For release on delivery
12:45 p.m. EDT
September 26, 2017
Inflation, Uncertainty, and Monetary Policy
Remarks by
Janet L. Yellen
Chair
Board of Governors of the Federal Reserve System
at
"Prospects for Growth: Reassessing the Fundamentals"
59th Annual Meeting of the National Association for Business Economics
Cleveland, Ohio
September 26, 2017
I would like to thank the National Association for Business Economics for
inviting me to speak today and for the vital role the association plays in fostering debate
on important economic policy questions.
Today I will discuss uncertainty and monetary policy, particularly as it relates to
recent inflation developments. Because changes in interest rates influence economic
activity and inflation with a substantial lag, the Federal Open Market Committee
(FOMC) sets monetary policy with an eye to its effects on the outlook for the economy.
But the outlook is subject to considerable uncertainty from multiple sources, and dealing
with these uncertainties is an important feature of policymaking. Key among current
uncertainties are the forces driving inflation, which has remained low in recent years
despite substantial improvement in labor market conditions. As I will discuss, this low
inflation likely reflects factors whose influence should fade over time. But as I will also
discuss, many uncertainties attend this assessment, and downward pressures on inflation
could prove to be unexpectedly persistent. My colleagues and I may have misjudged the
strength of the labor market, the degree to which longer-run inflation expectations are
consistent with our inflation objective, or even the fundamental forces driving inflation.
In interpreting incoming data, we will need to stay alert to these possibilities and, in light
of incoming information, adjust our views about inflation, the overall economy, and the
stance of monetary policy best suited to promoting maximum employment and price
stability.
Recent Inflation Developments and the Outlook
Let me begin by reviewing recent inflation developments and the economic
outlook. As the solid blue line in figure 1 indicates, inflation as measured by the price
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index for personal consumption expenditures (PCE) has generally run below the FOMC's
2 percent longer-run objective since that goal was announced in January 2012.1 Core
inflation, which strips out volatile food and energy prices, has also fallen persistently
short of 2 percent (the red dashed line). Furthermore, both overall and core inflation,
after moving up appreciably last year, have slipped again in recent months. Sustained
low inflation such as this is undesirable because, among other things, it generally leads to
low settings of the federal funds rate in normal times, thereby providing less scope to
ease monetary policy to fight recessions. In addition, a persistent undershoot of our
stated 2 percent goal could undermine the FOMC's credibility, causing inflation
expectations to drift and actual inflation and economic activity to become more volatile.
As noted in its recent statement, the FOMC continues to anticipate that, with
gradual adjustments in the stance of monetary policy, inflation will rise and stabilize at
around 2 percent over the medium term. This expectation is illustrated by the green stars,
which represent the medians of the inflation projections submitted by FOMC participants
at our meeting last week. In part, this expectation reflects the significant improvement in
labor market conditions over the past few years. As shown in figure 2, the
unemployment rate (the blue line) now stands at 4.4 percent, somewhat below the median
of FOMC participants' estimates of its longer-run sustainable level (the black line). As
the green stars indicate, labor market conditions are expected to strengthen a bit further.
The inflation outlook also reflects the Committee's judgment that inflation expectations
will remain reasonably well anchored at a level consistent with PCE price inflation of
2 percent in the long run, and that the restraint imposed in recent years by a variety of
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special factors, including movements in the relative prices of food, energy, and imports,
will wane in coming quarters.
To understand this assessment, it is useful to decompose the forces driving
movements in inflation since the financial crisis, as estimated using a simple model of
inflation that I presented in a speech two years ago.2 Figure 3 reports this decomposition
as the contributions made by various factors to the shortfall of PCE price inflation from
2 percent, year by year. As illustrated by the purple dotted portion of the bars, labor
underutilization, or "slack," accounts for a shrinking share of the shortfall since 2012 and
is now having a negligible effect. By comparison, the influence of changes in relative
food, energy, and import prices--the solid blue and checkered red portions--has been
more substantial in the past few years, although their contribution is estimated to have
greatly diminished this year.3
Not surprisingly, the simple model does not account for all of the year-to-year
movements in inflation. As indicated by the green striped portion of the bars, the residual
component of the shortfall was modestly positive on average from 2008 through last year.
This year, however, inflation has been unexpectedly weak from the model's perspective.
This unusually large error does not necessarily imply that inflation is more likely to
2
The simple model links the current rate of inflation to several factors, including lagged inflation, long-run
inflation expectations, labor utilization, and changes in the relative prices of food, energy and imports
(Yellen, 2015). Additional details on the model can be found in the appendix.
3
In the decomposition procedure, movements in core inflation affect headline inflation one-for-one; as a
result, the contributions of food and energy price inflation are defined as each component's price change
relative to the core, weighted by its share in total nominal consumer spending. The estimated contribution
of movements in import prices is also computed relative to core inflation; thus, if import prices are rising at
the same rate as core inflation, they have no estimated effect on the shortfall of overall inflation from
2 percent. In addition, the decomposition takes account of lags in the adjustment of core inflation to
movements in resource utilization and other factors. More details on the decomposition procedure can be
found in the appendix.
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continue to come in on the low side in coming years.4 Some of the recent decline in
inflation, although not all, reflects idiosyncratic shifts in the prices of some items, such as
the large decline in telecommunication service prices seen earlier in the year, that are
unlikely to be repeated. As the green dashed line in figure 4 illustrates, if the average
change in consumer prices each month is calculated excluding items whose price changes
are outliers on both the high and low side, the resulting "trimmed mean" measure of
inflation shows less of a slowdown this year.5
Based on analyses of this sort, my colleagues and I currently think that this year's
low inflation is probably temporary, so we continue to anticipate that inflation is likely to
stabilize around 2 percent over the next few years. But our understanding of the forces
driving inflation is imperfect, and we recognize that something more persistent may be
responsible for the current undershooting of our longer-run objective. Accordingly, we
will monitor incoming data closely and stand ready to modify our views based on what
we learn.
Uncertainty about the Inflation Outlook
Although we judge that inflation will most likely stabilize around 2 percent over
the next few years, the odds that it could turn out to be noticeably different are
considerable. This point is illustrated by figure 5. Here the red line indicates the median
4
In the simple model, inflation depends in part on lagged inflation. As a result, an unexplained movement
in inflation is predicted to influence inflation beyond the current quarter, but to a degree that fades over
time. On average, the model predicts that roughly 85 percent of any unexplained movement will have
disappeared after four quarters.
5
In general, price changes measured over a few months tend to be noisy, even when measured on a core or
trimmed-mean basis. For this reason, the FOMC usually focuses on the growth rate of PCE prices over the
previous 12 months, which smooths through the volatility in the monthly price data. This approach also
sidesteps distortions in the monthly data associated with residual seasonality; these distortions are likely to
hold down month-to-month changes in prices over the balance of the year (see Peneva, 2014). That said,
12-month rates of inflation will continue to be held down through early 2018 by the unusually weak
monthly readings on price changes recorded in early 2017.
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of the latest inflation projections submitted by FOMC participants that I showed
previously. The pertinent feature of this figure is the blue shaded region around the red
line, which shows a 70 percent confidence interval around FOMC participants' median
outlook. The width of this region reflects the average accuracy of inflation projections
made by private and government forecasters over the past 20 years. As the figure shows,
based on that history, there is a 30 percent probability that inflation could be greater than
3 percent or less than 1 percent next year.6
Most of this uncertainty reflects the influence of unexpected movements in oil
prices and the foreign exchange value of the dollar, as well as that of idiosyncratic
developments unrelated to broader economic conditions. These factors could easily push
overall inflation noticeably above or below 2 percent for a time. But such disturbances
are not a great concern from a policy perspective because their effects fade away as long
as inflation expectations remain anchored.7 For this reason, the FOMC strives to look
through these transitory inflation effects when setting monetary policy. Such was the
case when rising oil prices pushed headline inflation noticeably above 2 percent for
several years prior to the financial crisis. Similarly, the Committee substantially
discounted the reductions in inflation that occurred from 2014 through 2016 as a result of
the decline in oil prices and the effects of the dollar's appreciation on import prices.
A more important issue from a policy standpoint is that some key assumptions
underlying the baseline outlook could be wrong in ways that imply that inflation will
remain low for longer than currently projected. For example, labor market conditions
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may not be as tight as they appear to be, and thus they may exert less upward pressure on
inflation than anticipated. Alternatively, long-run inflation expectations, which have an
important influence on actual inflation, may not be consistent with the FOMC's 2 percent
goal. More broadly, the conventional framework for understanding inflation dynamics
could be misspecified in some fundamental way. Let's now consider each of these
possibilities in turn.
Resource Utilization
The unemployment rate consistent with long-run price stability at any time is not
known with certainty; we can only estimate it. The median of the longer-run
unemployment rate projections submitted by FOMC participants last week is around
4-1/2 percent. But the long-run sustainable unemployment rate can drift over time
because of demographic changes and other factors, some of which can be difficult to
quantify--or even identify--in real time.8 For these and other reasons, the statistical
precision of such estimates is limited, and the actual value of the sustainable rate could
well be noticeably lower than currently projected.9 Thus, although FOMC participants
generally view current labor utilization as probably somewhat greater than what can be
sustained in the longer run, the statistical evidence from past experience does not rule out
8
For example, Aaronson and others (2015) estimate that increases in the average age and educational
attainment of U.S. workers will reduce the sustainable rate of unemployment almost 1/2 percentage point
between 2014 and 2020. Barnichon and Mesters (2017) also present evidence that demographic changes
have somewhat reduced the structural unemployment rate in the United States in recent years. Relatedly,
Yoon, Kim, and Lee (2014) and Juselius and Takats (2015) estimate that ongoing demographic transitions
are having modest disinflationary effects in the United States and other developed economies.
9
The statistical evidence also suggests that the sustainable rate of unemployment could be higher. As
illustrated by the results reported in Reifschneider, Wascher, and Wilcox (2015) and Barnichon and
Matthes (2017), standard errors for estimates of the sustainable rate of unemployment are typically at least
1/2 percentage point. Accordingly, if the sustainable rate is estimated to be about 4-1/2 percent, there is
roughly a 15 percent probability that the actual value is less than 4 percent; symmetrically, there is a
15 percent probability that it is greater than 5 percent.
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the possibility that some slack still remains in the labor market. If so, the economy could
sustain a higher level of employment and output in the longer run than now anticipated--a
very beneficial outcome, albeit one that would require recalibrating monetary policy over
time in order to reap those benefits and compensate for the accompanying reduction in
inflationary pressures.
A related question is whether the unemployment rate alone is an adequate gauge
of economic slack for the purposes of explaining inflation. Although the unemployment
rate is probably the best single summary measure of labor utilization, some indicators
have shown less improvement since the financial crisis.10 As the solid blue line in figure
6 illustrates, the employed share of the "prime-age worker" population--that is, persons
from ages 25 to 54--remains noticeably below the 2007 level.11 But employment rates
for this group may now be permanently lower than in the past as a result of declining
employment opportunities for less-skilled workers, a rising number of people receiving
disability insurance, and other worrisome trends.12 Similarly, although the share of part-
time workers who would like a full-time job is still somewhat above where it stood
10
Several years ago, I discussed the interpretation of a wide range of labor market indicators at length
(Yellen, 2014).
11
The employment-to-population ratio for all persons aged 16 and over has recovered much less than the
prime-age ratio since 2007, in large part reflecting the ongoing retirement of the baby boomers and a rise in
school attendance rates for young adults aged 20 to 24 (Aaronson and others, 2014). Schanzenbach and
others (2017) estimate that the substantial overall employment-to-population gap that opened up in the
wake of the financial crisis finally closed in July 2017.
12
The labor force participation rate for prime-age men has been declining for decades. Evidence suggests
that a portion of the decline is attributable to a reduction in the demand for low-skilled workers resulting
from advances in technology and globalization. For a general discussion of the decline in male labor force
participation, see Aaronson and others (2014). For a discussion of the role played by technical factors in
this decline, see Deming (forthcoming) and Acemoglu and Autor (2011); for a discussion of the role of
globalization, see Autor, Dorn, and Hanson (2013) and Pierce and Schott (2016). In addition to these
factors, Autor and Duggan (2003) and French and Song (2014) present evidence suggesting that increases
in the number of people on disability rolls have also been important. Relatedly, an alarming deterioration
in health outcomes among low-education workers, including a rise in deaths related to alcohol, drugs, and
suicide, may be having an adverse effect on both male and female employment (Case and Deaton, 2017).
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before the last two recessions (the dashed red line), it could reflect a structural change in
firms' reliance on part-time labor.13 In addition, these two measures have to be weighed
against other labor indicators that have either returned to, or are currently above, their
pre-recession levels. As shown in figure 7, those indicators include the quits rate (the
short-dashed blue line), household perceptions of job availability (the short-and-long-
dashed green line), the jobs opening rate (the long-dashed red line), and the percentage of
small firms finding it hard to fill jobs (the solid black line).
On balance, the unemployment rate probably is correct in signaling that overall
labor market conditions have returned to pre-crisis levels. But that return does not
necessarily demonstrate that the economy is now at maximum employment because, due
to demographic and other structural changes, the unemployment rate that is sustainable
today may be lower than the rate that was sustainable in the past.
In that regard, some observers have pointed to the continued subdued pace of
wage growth as evidence that the economy is not yet back to full employment. As shown
in figure 8, labor compensation as measured by the employment cost index (the short-
dashed red line) has been growing at more or less the same rate since 2014, and hourly
compensation in the nonfarm business sector (the short-and-long-dashed green line)--a
quite noisy measure, even after smoothing--is actually growing more slowly. But growth
in average hourly earnings (the solid blue line) and the Atlanta Fed's Wage Growth
Tracker (the long-dashed black line) have clearly picked up.14 In addition, productivity
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growth has been quite weak in recent years, and empirical analysis suggests that it is has
been holding down aggregate growth in labor compensation independent of labor
utilization in recent years.15 An analysis of the pattern of wage growth at the U.S. state
level also suggests that subdued growth for the country as a whole probably reflects
sluggish productivity or some other factor common to all states, because cross-state
differences in wage growth are about what one would expect given cross-state differences
in unemployment rates.16 Finally, I would note that the percentage of firms planning
wage increases has moved back up to its pre-recession level, many firms report
difficulties in finding qualified workers, and some have responded by expanding training
programs and offering signing bonuses--possible harbingers of stronger wage gains
to come.
Overall, I view the data we have in hand as suggesting a generally healthy labor
market, not one in which substantial slack remains or one that is overheated. That said,
the evidence does not allow for any definitive assessment, so policymakers must remain
open minded on this question and its implications for reaching our inflation goal.
Inflation Expectations
Another source of uncertainty concerns inflation expectations. In standard
economic models, inflation expectations are an important determinant of actual inflation
because, in deciding how much to adjust wages for individual jobs and prices of goods
and services at a particular time, firms take into account the rate of overall inflation they
expect to prevail in the future. Monetary policy presumably plays a key role in shaping
these expectations by influencing the average rate of inflation experienced in the past
over long periods of time, as well as by providing guidance about the FOMC's objectives
for inflation in the future. Even so, economists' understanding of exactly how and why
inflation expectations change over time is limited.17 Moreover, we have to contend with
the fact that we do not directly observe the inflation expectations relevant to wage and
price setting. Instead, we can only imperfectly infer how they might have changed based
on survey responses and other data.
The FOMC's outlook depends importantly on the view that longer-run inflation
expectations have been stable for many years at a level consistent with PCE price
inflation that will average around 2 percent in the longer run. Provided this stability
continues, standard models suggest that actual inflation should stabilize at about
2 percent over the next two or three years in an environment of roughly full employment,
absent any future shocks. However, there is a risk that inflation expectations may not be
as well anchored as they appear and perhaps are not consistent with our 2 percent goal.
To assess this risk, the FOMC considers a variety of survey measures of expected longer-
run inflation, some of which are shown in figure 9. Long-range projections of PCE price
inflation made by private forecasters, the solid red line, have been remarkably stable for
many years, as have been the longer-run inflation expectations reported in surveys of
financial market participants (not shown).18 Households' longer-term expectations as
reported in the University of Michigan Surveys of Consumers, the short-dashed blue line,
have also been fairly stable overall since the late 1990s.19 That said, results from this
survey, as well as a survey of consumers carried out by the Federal Reserve Bank of New
York, do hint that expectations may have slipped a bit over the past two or three years. If
so, stabilizing inflation at around 2 percent could prove to be more difficult than
expected.20
In theory, differences between yields on conventional Treasury securities and
those on Treasury Inflation-Protected Securities (TIPS) are also informative about
inflation expectations in that they measure the compensation received by investors for
exposing themselves to future changes in consumer prices. As indicated by the long-
dashed green line, TIPS inflation compensation for the five-year period starting five years
from now has fallen roughly 1 percentage point over the past three years. This decline
18
In the Survey of Primary Dealers conducted by the Federal Reserve Bank of New York, the median of
respondents' longer-term projections for PCE inflation have been essentially flat at 2 percent since the
survey began in 2011. Similarly, in the Blue Chip Financial Indicators survey, which solicits the views of a
large number of financial firms (as well as a few other institutions) about the extended outlook every June
and December, the median of long-run expectations for GDP price inflation has stayed close to 2.1 percent
over the past six years. Comparisons of results from these surveys to those reported in the Survey of
Professional Forecasters (as well as surveys of households) are somewhat complicated by differences in the
projection period used. For example, some surveys include the low rates of inflation expected over the next
few years in the calculation of projected longer-run averages, while other surveys exclude them.
19
Expected inflation over the next 5 to 10 years as reported in the Michigan survey runs appreciably above
PCE price inflation on average since the mid-1990s, perhaps because households are less informed about
actual inflation developments than professional forecasters and financial firms. For this reason, it may be
best to focus on changes over time in the Michigan measure, not on the level.
20
In addition to monitoring survey measures of expected inflation, Federal Reserve staff also use statistical
techniques to try to directly estimate possible movements over time in the underlying long-run trend in
inflation, using data for actual inflation and other series, including resource utilization. Many of these
statistical estimates suggest that the underlying trend in PCE inflation is currently somewhat below
2 percent. Econometrically, however, it is extremely difficult if not impossible to disentangle estimates of
the underlying trend in PCE inflation from estimates of the sustainable rate of unemployment. To be
consistent with the data, the higher one's estimate of trend inflation or expected long-run inflation, the
lower must be one's estimate of the sustainable unemployment rate, at least over the medium run.
could be interpreted as a significant drop in market participants' expectations for the most
likely outcome for inflation in the longer run. However, research suggests that the fall in
TIPS inflation compensation instead primarily reflects a decline in inflation risk
premiums and differences in the liquidity of nominal and indexed Treasury securities.21
This research notwithstanding, the notable decline in inflation compensation may be a
sign that longer-term inflation expectations have slipped recently.
Misspecified Inflation Dynamics
Another risk is that our framework for understanding inflation dynamics could be
misspecified in some fundamental way, perhaps because our econometric models
overlook some factor that will restrain inflation in coming years despite solid labor
market conditions. One possibility in this vein is a continuation of the subdued growth in
health-care prices that we have seen in recent years--a sector-specific factor not
controlled for in standard models. Because health care accounts for a large share of total
consumer spending, this slow growth has restrained overall inflation materially and may
continue to do so for some time.22 A similar situation occurred during the 1990s, when a
significant shift in health insurance enrollment away from fee-for-service and toward
HMO (that is, Health Maintenance Organization) plans reduced cost pressures and held
21
For example, Andreasen and Christensen (2016) show that once TIPS liquidity premiums are taken into
account, the model-implied one-year inflation expectation becomes more stable and shows a smaller
decline since 2013. In addition, quotes on inflation derivatives suggest that most of the decline in inflation
compensation over this period is associated with investor perceptions of reduced risks of above-target
inflation outcomes rather than increased risks of below-target inflation outcomes.
22
Personal consumption expenditures include all medical services, including those paid by Medicare and
Medicaid; prices for the latter may be viewed as "administered" because they are essentially set by the
government. The formulas used to set Medicare prices were adjusted by the 2010 Affordable Care Act and
additional legislation passed in 2015, resulting in smaller increases in prices for the same increase in costs
than would have been the case in the prior decade. In addition, Medicaid prices have probably been
restrained somewhat by budget pressures on state governments. Aside from these direct influences of
government policy on healthcare prices, some research suggests that lower Medicare prices tend to lead to
lower negotiated prices by private insurers as well (see Clemens, Gottlieb, and Shapiro, 2016).
down overall inflation for several years. If these sorts of favorable supply-type shocks
continue, achieving our 2 percent inflation goal over the medium term may require a
more accommodative stance of monetary policy than might otherwise be appropriate.
Some commentators have conjectured that, because of rising trade volumes and
the integration of production chains across countries, U.S. inflation now depends on
global resource utilization, not just on conditions here at home and those effects arising
through movements in energy and import prices. However, studies of this issue do not,
on balance, provide much empirical support for this possibility.23 Moreover, foreign
economic growth has firmed this year and the global economy appears to have largely
recovered, so any influence that global resource utilization might have on U.S. inflation
would presumably be small. Nevertheless, increased competition from the integration of
China and other emerging market countries into the world economy may have materially
restrained price margins and labor compensation in the United States and other advanced
economies. In fact, one study concludes that most of the decline in the labor share of
national income in the United States since the late 1980s can be attributed to offshoring
of labor-intensive production.24 If this restraint on the labor share continues to build over
23
In an early study, Borio and Filardo (2007) reported results suggesting that global economic slack adds
considerable explanatory power to reduced-form inflation equations (such as the one discussed in the
appendix), and that its role has been growing over time. However, Ihrig, Kamin, Lindner, and Marquez
(2010) subsequently argued that the estimated link was not robust to alternative measures of global
resource utilization. Federal Reserve Board staff have updated this analysis using data through early 2017
and confirmed that global slack does not appear to exert an appreciable direct effect on domestic inflation
in the United States and most other advanced economies.
24
Using sector-level data, Elsby, Hobijn, and Sahin (2013) estimate the contributions of offshoring, the
substitution of capital for low-skilled labor, and several other factors on the aggregate U.S. labor share of
income, and find that only offshoring has been important. They also conclude that the decline in the labor
share since the late 1980s has been overstated as a result of statistical measurement problems. In contrast
to the influence of globalization on the U.S. labor share, Feenstra and Weinstein (2017) find that the
influence of increased globalization on price markups in the United States has been modest.
the next few years (and not merely holds steady), then it could indirectly hold down the
growth of domestic wages and prices in ways not captured by conventional models.
More speculatively, changes in the structure of the domestic economy may also
be altering inflation dynamics in ways not captured by conventional models. The
growing importance of online shopping, by increasing the competitiveness of the U.S.
retail sector, may have reduced price margins and restrained the ability of firms to raise
prices in response to rising demand.25 That said, the economy overall appears to have
increase
become more concentrated and less dynamic in recent years, which may tend to
firms' pricing power.26 Because these changes occur slowly, determining their complex
effects on the economy will, as a practical matter, require studying data over a
considerable time.
Finally, I would note the possibility that inflation may rise more sharply in
response to robust labor market conditions than anticipated. The influence of labor
utilization on inflation has become quite modest over the past 20 years, implying that the
inflationary consequences of misjudging the sustainable rate of unemployment are low.
But we cannot be sure that this modest sensitivity will persist in the face of strong labor
market conditions, given that we do not fully understand how it came to be so modest in
the first place. Although the evidence is weak that inflation responds in a nonlinear
manner to resource utilization, this risk is one that we cannot entirely dismiss.
Policy Implications
What are the policy implications of these uncertainties? For one, my colleagues
and I must be ready to adjust our assessments of economic conditions and the outlook
when new data warrant it. In this spirit, FOMC participants--like private forecasters--
have reduced their estimates of the sustainable unemployment rate appreciably over the
past few years in response to the continual flow of information about the always changing
economy.27 To the extent these assessments change over time, so too will the outlook
and judgments about the appropriate stance of monetary policy. Importantly, even if
resource utilization is currently lower than we estimate or if longer-run inflation
expectations are running at levels consistent with longer-run PCE price inflation
somewhat below 2 percent, the FOMC can still achieve its inflation goal. Under those
conditions, continuing to revise our assessments in response to incoming data would
naturally result in a policy path that is somewhat easier than that now anticipated--an
appropriate course correction that would reflect our commitment to maximum
employment and price stability.
Similar considerations apply to other important sources of uncertainty, such as the
value of the neutral real interest rate--that is, the inflation-adjusted level of the federal
funds rate consistent with keeping the economy operating on an even keel. Estimates of
this rate have declined considerably in recent years, and, by some estimates, the real
neutral rate is currently clos