William C Dudley: Important choices for the Federal Reserve in the
years ahead
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal Reserve
Bank of New York, at Lehman College, Bronx, New York City, 18 April 2018.
* * *
It is a pleasure to have the opportunity to speak here today at Lehman College. In my remarks, I
will focus on the economic outlook-both over the near and longer term-and I will discuss some
of the important monetary policy issues that will be considered in the years ahead, after my
tenure at the Federal Reserve Bank of New York is (sadly) over. As always, what I have to say
reflects my own views and not necessarily those of the Federal Open Market Committee
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(FOMC) or the Federal Reserve System.
The economic outlook
Over the near term, the economic outlook remains quite favorable. I anticipate that the economy
will continue to grow at an above-trend pace in 2018 and 2019, which will put sufficient pressure
on the nation's resources to push up inflation to the FOMC's longer-run 2 percent objective.
There are several reasons to be confident in this growth outlook: Monetary policy remains
accommodative, financial conditions are still easy, and the global economy is in the midst of a
synchronized expansion. Moreover, significant fiscal policy stimulus from tax cuts and increased
federal spending will boost real household disposable income and corporate profits, which
should support further gains in consumption and capital spending.
In this context, I would not take much signal from the slowdown in consumer spending in the first
two months of this year. As I see it, this slowdown was mostly due to two transitory factors: a
retrenchment following the spurt in activity from recovery efforts following Hurricanes Harvey,
Irma, and Maria, and the delay in this year's tax refund payments to those receiving certain tax
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credits.
Strong payroll employment gains also suggest that the slowdown in household spending will be
temporary. Over the last three months, payroll gains have climbed to a monthly pace of 202,000
jobs, somewhat above 2017's monthly average of 182,000. Robust job gains coupled with
moderate growth in labor compensation should ensure that household incomes will continue to
rise at a solid rate, even before factoring in the impact of this year's reduction in personal income
taxes.
With respect to inflation, most of the evidence is consistent with a slow movement toward the
FOMC's 2 percent objective. On a year-over-year basis through February, the overall Personal
Consumption Expenditures (PCE) price index and the core PCE price index-which excludes
the more volatile food and energy components-have risen by 1.8 percent and 1.6 percent,
respectively, from troughs of 1.4 percent and 1.3 percent last summer. Further gains appear
likely at the end of this month, when the sharp decline in cellular telephone services prices that
occurred a year ago drops out of the year-over-year calculations.
In the current environment, I see three important issues regarding the appropriate monetary
policy stance:
1. How quickly to remove monetary policy accommodation-is a gradual path of removal still
appropriate now that the unemployment rate is 4.1 percent?
2. How far to go in removing monetary policy accommodation-will monetary policy have to
move to a somewhat restrictive setting in the years ahead?
3. How should the FOMC factor fiscal policy and trade policy developments into its monetary
policy decisions?
I will take each of these in turn.
As I see it, a gradual path of interest rate increases remains appropriate. Even though the
unemployment rate is low, inflation remains below our 2 percent objective. As long as that is
true, the case for tightening policy more aggressively does not seem compelling. My conclusion
is reinforced by the fact that we do not know with much precision how low the unemployment
rate can go without prompting a significant rise in inflation. We do not directly observe the
nonaccelerating inflation rate of unemployment, or NAIRU. Rather, we only infer it from the response
of wage compensation and price inflation as the labor market tightens.
Also, the U.S. labor market may have more slack than the 4.1 percent unemployment rate
suggests. Over the past six months, the unemployment rate has remained steady despite
robust payroll gains. As the labor market has improved, more people have been actively seeking
employment. As a result, the labor force participation rate has flattened out despite the ongoing
aging of the workforce population. Furthermore, because the U.S. labor force participation rate
for prime age workers is low compared to many advanced economies, the labor market could
conceivably improve even further before encountering significant resource constraints.
That said, the Federal Reserve should not overstay its welcome. It is important to get monetary
policy back to a neutral setting before the labor market becomes so tight that wages and prices
begin to rise at a pace inconsistent with the FOMC's 2 percent inflation objective. Our mandate
from Congress is maximum sustainable employment and price stability-not simply a high level
of employment at one point of the business cycle.
With respect to how far the FOMC should go in removing monetary policy accommodation, two
major issues stand out. First, what represents a neutral monetary policy setting? Second, under
what circumstances would it be appropriate to move beyond neutral to a restrictive setting?
Unfortunately, we do not also observe the neutral real (i.e., adjusted for inflation) short-term
interest rate, or r*. There is a wide range of estimates at any time, and they evolve as the
economic environment changes. For example, all else equal, continued buoyant financial
conditions amid recent and anticipated future rate hikes imply that r* may be higher than
previously estimated. A shift to a more stimulative fiscal policy could also imply a somewhat
higher r*, at least temporarily.
One's view of the neutral rate may also be influenced by one's assessment of the longer-term
economic environment. For example, if we are in a period of "secular stagnation"-
characterized by chronic excess global savings and aging populations-then one would expect
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r* to remain persistently low. But, if we are in a world of abating headwinds as we recover from
the financial crisis, then one would expect r* to rise over time. This lack of clarity about the
environment increases the degree of uncertainty about the level of r*.
Despite all these uncertainties, one still has to have a viewpoint. In the current circumstances, I
would judge that r* over the medium term is likely to be somewhere around 1 percent. Although
that is higher than the estimates from some models, I have nudged up my estimate because
financial conditions are still easy and fiscal policy will likely be quite stimulative in 2018 and
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2019.
If the neutral real interest rate is around 1 percent, there is still some distance to go before
monetary policy actually gets tight. At the FOMC's 2 percent inflation objective, my estimate of r*
implies that the federal funds rate would need to rise to around 3 percent for monetary policy to
be considered neutral. Of course, as the factors that influence r* change, my estimate of r* will
also move around over time.
Whether monetary policy will need to move to a restrictive setting depends crucially on how low
the unemployment rate can go without inflation climbing meaningfully above 2 percent. Although
the jury is still out on this question, last month's Summary of Economic Projections, or SEP, is
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instructive. Most FOMC participants-including me-have the unemployment rate moving
considerably below their estimate of NAIRU by 2020, with inflation climbing slightly above 2
percent and the federal funds rate moving above their estimates of its likely long-run value. Thus,
the March SEP implies that most FOMC participants expect that monetary policy will need to
become slightly restrictive in the years ahead.
Recent fiscal and trade policy developments are likely to increase the uncertainty around the
distance to a neutral monetary policy stance and the possibility that the FOMC will have to move
to a restrictive stance. The shift in fiscal policy toward stimulus is somewhat challenging
because of its timing-it is unusual to move fiscal policy sharply in a stimulative direction at a
mature stage of a business cycle-and because the shift puts the nation's fiscal path on an
unsustainable trajectory. According to the projections released earlier this month from the
Congressional Budget Office, or CBO, the federal budget deficit is anticipated to exceed 41⁄2
percent of GDP in 2019, well above the level that would be needed to keep the federal
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debt-toGDP ratio from rising. Moreover, the CBO expects that the pressures on the budget will be
substantial over the next decade, with deficit projections ranging between 41⁄2 and 51⁄2 percent of
GDP throughout the period. Debt service costs will move sharply upward in coming years as
federal debt continues to grow and interest rates likely increase further. Additionally, entitlement
spending is likely to increase sharply as members of the baby boom generation continue to retire
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-myself included.
The shift toward a more aggressive U.S. posture on trade also likely increases uncertainty. On
the one hand, such a posture could lead to revised trade agreements that provide the United
States with greater access to foreign markets and better protection of intellectual property. This
would tend to raise U.S. productivity and real GDP growth. On the other hand, tougher
bargaining could lead to retaliation and higher trade barriers, here and abroad. In contrast to the
first scenario, this outcome would be quite negative-leading to higher inflation, lower
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productivity, and slower potential GDP growth. Over time, how U.S. trade policy evolves will
have important implications for the performance of the U.S. economy-and, by extension, for
U.S. monetary policy. By increasing uncertainty around the economic outlook, these shifts in
fiscal and trade policy could make it more difficult for the FOMC to achieve its dual mandate
objectives in the years ahead.
Longer-term monetary policy issues
Over the longer term, the FOMC will also need to address a number of other important issues.
These include: 1) Determining the appropriate long-term implementation framework for U.S.
monetary policy, and 2) deciding whether the strategic framework underlying monetary policy
decisions needs to be adjusted to mitigate the risks associated with getting pinned at the
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effective lower bound for short-term interest rates.
For the first issue, I see two options: return to the "corridor"-type system that was in place prior to
the financial crisis, or remain with the framework that has been in place since the crisis-
namely, a "floor" system. In a corridor system, reserves in the banking system are scarce, and
the federal funds rate is set by adjusting the supply of reserves through open market operations
to balance demand and supply at the FOMC's target range. In contrast, in a floor system,
reserves are abundant, so that the interest rate the Federal Reserve pays on excess reserves,
or IOER, is the primary tool used to control the federal funds rate.
In my view, the case for retaining the current floor system is very compelling for a number of
reasons. First, it is operationally much less complex than a corridor system. In the current
regime, the setting of IOER is largely sufficient to maintain the federal funds rate within the
FOMC's target range, as we have seen over the past few years. In contrast, a corridor system
requires forecasting the many exogenous factors that affect the amount of bank reserves
outstanding, and then engaging in open market operations on a near daily basis to keep reserves
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at a level consistent with the FOMC's target range. This task would likely be more difficult now
because of greater fluctuation in these exogenous factors relative to when the corridor regime
was last in place.
Second, a corridor system constrains the Federal Reserve's ability to provide the types of
lenderof-last-resort backstops that can help support financial stability. Prior to gaining the authority to
pay interest on reserves in the fall of 2008, Federal Reserve officials-myself included-were
faced with a question: if the take-down on a proposed liquidity facility were large, how would we
be able to drain the added reserves on a timely basis to maintain control of the federal funds
rate? This was not just a theoretical issue during the financial crisis. The initial auctions of the
Term Auction Facility, or TAF, were kept relatively small, in part, because of concerns that larger
programs would make it more difficult for the manager of the System Open Market Account (me,
in that particular case) to drain sufficient reserves to offset the TAF reserve additions. Similarly,
the Term Securities Lending Facility (TSLF)-which involved the swap of Treasury collateral
from the Federal Reserve against lower-quality collateral held by primary dealers-was
introduced in large part because collateral swaps, unlike cash loans, did not affect the amount of
reserves in the banking system. My overall point is that broad-based, open-ended
lender-of-lastresort facilities are more difficult to accommodate in a corridor system because of the need to
drain any reserve additions to keep the federal funds rate close to the FOMC's target.
I see this as an important shortcoming of the pre-crisis corridor regime that does not get
sufficient attention. Having the ability to introduce broad and credible lender-of-last-resort
backstops-well secured by pledged collateral-can be critical when confidence falters and
financial stability is at risk. Private sector participants are more likely to continue to engage with
their counterparties-and to borrow and lend-when they know a central bank backstop will be
available if economic and financial conditions deteriorate. A corridor regime could cause the
Federal Reserve to delay or avoid providing such backstops, which could increase financial
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stability risks by causing lenders and borrowers to disengage with one another earlier.
Although the FOMC has not made a final decision about a future framework for implementing
monetary policy, meeting minutes confirm that participants recognize the advantages of a floor
system. As the November 2016 FOMC minutes note: "Meeting participants commented on the
advantages of using an approach to policy implementation in which active management of the
supply of reserves would not be required....[S]uch an approach was seen as likely to be relatively
simple and efficient to administer, relatively straightforward to communicate, and effective in
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enabling interest rate control across a wide range of circumstances."
The second major issue facing the FOMC is whether to change its strategic framework to
mitigate the risk of a return to the effective lower bound for interest rates. Once the federal funds
rate is close to zero, the FOMC is constrained in its ability to lower short-term interest rates
further, and the other available policy options to provide monetary policy stimulus may be less
effective. If the FOMC were unable to provide sufficient stimulus, the economy could have
difficulty recovering. In turn, inflation and inflation expectations could fall-and thus raise real
interest rates-effectively tightening monetary policy and making the task of generating a
sustainable recovery even more difficult.
Some have argued that a desirable way to reduce this risk would be to raise the FOMC's inflation
objective from 2 percent to perhaps 3 or 4 percent. Their reasoning is that if the inflation
objective were somewhat higher, nominal interest rates at the later stages of the business cycle
would also tend to be higher, which would provide greater scope for the FOMC to cut short-term
interest rates to stimulate the economy, if necessary.
While recognizing that there is a legitimate effective lower bound risk, I do not support the option
of raising the inflation objective, for three reasons. First, I doubt that a higher inflation target
would be viewed as consistent with the Federal Reserve's Congressional mandate to pursue
price stability. Our employment and inflation mandates have been established by Congress, not
by the Federal Reserve.
Second, the risks of being pinned at the effective lower bound for interest rates may be
overstated. Only once in the postwar period have we reached the zero lower bound. Upending
several decades of effort to anchor inflation expectations around 2 percent might be too high a
price to pay to reduce the effective lower bound risk by what might prove to be a small amount.
In this vein, it is important to recognize that the FOMC now has a more credible set of tools
available to use at the effective lower bound than it did in 2008, when those tools were largely
unproven. Forward guidance about the path of short-term interest rates and quantitative easing
have been effective in providing monetary policy stimulus in the post-crisis period. Because this
is now more broadly appreciated, households and businesses should be more confident that the
Federal Reserve has sufficient tools available at the effective lower bound to generate a
sustainable economic recovery. This greater confidence, in turn, should help keep inflation
expectations from declining-which should also mitigate the risks associated with hitting the
lower bound.
Third, there are arguably better ways of reducing risks associated with the effective lower bound
than a higher inflation objective. In particular, Congress could increase the size and scope of the
automatic fiscal stabilizers that support economic activity and income during economic
downturns. For example, Congress could enact legislation in which employment payroll taxes
would be automatically reduced when the unemployment rate rose above a particular threshold.
With such stabilizers in place, households and businesses would anticipate additional income
support in the face of a cyclical downturn. This approach would be more powerful than
discretionary fiscal actions that carry a greater degree of uncertainty.
Another option to help better anchor inflation expectations around the current objective would be
to move to a price-level targeting, or PLT, regime. Under the current inflation targeting regime,
the FOMC follows a "bygones are bygones" policy: Misses of the inflation objective on one side
are not deliberately offset by subsequent misses on the other. Therefore, when inflation runs
persistently below the objective, policymakers do not strive to push inflation above the objective in
the future. Under these conditions, the risk is that inflation expectations will become unanchored
to the downside. In contrast, under a price-level targeting regime, the FOMC would commit to
make up any shortfalls below its 2 percent objective by allowing inflation to climb above the
objective for the time necessary to eliminate the shortfall. This commitment to offsetting the
period of below-target inflation with a period of above-target inflation would, presumably, help
keep inflation expectations from becoming unanchored to the downside.
However, a symmetric PLT regime-in which misses have to be made up on both sides of the
inflation objective-has an important shortcoming. Compensating for inflation overshoots by
deliberately keeping inflation below the FOMC's 2 percent objective would increase the risk of
getting pinned at the effective lower bound for interest rates.
As a consequence, some-including former Chairman Ben Bernanke-have proposed adopting
an asymmetric PLT regime. In such a system, misses below the objective would be offset by
misses above only when the effective lower bound was binding. Under normal circumstances,
misses above the objective would not be offset. Rather, they would be treated as "bygones," as
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is currently the case.
However, I suspect that establishing a modified PLT regime would present some challenges.
First, for such a modified PLT to be effective in anchoring inflation expectations, households and
businesses would have to understand how the regime would work, and view the Federal
Reserve's commitment as credible. One can imagine that such credibility might be hard to
sustain during a long spell of inflation misses to the downside. Second, while such a regime
might be attractive in broad brush form, the devil lies in the details. If inflation undershot for a few
years, what would the desired overshoot path look like? How high would the FOMC permit
inflation to go above its objective, and for how long? What would happen if the Fed failed to fully
offset past downside misses and cumulative undershoots became sizable?
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My view is that we should further study how PLT frameworks might work in practice. But, it is
possible that a simpler approach of committing to keeping the average inflation rate around 2
percent over the medium term might be just as appealing. It might be sufficient to better anchor
inflation expectations while avoiding the communication challenges and complexity of an
asymmetric PLT regime.
In this vein, I also would evaluate whether the inflation goal should be recast as a range of,
perhaps, 11⁄2 to 21⁄2 percent, from the current 2 percent objective. A range might have several
advantages over a point target. First, it might be viewed as more realistic given that measured
inflation will always randomly fluctuate relative to its underlying trend. That is to say, even if the
FOMC performs its job exceedingly well, very rarely will the inflation rate, as measured by the
PCE price index, be precisely at 2 percent. Second, having a relatively narrow range would send
a message that the FOMC is discriminating between two regimes-one in which inflation is
within the range and concerns about inflation are low, versus another in which inflation is outside
the range and concerns about inflation are more elevated.
Even so, I would not recommend shifting to such a range currently. I would only consider doing
so once the FOMC has successfully and sustainably pushed inflation back to its 2 percent
objective. Making such a change now might be viewed as "moving the goal posts," given the
persistent shortfall of inflation in recent years relative to the objective. And, doing so now might
imply a greater tolerance for missing inflation to the low side in an asymmetric way. That would
not be desirable at a time when inflation expectations are, if anything, too low, rather than too high
relative to the FOMC's objective.
To sum up, the economy is broadly in a good place and the short-term economic outlook
remains favorable. On a personal level, I am pleased that I will be leaving my current position at
a time when the FOMC is likely to be very close to its employment and inflation objectives-
recognizing, of course, the terrible damage of the financial crisis and the long time it has taken to
get here.
Uncertainty about trade policy and the fact that we are now on an unsustainable fiscal path,
however, have raised the longer-term risks. With respect to monetary policy, there are a number
of important choices the FOMC will need to make in the years ahead. I have outlined some of
my preferences today: continuing with the current floor system for the implementation of
monetary policy, and some of the steps that we could take to reduce the risk should interest
rates return to the effective lower bound in the future.
Thank you for your kind attention. I would be happy to take a few questions.
Rate of Interest Redux," Business Economics, v. 51, iss. 2, pp. 57-67; and Kathryn Holston, Thomas Laubach
and John C. Williams (2017), "Measuring the Natural Rate of Interest: International Trends and
Determinants," Journal of International Economics, Supplement 1, v. 108, pp. S59-75.
5
See Economic projections of Federal Reserve Board members and Federal Reserve Bank presidents under
their individual assessments of projected appropriate monetary policy, March 2018.
6
See Congressional Budget Office (2018), The Budget and Economic Outlook: 2018 to 2028, April 9, 2018.
7
See also William C. Dudley, The Outlook for the U.S. Economy and Beyond, January 11, 2018.
8
For a further discussion, see William C. Dudley, Making Globalization Work, March 1, 2018.
9
The costs of holding cash make possible the use of (slightly) negative interest rates-employed by some
countries outside the U.S. in recent years-as a result, the term "effective lower bound" is used here.
10
Control of the federal funds rate has also been supported by the overnight reverse repurchase agreement
facility, which accepts cash from an array of institutional investors at a rate 25 basis points below the interest
rate paid on excess reserves.
11
These exogenous factors include the U.S. Treasury's cash balance at the Federal Reserve, the foreign central
bank repo pool, the overnight reverse repo facility, and currency outstanding.
12
Because the amount of reserves in a floor system is greater than in a corridor system, this also can be helpful in
easing frictions in terms of payment flows. With large reserve balances, banks have higher cash balances at
the Fed. As a result, they are less likely to incur daylight overdrafts and, thus, they have less need to monitor,
and, at times, delay outgoing payments.
13
See Minutes of the Federal Open Market Committee, November 1-2, 2016.
14
See Ben Bernanke, Monetary Policy in a New Era, Brookings Institution, October 2, 2017.
15
Others have proposed adopting a nominal GDP targeting regime, which has its own strengths and
weaknesses, but it is not considered here for the sake of brevity.