Lael Brainard: The US economic outlook and implications for monetary
policy
Speech by Ms Lael Brainard, Member of the Board of Governors of the Federal Reserve
System, at the Center for Strategic and International Studies, Washington DC, 2 June 2015.
* * *
This spring marks the end of the Federal Reserve's calendar-based forward guidance and
the return to full data dependency in the setting of the federal funds rate. So it is notable that
just as policymaking is becoming more anchored in meeting-by-meeting assessments of the
data, the data are presenting a mixed picture that lends itself to materially different readings.1
No doubt, bad weather, port disruptions, and statistical issues are responsible for some of
the softness in first-quarter indicators of aggregate spending. Indeed, it may be that the
dismal estimate by the Bureau of Economic Analysis of the annualized change in first-quarter
gross domestic product (GDP), negative 0.7 percent, is principally an extension of the
pattern, seen for several years, of significantly slower measured GDP growth in the first
quarter followed by considerably stronger readings during the remainder of the year. In that
case, it would be appropriate to minimize the importance of the first-quarter estimate in
judging the likely path of the economy over the remainder of the year.
But there may be reasons not to ignore the recent readings entirely. First, the limited data in
hand pertaining to the second quarter do not suggest a significant bounceback in aggregate
spending, which we would expect if all of the weakness in the first quarter were due to
transitory factors. Private-sector forecasts of second-quarter growth are centered around
2-1/2 percent, while the Federal Reserve Bank of Atlanta's GDPNow forecast, which was
quite accurate in its prediction of the first estimate of first-quarter GDP growth, is projecting
second-quarter GDP growth of only 0.8 percent.2
Second, it would not be the first time this recovery has proceeded in fits and starts. The
underlying momentum of the recovery has proven relatively susceptible to successive
headwinds, which have kept overall economic growth well below the average pace of
previous upturns.
My own reading is that earlier, more optimistic growth projections may have placed too much
weight on the boost to spending from lower energy prices and too little weight on the
negative implications for aggregate demand of the significant increase in the foreign
exchange value of the dollar and large decline in the price of crude oil.
Turning first to the expected positive effects, at a time when a lot of the growth burden is
riding on U.S. consumers, consumers appear to be disinclined to spend much of the gains
from cheaper prices at the pump, preferring, it seems, to strengthen household balance
sheets instead. Relative to expectations predicated on the boost to real income from lower
gas prices, consumer spending so far this year has been undeniably weak, especially given
a backdrop of improving labor market prospects, solid consumer sentiment, and improving
credit availability. Consumer spending is reported to have increased at an annual rate of only
1.8 percent in the first quarter - far below the 5.3 percent increase in household real
disposable income. Moreover, monthly data on expenditures through April do not suggest a
large bounceback going into the second quarter.
Continuing softness in consumption this year would naturally raise some questions about a
more persistent change in consumer behavior. For example, the financial crisis may have
altered expectations of longer-run income growth and attitudes toward risk such that
consumers may be more cautious about spending gains in income and wealth that are
perceived to be temporary.
Modest growth in consumer spending would be significant because strength in other
categories of aggregate demand remains elusive. Although the data on April housing starts
and permits look promising, the current level of single-family housing permits is little changed
from the level in the fourth quarter of last year, and average growth in residential investment
over the past year and a half has been tepid. Given low interest rates and continued job
gains, it is puzzling that housing starts have remained far below the trend levels implied by
population growth. Tight credit for borrowers with less-than-pristine credit may explain some
of the weakness. But it is also possible that attitudes toward homeownership have changed
as a result of the financial crisis and recent recession, especially among the millennial Great
Recession generation.
Meanwhile, government spending has contributed very little, on average, to GDP growth in
recent quarters. With the Budget Control Act of 2011 restraining federal outlays and with
pension and health-care obligations limiting expenditures at the state and local level, the
public sector is not likely to contribute significantly to GDP growth over the next few years.
Just as the positive effects appear to have been more muted than expected, so, too, the
negative effects from the substantial decline in the price of oil and appreciation of the
exchange rate on business investment, manufacturing, and exports seem to have been
greater than expected. In response to the drop in oil prices, drilling activity is reported to have
fallen at an annual rate of nearly 50 percent in the first quarter, and data on drilling rigs in
operation suggest another large decline this quarter.
At the same time, the dollar's rise is reducing net exports, and perhaps restraining
investment in areas sensitive to foreign demand, with greater force than anticipated. Net
exports subtracted 1 percentage point from GDP growth in the fourth quarter and a whopping
1.9 percentage points in the first quarter. This large decline likely reflects more than
exchange rate appreciation alone, but some drag on net exports from exchange rate
appreciation is likely to persist. Indicators of business equipment spending - such as orders
and shipments of capital goods, as well as business sentiment - have also been weak,
suggesting that overall business investment will change little over the first half of the year.
Other indicators also suggest a negative effect on manufacturing activity from foreign
headwinds. The Institute for Supply Management (ISM) national manufacturing diffusion
index of new export orders has been in contractionary or neutral territory for four of the past
five months. Manufacturing production declined at an annual rate of 1 percent in the first
quarter, and the outlook for internationally oriented firms has worsened appreciably recently.
Of course, there is a danger in reading too much into these data. Indicators, such as the
ISM's nonmanufacturing composite index, suggest that activity has remained solid in the
private services sector, which accounts for the bulk of economic activity. It is possible that we
will soon see the stronger trend in domestic economic activity that was apparent in the
second half of last year reassert itself. In assessing this possibility, it is important to keep in
mind the international context, which I will turn to next.
International context
The notable effects of recent crosscurrents from abroad should lay to rest any remaining lore
that the United States is a closed economy. Financial linkages between the United States
and foreign economies are immediate and extensive. Equity prices, long-term interest rates
and risk spreads, and exchange rates show strong reactions to developments abroad, and,
in recent months, foreign developments have at times been the dominant factor driving U.S.
financial conditions. Weak foreign aggregate demand, as well as accompanying
accommodative monetary policies in the euro area and Japan, and diverging expectations
have been key among the factors causing a significant 10 percent appreciation of the dollar
since last June. To the extent that exchange rate appreciation exerts a tightening force on
financial conditions in the United States, it delays the return of U.S. interest rates to more
normal levels.
While trade is a smaller share of the U.S. economy than in many other economies, exchange
rate changes of the magnitude seen recently can have large effects on aggregate demand.3
We have already seen a large negative contribution of net exports to U.S. GDP growth in the
past two quarters. In addition, because some models estimate that exchange rates' effect on
net exports can last up to three years, it is possible that the drag from net exports will persist
for some time. Even before the latest estimate of the first-quarter contribution of net exports
to GDP was published, many private-sector forecasters (as well as the Congressional
Budget Office) expected net exports to subtract from GDP growth this year and next.
Recently, the euro area has seen some encouraging data on retail sales, industrial
production, and inflation, auguring well for some sustained improvement in aggregate
demand within the euro area. Nonetheless, there remain risks and uncertainties surrounding
foreign growth that could prolong or intensify foreign headwinds going forward.
Most immediately, negotiations between Greece and its creditors are challenging, and the
risk of further deterioration cannot be ruled out. While the euro area has broadened its policy
toolkit and most member states have made significant strides in building resilience in the
past couple of years, the recovery is still fragile in several member states, and vulnerabilities
to financial stresses remain.
In addition, Chinese GDP growth looks to have slowed noticeably in the first quarter, and
there is some risk of further slowing. This development reflects in part a significant correction
in the property market and the shadow banking sector following years of rapid growth. But
structural factors are also at work. After growing at a nearly double-digit rate for more than
three decades, China has reached a transitional phase in which potential output growth is
expected to slow in part because of challenging demographics and the transition from heavy
reliance on exports and investment toward greater dependence on household demand.
Ultimately, lower interest rates abroad should boost domestic demand in the euro area and
Japan, which could eventually be a net positive for U.S. net exports. But the most immediate
effect appears to be a shift in asset demand toward countries with relatively higher expected
interest rates, such as the United States.
Inflation, employment, and the implications for monetary policy
Foreign headwinds also appear to be affecting U.S. inflation. Weak foreign demand appears
to be the dominant factor driving recent reductions in the prices of some non-oil commodities
and also likely played some role in last year's decline in oil prices, although changes in
supply are likely the more important driver.
The stronger dollar is also weighing on U.S. inflation through lower import prices. Non-oil
import prices are reported to have declined at an annual rate of 4-1/2 percent last quarter,
and data on trade prices through April suggest a decrease of a similar magnitude this
quarter. Based on the share of imports in consumption, econometric models imply that falling
import prices might subtract about 0.3 percentage point from consumer price inflation this
year.
Starting this month, with the end of calendar-based forward guidance, the decisions of the
Federal Open Market Committee (FOMC) regarding the level of the federal funds rate will
depend on the evolution of incoming economic data. While the date of liftoff will not be
predetermined, the conditions governing the decision to lift off have been clearly stated. First,
to have reasonable confidence that inflation will be on track to reach its target of 2 percent
over the medium term, I will be looking closely at a variety of indicators - in particular, signs
that core inflation is firming, deflationary pressures from abroad are abating, and both
survey- and market-based measures of inflation expectations are stable.
Despite the deflationary pressures from abroad, the recent data have provided some
reassurance that inflation in the United States is starting to firm. Oil prices have now retraced
part of their decline from the middle of last year through January, and monthly changes in
core personal consumption expenditures (PCE) prices have increased from the very low
levels reached around the turn of the year.
In the face of the long period of weak overall inflation, it is reassuring that survey-based
measures of longer-run inflation expectations appear to have remained stable. In addition,
market-based measures of inflation expectations have moved up somewhat in the past few
months after several months of decreases that appeared to have been associated with oil
price declines and heightened anxiety about global deflationary pressures. Even so, most
indicators of the underlying trend in PCE inflation, such as the 12-month change in core PCE
prices or the Federal Reserve Bank of Dallas's 12-month trimmed mean PCE inflation rate,
are around 1-1/4 to 1-1/2 percent, noticeably below the FOMC's 2 percent target.
Second, I will also want to see further improvement in the labor market with solid further
employment growth and further evidence of a narrowing of resource utilization gaps based
on various indicators, including the unemployment rate, the labor force participation rate, the
percentage of employees who are working part time for economic reasons, and faster wage
growth.
The robust pace of labor market improvement was perhaps the brightest part of the data
picture over 2014. As we have advanced into 2015, the pace of job gains has slowed.
Average monthly nonfarm payroll employment gains in the past three months were a little
under 200,000, down from last year's pace of 260,000. Even so, job gains still appear to be
consistent with declining labor market slack, as do indicators such as unemployment
insurance claims and job openings, which remain robust.
My judgment is that there is still room for employment and hours worked to grow further, as
there are other labor market indicators that suggest slack not captured by the unemployment
rate. For example, the labor force participation rate remains low relative to its declining
precrisis trend, and the number of employees who are working less than they would like is still
elevated relative to pre-crisis standards. Moreover, on balance, aggregate measures of wage
growth remain soft and have not significantly strengthened in the past year, suggesting there
is remaining slack in the labor market.
In addition, although the unemployment rate is now near levels commonly associated with
the natural rate of unemployment, there are reasons to think that the natural rate may have
declined over the past few years such that a gap remains between the unemployment rate
and its natural rate. The composition of the labor force, for example, looks to be shifting
toward groups with relatively low levels of unemployment.4 In addition, it may be that a
reduction in worker bargaining power or perhaps reduced levels of labor market churning are
putting downward pressure on the natural rate.5
With the labor market evidencing additional slack not well captured by the standard
unemployment rate and with inflation remaining soft, there may be additional room to support
further healing in the labor market, which is appropriate following the deep damage from the
Great Recession.
Given the softness in the data we have seen so far this year and some uncertainty about
how much to attribute to temporary or statistical factors, I think there is value to watchful
waiting while additional data help clarify the economy's underlying momentum in the face of
the headwinds from abroad. If continued labor market strengthening is confirmed and
inflation readings continue to improve, liftoff could come before the end of the year.
It is important to underscore, however, that the date of liftoff is only one in an ongoing series
of decisions the FOMC will be making in response to incoming data. Just as no previous
recovery has proceeded as this one has, so, too, there is no reason to expect monetary
policy to follow previous tightening cycles. Given the unique conditions in the labor market
and the economy more broadly, I will want to move step by step - observing how the
markets and the economy respond before gauging the appropriate next step in the policy
path.
The divergence in conditions here and abroad also injects an element of uncertainty with
regard to the path of policy. While, as noted earlier, the dollar's appreciation is generally
transmitted into somewhat tighter financial conditions, the advent of quantitative easing in
Europe appeared to have led to some compression in term premiums not only in European
bond markets, but also in the United States. Although longer-dated yields have recently
moved somewhat higher, it is nonetheless difficult to know in advance how term premiums
will respond when U.S. normalization gets under way. To the extent that the commencement
of normalization leads to relatively greater demand for U.S. assets, we could see echoes of
the so-called conundrum in the period from 2004 to 2005, when rising short-term rates were
accompanied by falling forward rates. But the reverse is also possible, with term premiums
moving more steeply than appropriate for underlying economic conditions, which we saw in
the so-called taper tantrum episode in 2013.
Certainly, my colleagues and I are mindful of recent episodes in which we have seen
unusually sharp spikes in market volatility. Accordingly, I expect that the FOMC will continue
proceeding to the greatest extent possible in a very deliberate manner, aiming to provide
clear communications about Committee members' assessments of the economic and policy
outlook.
Based on today's picture of moderate underlying momentum in the domestic economy and
the likelihood of continued crosscurrents from abroad, the process of normalizing monetary
policy is likely to be gradual. It is also important to remember that the stance of monetary
policy will remain highly accommodative even after the federal funds rate moves off the
effective lower bound, because the real federal funds rate will initially still be low and
because of the elevated size of the Federal Reserve's balance sheet and the associated
downward pressure on long-term rates. Moreover, the FOMC has stated clearly that it will
reduce the size of the balance sheet in a gradual and predictable manner starting at an
appropriate time after liftoff, which will depend on how economic and financial conditions
evolve.
In summary, the string of soft data in the first quarter raises some questions about the
contours of the outlook. While it is possible that residual seasonality and temporary factors
were responsible, it would be difficult, based on the data available today, to dismiss the
possibility of a more significant drag on the economy than anticipated from foreign
crosscurrents and the negative effects of the oil price decline, along with a more cautious
U.S. consumer. This possibility argues for giving the data some more time to confirm further
improvement in the labor market and firming of inflation toward our 2 percent target. But
while the case for liftoff may not be immediate, it is coming into clearer view. When that time
comes, the policy path will be highly attuned to incoming data and not on a preset course,
and it is important to be mindful of the possibility of volatility as markets adjust to a change in
the stance of policy. Thus, the FOMC will continue communicating as clearly as possible
regarding the outlook and the factors underlying its policy determinations.