For release on delivery
8:00 a.m. EDT
June 1, 2017
Thoughts on the Normalization of Monetary Policy
Remarks by
Jerome H. Powell
Member
Board of Governors of the Federal Reserve System
at
The Economic Club of New York
New York, New York
June 1, 2017
Thank you for the opportunity to speak here at the Economic Club of New York.
Today I will discuss the ongoing progress of our economy and the prospects for returning
both the federal funds rate and the size of the Fed's balance sheet to more normal levels.
As always, the views I express here are mine and not necessarily those of the Federal
Open Market Committee (FOMC).
Economic Developments
The Federal Reserve is committed to fulfilling our statutory mandate of stable
prices and maximum employment. To begin with the labor market, many indicators
suggest that the economy is close to full employment. In April, the unemployment rate
was 4.4 percent, a level not reached since May 2007 and below most current estimates of
the natural rate of unemployment (figure 1).1 Estimates of the natural rate are inherently
uncertain, but other labor market measures are also near their pre-crisis levels, including
a broader measure of labor market underutilization that includes those who would like to
work but have not recently looked for a job and those working part time who want full-
time work.2 The labor force participation rate, which had declined sharply after the
crisis, has now been roughly stable for 3-1/2 years, which represents an improvement
1
For example, the Congressional Budget Office estimates that the natural rate of unemployment is
currently 4.7 percent. The March 2017 Blue Chip Economic Indicators reported that the consensus forecast
for the unemployment rate over 2024 to 2028 was 4.7 percent, with the top 10 projections averaging
5.1 percent and the bottom 10 averaging 4.3 percent. The median estimate of the longer-run normal rate of
unemployment in the March 2017 Summary of Economic Projections was 4.7 percent. The uncertainty
around these estimates is large. The canonical paper by Staiger, Stock, and Watson puts the 95 percent
confidence interval at 1-1/2 percentage points on either side of the point estimate; see Douglas Staiger,
James H. Stock, and Mark W. Watson (1997), "How Precise Are Estimates of the Natural Rate of
Unemployment?" in Christina D. Romer and David H. Romer, eds., Reducing Inflation: Motivation and
Strategy (Chicago: University of Chicago Press).
2
The broader measure is the Bureau of Labor Statistics' U-6 alternative measure of labor underutilization.
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against its estimated downward trend (figure 2). Participation is now close to estimates
of its trend level.3
Wage data have gradually moved up, consistent with a tightening labor market.
Although average hourly earnings are rising only about 2.5 percent per year, slower than
before the crisis, much of that downshift may reflect the slowdown in productivity
growth we have experienced. For example, over the past three years, unit labor costs--
that is, nominal wages adjusted for increases in productivity--have been generally rising a
bit faster than prices.4
Turning to inflation, the FOMC interprets price stability to mean inflation of 2
percent as measured by the price index for personal consumption expenditures (PCE).5
This objective is symmetric, so the Committee would be concerned if inflation were to
run persistently above or below this target. Inflation has run below 2 percent for most of
the period since the financial crisis, reflecting generally soft economic conditions as well
as transitory factors such as the earlier declines in energy prices. But over the past two
years, inflation has moved gradually closer to our objective. Prices rose 1.6 percent over
3
The labor force participation rate is currently slightly below the Congressional Budget Office's estimate
of trend and slightly above trend estimates based on the methodology of Aaronson and others. See
Congressional Budget Office (2017), The Budget and Economic Outlook: 2017 to 2027 (Washington:
CBO, January), https://www.cbo.gov/publication/52370; and Stephanie Aaronson, Tomaz Cajner, Bruce
Fallick, Felix Galbis-Reig, Christopher Smith, and William Wascher (2014), "Labor Force Participation:
Recent Developments and Future Prospects," Brookings Papers on Economic Activity, Fall, pp. 197-275,
https://www.brookings.edu/bpea-articles/labor-force-participation-recent-developments-and-futureprospects.
4
There are several other measures of nominal wage growth in addition to the Bureau of Labor Statistics'
(BLS) average hourly earnings. The BLS employment cost index measure of year-over-year wage and
salary growth was also 2.5 percent in the first quarter, while the BLS measure of compensation per hour
rose to 3.9 percent. Compensation per hour is quite volatile and subject to large revisions. The unit labor
cost measure is based on the BLS measures of compensation per hour and productivity for the business
sector. All of these measures indicate that compensation has picked up in recent years.
5
See Federal Open Market Committee (2017), Statement on Longer-Run Goals and Monetary Policy
Strategy, amended effective January 31 (original version adopted effective January 24, 2012),
https://www.federalreserve.gov/monetarypolicy/files/fomc_longerrungoals.pdf.
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the 12 months ending in April, compared with only 0.2 percent two years earlier
(figure 3). But much of that movement reflects price changes in the often-volatile energy
and food components of the index. Core inflation, which excludes food and energy
prices, has proven historically to be a better indicator of where overall inflation is
heading, although it, too, can be affected by transitory factors such as import prices.
Core inflation was 1.5 percent for the 12 months through April. This measure has also
risen since 2015, although its gradual increase appears to have paused because of weak
inflation readings for March and April. Some of the recent weakness can be explained by
transitory factors. And there are good reasons to expect that inflation will resume its
gradual rise. Incoming spending data have been relatively strong, and the labor market
should continue to tighten, exerting some upward pressure on wages and prices.
Nonetheless, it is important that the Committee assess incoming inflation data carefully
and continue to demonstrate a strong commitment to achieving our symmetric 2 percent
objective.
Despite strong job gains, very weak productivity gains have led to disappointingly
slow economic growth of only about 2 percent over the course of this expansion
(figure 4). While monetary policy can contribute to growth by supporting a durable
expansion in a context of price stability, it cannot reliably affect the long-run sustainable
level of the economy's growth.6 The success of monetary policy should be judged by the
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economy's performance against our statutory mandates of price stability and maximum
employment. Today, the economy is as close to our assigned goals as it has been for
many years (figure 5).
My baseline expectation is that the economy will continue on a path of growth of
about 2 percent, strong job creation and tightening labor markets, and inflation moving
up toward our 2 percent target. I expect that unemployment will decline a bit further and
remain at low levels for some time, which could draw more workers into the workforce,
put upward pressure on wages, or cause businesses to invest more as labor costs rise, all
of which I would view as desirable outcomes. Risks to the forecast now seem more
balanced than they have been for some time. In particular, the global picture has
brightened as growth and inflation have broadly moved up for the first time in several
years. Here at home, risks seem both moderate and balanced, including the downside
risk of lower inflation and the upside risk of labor market overheating.
Monetary Policy Normalization
The healthy state of our economy and favorable outlook suggest that the FOMC
should continue the process of normalizing monetary policy. The Committee has been
patient in raising rates, and that patience has paid dividends. While the recent
performance of the labor market might warrant a faster pace of tightening, inflation has
been below target for five years and has moved up only slowly toward 2 percent, which
argues for continued patience, especially if that progress slows or stalls. If the economy
performs about as expected, I would view it as appropriate to continue to gradually raise
rates. I would also see it as appropriate to begin the process of reducing the size of the
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balance sheet later this year. Of course, both decisions will depend on the performance
of the economy.
To put this process in context, consider where we have come from. Ten years
ago, in the summer of 2007, we were just entering the most painful economic crisis since
the Great Depression. The crisis and its aftermath prompted large-scale policy
interventions by the Federal Reserve and other authorities to avert the collapse of the
financial system and prevent the economy from spiraling into depression.
Most of the Federal Reserve's targeted financial measures--such as liquidity
facilities to ensure the flow of credit to households and businesses--were withdrawn soon
after the crisis as orderly conditions resumed in financial markets. In contrast, the
FOMC's easing of monetary policy increased over time as the longer-term economic
effects of the crisis gradually became clear. From 2007 through 2013, the FOMC added
ever greater support for the economy.7 From late 2008, with rates pinned at the zero
lower bound, the Committee resorted to unconventional policies to put additional
downward pressure on long-term rates, including strong calendar-based forward guidance
regarding the likely future path of the federal funds rate, and several rounds of large-scale
asset purchases (often referred to as quantitative easing (QE)).8
Both the federal funds rate and the balance sheet are currently set at levels
intended to provide significant support to economic activity. Normalization of the stance
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of monetary policy will return both tools to a more neutral setting over time. That
process can be said to have begun in 2014, when the FOMC ended its asset purchases and
began active discussions on lifting the federal funds rate from its lower bound.9 Our first
rate hike came in December 2015, with another in December 2016, and one additional
increase so far this year. The normalization process is projected to have several years left
to run.
In the case of the federal funds rate, the endpoint of that process will occur when
our target reaches the long-run neutral rate of interest. Estimates of that rate are subject
to significant uncertainty. The median estimate of its level by FOMC participants in
March was 3 percent, more than a full percentage point below pre-crisis estimates. This
decline in the long-run neutral rate, and an even larger decline in the short-run neutral
rate, imply that even the very low rates of recent years may be providing less support to
the economy than may appear. At present, the median FOMC participant estimates that
we will reach a long-run neutral level by year-end 2019 if the economy performs about as
expected (figure 6).
The Balance Sheet
In September 2014, the FOMC outlined its plans for the balance sheet. That
initial guidance has been supplemented over time in other FOMC communications, most
recently in the minutes of the May meeting. Here is a summary of the key points:
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•
Normalization of the balance sheet will commence only after the
normalization of the level of the federal funds rate is well under way.10 Most
FOMC participants think that this condition will be satisfied later this year if
the economy continues broadly on its current path.11
• The balance sheet will be allowed to shrink passively as our holdings of
Treasury and agency securities mature (or prepay) and roll off.12
• The process will be gradual and predictable. As noted in the May minutes,
although no decisions have been made, the Committee has discussed
preannouncing a schedule of gradually increasing caps on the dollar value of
securities that would be allowed to run off in a given month.
•
The Committee will continue to use the federal funds rate as its principal tool
for adjusting the stance of monetary policy.13
•
Once the process of balance sheet normalization has begun, it should continue
as planned as long as there is no material deterioration in the economic
outlook.14
10
See Board of Governors of the Federal Reserve System (2015), "Federal Reserve Issues FOMC
Statement," press release, December 16,
https://www.federalreserve.gov/newsevents/pressreleases/monetary20151216a.htm.
11
See Board of Governors of the Federal Reserve System (2017), "Minutes of the Federal Open Market
Committee, May 2-3, 2017," press release, May 24,
https://www.federalreserve.gov/newsevents/pressreleases/monetary20170524a.htm.
12
See Board of Governors of the Federal Reserve System (2014), "Federal Reserve Issues FOMC
Statement on Policy Normalization Principles and Plans," press release, September 17,
https://www.federalreserve.gov/newsevents/pressreleases/monetary20140917c.htm.
13
See Board of Governors of the Federal Reserve System (2017), "Minutes of the Federal Open Market
Committee, March 14-15, 2017," press release, April 5,
https://www.federalreserve.gov/newsevents/pressreleases/monetary20170405a.htm.
14
See Board of Governors, "Minutes of the Federal Open Market Committee, May 2-3, 2017," in note 11.
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•
In the long run, the balance sheet should be no larger than it needs to be to
allow the Committee to conduct monetary policy under its chosen
framework.15
Taken together, the Committee's communications present the broad outline of our
likely approach to normalizing the balance sheet. Although the process of normalizing
the size of the balance sheet will be in the background, that process will interact with the
Committee's decisions regarding the federal funds rate. As the Fed's balance sheet
shrinks, so debt held by the public will grow, which in theory should tighten financial
conditions by putting upward pressure on long-term rates. Any such tightening could
affect the Committee's decisions on the federal funds rate. But how big is this effect
likely to be?
Model-based approaches to that question estimate changes to financial conditions
through increases in the term premium as the balance sheet shrinks. These estimates vary
but are generally modest.16 One reason is that, for several years, the FOMC has signaled
its intention to normalize the balance sheet as economic conditions allow, and so some of
the effects of normalization should already be priced in. A recent research paper by
Federal Reserve staff estimated that unconventional policies are holding down term
15
See Board of Governors, "Federal Reserve Issues FOMC Statement on Policy Normalization Principles
and Plans," in note 12.
16
See, for example, Eric M. Engen, Thomas Laubach, and David Reifschneider (2015), "The
Macroeconomic Effects of the Federal Reserve's Unconventional Monetary Policies," Finance and
Economics Discussion Series 2015-005 (Washington: Board of Governors of the Federal Reserve System,
February), http://dx.doi.org/10.17016/FEDS.2015.005; Brian Bonis, Jane Ihrig, and Min Wei (2017), "The
Effect of the Federal Reserve's Securities Holdings on Longer-Term Interest Rates," FEDS Notes
(Washington: Board of Governors of the Federal Reserve System, April 20),
https://dx.doi.org/10.17016/2380-7172.1977; and Troy Davig and A. Lee Smith (2017), "Forecasting the
Stance of Monetary Policy under Balance Sheet Adjustments," Macro Bulletin (Kansas City, Mo.: Federal
Reserve Bank of Kansas City, May 10),
https://www.kansascityfed.org/~/media/files/publicat/research/macrobulletins/mb17davigsmith0510.pdf.
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premiums by about 100 basis points, but that these effects should decline to about
85 basis points by the end of 2017 as market participants see the normalization process
approaching.17 The same approach suggests that bringing forward the date of the start of
the anticipated phasing out of the Federal Reserve's reinvestments from mid-2018 to the
end of 2017 should have raised the term premium by only about 5 basis points.18 Of
course, markets sometimes react quite differently than expected, as the 2013 taper
tantrum showed.
The market's response to recent changes in expectations for reinvestment policy
also suggests that there need not be a major reaction when the Committee begins to phase
out reinvestments. Long-term rates did not react strongly to the reinvestment discussions
in the minutes for the FOMC's March and May meetings, which led market participants
to bring forward their expectations about the starting date for this process by about six
months (figure 7).19 A recent survey of economists also suggests that they expect that a
gradual, well-telegraphed reduction in the Fed's balance sheet should have modest
effects.20 These results augur well for an orderly phaseout of reinvestments. If changes
to reinvestment policy do tighten financial conditions more than anticipated, then I expect
that the FOMC would take that into account.
17
See Bonis, Ihrig, and Wei, "Effect of the Federal Reserve's Securities Holdings," in note 16.
18
Of course, estimates of the effects of monetary policy on term premiums often differ. Engen, Laubach,
and Reifschneider estimated that the Federal Reserve's asset purchases are currently holding down term
premiums by about 60 basis points, less than the estimate of Bonis, Ihrig, and Wei, but their findings still
imply a similar small effect of bringing forward the date of normalization by six months; see Bonis, Ihrig,
and Wei, "Effect of the Federal Reserve's Securities Holdings," and Engen, Laubach, and Reifschneider,
"Macroeconomic Effects," in note 16.
19
See the results of the March and May 2017 primary dealer surveys, which are available on the Federal
Reserve Bank of New York's website at
https://www.newyorkfed.org/markets/primarydealer_survey_questions.html.
20
See David Harrison (2017), "Economists See Modest Impact from a Fed Balance-Sheet Reduction," Wall
Street Journal, May 11.
The Long-Run Framework
Over the next few years, the runoff of assets acquired through QE is expected to
reduce the balance sheet substantially below its current level of $4.5 trillion. In the long
run, the ultimate size of the balance sheet will depend mainly on the demand for Federal
Reserve liabilities--currency, reserves, and other liabilities--and on the Committee's long-
run framework for setting interest rates.21
The next slide compares the Fed's balance sheet of May 2007 with that of May
2017 (figure 8). On the asset side, the balance sheet increased by about $3.5 trillion as
the FOMC acquired securities in its QE programs. These assets were matched on the
liability side of the Federal Reserve's balance sheet by a $2.2 trillion increase in reserve
balances held by commercial banks, a $700 billion increase in currency outstanding, and
a $500 billion increase in other liabilities.
As can be seen more clearly in the next slide, prior to the crisis, currency was the
Fed's main liability (figure 9). Currency outstanding has nearly doubled over the past 10
years to $1.5 trillion, growing at a compound annual rate of 6.8 percent. This growth
reflects strong domestic and international demand for U.S. currency, which is expected to
continue. The eventual level of demand for reserves is less certain but is highly likely to
exceed pre-crisis levels when reserve balances averaged only about $15 billion. Reserves
are the ultimate "safe asset," and demand for safe assets has increased substantially over
time because of long-run trends, including regulatory requirements. Other liabilities
include the Treasury General Account, the foreign repurchase agreement (or repo) pool,
balances held at the Fed by designated financial market utilities, and other items.
To gain a sense of the possible long-run size of the balance sheet, the next slide
shows simulations under three different assumptions for the ultimate level of reserve
balances: $100 billion, $600 billion, and $1 trillion (figure 10).22 These simulations
show that, due to the growth of currency and other liabilities, the balance sheet will
remain considerably above its pre-crisis levels even if reserves were to fall back to $100
billion (the black line). At its current growth rate, currency in circulation would reach $2
trillion by 2022 and $2.8 trillion in 2027. Even in the low case in which reserves decline
to $100 billion, our balance sheet would be about $2.4 trillion in 2022 and would grow
from there in line with currency demand. If the long-run level of reserves is $600 billion
in 2022, then the balance sheet would be about $2.9 trillion.23
The appropriate long-run level of reserves will also depend on the operating
framework the Committee chooses. Before the crisis, reserves were scarce, and the
Committee used open market operations to control the federal funds rate by managing
22
The intermediate figure of $600 billion is based on the Federal Reserve Bank of New York's May 2017
surveys of primary dealers and market participants. Following the 2017 study by Ferris, Kim, and
Schlusche, the federal funds rate path used in the balance sheet simulations consists of the modal path
given in the FOMC participants' Summary of Economic Projections (SEP); see Erin E. Syron Ferris, Soo
Jeong Kim, and Bernd Schlusche (2017), "Confidence Interval Projections of the Federal Reserve Balance
Sheet and Income," FEDS Notes (Washington: Board of Governors of the Federal Reserve System,
January 13), https://dx.doi.org/10.17016/2380-7172.1875. In the simulations shown here, the SEP used
pertains to the projections submitted in conjunction with the March 2017 FOMC meeting. All three of the
simulated balance sheet paths shown are predicated on a 12-month reinvestment phaseout commencing in
late 2017. The FRB/US model is used to generate the associated paths of the 10-year Treasury yield as
well as the paths of other financial and macroeconomic variables. Different paths of these variables imply
different trajectories of the balance sheet, in part by changing the implied path of currency in circulation.
Other assumptions used in generating the simulations are like those described in Ferris, Kim, and Schlusche
(2017). The time of balance sheet normalization is defined as the point at which reserve balances decline to
their assumed terminal value. Both in Ferris, Kim, and Schlusche (2017) and in the illustration here, the
evolution of the balance sheet is represented by the path of the Federal Reserve's System Open Market
Account holdings.
23
In the simulations from which these values are obtained, it is assumed that some prominent items in the
"Other liabilities" category diminish to zero by the end of 2022.
reserve supply. This process was operationally and resource intensive for the Desk and
its counterparties. As a consequence of QE, however, reserves have been highly
abundant and will remain so for some years. To affect financial conditions, the Federal
Reserve has therefore used administered rates, including the interest rate paid on excess
reserves (IOER) and, more recently, the offering rate of the overnight reverse repurchase
agreement (ON RRP) facility. This approach, sometimes referred to as a "floor system,"
is simple to operate and has provided good control over the federal funds rate. In
November 2016, when the Committee discussed using a floor system as part of its
longer-run framework, I was among those who saw such an approach as "likely to be
relatively simple and efficient to administer, relatively straightforward to communicate,
and effective in enabling interest rate control across a wide range of circumstances."24
Some have advocated a return to a framework similar to the pre-2007 system, in
which the volume of reserves would likely be far below its present level and the federal
funds rate would be managed by frequent open market operations.25 This "corridor"
framework remains a feasible option, although, in my view, it may be less robust over
time than a floor system.
Concluding Remarks
After a tumultuous decade, the economy is now close to full employment and
price stability. The problems that some commentators predicted have not come to pass.
Accommodative policy did not generate high inflation or excessive credit growth; rather,
it helped restore full employment and return inflation closer to our 2 percent goal. The
current discussions of the normalization of monetary policy are a result of that success.