William C Dudley: Prospects for the economy and monetary policy
Speech by Mr William C Dudley, President and Chief Executive Officer of the Federal
Reserve Bank of New York, at the New York University's Stern School of Business, New
York, 28 February 2011.
* * *
It is a pleasure to have the opportunity to speak here today. My remarks will focus primarily
on two areas. First, what is the outlook for economic activity, employment and inflation? In
particular, what are the areas of vulnerability that we should be most concerned about?
Second, what does the outlook imply for monetary policy? As always, what I will say reflects
my own views and opinions, not necessarily those of the Federal Open Market Committee
(FOMC) or the Federal Reserve System.
In my talk, I'll argue that the economic outlook has improved considerably. Despite this, we
are still very far away from achieving our dual mandate of maximum sustainable employment
and price stability. Faster progress toward these objectives would be very welcome and need
not require an early change in the stance of monetary policy.
However, I'll also focus on some issues with respect to inflation that will merit careful
monitoring. In particular, we need to keep a close watch on how households and businesses
respond to commodity price pressures. The key issue here is whether the rise in commodity
prices will unduly push up inflation expectations.
Inflation expectations are well-anchored today and we intend to keep it that way. A sustained
rise in medium-term inflation expectations would represent a threat to our price stability
mandate and would not be tolerated.
Turning first to the economic outlook, the situation looks considerably brighter than six
months ago. On the activity side, a wide range of indicators show a broadening and
strengthening of demand and production. For example, on the demand side, real personal
consumption expenditures rose at a 4.1 percent annual rate during the fourth quarter. This
compares with only a 2.2 percent annual rate during the first three quarters of 2010 (Chart 1).
Orders and production are following suit. For example, the Institute of Supply Management
index of new orders for manufacturers climbed to 67.8 in January, the highest level since
January of 2004 (Chart 2).
The revival in activity, in turn, has been accompanied by improving consumer and business
confidence. For example, the University of Michigan consumer sentiment index rose to 77.5
in February, up from 68.9 six months earlier (Chart 3).
Indeed, the 2.8 percent annualized growth rate of real gross domestic product (GDP) in the
fourth quarter may understate the economy's forward momentum. That is because real GDP
growth in the quarter was held back by a sharp slowing in the pace of inventory
accumulation. The revival in demand, production and confidence strongly suggests that we
may be much closer to establishing a virtuous circle in which rising demand generates more
rapid income and employment growth, which in turn bolsters confidence and leads to further
increases in spending. The only major missing piece of the puzzle is the absence of strong
payroll employment growth. We will need to see sustained strong employment growth in
order to be certain that this virtuous circle has become firmly established.
With respect to the labor market, there are conflicting signals. On one hand, the
unemployment rate has fallen sharply over the past two months, dropping to 9.0 percent from
9.8 percent two months earlier (Chart 4). This is the biggest two-month drop in the
unemployment rate since November of 1958. On the other hand, payroll employment gains
have remained very modest - rising by only 83,000 per month over the last three months
(Chart 5). Such modest payroll growth is not consistent with a sustained drop in the
unemployment rate.
The true story doubtless lies somewhere in between - but probably more on the side of the
household survey that tracks unemployment. That is because measured payroll employment
growth in January was probably temporarily depressed by unusually bad winter weather.
Although some of the recent decline in unemployment is due to a drop in the number of
people actively seeking work, the household survey does show a pick-up in hiring. Other
labor market indicators, such as initial claims and the employment components of the ISM
surveys for manufacturing and nonmanufacturing, have also shown improvement recently
(Chart 6 and Chart 7), which suggests that the weakness in payroll growth is the outlier.
Although there is uncertainty over the timing and speed of the labor market recovery, I do
expect that payroll employment growth will increase considerably more rapidly in the coming
months. We should welcome this. A substantial pickup is needed. Even if we were to
generate growth of 300,000 jobs per month, we would still likely have considerable slack in
the labor market at the end of 2012.
In monitoring employment trends, we also need to recognize that the data are likely to be
quite noisy on a month-to-month basis. This is particularly the case during the winter months,
when weather can play an important role. Recall, for example, the aftermath of the blizzard of
1996 in the Northeast when the February payroll employment count was originally reported
as rising by 705,000 workers. It will be important not to overreact to monthly data but to focus
on the underlying trend.
So why is the economy finally showing more signs of life? In my view, the improvement
reflects three developments. First, household and financial institution balance sheets
continue to improve. On the household side, the saving rate, which moved up sharply in
2008 and 2009, appears to have stabilized in the 5 percent to 6 percent range. Meanwhile,
debt service burdens have fallen sharply to levels that prevailed during the mid-1990s. Debt
service has been pushed lower by a combination of debt repayment, refinancing at lower
interest rates and debt write-offs (Chart 8). Financial institutions have strengthened their
balance sheets by retaining earnings and by issuing equity. For many larger institutions, a
release of loan loss reserves has been important in supporting earnings. Credit availability
has improved somewhat as very tight standards start to loosen (Chart 9). As a result, some
measures of bank credit are beginning to expand again (Chart 10).
Second, monetary policy and fiscal policy have provided support to the recovery. On the
monetary policy side, the unusually low level of short-term interest rates and the Federal
Reserve's large-scale asset purchase programs (LSAPs) have fostered a sharp improvement
in financial market conditions. Since August 2010, for example, when market participants
began to anticipate that the Federal Reserve would initiate another LSAP, U.S. equity prices
have risen sharply and credit spreads have narrowed (Chart 11 and Chart 12). Long-term
interest rates have moved higher after initially declining, but this does not appear
troublesome as it primarily reflects the brightening economic outlook.
On the fiscal side, the economy has been supported by the shift in policy toward near-term
accommodation. In particular, the temporary reduction in payroll taxes is providing
substantial support to real disposable income and consumption. This could have a
particularly strong impact on growth during the first part of the year.
Third, growth abroad - especially among emerging market economies - has been strong and
this has led to an increase in the demand for U.S.-made goods and services. Over the four
quarters of 2010 real exports rose 9.2 percent (Chart 13). After a disappointing performance
earlier in the year, U.S. net exports surged in the fourth quarter (Chart 14).
The firming in economic activity, in short, is due both to natural healing and past and present
policy support.
In this regard, it important to emphasize that we did expect growth to strengthen. We
provided additional monetary policy stimulus via the asset purchase program in order to help
ensure the recovery did regain momentum. A stronger recovery with more rapid progress
toward our dual mandate objectives is what we have been seeking. This is welcome and not
a reason to reverse course.
We also have to be careful not to be overly optimistic about the growth outlook. The coast is
not completely clear - the healing process in the aftermath of the crisis takes time and there
are still several areas of vulnerability and weakness. In particular, housing activity remains
unusually weak and home prices have begun to soften again in many parts of the country
(Chart 15 and Chart 16). State and local government finances remain under stress, and this
is likely to lead to further fiscal consolidation and job losses in this sector that will offset at
least a part of the federal fiscal stimulus (Chart 17). And we cannot rule out the possibility of
further shocks from abroad, whether in the form of stress in sovereign debt markets or
geopolitical events. Higher oil prices act as a tax on disposable income, and the situation in
the Middle East remains uncertain and dynamic. Also, we cannot ignore the risks stemming
from the longer-term fiscal challenges that we face in the United States.
But in the near-term, the most immediate domestic problems may recede rather than
become more prevalent. On the housing side, stronger employment growth should lead to
increased household formation, which should provide more support to housing demand. And
anxieties about the large overhang of unsold homes represented by the foreclosure pipeline
may overstate the magnitude of the excess supply of housing. Families that have lost their
homes through foreclosures are likely to seek new homes as their income permits, even
though many may re-enter the housing market as renters rather than buyers. On the state
and local side, a rising economy should boost sales and income tax revenue and help narrow
near-term fiscal shortfalls.1
Moreover, although we do need to remain ever-watchful for signs that low interest rates
could foster a buildup of financial excesses or bubbles that might pose a medium-term risk to
both full employment and price stability, risk premia on U.S. financial assets do not appear
unduly compressed at this juncture.
On the inflation side of the ledger, there are some signs that core inflation is now stabilizing.
However, both headline and core inflation remain below levels consistent with our dual
mandate objectives - which most members of the FOMC consider to be 2 percent or a bit
less on the personal consumption expenditures (PCE) measure.
Recent evidence shows that the large amount of slack in the economy has contributed to
disinflation over the past couple of years. This can be seen in the steady decline in core
inflation between mid-2008 and the end of 2010. As shown in Chart 18, core PCE inflation in
December had risen at just 0.7 percent on a year-over-year basis, down from 2.5 percent in
mid-2008. Slack in our economy is still very large, and this will continue to be a factor that
acts to dampen price pressures.
Nevertheless, there are several reasons why we need to be careful about inflation even in an
environment of ample spare capacity. First, commodity prices have been rising rapidly
(Chart 19). This has already increased headline inflation relative to core inflation, and the
commodity price changes that have already taken place will almost certainly continue to push
the headline rate on year-over-year basis higher over the next few months. Second, some of
this pressure could feed into core inflation. Third, medium-term inflation expectations have
recently risen back to levels consistent with our dual mandate objectives (Chart 20). If
medium-term inflation expectations were to move significantly higher from here on a
sustained basis, that would pose a risk to inflation and, thus, would have important
implications for monetary policy.
With respect to the inflation outlook, I think there are four important questions that deserve
attention.
1. How much slack is there in the economy? In other words, how fast can the economy
grow for how long until the economy is close to full employment?
2. Are there speed-limit effects on inflation? In other words, could inflation rise because
the rate of economic growth was unusually high, even though plenty of slack
remained in the economy?
3. Given the emergence of such economies as China and India, can commodity price
pressures be safely ignored as temporary "noise" in terms of the long-term inflation
outlook or are these pressures likely to prove persistent? If commodity price
pressures persisted, this could undercut one rationale for focusing on core
measures of inflation - the argument that core measures are better predictors of
future headline inflation than today's headline rate.
4. What can the Federal Reserve do to ensure that inflation expectations stay
wellanchored?
With respect to the first question, the economy retains a very large amount of slack by
virtually all measures. For example, last month the industrial capacity utilization rate was
76.1 percent. This compares with a long-term average of 80.9 percent (Chart 21). Similarly,
the current unemployment rate of 9 percent is well above most estimates of the
nonaccelerating inflation rate of unemployment (NAIRU) - the lowest rate of unemployment
consistent with sustained price stability.
In the pre-crisis period, the NAIRU was likely in the region of 4.5 percent to 5 percent. There
are several reasons why the NAIRU may now be higher. First, extended unemployment
compensation benefits create incentives for prospective workers to keep looking for better
jobs rather than accept less attractive positions. Empirical work on this subject suggests that
the NAIRU might currently be roughly 1 percentage point higher because of this factor.
However, this effect will only persist for as long as the extended benefits are in place.
Second, the rise in unemployment has been associated with an increase in the degree of
mismatch between unemployed workers' job skills and available job vacancies. Some cite
the upward shift in the Beveridge curve, which illustrates the relationship between
unemployment and job vacancies (Chart 22), as evidence of this effect.
Third, the longer that people are unemployed, the more their skills tend to atrophy, which
makes it harder for them to become employed in the future. For unemployed workers, the
median duration of unemployment has climbed and a growing proportion of the unemployed
has been jobless for long periods (Chart 23).
In my view, these last two factors have probably pushed up the NAIRU by 0.5 to
1 percentage point on top of the about 1 percentage point effect of extended unemployment
benefits, which is likely to be a temporary effect. Taken together, this suggests that the
current NAIRU might be between 6 percent and 7 percent.
Although undesirable, this rise should not create concern about the medium-term inflation
outlook. First, even the higher estimate of NAIRU is still far below the current unemployment
rate of 9 percent. Second, as discussed above, much of this rise is likely to be temporary
rather than permanent. As the labor market improves, the extension of unemployment claims
benefits will almost certainly be allowed to lapse. When this occurs, the NAIRU is likely to
drop back to somewhere in the region of 5 percent to 6 percent.
Third, some of the evidence that the NAIRU has increased is not particularly compelling. For
example, the loop in the Beveridge curve that is evident now has been seen in past business
cycles - cycles in which there was no persistent rise in the NAIRU. This strongly suggests
that the rise in job mismatch has a cyclical component. Fourth, the 9 percent unemployment
rate may understate the amount of labor market slack. That is because the labor participation
rate has fallen sharply.
In my view, the large gap between the current unemployment rate and the long-run NAIRU
suggests there is little payoff from investing much energy to more precisely estimate the
NAIRU. As the economy expands and the unemployment rate falls, we will have plenty of
time to be able to refine our estimates of NAIRU in light of what happens to labor cost trends
such as the employment cost index, and to unit labor costs. Currently, all these measures
are quiescent and consistent with a large amount of labor market slack (Chart 24).
The second question is whether the economy could grow so fast that inflation pressures
could rise even with an unemployment rate still well above the NAIRU. The notion is that at
very fast growth rates wages and prices might have to rise in order to funnel labor and capital
to those areas where demand and output were rising particularly rapidly.
Although this possibility shouldn't be ruled out, we should not be too worried about this,
particularly if growth is broadly based. In particular, the economy is not growing quickly right
now relative to past recoveries. For example, in the rebound from the comparably deep early
1980s recession, the annualized growth rate exceeded 7 percent for five consecutive
quarters. Moreover, empirically there is little historical evidence that discontinuous "speed
limit" effects play a significant role in influencing inflation in the United States.
The third issue is whether the rise in commodity prices will turn out to be persistent and, if so,
how this might impact the inflation outlook. Recently, commodity prices have risen sharply.
For example, the spot GSCI - a broad measure of commodity prices - has risen more than
35 percent over the past year. This was in train before the upheavals in the Middle East
raised market concerns about potential disruption to oil supplies, pushing energy prices
- though not other commodity prices - still higher. Commodity price pressures are pushing
measures of headline inflation above measures of core inflation, which exclude food and
energy prices. How worried should policymakers be about this development?
Although there have been commodity price cycles in the past, commodity prices have not
consistently increased relative to other prices, and indeed have declined in relative terms
over the very long term. Historically, if commodity prices rose sharply in a given year, it has
been reasonable to expect that these prices would stabilize or fall within a year or two. This
property has been important because it has meant that measures of current "core" inflation,
rather than current headline inflation, have been more reliable in predicting future headline
inflation rates.
In contrast, over the past decade, commodity prices generally have been on an upward
trend. For example, as shown in Chart 25, fuel prices have generally been in a rising trend
since 1999 and non-fuel prices since 2001 - both trends interrupted temporarily by the
financial crisis.
Setting to one side the near-term effects of geopolitical developments, the rapid urbanization
and industrialization of nations such as China and India could be generating an ongoing
secular rise in commodity prices that might not be fully captured in today's spot and futures
market prices. If so, this would undercut the role of core inflation as a good predictor of future
headline inflation.
Nevertheless, there are important mitigating factors that suggest that it would be unwise for
the Federal Reserve to over-react to recent commodity price pressures. First, despite the
general uptrend, some of the recent commodity price pressures are likely to be temporary. In
particular, much of the most recent rise in food prices is due to a sharp drop in production
caused by poor weather rather than a surge in consumption (Chart 26). More typical weather
and higher prices should generate a rise in production that should push prices somewhat
lower. This is certainly what is anticipated by market participants, as shown in Chart 27.
Second, even if commodity price pressures were to prove persistent, the U.S. situation
differs markedly from that of many other countries. Relative to most other major economies,
the U.S. inflation rate is lower and the amount of slack much greater.
Moreover, for the United States, commodities represent a relatively small share of the
consumption basket (Chart 28). This small share helps to explain why the pass-through of
commodity prices into core measures of inflation has been very low in the United States for
several decades.
Third, the Federal Reserve's success in anchoring inflation expectations has also been
important in limiting pass-through. Since 1984, for example, when the Federal Reserve
began to achieve success in driving down and then subsequently anchoring long-term
inflation expectations, there has been very little evidence of commodity price pass-through
into core inflation. In contrast, prior to 1984, when inflation expectations were much less
wellanchored, pass-through did occur and, at times, played an important role in pushing
underlying inflation higher.
This leads to our final issue - the importance of inflation expectations in shaping the inflation
outlook.
Rising inflation expectations tends to push up inflation in a number of ways - by reducing the
expected cost of borrowing at a given level of interest rates, by pulling forward buying
decisions to beat future expected price increases, and by encouraging more aggressive price
and wage setting behavior. In a world of unanchored inflation expectations, commodity price
pressures would more easily be passed through into core inflation.
Fortunately, inflation expectations remain well-anchored. This can be seen in all three major
measures of inflation expectations. First, market-based measures of inflation expectations
are generally well-behaved. For example, the five-year forward measure of breakeven
inflation generated from differences in the nominal Treasury yield curve and the TIPS yield
curve has shown a modest rise since mid-2010 back into the range that has generally been
in place for the past decade (Chart 29). Second, the long-term inflation expectations of
professional forecasters have been very stable. As shown in Chart 30, the median long-term
inflation forecast in the Professional Forecasters' survey remains around 2.1 percent for the
PCE deflator. In terms of household expectations, there has been an increase in short-term
expectations. This typically occurs when commodities such as gasoline go up sharply in
price. However, even here longer-term expectations remain well-anchored. As shown in
Chart 31, the University of Michigan median five-year inflation expectations measure remains
around 2.9 percent - comfortably within its normal range and historically consistent with
slightly lower realized inflation.
To summarize the main points, we have a considerable amount of slack, little evidence of
discontinuous speed limit effects, and little inflation pass-through from commodities into core
inflation when inflation expectations are well-anchored, which is currently the case. This
suggests that the biggest risk in terms of higher underlying inflation over the next year or two
is that inflation expectations could become unanchored. This might occur, for example, if
there were a loss of confidence in the ability and/or willingness of the Federal Reserve to
tighten monetary policy in a timely way in order to keep inflation in check.
In this regard, the proof of the pudding will be in our actions - talk is cheap. What is key -
that the appropriate policy steps are taken in a timely manner.
However, let me make two points. First, I am very confident that the enlarged Federal
Reserve balance sheet will not compromise our ability to tighten monetary policy when
needed consistent with our dual mandate goals. Second, I am equally confident that no one
on the FOMC is willing to countenance a sustained rise in either inflation expectations or
inflation.
Let me explain why our enlarged balance sheet does not compromise our ability to tighten
monetary policy. Although our enlarged balance sheet has led to a sharp rise in excess
reserves in the banking system, this has the potential to spur inflation only if banks lend out
these reserves in a manner that generates a rapid expansion of credit and an associated
sharp rise in economic activity. The ability of the Federal Reserve to pay interest on excess
reserves (IOER) provides a means to prevent such excessive credit growth.
Because the Federal Reserve is the safest of counterparties, the IOER rate is effectively the
risk-free rate. By raising that rate, the Federal Reserve can raise the cost of credit more
generally. That is because banks will not lend at rates below the IOER rate when they can
instead hold their excess reserves on deposit with the Fed and earn that risk-free rate. In this
way, the Federal Reserve can drive up the rate at which banks are willing to lend to more
risky borrowers, restraining the demand for credit and preventing credit from growing
sufficiently rapidly to fuel an inflationary spiral.
For this dynamic to work correctly, the Federal Reserve needs to set an IOER rate consistent
with the amount of required reserves, money supply and credit outstanding needed to
achieve its dual mandate of full employment and price stability. If the demand for credit were
to exceed what was appropriate, the Federal Reserve would raise the IOER rate - pushing
up the federal funds rate and other short term rates - to tighten broader financial conditions
and reduce demand.2 If the demand for credit were insufficient to push the economy to full
employment, then the Federal Reserve would reduce the IOER rate - pushing down the fed
funds rate and other short term rates - to ease financial conditions and support demand,
recognizing that the IOER rate cannot fall below zero. While the mechanism is different, the
basic approach is very similar to the way the Federal Reserve has behaved historically.
Although our ability to pay interest on excess reserves is sufficient to retain control of
monetary policy, it is not bad policy to have both a "belt and suspenders" in place. As a
result, we have developed means of draining reserves to provide reassurance that we will
not - under any circumstance - lose control of monetary policy. These include reverse repo
transactions with dealers and other counterparties, auctions of term deposits for banks, or
securities sales from the Fed's portfolio.
A related concern is whether the Federal Reserve will be able to act sufficiently fast once it
determines that it is time to raise the IOER. This concern reflects the view that the excess
reserves sitting on banks' balance sheets are essentially "dry tinder" that could quickly fuel
excessive credit creation and put the Fed behind the curve in tightening monetary policy.
In terms of imagery, this concern seems compelling - the banks sitting on piles of money that
could be used to extend credit on a moment's notice. However, this reasoning ignores a very
important point. Banks have always had the ability to expand credit whenever they like. They
didn't need a pile of "dry tinder" in the form of excess reserves to do so. That is because the
Federal Reserve's standard operating procedure for several decades has been a
commitment to supply sufficient reserves to keep the fed funds rate at its target. If banks
wanted to expand credit that would drive up the demand for reserves, the Fed would
automatically meet that demand by supplying additional reserves as needed to maintain the
fed funds rate at its target rate. In terms of the ability to expand credit rapidly, it makes no
difference whether the banks have lots of excess reserves on their own balance sheets or
can source whatever reserves they need from the fed funds market at the fed funds rate.3
So we have the means to tighten monetary policy when the time comes, but do we have the
will? I think there should be no doubt about this. It is well understood among all the members
of the FOMC that allowing inflation to gain a foothold is a losing game with large costs and
few, if any, benefits.
In this regard, some have argued that Fed officials might be reluctant to raise short-term
rates because such increases would squeeze the net interest margin on the Fed's System
Open Market Account (SOMA) portfolio. Although it is true that a rise in short-term interest
rates would reduce the Fed's net income from the extraordinary high levels seen in 2009 and
2010,4 this will not play a significant role in the Fed's monetary policy deliberations.
Fed policy is driven by the objectives set out in the dual mandate, and the net income earned
by the Fed is the consequence of the policy choices that advance those objectives. The
Federal Reserve's net income statement does not drive or constrain our policy actions. In
short, we act as a central bank, not an investment manager.
It is also worth pointing out in passing that a failure to raise short-term interest rates at the
appropriate moment based on our dual mandate objectives would also be a losing strategy
with respect to net income. Inflation would climb, bond yields would rise and the Fed would
ultimately be forced to raise short-term rates more aggressively, or to sell more assets at
lower prices to regain control of inflation. This would almost certainly result in larger
reductions in net income than a timelier exit from the current stance of monetary policy. So
what does this all imply for monetary policy? First, barring a sustained period of economic
growth so strong that the economy's substantial excess slack is quickly exhausted or a
noteworthy rise in inflation expectations, the outlook implies that short-term interest rates are
likely to remain unusually low for "an extended period." The economy can be allowed to grow
rapidly for quite some time before there is a real risk that shrinking slack will result in a rise in
underlying inflation. We will learn more as we go, and, as always, should be prepared to
adjust course in a timely manner if incoming information suggests a different strategy would
better promote our objectives.
Second, the Federal Reserve needs to continue to communicate effectively about its
objectives, the efficacy of the tools it has at its disposal to achieve those objectives, and the
willingness to use these tools as necessary. This is important in order to keep inflation
expectations well-anchored. If inflation expectations were to become unanchored because
Federal Reserve policymakers failed to communicate clearly, this would be a self-inflicted
wound that would make our pursuit of the dual mandate of full employment and price stability
more difficult. If we consistently and effectively communicate our objectives and our
strategies, we can avoid this outcome.
Thank you for your kind attention. I would be happy to take a few questions.
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