional population grew in March by 193,000 people. If the population grows by the same
absolute amount in April and the labor force participation rate remains unchanged at 65.9 percent, the
labor force will grow by about 127,000 during the month. To keep the unemployment rate at
5.7 percent in April, then, household employment (as opposed to payroll employment) would have to
grow by 120,000 jobs. To reduce the unemployment rate under these assumptions, of course, more
than 120,000 net new jobs would be needed.
The standard calculation I just presented was based on the assumption that the rate of labor force
participation does not change, an assumption that may not be valid during a cyclical recovery in the
labor market. If people perceive a significant improvement in the job market, new job seekers may
enter or re-enter the labor force as employment grows. To illustrate the possible implications, let us
suppose that improving job prospects lead the participation rate to rise 0.1 percentage point in April,
from 65.9 percent to 66.0 percent. (Remember, the rate was 66.5 percent as recently as last June.)
This increase in the participation rate would imply a total increase in the labor force (including the
portion attributed to the rise in population) of some 350,000 people and hence a need for more than
330,000 net new jobs to keep the unemployment rate from rising. The implication is that, with the labor
market still in a relatively early stage of its cyclical recovery, an unusually high rate of job creation may
be required for a time to bring the labor market back into balance.
In short, the unusual rate of productivity growth has driven a wedge between the recovery in output
and the recovery in the labor market, leaving considerable cyclical slack in the labor market despite
ongoing growth in output. The economic recovery will not be fully realized, in my view, until the labor
market has established a more normal cyclical pattern of expansion.5
The outlook for inflation
Forecasts of inflation, particularly core inflation (which excludes the more volatile energy and food
price components), are of course another key input to monetary policy decisions. The core inflation
data for the past couple of months have been slightly above market expectations. More time will be
needed to assess the significance of these recent numbers; possibly, they may reflect the unwinding
of some downward surprises to core inflation late last year. Based on the information currently
available, my own best guess is that core inflation has stopped falling and appears to be stabilizing in
the vicinity of 1-1/2 percent, comfortably within my own preferred range of 1 to 2 percent.
The dominant fundamental factors influencing the inflation outlook are the ongoing resource slack and
the remarkable rate of productivity growth. Together, these factors imply that unit labor costs will either
continue to fall or at least remain quiescent. Moreover, price-cost margins are at high levels (as can be
seen in the strong growth of profits), providing an additional cushion for absorbing any inflation
pressures that may emerge on the cost side. These forces should largely offset the effects on core
consumer price inflation of the rising costs of raw materials - the byproduct of the gathering global
recovery and continuing rapid growth in East Asia - and last year's decline in the foreign exchange
value of the dollar. As I discussed in some detail in a speech earlier this year (Bernanke, 2004a), the
direct effects of commodity price increases and a depreciating dollar on inflation at the consumer level
are generally small. This modest direct impact reflects the small share of total costs accounted for by
raw materials and imported inputs as well as the fact that a portion of cost increases tends to be
absorbed in producers' margins.
In thinking about the implications of higher commodity prices for inflation, one should also make the
distinction between a one-time rise in commodity prices and an ongoing process of commodity price
inflation. Commodity prices can only contribute to inflation at the consumer level when they are rapidly
rising. Commodity prices may well remain high in an absolute sense over the next few years because
of the high global demand for raw materials. Yet if the rate of increase in commodity prices slows
significantly, as is implied for example by futures prices, the effect of commodity prices on the rate of
inflation will eventually become negligible. Similarly, dollar depreciation contributes to inflation only to
the extent that it is ongoing; we cannot predict whether last year's decline in the dollar will continue, of
course, but so far this year it has not.
In describing what I consider to be the most likely scenario for inflation, I do not wish to convey an
unwarranted degree of certainty. Like employment, inflation is difficult to forecast. One factor that may
be of great importance in inflation determination but can be particularly hard to gauge is the state of
the public's inflation expectations (Poole, 2004). For example, wages and prices that are set for some
period in the future will of necessity embody the inflation expectations of the parties to the negotiation;
increases in expected inflation will thus tend to promote greater actual inflation. More subtly, my
conclusion that the effects on inflation of transitory changes in commodity prices or in the value of the
dollar tend to dissipate in the longer run depends on the assumption that the public's inflation
expectations are well anchored. If expectations are not well tied down, inflationary impulses that are in
themselves transitory may become embedded in expectations and hence affect inflation in the longer
inflation
term. Therefore, an essential prerequisite for controlling is controlling inflation expectations.
Assessing the current state of inflation expectations in the United States is not entirely straightforward.
Survey measures of near-term inflation expectations, including those based on interviews of
professional forecasters, individual consumers, and firm managers, have in some cases ticked up
slightly in recent months, though long-term inflation expectations appear stable. The spread between
the yields on Treasury debt and inflation-indexed Treasury securities of similar maturity, known as the
breakeven inflation rate and conventionally treated as an indicator of expected inflation, has also risen.
From a policy perspective, a difficulty with all these measures is that they reflect expectations of
headline inflation rather than the core inflation measures usually emphasized in the monetary policy
context. Headline inflation has of course been significantly affected by the recent surge in energy
prices. The breakeven inflation rate derived from indexed Treasury securities has additional problems
as a measure of expected inflation. As I discussed in a recent speech (Bernanke, 2004b), breakeven
inflation may differ substantially from the market's true expectation of inflation because of possibly
time-varying risk and liquidity premiums. I will discuss inflation expectations further in the context of
monetary policy, to which I turn next.
Monetary policy
The federal funds rate stands at a historically low level of 1 percent, and the Federal Open Market
Committee (FOMC) has declared its intention to be "patient in removing policy accommodation." As a
number of my FOMC colleagues have noted in various public venues, inevitably the funds rate will
have to return to a more normal level. What considerations should the Committee keep in mind as it
plans this normalization process?
Before addressing this question, I would like to point out that, in an appropriately broad sense,
monetary conditions in the United States are already in the process of normalizing. I base this
statement on my view that the stance of monetary policy should be judged not only by the current
setting of the federal funds rate but also by the level of rates that are tied directly or indirectly to
expectations about the future path of monetary policy, of which the yields on Treasury securities are
the leading examples. In part because of the FOMC's communication strategy, which has linked the
future stance of policy to the level of inflation and the extent of slack in resource utilization, market
interest rates have generally responded continuously and in a stabilizing manner to economic
developments.
The March employment report, which cited an unexpectedly high rate of job creation, provides a
recent example. Treasury yields rose sharply on its release as market participants traced out the
report's presumed implications for monetary policy. Mortgage rates, corporate bond rates, and other
yields and asset prices moved in sympathy, with important effects on the cost of borrowing and hence,
presumably, on aggregate demand. For practical purposes, therefore, monetary conditions tightened
significantly the day of the March employment report, notwithstanding the fact that the federal funds
rate itself was unchanged. This episode illustrates both the power and the importance of clear
communication by monetary policymakers about their objectives and their evaluation of economic
conditions.
With respect to future decisions about the policy rate, for me two considerations are most relevant:
first, the degree of confidence one can place in the sustainability of the economic expansion and,
second, the evolution of inflation and inflation expectations.
As I have indicated, the economic expansion is showing increasing signs of being both strong and
self-sustaining. However, to my mind, some uncertainty about that sustainability remains, arising
primarily from the slow recovery of the labor market. Indeed, if one takes into account the long delay
between the official recession trough and the trough in employment, the labor market today remains at
what effectively is an early stage of its normal cyclical expansion. Although the recent improvement in
employment is encouraging, from the data in hand it is not yet clear that employers have overcome
their reluctance to hire at a normal pace. Additional confirmation that the recovery in the job market is
both sustainable and quickening would be most welcome.
Regarding inflation, as I noted earlier, the economic fundamentals appear consistent with core
inflation's remaining under control, in the general range of 1 to 2 percent. In particular, I see no
indication that the U.S. economy is in imminent danger of overheating, productivity growth is keeping
the lid on labor costs, and the effects on inflation of the increases in commodity prices and the decline
in the dollar to date, which are likely to be small in any event, may well have dissipated a year from
now. As I have acknowledged, however, there are risks to my relatively sanguine inflation forecast. In
particular, a rise in the public's expectations of inflation, whether "justified" by underlying forces or not,
may put upward pressure on the actual rate of inflation. Moreover, expectations of inflation can
themselves be destabilizing, as when an "inflation scare" in the bond market inappropriately raises
long-term yields, with adverse effects for the real economy. To avoid instability in expected inflation,
and the volatility in actual inflation, output, and employment that might result, I believe that the Federal
Reserve should maintain at all costs its hard-won credibility for keeping the inflation rate low and
stable. That involves, at a minimum, formulating policy with a close eye to indicators of inflation and
inflation expectations. More generally, as I have suggested in earlier talks, I believe that the FOMC's
credibility and clarity would be enhanced if it announced the inflation range with which it would be
comfortable in the medium term (Bernanke, 2003a, 2003b). In particular, policy would be both more
coherent and more predictable if FOMC members shared an explicit common objective for inflation at
the medium-term horizon.
To conclude, monetary policy is now in a transition phase. That short-term interest rates must
eventually be normalized is a given. However, the remaining uncertainty about the likely paths of both
employment and inflation of necessity implies that the timing of policy changes at this point also
remains uncertain. Like my colleagues on the FOMC, I will continue to watch the relevant data very
closely. The challenge that lies before the Committee is to manage policy in a way that permits the
economy to realize its productive potential while simultaneously maintaining firm control of inflation
and inflation expectations.