William C Dudley: The US economic outlook and the implications for
monetary policy
Speech by Mr William C Dudley, President and Chief Executive Officer of the Federal Reserve
Bank of New York, at the Bank Indonesia - Federal Reserve Bank of New York Joint
International Seminar, Bali, 31 July 2016.
* * *
It is a pleasure to have the opportunity to speak here in Bali. Today I plan to provide a brief
summary of the U.S. economic outlook, incorporating recent U.S. economic data and global
and financial market developments. I will then discuss the implications of the outlook for U.S.
monetary policy, and explain how international and financial market developments influence
my thinking. I will emphasize two key points.
First, financial market conditions matter in determining the appropriate stance of monetary
policy. Financial conditions affect households' and firms' decisions, so that the transmission of
U.S. monetary policy to the real economy depends, to a large extent, on how changes in
monetary policy help deliver the appropriate financial market conditions to support our
objectives of price stability and maximum employment. But financial conditions also evolve in
response to domestic and international events. Thus, when I reiterate that U.S. monetary policy
is data dependent, that includes not just the information gleaned from important economic
releases such as payroll employment and retail sales, but also how financial market conditions
react to economic and financial market developments in the global economy.
Second, external events - such as Brexit - can have effects that go beyond just their impact
on global trade. Conversely, what we do in the United States has an impact far beyond our
borders, and we need to take that into consideration in how we conduct and communicate
monetary policy in the United States. Put simply, monetary policy is a two-way street, and we
all need to be cognizant of that.
As always, what I have to say today reflects my own views and not necessarily those of the
Federal Open Market Committee (FOMC) or the Federal Reserve System.1
The US economic outlook
Despite the many twists and turns in the road so far, my baseline outlook for growth and
inflation in the United States has not changed much in recent months. After a weak first quarter,
real GDP continued to grow sluggishly in the second quarter. On the positive side, consumer
spending rose more quickly during the second quarter. On the negative side, business
fixedinvestment spending continued to disappoint, residential investment was weak and inventory
investment was a substantial drag on growth.
Looking forward, I expect economic activity to expand at roughly a 2 percent annualized pace
over the next 18 months, appreciably above that of the past three quarters. Over the remainder
of this year, the economy should continue to get some lift from consumption and from a fiscal
policy stance that remains mildly stimulative. Moreover, I anticipate that residential investment
will rebound from its decline in the second quarter. This pace of growth would likely be sufficient
to continue to absorb any remaining slack in the labor market and to support inflation moving
back to our 2 percent objective.
However, any forecast is uncertain and growth could end up higher or lower. Let me turn to an
assessment of the balance of risks around my growth outlook. I believe that a sizable pickup
in the rate of growth of economic activity relative to that in my forecast seems unlikely for a
number of reasons. Although consumer spending strengthened substantially in the second
quarter, that stronger pace is unlikely to be sustained going forward. That is because the
fundamentals supporting consumption have softened somewhat. Real income growth
moderated in the second quarter as the pace of job gains slowed and the inflation rate rose,
boosted by somewhat higher energy prices. Even with the surprisingly large addition of
287,000 payroll jobs in June, the pace of improvement in the U.S. labor market appears to
have slowed somewhat. For example, over the past three months, payroll gains have averaged
about 150,000 per month, as compared to an average of more than 200,000 per month over
the course of 2015 and the first quarter of this year. But even 150,000 job gains per month
would be consistent with gradually using up any remaining slack present in the U.S. labor
market.
Although I expect business fixed investment to begin to grow again in the second half, it will
likely remain soft as profits have stagnated and election year uncertainty could act as an
additional depressant. All else equal, investment tends to be weaker when uncertainty rises
because this creates an incentive for businesses to delay decisions until the uncertainty is
resolved.
Also, trade seems likely to exert a net drag on growth. There are two factors at play here: the
sluggish growth rate of aggregate demand abroad and the continuing impact of earlier dollar
appreciation on U.S. export competitiveness.
With respect to downside risks to the growth outlook, one that is hard to gauge is the potential
fallout from the result of the recent U.K. referendum. It is widely anticipated that U.K. growth
will slow as a consequence. Although the direct impact of slower U.K. growth on U.S. trade will
almost certainly be very small - total U.S. exports to the U.K. are only about 0.7 percent of
U.S. GDP - there are a number of other channels that could amplify the impact of the Brexit
decision on U.S. economic activity. These include the potential adverse effects on European
economic activity, on the perceived health of the global banking system, and on broader
financial market conditions.
To date, the global financial market fallout from the Brexit vote has been short-lived, and U.S.
financial market conditions remain supportive to economic growth. Nevertheless, I believe that
the potential aftershocks pose medium-term downside risks to the global economy, and that
these risks need to be monitored.
With respect to inflation, I think the outlook has not changed much recently. Headline inflation,
as anticipated, has climbed a bit this year as earlier energy price declines have fallen out of
the year-over-year inflation calculations. In contrast, core inflation has been broadly stable,
with the core PCE deflator rising by 1.6 percent over the past four quarters, moderately below
our 2 percent objective.
The fact that core inflation has been broadly stable over recent months in the face of the earlier
declines in energy and non-energy import prices is notable. It makes me somewhat more
confident that overall inflation will return to our 2 percent inflation objective over the medium
term as long as the economic growth that I expect actually materializes. If the economy were
to grow at the pace I discussed earlier, this would likely translate into sufficient job gains to
continue to remove any remaining slack in the labor market - which, by my assessment, is
already operating quite close to a level that is consistent with what is achievable on a
sustainable basis. This would likely lead to further pressure on labor resources, higher wages
and, over time, somewhat higher inflation.
In contrast, if growth were instead to fall below my forecast, then I would be less confident that
inflation would return to our 2 percent objective. In addition, I put some weight on the fact that
surveys from both the University of Michigan and the New York Fed indicate that household
longer-term inflation expectations have declined somewhat over the past year and are in the
lower end of their historical ranges. Nevertheless, I am not unduly worried because the
magnitude of these declines has been modest, and because the New York Fed's three-year-
ahead inflation measure has been gradually increasing since January and has reversed much
of the decline observed in the second half of 2015. Low longer-term inflation expectations, if
allowed to become entrenched, would act as a restraint on actual inflation making it more
difficult for us to meet our inflation objective.
In contrast, I put less weight on the significantly larger declines in market-based measures of
inflation compensation over the past two years. From my perspective, these declines seem
driven more by changes in bond term premia and the relative liquidity characteristics of nominal
versus inflation-protected Treasury securities than by sharply falling inflation expectations.
Implications of the outlook for US monetary policy
If, as I have indicated, the U.S. growth and inflation outlooks have not changed notably, then
why have expectations about U.S. monetary policy shifted so much? Compared to the start of
the year, the expected timing of any further Fed interest rate hikes has been pushed back, and
the expected upward trajectory of U.S. short-term rates is now much flatter.
There are several reasons to explain these shifts. First, assessments of the neutral real
shortterm interest rate have declined as economic growth has consistently fallen short of consensus
forecasts. With the U.S. economy having grown at only a 2.1 percent annual rate over the past
seven years, it has become harder to sustain the view that the neutral real short-term interest
rate is close to, or will soon be close to, its historical level of around 2 percent. Estimates of
the neutral real short-term interest rate obtained from many of the DSGE models used within
the Federal Reserve System are currently clustered around zero, and this seems reasonable
to me. An implication is that at present there is only a small gap between the actual real
shortterm rate of about -1 percent and the neutral real short-term rate. In other words, U.S. monetary
policy is accommodative, but only moderately so.
In addition, I suspect that many have come to question the view that headwinds from the
financial crisis are temporarily depressing the neutral short-term rate, and that the neutral
short-term rate will significantly rise in the near-future as these headwinds dissipate. If the
headwinds have not dissipated to a meaningful degree in the seven years since the recession
ended, then why should one expect them to necessarily diminish quickly over the next couple
of years? Evidence is accumulating that some of the headwinds are likely to prove more
persistent. For example, the reduced availability of mortgage financing for those with lower
credit scores seems likely to continue. Lenders now appreciate that home prices can decline
significantly. Thus, they cannot rely as much on the value of the housing collateral in securing
their mortgage loans, and consequently now put more weight on the credit histories of the
borrowers.
Market participants may also be taking some signal from the gradual decline in the median
long-run federal funds rate projection of FOMC participants shown in the FOMC's Summary of
Economic Projections (SEP). I think this indicates a growing consensus that the neutral real
short-term rate will not return anytime soon to its historical norm of 2 percent.
A second reason for the downward adjustment in U.S. interest rate expectations is that U.S.
financial market conditions depend, in part, on the stance of U.S. monetary policy relative to
monetary policies abroad. If the economic outlook abroad deteriorates and this causes foreign
countries to pursue a more accommodative set of monetary policies, then the dollar would
likely appreciate - other things equal - reflecting expectations of lower interest rates abroad
relative to U.S. interest rates. In this case, the U.S. may need to adjust its own monetary policy
path. If the FOMC did not make this adjustment, the stronger dollar could result in an undesired
tightening of U.S. financial conditions. The expected forward interest rate paths in Europe and
Japan have fallen considerably this year. If the FOMC had followed the median federal funds
rate path from the December 2015 SEP projection, then the U.S. dollar would likely have
appreciated much more significantly. Instead, the U.S. interest rate path has come down in
tandem with the foreign interest rate paths and the dollar has appreciated only modestly.
This is a crucial point and I want to make sure there is no misunderstanding. The Federal
Reserve is not targeting the exchange value of the U.S. dollar. What the FOMC considers are
financial conditions broadly defined, because they affect the saving and investment decisions
of households and firms. The dollar is but one component of these financial conditions. The
level of short- and long-term rates, credit spreads, and equity prices are also important
components of the financial conditions that we closely monitor. If international developments
shift U.S. financial market conditions - including the dollar - then we need to take this into
consideration in our U.S. monetary policy decisions.
Third, I have found that market participants broadly appreciate that the FOMC needs to take a
risk management approach in its conduct of monetary policy. There are at least two important
aspects of this approach. The first is whether the balance of risks to the outlooks for either
economic growth or inflation are skewed to the upside or downside. The second is whether the
efficacy of monetary policy itself is asymmetric when monetary policy is at, or close to, the zero
lower bound for interest rates. In this situation, it may be easier to implement a tighter monetary
policy through raising rates, than it would be to implement a looser policy using unconventional
tools. Also, the effects of a policy of raising rates may be more predictable compared to the
effects from using unconventional tools.
As I noted earlier, I think the medium-term risks to the U.S. economic growth outlook are
somewhat skewed to the down side. Thus, this needs to be taken into consideration in terms
of the appropriate stance for U.S. monetary policy. With respect to the efficacy of monetary
policy, given how close we remain to the zero lower bound for interest rates, I also think the
risks are asymmetric. Therefore, we need to be a bit more careful about the risk of tightening
monetary policy in a manner that proves to be premature, as compared to the alternative risk
of being a little late. If we were to realize that we were slightly late, policy can be adjusted by
raising short-term interest rates more quickly.2
All three of these reasons - evidence that U.S. monetary policy is currently only moderately
accommodative, the fact that U.S. financial conditions have been influenced by economic and
financial market developments abroad, and risk management considerations - argue, at the
moment, for caution in raising U.S. short-term interest rates. So, directionally, the movement
in investor expectations towards a flatter path for U.S. short-term interest rates seems broadly
appropriate.
That said, to my eye, market expectations derived from futures prices - which price in about
one 25 basis point rate hike through the end of 2017 - appear to be too complacent. If the
incoming information validates my view of the outlook, then I believe that U.S. monetary policy
will likely need to move at a faster pace than implied by futures prices towards a more neutral
posture as the labor market tightens further and U.S. inflation rises. Moreover, market
expectations may be putting insufficient weight on the possibility that the economy could
outperform our expectations, that financial conditions could ease, or that the risks to growth
from Brexit and other international developments could fade away. If such events were to
occur, this might necessitate a faster pace of adjustment.
For these reasons, I think it is premature to rule out further monetary policy tightening this year.
As I said before, it depends on the data, broadly defined, and, as we all know, that is not
something one can predict with any accuracy.
It's a two-way street
The U.S. economy plays a large role in the global economy. Most significantly, the U.S.
economy represents a sizable share of world GDP - roughly 25 percent at current exchange
rates - and the U.S. dollar is the most important international reserve currency. More than
60 percent of central bank reserve assets are denominated in dollars, and that share has been
stable to rising in recent years. Most foreign trade is denominated in dollars and most of the
foreign currency debt issued by corporations abroad is denominated in dollars. Thus, what
happens to the U.S. economy, U.S. financial asset prices and the exchange value of the dollar
has important implications for the global economy.
At the same time, prosperity is very much a two-way street. Developments outside the United
States affect our domestic economic outlook through their impact on trade and financial market
conditions, and we have to take such developments into consideration in our monetary policy
decision-making.
In many ways, international linkages have become more important over time. This is because
international trade has increased rapidly over the past few decades as the world economy has
become more developed and globalized - notwithstanding the flattening of the global
trade-toGDP ratio over the past few years. And, global trade interactions have become more complex
as supply chains have become more extensive and intricate, often involving many different
countries.
Financial markets across the globe have also become more integrated. Developments in one
market now appear to have larger effects on other markets than was generally the case
historically. Consider, for example, how European and Japanese central bank quantitative
easing activity has helped drive the sharp decline in long-term U.S. Treasury yields this year.
Or, in the other direction, consider the global bond market taper tantrum in 2013. In this case,
markets reacted to then-Chairman Bernanke's musing that the Federal Reserve was beginning
to evaluate when the time would be right to begin the tapering of the Fed's asset purchase
program. Or, in a similar vein, consider the international financial market reaction to China's
decision to alter its foreign exchange rate regime and how the RMB is managed relative to the
dollar versus a broader basket of foreign currencies.
The growing interdependence can be seen in the increased correlation of market movements
both across countries and across asset classes. Periods of "risk on" versus "risk off" trading
now occur on a global basis. For example, equity market movements in developed and
emerging markets have exhibited a 76 percent positive correlation over the past six months.
This is only slightly below the all-time peak of 82 percent in 2009, and significantly above the
57 percent correlation that prevailed from 1995 through 2007.
Correlations across asset classes have also been increasing. For example, consider the set
of assets comprised of the 10-year U.S. Treasury, U.S. equities, international equities, oil, the
VIX, a trade-weighted dollar index and the BAA credit spread. We can construct a variable -
called a common factor - to capture as much of the overall movement and co-movements for
the series in this set. The more closely the series' movements are tied together, the greater
the explanatory content of the common factor. Currently, the derived common factor accounts
for 50 percent of the variation in these financial variables, up from 30 percent in early 2014.
Oil, in particular, has become more correlated with other assets. Prior to 2008, oil was virtually
uncorrelated with equities and Treasuries. Whereas, in 2016, its correlation with these two
asset classes has been more than 45 percent.
These effects are transmitted via many linkages, not just through trade and financial markets.
Consider, the many different channels of potential Brexit influence - not only the impact on
international trade and global interest rates and currencies, but also on bank equity prices and
on political uncertainty.
Given this interdependency, what should we do about it? Interdependency and linkages do not
mean that U.S. monetary policy should subordinate its domestic goals for international ones.
The Federal Reserve has a clear domestic-oriented mandate that was set by the U.S.
Congress. Instead, I believe that setting U.S. monetary policy to best achieve our domestic
mandate will help to support sustainable growth and development abroad. As I see it, there
are two key steps that are essential in the design of an appropriate monetary policy strategy.
Step one is to take an expansive view of the global eco-system in which we all operate. We
need to take into consideration that our decisions have broad consequences for the global
economy and, conversely, that international developments can have significant consequences
for the U.S. economic outlook and therefore the appropriate stance of U.S. monetary policy.
As part of this, we need to be nimble in incorporating new developments into our monetary
policy decision-making.
Step two is to communicate clearly and consistently. That means clarity about the objectives
of monetary policy, how the Fed plans to meet those objectives in light of the economic and
financial market environment, and how it formulates its responses to unforeseen
circumstances that lead to revisions to its economic forecast.
In my view the Federal Reserve is making progress in both of these areas. With respect to the
first step, I believe we do take an expansive view of those factors that might affect the U.S.
outlook and we revise our views accordingly. Our speeches, statements, and actions this year
illustrate this is how we operate. For example, after the market turbulence at the start of the
year, we kept monetary policy on hold at the March FOMC meeting and explicitly referenced
"readings on financial and international developments" in the FOMC statement. Similarly, in
speeches prior to the Brexit vote and in the FOMC minutes, we raised our concerns about the
risks of disorderly outcomes associated with the U.K. referendum. For instance, the June
FOMC minutes state: "Most participants noted that the upcoming British referendum on
membership in the European Union could generate financial market turbulence that could
adversely affect domestic economic performance."
In addition we are doing a reasonably good job incorporating the flow of new information into
our forecasts. The fact that the federal funds rate projections from the SEP have changed
significantly from quarter to quarter indicates that FOMC participants are responsive to new
information.
Now, some have expressed an alternative view that the movement in these rate projections is
an indication that the FOMC's reaction function is unstable and unmoored. I do not see it that
way at all. The forecasts of FOMC participants with respect to growth and inflation have not
changed much this year. What have changed are expectations about the monetary policy
stance that would be appropriate in order to achieve those outcomes. It is important to
emphasize that these interest rate projections are not commitments. They are point-in-time
views of the appropriate interest rate path and are updated as economic circumstances and
financial market conditions change and evolve.
With respect to communication, in recent years the Federal Reserve has shifted towards much
greater transparency. This includes quarterly press conferences by the Fed chair following
FOMC meetings; publishing growth, inflation and short-term interest rate forecasts of FOMC
participants on a quarterly basis; and a concerted effort to lay out the guideposts that the
FOMC will look at in assessing progress towards our dual mandate objectives.
On the communication front, although we have come a long way, I would admit that there is
still room for further improvement. For example, the focus of the SEP on the each participant's
modal forecast does not convey how much uncertainty there is about the economic outlook.
Similarly, language used in FOMC statements can become stale over time. We tend to make
relatively few changes to the statement language each meeting because of the acute market
sensitivity to such changes. One could argue that this might not be the best practice to follow,
but we should recognize that there would also be significant transition costs if we were to make
more extensive revisions to the statement at each meeting.
For monetary policy to be effective, it is important to have clarity about what the FOMC can be
clear and consistent about - its manner of responses to mitigate the potential harmful effects
of disturbances and the goals of policy. In contrast, our monetary policy projections and the
actions we take cannot be static. If economic circumstances change, then monetary policy
needs to change too. Otherwise, we will not be able to achieve our objectives.
Thank you for your kind attention. I would be happy to take a few questions.