For release on delivery
12:15 p.m. EST
March 7, 2019
Navigating Cautiously
Remarks by
Lael Brainard
Member
Board of Governors of the Federal Reserve System
at the
Julis-Rabinowitz Center for Public Policy and Finance
and the Bendheim Center for Finance
Woodrow Wilson School of Public and International Affairs
Princeton University
Princeton, New Jersey
March 7, 2019
While our economy continues to add jobs at a solid pace, demand appears to have
softened against a backdrop of greater downside risks. Prudence counsels a period of
watchful waiting--especially with no signs that inflation is picking up. With balance
sheet normalization now well advanced, it will be appropriate to wind down asset
redemptions later in the year.1
The Modal Outlook
Let me start by discussing prospects for the U.S. economy. Policymakers tend to
distinguish the most likely path, which I will refer to as the "modal" outlook, from risks
around that path--events that are not the most likely to happen, but that have some
probability of happening and that, if they do materialize, would have a one-sided effect.
Both the modal outlook and the risks around it have important implications for monetary
policy, but in somewhat different ways.
Let me first discuss the modal outlook. While the economy performed very well
last year, I have revised down my modal outlook for this year, in part reflecting some
softening in the recent spending and sentiment data. This softening could be a harbinger
of some slowing in the underlying momentum of domestic demand. In the initial
estimate released last week, real gross domestic product (GDP) rose at a 2.6 percent
annual rate in the fourth quarter of 2018. However, the latest report on retail sales
showed a sharp decline. Analysts note that there is some reason to be skeptical of that
report; it is subject to revision, and other data sources suggest a more muted
movement. Although the magnitude of the drop may be revised smaller, coming in the
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last month of the quarter, that decline suggests that growth in consumer spending may be
held down in the first quarter of this year.
Surveys of consumer sentiment, which may provide some additional insight into
the strength of spending in the first quarter, fell on net between November and January
and rebounded partially in February. The lengthy government shutdown likely
contributed to the January decline. And although recent readings are below those that
prevailed for much of 2018, they are still in a range consistent with ongoing spending
growth.
Other spending indicators have also shown some slowing. Residential
construction data have been soft for some time, reflecting in part earlier increases in
interest rates, and homebuilders report that supply constraints on available lots, shortages
of skilled workers, and tariffs on inputs are also contributing to the slowdown.
Business investment registered strong gains last year, including in the latest
quarter, but there are some indications of softening there as well. The latest data on
capital goods orders, for example, suggest some softening in equipment spending gains.
Surveys of businesses, such as the Institute for Supply Management's purchasing
managers index and similar regional indexes, have generally moved lower over the past
six months, reversing much of the run-up seen in 2017 and late 2016. The National
Federation of Independent Business's Small Business Optimism Index is also lower than
its mid-2018 peak, although it remains well above the levels of 2015 and much of 2016.
The weaker foreign outlook also acts as a crosscurrent to the modal outlook.
While strong foreign growth provided tailwinds early last year, foreign growth
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projections have been revised down repeatedly more recently.2 The slowdown of foreign
growth now appears to be more persistent than initially assumed, with growth likely
running below potential for most of last year.
Economic activity slowed noticeably in the second half of 2018 in China, where
policymakers have been trying to achieve a balance between restraining very elevated
levels of domestic debt, on the one hand, and maintaining strong aggregate growth, on
the other. The protracted trade conflict with the United States has further complicated
that challenge.
Concerns about China's slowdown are reverberating globally, as was true in
2015-16, although the incidence is somewhat different. While Germany had appeared to
be weighed down primarily by transitory factors late last year, some of the weakness in
industrial production now appears likely to be more persistent, in part reflecting
spillovers from China. The euro area is also seeing slowing in some other large member
economies. Global weakness in trade and manufacturing has also weighed on Japan.
The slowdown in foreign demand spills over into the United States through a
variety of channels. Although the dollar has weakened somewhat lately, its earlier
appreciation and slowing foreign growth contributed to a decline in exports and a fall in
import prices over the second half of last year. In contrast, the recent step-down in long-
term rates and easing in the dollar have lessened pressures on yields in emerging markets
and provided more policy space in some cases.
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In the United States, financial markets saw substantial volatility late last year,
which may still be affecting sentiment. From September to December of last year,
financial conditions tightened considerably, with the stock market falling as much as 20
percent, and corporate bond premiums rising. This year, much of that tightening has
reversed: The S&P 500 has made up more than half of its earlier losses, and corporate
risk spreads have reversed much of their earlier tightening. Long-term Treasury yields
rose from September through November and have since more than retraced, returning to
the levels of early 2018. While the dollar has edged down from the peaks reached in the
fall, it is about 7 percent higher than the lows seen early last year.
Overall, the softer spending data in the U.S. and the slowdown abroad, along with
earlier financial volatility, are likely weighing on the modal outlook and might in turn
warrant a softening in the modal path for policy.
Risks to the Outlook
Let me turn now to the second category of crosscurrents facing the U.S. economy:
the risks around the modal outlook. Policy uncertainty has been elevated recently and
has been cited as an important factor in the financial volatility late last year. Although
some of the risks have been anticipated for some time, recent events have brought them
into heightened focus, and the accumulation of these risks could lead to some erosion in
sentiment that could in turn feed into activity.
Trade dispute escalation remains a risk. The tariffs and trade disruptions that
have occurred so far are estimated to have had relatively modest effects on aggregate
growth and inflation, although damaging disruptions have been concentrated in some
sectors, such as soybeans. While recent reports suggest some progress, the prospect of
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additional tariffs in the trade conflict with China or on automobiles have been cited
frequently as a risk in earnings reports and reports from business contacts.
The recent longest-ever government shutdown created hardship for many families
and has increased attention on upcoming fiscal negotiations. On current estimates, the
debt ceiling will need to be raised around the fall. The Bipartisan Budget Act, which is
estimated to boost GDP growth by 0.3 percentage point, on average, per year in 2018 and
2019, is scheduled to expire in 2020. If agreement is not reached, spending levels could
fall back to the sequester caps, which would amount to a significant headwind.
There are also important downside risks abroad. Most immediately, a "no-deal
Brexit" would have adverse consequences for Britain, and potentially more broadly,
given London's role as a financial center. Within the euro area, countries such as Italy
and France face domestic challenges. And a hard landing in China would have spillovers
through financial and trade channels.
Employment, Inflation, and Policy
In contrast to the softening in spending indicators, job gains have remained strong
so far. Job gains have averaged 240,000 per month over the past three months--more
than twice the pace necessary to absorb new entrants into the labor force. The January
unemployment rate of 4 percent is near a multidecade low. The strong labor market has
drawn many Americans into productive work, and the overall employment-to-population
ratio for workers between the ages of 25 and 54 is now within 1/2 percentage point of its
pre-crisis peak. Many of the main measures of wages have been increasing at rates not
seen on a sustained basis in almost 10 years, although labor's share of overall income
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remains stubbornly depressed.3 Nonetheless, recent data on claims have shown some
softening, and I will be watching a broad set of labor market indicators carefully,
including the payrolls data for February, which will be released tomorrow.
Just as the economy is performing well on the maximum-employment goal set by
the Congress, it is also close to meeting our price-stability mandate. Following many
years of low readings, the core price index for consumer purchases for the 12 months
through December was up 1.9 percent.4 That reading lines up with the median Summary
of Economic Projections (SEP) forecast from a year ago. So inflation is very close to the
Committee's 2 percent objective and its earlier expectation.
Even so, we will need to be vigilant to ensure inflation achieves 2 percent on a
sustained basis. As I have observed for some time, underlying trend inflation may be
running slightly below the Committee's 2 percent objective. Many statistical filtering
models put underlying inflation modestly below 2 percent, and some survey measures of
inflation expectations are running somewhat below pre-crisis levels. Similarly, the
difference between the yields on nominal and inflation-indexed Treasury securities is
lower than it was before the crisis, and that difference may provide some insight into
market participants' views of underlying inflation.5
The fact that estimates of underlying trend inflation remain a bit on the soft side
reinforces the evidence that the Phillips curve is very flat, a key element of the post-crisis
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new normal that I have noted previously.6 The responsiveness of price inflation to
resource utilization at the national level has been very weak for some time. This raises
the possibility that the economy may have room to run. As the unemployment rate has
fallen to levels not seen in many decades, we have heard concerns that the steeper
Phillips curve of the past might reassert itself, perhaps in a nonlinear manner.7 But all
available evidence suggests inflation expectations remain well anchored to the upside.
Indeed, the contours of today's new normal suggest we should be equally
attentive to a risk of erosion in inflation expectations to the downside. A range of
evidence suggests that the long-run "neutral" rate of interest--the rate of interest
consistent with the economy growing at its potential rate and stable inflation--is very low
relative to its historical levels. The low long-run neutral rate limits the amount of space
available for cutting the federal funds rate to buffer the economy from adverse
developments and is likely to increase the frequency or length of periods when the policy
rate is pinned at the lower bound. In turn, more frequent or extended episodes when
inflation is below target and policy is at the effective lower bound risk pulling down
private-sector inflation expectations in a self-reinforcing downward spiral, which could
further compress the monetary policy buffer to cushion downside shocks.8
The Federal Open Market Committee (FOMC) has made clear that the 2 percent
inflation goal is symmetric.9 As the median SEP forecasts have indicated, a number of
Committee members have previously projected a policy path consistent with inflation
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rising somewhat above 2 percent for a time, which is in line with the symmetry of the
target.
There is a separate discussion of policies that would pre-commit to make up for
past misses on inflation, such as temporary price-level targeting, which may be important
in circumstances with a low long-run neutral rate and more frequent effective-lower-
bound episodes.10 I expect this will be part of our review of monetary policy strategies,
tools, and communication practices later this year.11
Our policy goal now is to preserve the progress we have made on maximum
employment and target inflation. Core inflation last year came in around target. It is
heartening to see so many American workers coming back into the jobs market with
rising wages. Our business contacts note they are currently hiring and investing in
training workers who may not have been considered just a few years ago.
With regard to policy, modest downward revisions to the baseline outlook for
output and employment would call for modest downward revisions to the path for our
conventional policy tool, the federal funds rate, helping to offset some of the weakness
that would otherwise weigh on the economy. Moreover, basic principles of risk
management would suggest that the increase in downside risks warrants a modest
downward revision to the modal path for policy. These downside risks, if realized, could
weigh on economic activity.12 So heightened downside risks to output and employment
would argue for a softer federal funds rate path even if the modal outlook for the
economy were unchanged.
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At a time when the modal outlook appears to have softened a bit, and risks appear
more weighted to the downside than the upside, the best way to safeguard the gains we
have made on jobs and inflation is to navigate cautiously on rates. Risk management in
an environment of a low long-run neutral rate and an attenuated relationship between
resource utilization and overall inflation supports this approach. Watchful waiting will
allow us to gather more information about domestic momentum and foreign growth as
well as some of the policy risks weighing on sentiment.
Balance Sheet Normalization
Let me turn now to the second tool used by the Federal Reserve in recent years--
asset purchases. Recall that, after reducing the federal funds rate to its effective lower
bound of zero in the 2008-09 recession, the FOMC sought a mechanism for providing
additional stimulus in order to achieve maximum employment and target inflation.13 The
Federal Reserve purchased longer-term Treasury securities in an effort to push down
longer-term interest rates to support economic activity, an approach sometimes referred
to as quantitative easing. It also purchased agency mortgage-backed securities for the
same reason, as well as to provide support to the housing sector, which was at the heart of
the crisis. Although the empirical estimates vary, most conclude that the asset purchase
programs were successful in supporting the recovery.14
Once recoveries become well established, the Federal Reserve moves its policy
settings to more normal levels. Our current extended recovery is no exception: The
Federal Reserve first started moving the federal funds rate to more normal values once
the expansion was well established, and then it started normalizing the balance sheet once
normalization of the federal funds rate was well under way.
Of course, the benchmark for normalization has changed since before the
financial crisis. Demand has grown for the Fed's liabilities from a variety of sources.
The demand for U.S. currency has grown notably relative to nominal GDP, the Treasury
Department now holds large balances in its account at the Fed as an important part of its
cash management, and foreign central banks hold larger deposits than in the past. In
addition, the demand from commercial banks for deposits at the Fed--that is, "reserves"--
appears to have increased substantially. Spurred by new liquidity regulations and their
own internal liquidity management practices, the largest banks hold substantial amounts
of so-called high-quality liquid assets to protect against the risk of a sudden "run" on
their uninsured short-run liabilities, as occurred during the financial crisis.
So it appears that the new normal size of the balance sheet is likely to remain
greater relative to the size of the economy than it was before the financial crisis. How
much larger is still an open question. For the past decade, the Federal Reserve has
operated a regime with reserves that are very abundant relative to banks' demand for
reserves. The current framework relies on the Federal Reserve's interest rate on reserves
to control the federal funds rate, in the context of the provision of ample reserves. In
contrast, the pre-crisis framework featured a scarce supply of reserves, which the Federal
Reserve would vary on a daily basis to control the federal funds rate by closely matching
the demand for reserves.
The FOMC recently affirmed that it would continue to operate the current
framework.15 This approach makes sense for a variety of reasons. The current
framework has been effective in providing good control of the policy rate and ensuring
effective transmission to other money markets and the financial system. Not only is the
demand for reserves likely to remain much higher than it was before the crisis, but it is
also likely that there will be fluctuations in reserves, along with other elements of the
Fed's liabilities, such as the deposits the Treasury holds with the Fed. Accommodating
those swings with scarce reserves would require much larger daily open market
operations than was the case before the crisis.
By remaining in a regime with ample reserves, the Fed is able to control short-
term interest rates without the need to conduct daily open market operations. Because
there are ample reserves, the federal funds rate and other short-term interest rates are
determined along the flat portion of the reserve demand curve. As a result, the system
can absorb swings in the demand and supply of reserves with limited need for open
market operations. The alternative of pushing reserves close to the transition point
between the flat and steep parts of the demand curve would likely lead to active
intervention as an ongoing feature, along with volatility in rates.
Given that the Committee is now operating with two instruments, it is important
to note that the Committee clarified that it would seek to use only one tool actively at a
time, and that the preferred active tool would be the federal funds rate when it is above
the effective lower bound. I want to make it clear that we would not want our two tools
to be working at cross-purposes. For instance, we would not want the balance sheet to be
15
See Board of Governors (2019c).
shrinking at a time when the FOMC thought it was appropriate to cut the federal funds
rate.
After holding the size of the balance sheet roughly flat since mid-2014, once the
normalization of the federal funds rate was deemed well under way in October 2017, the
Committee started to allow the size of the balance sheet to shrink in line with the pledge
to "hold no more securities than necessary to implement monetary policy efficiently and
effectively."16 We have made substantial progress, as demonstrated by the level of
reserves. Reserves are already down by 40 percent since their peak and are likely to be
down by more than half this summer. In my view, asset redemptions should come to an
end later in the year, which would provide a sufficient buffer of reserves to meet demand
and avoid volatility. We have gathered information from market contacts and have
surveyed banks to assess their demand for reserves.17 I would want to see a healthy
cushion on top of that to avoid unnecessary volatility and ensure that the federal funds
rate will be largely insulated from daily swings in factors affecting reserves.
With regard to the composition of the balance sheet, I favor moving eventually to
a portfolio of only Treasury securities--that is, without any agency mortgage-backed
securities remaining. It is important to do so in a way that continues to avoid market
disruptions. That shift will be under way naturally, albeit slowly, as these securities
mature and are replaced by Treasury securities.18
For the portion of our portfolio in Treasury securities, the Federal Reserve
currently holds no Treasury bills, and our portfolio has a much longer weighted-average
maturity than the current stock of Treasury securities outstanding in the market or than
our pre-crisis portfolio, which was more heavily weighted toward short-dated securities
than the holdings of the public. When the Federal Reserve System begins once again
purchasing Treasury securities, we will need to decide what maturities to purchase.
Given how far out of step the System's current portfolio is from common benchmarks,
however, it might make sense to weight those purchases more heavily toward Treasury
bills and other shorter-dated Treasury securities for a time. Further into the future, there
may be good reasons to shift toward greater holdings of shorter-term securities to provide
greater flexibility. However, I want to emphasize that I do not expect this issue to be
addressed for some time.
Conclusion
The most likely path for the economy appears to have softened against a backdrop
of greater downside risks. Our goal now is to safeguard the progress we have made on
full employment and target inflation. Prudence counsels a period of watchful waiting.
And with balance sheet normalization now well advanced, it will soon be time to wind
down our asset redemptions.
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