Jeffrey M Lacker: Economic outlook, January 2015
Speech by Mr Jeffrey M Lacker, President of the Federal Reserve Bank of Richmond, at a
conference, sponsored by the Virginia Bankers Association and the Virginia Chamber of
Commerce, Richmond, Virginia, 9 January 2015.
* * *
I would like to thank Roy Web for assistance in preparing these remarks.
Highlights
• While GDP growth in 2015 may revert to its post-recession average of around
2 1⁄4 percent, there are reasons to believe that growth could rise to between 2 1⁄2 and
3 percent this year.
• We have seen pickups at other times during this expansion, only to see them
subside, but the recent strength in consumer spending and the decline in the saving
rate suggest the current higher growth rate can be sustained. Many labor market
indicators also have strengthened.
• The economy still faces some challenges, however, including sluggishness in the
housing market, potentially weaker exports and declines in government spending.
• Inflation is currently below the FOMC's target of 2 percent but is likely to move
closer to 2 percent after energy price movements subside.
• The FOMC has no pre-set timetable for raising the federal funds rate target.
Policymakers should strive to look through transitory phenomena to assess the
appropriate path for interest rates.
It's a pleasure to be with you to discuss the economic outlook this afternoon. Before I begin, I
would like to emphasize that these are my own views and should not be attributed to anyone
else in the Federal Reserve System.
To put the current outlook in context, it helps to take a glance at the rearview mirror. This
expansion has been much slower than any other expansion that anyone in this room is likely
to remember. Real GDP, for example - our best single gauge of overall economic activity -
has increased at an annual rate of 2 1⁄4 percent per year since the recession ended in the
second quarter of 2009. In contrast, the half century before the recession began - including
both expansions and recessions - saw real GDP grow at an average rate of around
3 1⁄2 percent. That lengthy period of rapid growth naturally encouraged a strong sense that
growth ought to be at least 3 percent and that anything less is disappointing.
Two fundamental factors contribute to GDP growth over the longer run. One is population
growth, which has slowed appreciably in recent years. Since the end of the recession, the
so-called prime working age population, which consists of individuals ages 25 to 54, has
actually declined. Baby boomers are moving out of the age ranges associated with peak
labor force participation. In contrast, in the 50 years before the recession, the prime working
age population grew at a rate of 1.3 percent per year. Thus a good part of the recent slowing
of GDP growth is simply slower population growth.
The other fundamental component of growth is the increase in real GDP per worker, which is
a measure of productivity. Since the end of the recession, this measure of productivity has
increased at a 1.4 percent annual rate, well below the average rate over the five decades
before the recession. So a good portion of the recent slowing of GDP growth is also
attributable to slower productivity growth.
The remainder of the difference between pre- and post-recession growth is much smaller
and is accounted for by the change in the ratio of employment to population - in other words,
the combined effect of changes in unemployment and labor force participation.
As the economy recovered from the Great Recession and real GDP growth continued to
disappoint, most economists scaled back their expectations regarding future growth. In fact,
one plausible scenario is for U.S. economic performance over the near term to closely
resemble the average experience over the last five years - that is, real growth around
2 1⁄4 percent per year.
A somewhat brighter scenario is looking more plausible to me now, however. In recent
quarters growth has been noticeably better than the post-recession average. Real GDP has
increased by 2.7 percent over the last four quarters, versus 2.1 percent over the previous
three years. Payroll employment rose by an average of 246,000 jobs per month over the
12 months ending in December, whereas it rose by an average of 185,000 jobs per month
over the previous three years.
Granted, we've seen short-run growth spurts before during the course of this expansion, only
to see the pace of growth subside. But some recent developments that were largely absent
during previous spurts have improved the likelihood that the recent pickup in growth will be
sustained.
I would point first to consumer behavior. Household spending represents about two-thirds of
GDP, and thus it is critical to headline growth. From the end of the recession to November
2013, consumer spending rose at an average annual rate of 2.4 percent. Over the 12 months
ending in November 2014, however, consumer spending has expanded by 2.8 percent. And
over the six months ending in November, consumer spending has grown at a 4.3 percent
annual rate, the highest six-month growth rate since the middle of 2005.
This pickup in household spending was accompanied by an increase in real disposable
income over the last year. But the increase was not as large as the rise in spending in recent
months, and thus the personal saving rate has fallen. A declining saving rate in this situation
typically signals consumer confidence that the increase in incomes is solidly based and likely
to continue. And other indicators point to the same conclusion. In the latter half of last year,
the major survey measures of consumer sentiment all moved back to levels not seen since
before the recession began. In particular, survey components related to expectations
regarding future income and finances have shown notable strength.
Direct readings on labor market conditions suggest that consumers may have good reason
for improved confidence in their employment prospects. I've already mentioned last year's
improvement in employment growth. The decline in the headline unemployment rate, which
peaked at 10 percent in 2009, also picked up pace last year and was down to 5.6 percent in
December. And the number of persons who were unemployed for over 26 weeks has fallen
by 57 percent since 2010.
We've seen noteworthy improvements in measures of turnover in labor markets as well. The
number of job openings is up 20 percent year-over-year, and the hiring rate has increased
significantly. Moreover, "quits" are up 20 percent year-over-year, suggesting that workers are
becoming more confident in their job prospects. The fact that these indicators of labor market
"flows" are showing strong improvement is significant, I think. During this expansion, some
observers noted that measures of labor market "fluidity" or "dynamism" appeared to be
depressed relative to historical standards. In that context, the recent flow data suggests
some progress toward restoring the vitality of labor markets.
We also know that a substantial improvement in labor markets has been associated
historically with stronger wage and salary growth. The employment cost index, which is a
comprehensive measure of wages and benefits for private-sector workers, has increased at
a 3 percent annual rate over the last two quarters. That is well above its 1.9 percent annual
growth over the previous five years. I should caution that a similar acceleration is not evident
in other prominent measures of wages, so this is just tentative evidence at this point.
If labor market conditions continue to improve in the months ahead, it should provide further
support to household incomes and confidence. The improvement we've seen in consumer
finances in recent years should also bolster growth. The value of household assets has
increased by 38 percent since early 2009, while household liabilities have fallen slightly over
the same time period. While the process of balance sheet repair may not yet be complete,
substantial progress clearly has been made.
Recent advances in consumer sentiment and financial wherewithal have not invigorated the
housing market, however. Over the last 12 months, new home sales have fallen by
1.6 percent and new housing starts have fallen by 7 percent. Much of this sluggishness, I
believe, is due to factors that are unlikely to change quickly. The fall in home prices during
the recession has given households a greater appreciation of the risks of leveraged
investments in housing. This is contributing to what appears to be a relatively persistent shift
in preferences away from ownership of single-family detached homes. So while I expect
some gains in housing activity in 2015, I don't think we should look for housing to make
major contributions to overall growth.
In contrast, business investment in plant, equipment and intellectual property has been a
solid contributor to this expansion. Coming out of the recession, this measure of investment
grew rapidly for a couple of years, then more moderately, but it picked up steam in the
second quarter last year. Business investment seemed to be carrying good momentum into
the year-end, and in my view is likely to continue to contribute to growth in overall activity in
2015.
Net exports are likely to be more of a challenge this year. Over the last year, the value of the
dollar in foreign exchange markets has risen by 8 percent. That makes imports more
attractive here and domestic producers less competitive globally, which can be expected to
increase our trade deficit and slow the growth of overall economic production.
Finally, federal government spending on goods and services is likely to continue to restrain
growth. Over the last three years, we've seen such spending fall at a 2.5 percent annual rate.
That may sound surprising, but note that this is only spending for goods and services, and it
excludes transfer payments, such as Medicare or food stamps. These transfer payments do
not add directly to GDP; their only effect is through household incomes. Most forecasters are
projecting federal spending to contract further in 2015 and beyond.
You are probably well aware of the importance of federal spending on goods and services for
Virginia; for example, close to 13 percent of all federal contract spending in fiscal year 2014
landed in the commonwealth. Northern Virginia has been hit hard by reduced spending with
government contractors, and the Hampton Roads area has been hit hard by defense cuts.
Virginia's revenue stream has been significantly affected as well, which will make this year's
legislative session particularly challenging. The broader context to bear in mind, though, is
that the state generally fared better than the rest of the nation prior to and during the most
recent recession.
To sum up, the key consumer sector has picked up in recent months, and I believe the
growth we've seen recently is more solidly based and is likely to continue. Business
investment should also contribute to growth this year, but residential investment probably
won't add much. Federal spending and net exports will likely subtract from overall activity.
Taking stock of the recent data, I believe the odds are better now that the current pickup in
growth will be sustained. In this higher-growth scenario we could see real GDP grow by 2 1⁄2 to
3 percent in 2015. We should not completely dismiss, however, a more temperate scenario in
which growth reverts once again to the post-recession average of around 2 1⁄4 percent.
Throughout this expansion we have seen periods of growth that were vigorous enough to get
our hopes up but were followed by lower growth intervals that left the average growth rate fairly
low. On balance, though, while we don't have enough evidence to rule out a return to a more
moderate growth path, I am leaning toward the higher-growth scenario as more likely.
Turning to inflation, let me start by noting that in 2012 the Federal Open Market Committee
stated that its inflation goal was for the price index for personal consumption expenditures to
rise at a 2 percent annual rate over time. Over the last 25 years that measure of inflation has
averaged 2.06 percent per year. I am old enough to remember when the president of the
United States declared that inflation was "Public Enemy Number One." So I am grateful that
the Fed took responsibility for inflation and has kept inflation under control. That long-run
record may explain why survey measures of expected inflation have been remarkably stable
over the last several years, despite the turmoil of the Great Recession and widespread
media speculation about deflation or inflation.
At short time horizons, inflation can be volatile, however, and over the last year inflation has
only averaged 1.2 percent. As you probably suspect, much of that weakness reflects the
decline in energy prices. Prior to the fall in energy prices, the 12-month PCE inflation rate
was 1.7 percent - not that far from 2 percent. To get a sense of the near-term direction of
inflation, many economists look at core price indices, which exclude the volatile food and
energy categories. Core inflation over the last year was 1.4 percent - a bit higher than overall
inflation but still below 2 percent and down a bit from earlier last year. In past episodes of
large energy price movements, we have seen some bleed through into core inflation, and
that seems to be happening again. As a result, inflation trends may be a bit more difficult to
discern in coming months. Nonetheless, I expect inflation to move tolerably close to the
FOMC's 2 percent target after the fall in energy prices has played out.
I'll conclude with a few remarks on monetary policy. The Fed entered 2015 with a balance
sheet of unprecedented size - around $4.5 trillion - and interest rates very close to zero. We
are widely expected to begin raising interest rates this year, and in September the FOMC
issued a statement outlining how it will go about doing that. Here are the key takeaways from
that document. When the time comes, the Committee will raise its target range for the federal
funds rate (the market interest rate on interbank loans). Currently, the target range is zero to
25 basis points. Second, the Fed will move the federal funds rate into the target range
primarily by adjusting the interest rate it pays to banks on excess reserve balances, which is
currently 25 basis points. Third, sometime after raising the interest rate target, the Fed will
begin gradually reducing its balance sheet by allowing maturing security holdings to run off,
rather than be reinvested, as is current practice. And fourth, the Fed will move in the longer
run toward holding only U.S. Treasury securities and will hold no more securities than
necessary to implement monetary policy efficiently and effectively.
That basic framework pertains to how the Fed intends to move toward more normal levels of
interest rates and asset holdings. I suspect some of you are just as avidly interested, if not
more so, in when and how rapidly the Fed will raise rates. I hate to disappoint you, but the
truth is nobody knows yet. There is no pre-set timetable for raising rates. The FOMC's
actions genuinely will depend on the economic data available at the time. So I cannot tell you
when and, more importantly, how rapidly our rate target will rise.
I will share an observation, however. The economic outlook can change rapidly, and
judgments about appropriate policy need to respond accordingly. It's not hard to find
historical examples: The outlook for real activity shifted dramatically from late 1998, when
overseas turmoil was thought to jeopardize U.S. growth, to early 1999, when it became clear
that the effects would be minimal and activity was accelerating. Similarly, the outlook for
growth and inflation shifted significantly from mid-2003, when inflation seemed to be sinking
below 1 percent, to early 2004, when growth and inflation were clearly rising. Arguably, the
Fed fell at least somewhat behind the curve in each case. The lesson, I believe, is that
policymakers should strive to look through clearly transitory phenomena to assess the
underlying real economic developments that - as long as inflation is anchored - determine
the appropriate path for interest rates. And they need to be prepared to respond promptly.