William C Dudley: The outlook for the US economy in 2018 and
beyond
Remarks by Mr William C Dudley, President and Chief Executive Officer of the Federal Reserve
Bank of New York, at the Securities Industry and Financial Markets Association, New York City,
11 January 2018.
* * *
Good afternoon. It is a pleasure to have the opportunity to speak with you at this event. Today, I
will focus on the economic outlook for 2018 and beyond. As always, what I have to say reflects
my own views and not necessarily those of the Federal Open Market Committee (FOMC) or the
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Federal Reserve System.
Broadly speaking, the prospects for continued economic expansion in 2018 look reasonably
bright. The economy is likely to continue to grow at an above-trend pace, which should lead to a
tighter labor market and faster wage growth. Under such conditions, I would expect the inflation
rate to drift higher toward the FOMC's 2 percent long-run objective.
Over the longer term, however, I am considerably more cautious about the economic outlook.
Keeping the economy on a sustainable path may become more challenging. While the recently
passed Tax Cuts and Jobs Act of 2017 likely will provide additional support to growth over the
near term, it will come at a cost. After all, there is no such thing as a free lunch. The legislation
will increase the nation's longer-term fiscal burden, which is already facing other pressures, such
as higher debt service costs and entitlement spending as the baby-boom generation retires.
While this does not seem to be a great concern to market participants today, the current fiscal
path is unsustainable. In the long run, ignoring the budget math risks driving up longer-term
interest rates, crowding out private sector investment and diminishing the country's
creditworthiness. These dynamics could counteract any favorable direct effects the tax package
might have on capital spending and potential output.
Favorable near-term outlook
Turning to the near-term outlook, the prospects appear favorable for another year of above-trend
growth. Consumer spending should continue to grow at a moderate pace, supported by solid
fundamentals. Household income is being bolstered by faster compensation growth and
continued healthy employment gains. Moreover, the aggregate household balance sheet
remains in good shape, due in part to rising home prices, a strong stock market, and only
moderate growth in household debt. Over the past year, home prices have risen by about 7
percent on a national basis, and the S&P 500 equity index has risen by nearly 20 percent. In
contrast, household debt has risen about 4 percent over the past year, only slightly higher than
the growth in personal income. Further, the household debt service burden is low, reflecting the
extended period of low interest rates.
Of course, the aggregate figures mask some underlying problems. Two issues worth
highlighting are the persistent growth in income and wealth inequality and the burden of rising
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student loan debt. Many people of more modest means don't directly benefit from rising home
and stock prices. And, increasing student debt burdens have made it more difficult for many
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young adults to become homeowners. This is significant because homeownership is a major
avenue for wealth accumulation for many households. Nevertheless, the tightening labor market
should provide greater opportunities for workers to obtain employment, build human capital, and
gain greater opportunities to improve their financial circumstances.
On the business side of the ledger, investment spending should remain solid. Business cash
flows are strong, and the corporate sector is set to receive a meaningful lift from the recently
enacted tax legislation. The large reduction in the statutory corporate income tax rate from 35
percent to 21 percent and the 100 percent expensing provision for investment should drive down
the effective cost of capital for business.
In addition, the U.S. economy should be well supported by the recent improvement in the global
economic outlook. More synchronized cyclical recoveries in Europe and Japan-and a revival of
growth in many emerging market economies-should ensure that demand for U.S. goods and
services remains strong.
Putting it all together, I have raised my real GDP forecast for 2018 by about half a percentage
point to three quarters of a percentage point to a 21⁄2 percent to 23⁄4 percent range. About
onethird of this upward revision reflects the firmer momentum of the economy going into 2018 and
about two-thirds the stimulative impact of the tax legislation.
While this legislation will reduce federal revenues by about 1 percent of GDP in both 2018 and
2019, I anticipate the boost to economic growth will be less than that. Most importantly, most of
the tax cuts accrue to the corporate sector and to higher-income households that have a
relatively low marginal propensity to consume. This suggests that a significant portion of the tax
cuts will be saved, not spent.
On the business side, the boost to investment from the lower corporate tax rate and full
expensing is likely to be relatively modest. In the past, aggregate investment spending has not
been very sensitive to the cost of capital, which is only one of many factors that influence
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investment spending. Moreover, the reduction in the effective tax rate for corporations-or what
they typically pay in practice-is only about 3 to 4 percentage points, far smaller than the
reduction in the statutory rate. On the household side, the impact is likely to be attenuated by the
temporary nature of many important provisions. Households may not spend much of the
additional after-tax income if they perceive the gains as likely to be transitory.
Finally, the legislation is likely to generate some frictional costs that will mitigate its effects on
growth. In particular, it likely will have disparate impacts regionally and across economic
sectors. For example, the $10,000 cap on the amount of state and local income and property
taxes that can be deducted will raise the effective cost of owning higher-end residential property
in high-tax states. This could adversely affect prices and construction activity of high-end
housing in such states.
If the economy continues to grow at an above-trend pace in 2018, the labor market should tighten
further. In fact, I anticipate that the civilian unemployment rate will fall below 4 percent this year
and reach the lowest level since at least 2000. If this scenario proves accurate, this should lead
to further firming of wage growth.
On this point, some wonder whether the relationship between tight labor markets and higher
inflation has broken down. I have not lost faith in this relationship. As the labor market has
tightened over the past few years, we have seen a discernible firming in the wage inflation trend
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from 2 percent to around 21⁄2 percent. Also, data at the state level indicate that states with lower
unemployment rates tend to have firmer wage trends. This supports the case that tighter labor
markets tend to be associated with higher wage growth.
As the labor market tightens and wage growth firms further, I would expect these conditions to
push up price inflation, particularly for services. Research by the New York Fed has found that
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prices of manufactured goods do not appear to be sensitive to labor market tightness. In
contrast, tighter labor markets tend to be associated with higher price inflation for services. This
difference presumably reflects several factors. First, prices of manufactured goods are
determined in global markets, whereas prices for most services are determined locally. Second,
there remains significant excess capacity in manufacturing across much of the world. In the
United States, for example, the manufacturing capacity utilization rate was only 76.4 percent in
November, about 2 percentage points below its average since 1972. Third, for manufactured
goods, there may be more scope for substituting capital for labor, and/or lowering labor costs by
importing labor-intensive intermediate goods. To the extent that this margin of adjustment is
available, it would tend to dampen the impact of higher wage costs on prices of manufactured
goods. Finally, the so-called "Amazon" effect, which results in greater price transparency for
buyers, may weigh disproportionately on goods prices.
Although inflation remains somewhat below the FOMC's 2 percent objective on a year-over-year
basis, I still anticipate that it will stabilize around that level over the medium term. As I noted
earlier, above-trend growth should tighten the labor market further, pushing up wage inflation and
eventually services prices. In fact, we have already seen some increase in inflation in recent
months. Over the three months ending with November, core personal consumption expenditure
prices rose at a 1.8 percent annual rate, up from a corresponding rate of just 0.4 percent last
May. The pronounced slowing of core inflation during the first half of 2017 was due, in part, to
transitory factors, such as a sharp fall in prices for cellular phone services. Those influences
have been temporarily depressing the year-over-year figures.
When these transitory influences drop out of the year-over-year numbers this spring, the inflation
rate is likely to move higher. Importantly, even as inflation undershot the FOMC's objective over
the past year, inflation expectations have been broadly stable. I would be much more concerned
if low inflation outcomes were contributing to a decline in inflation expectations. That would make
it more difficult to push inflation back toward our 2 percent objective and would increase the risk
of getting stuck at the effective lower bound for interest rates following the next economic
downturn, which inevitably will come.
Even if inflation were to remain somewhat below 2 percent over the near future, that might not be
a serious problem, if the economy were to continue to perform well in other respects. To me, it
would imply that the unemployment rate associated with "maximum employment" is lower than
current estimates and that we could let the labor market tighten a bit further. This would be a
positive outcome because the productive capacity of the U.S. economy would be enhanced and
more people would be able to find jobs, develop their job skills, and build their human capital.
In short, 2018 looks like it will be a good year for the economy. I anticipate that the Federal
Reserve will make further progress in achieving its dual mandate objectives of maximum
sustainable employment and price stability. If circumstances evolve close to what I have outlined
today, I will continue to advocate for gradually removing monetary policy accommodation. As I
see it, the case for doing so remains strong. While the fact that inflation is below the FOMC's 2
percent objective argues for patience, I think that is more than offset by an outlook of above-trend
growth, driven by accommodative monetary policy and financial conditions as well as an
increasingly expansionary fiscal policy.
Moreover, if the labor market were to tighten much further, there would be a greater risk that
inflation could rise substantially above our objective. But, let me be clear: A small and transitory
overshoot of 2 percent inflation would not be a problem. Were it to occur, it would demonstrate
that our inflation target is symmetric, and it would help keep inflation expectations well-anchored
around our longer-run objective. In contrast, if inflation were to shoot appreciably above 2
percent for a considerable time, the FOMC would have to adopt a markedly tighter policy stance
that would put the economic expansion at risk. In such circumstances, it is unlikely that we
would be able to sustain a low level of unemployment and also achieve our inflation objective.
Potential concerns for the longer-term outlook
So, if 2018 looks good, what about the longer term? Let me start by discussing what I'm not
worried about, before turning to those areas where I have greater concerns. For one, I do not
think the economic expansion-now in its ninth year-is vulnerable just because it is "old." As
we like to say, expansions don't die of old age-they die either because monetary policy needs to
be tightened appreciably to combat rising inflation, or because the economy gets hit with a large
shock that overwhelms the ability of the Federal Reserve and other policymakers to stabilize it
successfully. In general, with inflation below the FOMC's long-run objective we can be cautious
in how we adjust monetary policy.
Similarly, I am not concerned about the recent flattening of the Treasury yield curve even though
some commentators believe that such a flattening foreshadows a recession. At the end of 2017,
the spread between the 10-year Treasury bond and 2-year Treasury note had narrowed to 52
basis points, from 125 basis points at the start of the year. As I see it, some flattening in the yield
curve should be expected as we gradually remove monetary policy accommodation. If the yield
curve were not flattening, it would suggest that we were behind the curve in removing
accommodation. Moreover, this recent flattening is not particularly pronounced. For example,
the 10-year/2-year spread of 52 basis points is only 46 basis points narrower than the average
since 1978.
In addition, all else equal, we should expect the yield curve to be flatter than normal in the current
environment. Not only are bond term premia depressed due to quantitative easing both here and
abroad, but the low inflation environment is also likely a contributing factor. If investors perceive
that the risk of significantly higher inflation has fallen over time as inflation has persistently
undershot 2 percent, they should demand lower bond term premia as compensation for inflation
risk. Finally, while inverted yield curves have typically preceded recessions, I am unaware of any
causal element in that relationship. For example, I don't believe that banks become unwilling to
lend when the yield curve inverts and that this tightening of credit availability "causes" a
recession. I think it is noteworthy that in the current environment, higher short-term interest rates
tend to raise-not lower-the banking industry's profitability. This is demonstrated, in part, by the
strong performance of bank stocks in 2017 as the Federal Reserve raised short-term interest
rates.
As I see it, the Treasury yield curve becomes inverted when investors believe that short-term real
interest rates are high and monetary policy is tight. Investors anticipate that such a regime will
slow the economy and be followed by a reduction in short-term rates. Because these
expectations turn out to be validated eventually, we observe that inverted yield curves precede
and signal recessions. But, we are not in this situation currently. Investors expect short-term
interest rates to rise, not drop, and to remain higher in the future than they are now. Despite the
flatter yield curve, the consensus view continues to be that monetary policy is not yet tight.
One area I might be slightly-but not particularly-worried about is financial market asset
valuations, which I would characterize as elevated. While valuations are noteworthy, I am less
concerned than I might be otherwise because the economy's performance and outlook seem
consistent with what we see in financial markets. Volatility in the real economy has been low,
and this has been matched by low volatility in financial markets, which has helped support high
valuations. I am also less worried because the financial system today is much more resilient
and robust than it was a decade ago. Thus, even if financial asset prices were to decline
significantly-which presumably would occur if the economic outlook were to deteriorate-I don't
think such declines would have the destructive impact we saw a decade ago. Higher capital and
liquidity requirements for major banks have made the banking system more resilient and better
able to absorb market shocks without this impairing its ability to intermediate credit flows
between borrowers and savers. It was the collapse of confidence in the financial system in 2008
that caused credit availability to dry up, contributing greatly to the severity of the Great
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Recession.
So, what am I worried about? Two macroeconomic concerns warrant mention. The first is the
risk of economic overheating. Now, this seems like an odd issue to focus on when inflation is
low, but it strikes me that this is a real risk over the next few years. Not only do we have an
economy that is growing at an above-trend pace-at a time when the labor market is already
quite tight-but the economy will be getting an extra boost in 2018 and 2019 from the recently
enacted tax legislation. Moreover, even though the FOMC has raised its target range for the
federal funds rate by 125 basis points over the past two years, financial conditions today are
easier than when we started to remove monetary policy accommodation.
This suggests that the Federal Reserve may have to press harder on the brakes at some point
over the next few years. If that happens, the risk of a hard landing will increase. Historically, the
Federal Reserve has found it difficult to achieve a soft landing-especially when the
unemployment rate has fallen below the rate consistent with stable inflation. In those
circumstances, the Federal Reserve has been unable to both push up the unemployment rate
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slightly to a level that is consistent with stable inflation and avoid recession. Now, I don't want to
imply that a recession is inevitable once the FOMC finds it necessary to nudge up the
unemployment rate to a sustainable level. The starting point in terms of the inflation rate is also
important because it will influence how far the FOMC is likely to go in terms of making monetary
policy tight. Nevertheless, I think it is fair to say that the track record on this score is not
encouraging.
The second risk is the long-term fiscal position of the United States. Recognizing that fiscal
policy is the domain of the executive and legislative branches rather than the Federal Reserve, I
would emphasize several points. For one, the current U.S. fiscal position is far worse than it was
at the end of the last business cycle. For example, in fiscal year 2007, the budget deficit was 1.1
percent of GDP; in fiscal 2017, it was 3.5 percent of GDP. Similarly, federal debt held by the
public was 35 percent of GDP in fiscal 2007, and 77 percent in fiscal 2017. Additionally, three
factors will undoubtedly cause these budgetary pressures to intensify over time: the tax
legislation will push up the federal deficit and federal debt burden; debt service costs will rise as
interest rates normalize; and entitlement outlays will increase as the baby boom generation
retires. Let me discuss each of these in turn.
With respect to the tax legislation, the Joint Committee on Taxation estimates the cost at around
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$1.1 trillion over the next 10 years. This estimate takes into consideration the likelihood that the
legislation will boost the productive capacity of the U.S. economy somewhat-raising the
economy's potential growth rate-and that this incremental growth will generate additional tax
revenues. To me, this seems like a reasonable estimate, recognizing that with any complex tax
legislation, there is a high level of uncertainty about its impact on longer-term growth and
revenues. It is possible that the boost to the nation's productive capacity from higher capital
spending and greater labor supply will be higher than anticipated, leading to faster growth and
greater revenue. But, on the other side, the revenue projections might also turn out to be overly
optimistic as households and businesses react to changes in the tax code by adjusting how they
conduct their activities in a way to minimize their tax liabilities. This might especially be true as
people look to take advantage of the lower top marginal pass-through rate that is available on
sole proprietorships, partnerships, LLCs and S corporations compared to wage income.
Debt service costs will undoubtedly be boosted by higher levels of federal debt and higher
interest rates. In fiscal year 2007, federal debt service costs totaled $237 billion on $5 trillion of
federal debt held by the public. By fiscal year 2017, although federal debt held by the public had
nearly tripled to almost $15 trillion, debt service costs were $263 billion, only modestly above
where they were 10 years earlier. Over the past decade, the sharp decline in short- and
longterm interest rates has kept a lid on debt service costs-that lid is now being lifted.
Although the future path of interest rates is highly uncertain, the most recent 10-year projections
of the Congressional Budget Office (CBO) illustrate where debt service costs are heading. For
example, the CBO projects that debt service costs in 2027 will be more than $800 billion-nearly
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3 percent of GDP, more than double their current share.
Finally, the retirement of the baby boom generation over the next decade will put considerable
pressure on outlays. The CBO projects that, by 2027, outlays on Social Security and Medicare
will rise to 6 percent and 5 percent of GDP, respectively-each more than a percentage point
higher than in 2017.
As the economist Herbert Stein once remarked, trends that are unsustainable must end. How,
precisely, the United States chooses to address its fiscal challenges will have important
consequences for the economy, monetary policy, and financial markets in the years ahead.
To sum up, I am optimistic about the near-term economic outlook and the likelihood that the
FOMC will be able to make progress this year in pushing inflation up toward its 2 percent
objective. The economy has considerable forward momentum, monetary policy is still
accommodative, financial conditions are easy, and fiscal policy is set to provide a boost. But,
there are some significant storm clouds over the longer term. If the labor market tightens much
further, it will be harder to slow the economy to a sustainable pace, avoiding overheating and an
eventual economic downturn. Another important issue is the need to get the country's fiscal
house in order for the long run. The longer that task is deferred, the greater the risk for financial
markets and the economy, and the harder it will be for the Federal Reserve to keep the economy
on an even keel.
Thank you for your kind attention. I would be happy to take a few questions.
1
Gerard Dages, Saraphin Dhanani, Beverly Hirtle, Jonathan McCarthy, Richard Peach, and Paolo Pesenti
assisted in the preparation of these remarks.
2
See William C. Dudley, Remarks at the Economic Press Briefing on the Regional Economy, August 10,
2017 and 2017 Economic Press Briefing: Wage Inequality in the Region. See also William C. Dudley, The
Monetary Policy Outlook and the Importance of Higher Education for Economic Mobility, October 6, 2017.
3
See the New York Fed's Economic Press Briefing on Household Borrowing, Student Debt Trends and
Homeownership, April 3, 2017. See also Bleemer, Brown, Lee, Strair, and van der Klaauw, 2017. Echoes of
Rising Tuition in Students' Borrowing, Educational Attainment, and Homeownership in Post-Recession
America. Federal Reserve Bank of New York Staff Reports, no. 820 (July).
4
For example, business investment in new equipment has historically been highly correlated with the capacity
utilization rate, which remains relatively low.
5
As measured by average hourly earnings or the Employment Cost Index.
6
Peach, Richard, Robert Rich, and M. Henry Linder. 2013. The Parts Are More Than the Whole: Separating Goods
and Services to Predict Core Inflation. Federal Reserve Bank of New York, Current Issues in Economics and
Finance, Vol. 19, No. 7.
7
See William C. Dudley, Lessons from the Financial Crisis.
8
Since the late 1940s, any time the three-month moving average of the unemployment rate increased by 0.3
percentage points or more, it was a sign that the economy was either already in or about to enter recession. The
cumulative rise in the monthly unemployment rate from its low prior to the official start of the recession to its
peak has been at least 2 percentage points.
9
See Joint Committee on Taxation, Macroeconomic Analysis of the Conference Agreement for H.R. 1, the 'Tax
Cuts and Jobs Act', December 22, 2017.
10
Congress of the United States, Congressional Budget Office, An Update to the Budget and Economic Outlook:
2017 to 2027, June 2017.