For release on delivery
8:30 a.m. EST
November 27, 2018
Data Dependence and U.S. Monetary Policy
Remarks by
Richard H. Clarida
Vice Chairman
Board of Governors of the Federal Reserve System
at
The Clearing House and The Bank Policy Institute Annual Conference
New York, New York
November 27, 2018
I am delighted to be speaking at this annual conference of the Clearing House and
the Bank Policy Institute. Today I will discuss recent economic developments and the
economic outlook before going on to outline my thinking about the connections between
data dependence and monetary policy. I will close with some observations on the
implications for U.S. monetary policy that flow from this perspective.1
Recent Economic Developments and the Economic Outlook
U.S. economic fundamentals are robust, as indicated by strong growth in gross
domestic product (GDP) and a job market that has been surprising on the upside for
nearly two years. Smoothing across the first three quarters of this year, real, or inflation-
adjusted, GDP growth is averaging an annual rate of 3.3 percent. Private-sector forecasts
for the full year--that is, on a fourth-quarter-over-fourth-quarter basis--suggest that
growth is likely to equal, or perhaps slightly exceed, 3 percent. If this occurs, GDP
growth in 2018 will be the fastest recorded so far during the current expansion, which in
July entered its 10th year. If, as I expect, the economic expansion continues in 2019, this
will become the longest U.S. expansion in recorded history.
Likewise, the labor market remains healthy. Average monthly job gains continue
to outpace the increase needed to provide jobs for new entrants to the labor force over the
longer run, with payrolls rising by 250,000 in October. And, at 3.7 percent, the
unemployment rate is the lowest it has been since 1969. In addition, after remaining
stubbornly sluggish throughout much of the expansion, nominal wage growth is picking
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up, with various measures now running in the neighborhood of 3 percent on an annual
basis.
The inflation data in the year to date for the price index for personal consumption
expenditures (PCE) have been running at or close to our 2 percent objective, including on
a core basis--that is, excluding volatile food and energy prices. While my base case is for
this pattern to continue, it is important to monitor measures of inflation expectations to
confirm that households and businesses expect price stability to be maintained. The
median of expected inflation 5-to-10 years in the future from the University of Michigan
Surveys of Consumers is within--but I believe at the lower end of--the range consistent
with price stability. Likewise, inflation readings from the TIPS (Treasury Inflation-
Protected Securities) market indicate to me that financial markets expect consumer price
index (CPI) inflation of about 2 percent to be maintained. That said, historically, PCE
inflation has averaged about 0.3 percent less than CPI inflation, and if this were to
continue, the readings from the TIPS market would indicate that expected PCE inflation
is running at somewhat less than 2 percent.
What might explain why inflation is running at or close to the Federal Reserve's
long-run objective of 2 percent, and not well above it, when growth is strong and the
labor market robust? According to the Bureau of Labor Statistics, productivity growth in
the business sector, as measured by output per hour, is averaging 2 percent at an
annualized rate this year, while aggregate hours worked in the business sector have risen
at an average annual rate of 1.8 percent through the third quarter. This decomposition--in
which the growth in output is broken down into measures of aggregate supply, the growth
of aggregate hours and the growth of output per hour--suggests that the growth rates of
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productivity and hours worked in 2018 each have been exceeding their respective longer-
run rates as estimated by the Congressional Budget Office.2 In other words, while
growth in aggregate demand in 2018 has been above the expected long-run growth rate in
aggregate supply, it has not been exceeding this year's growth in actual aggregate supply.
Ultimately, hours growth will likely converge to a slower pace because of
demographic factors. But how rapidly this happens will depend in part on the behavior of
labor force participation. And recent years' developments suggest there may still be
some further room for participation in the job market--especially in the prime-age group
of 25-to-54-year-olds--to rise. Labor participation by prime-age women has increased
around 2 percentage points in the past three years and is now at its highest level in a
decade. That said, it is still 1-1/2 percentage points below the peak level reached in 2000.
Labor force participation among 25- to 54-year-old men has risen by roughly 1
percentage point in the past several years. But it is still 2 percentage points below levels
seen a decade ago, and it is 3 percentage points below the levels that prevailed in the late
1990s.
As for productivity growth, there is considerable uncertainty about how much of
the rebound in productivity growth that we have seen in recent quarters is cyclical and
how much is structural. I believe both factors are at work. The structural, or trend,
component of productivity growth is a function of capital deepening through business
investment as well as a multifactor component sometimes referred to as the "Solow
residual." Initial estimates from the recent GDP release indicate that equipment and
software investment in the third quarter moderated from the rapid pace recorded in the
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first half of the year. One data point does not make a trend, but an improvement in
business investment will be important if the pickup in productivity growth that we have
seen in recent quarters is to be sustained.
As for the economic outlook, in the most recent Summary of Economic
Projections (SEP) released in September, participants had a median projection for real
GDP growth of 3.1 percent in 2018 and 2-1/2 percent in 2019. The unemployment rate
was expected to decline to 3-1/2 percent next year. And, for total PCE inflation, the
median projection remains near 2 percent.
With a robust labor market and inflation at or close to our 2 percent inflation goal
and based on the baseline economic outlook for 2019 I have just laid out, I believe
monetary policy at this stage of the economic expansion should be aimed at sustaining
growth and maximum employment at levels consistent with our inflation objective. At
this stage of the interest rate cycle, I believe it will be especially important to monitor a
wide range of data as we continually assess and calibrate whether the path for the policy
rate is consistent with meeting our dual-mandate objectives on a sustained basis.
Data Dependence of Monetary Policy: What It Means and Why It Is Important
Economic research suggests that monetary policy should be "data dependent."3
And, indeed, central banks around the world, including the Federal Reserve, often
describe their policies in this way. I would now like to discuss how I think about two
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distinct roles that data dependence should play in the formulation and communication of
monetary policy.
It is important to state up-front that data dependence is not, in and of itself, a
monetary policy strategy. A monetary policy strategy must find a way to combine
incoming data and a model of the economy with a healthy dose of judgment--and
humility!--to formulate, and then communicate, a path for the policy rate most consistent
with our policy objectives. In the case of the Fed, those objectives are assigned to us by
the Congress, and they are to achieve maximum employment and price stability.
Importantly, because households and firms must make long-term saving and investment
decisions and because these decisions--directly or indirectly--depend on the expected
future path for the policy rate, the central bank should find a way to communicate and
explain how incoming data are or are not changing the expected path for the policy rate
consistent with best meeting its objectives.4 Absent such communication, inefficient
divergences between public expectations and central bank intentions for the policy rate
path can emerge and persist in ways that are costly to the economy when reversed.
Within this general framework, let me now consider two distinct ways in which I
think that the path for the federal funds rate should be data dependent. U.S. monetary
policy has for some time and will, I believe, continue to be data dependent in the sense
that incoming data reveal at the time of each Federal Open Market Committee (FOMC)
meeting where the economy is at the time of each meeting relative to the goals of
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monetary policy. This information on where the economy is relative to the goals of
monetary policy is an important input into the policy decision. If, for example, incoming
data in the months ahead were to reveal that inflation and inflation expectations are
running higher than projected at present and in ways that are inconsistent with our 2
percent objective, then I would be receptive to increasing the policy rate by more than I
currently expect will be necessary. Data dependence in this sense is easy to understand,
as it is of the type implied by a large family of policy rules in which the parameters of the
economy are known.5
But what if key parameters that describe the long-run destination of the economy
are unknown? This is indeed the relevant case that the FOMC and other monetary
policymakers face in practice. The two most important unknown parameters needed to
conduct--and communicate--monetary policy are the rate of unemployment consistent
with maximum employment, u*, and the riskless real rate of interest consistent with price
stability, r*. As a result, in the real world, monetary policy should, I believe, be data
dependent in a second sense: that incoming data can reveal at each FOMC meeting
signals that will enable it to update its estimates of r* and u* in order to obtain its best
estimate of where the economy is heading.6 And, indeed, as indicated by the SEP,
5
See the Board of Governors of the Federal Reserve System (2018), Monetary Policy Report (Washington:
Board of Governors, July), pp. 37-41,
https://www.federalreserve.gov/monetarypolicy/files/20180713_mprfullreport.pdf, or the webpage
"Monetary Policy Principles and Practice" available on the Federal Reserve Board's website at
https://www.federalreserve.gov/monetarypolicy/monetary-policy-principles-and-practice.htm for a
discussion of the policy rate paths implied by five different policy rules using parameter values typically
assumed in the literature.
6
If the economy can be described by a linear model in which the only two unknown parameters are r* and
u* and the shocks that hit the economy are normal, Kalman filtering can be used to derive a closed form
mathematical expression for how to update one's estimate of r* and u* as new macro data arrive. But, in
practice, "the" model of the economy is neither known, nor linear, and the shocks that strike it are not
normal. Thus, monetary policy in practice is, of necessity, as much or more an art than a science.
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FOMC participants have, over the past nearly seven years, revised their estimates of both
u* and r* substantially lower as unemployment fell and real interest rates remained well
below prior estimates of neutral without the rise in inflation or inflation expectations
those earlier estimates would have predicted. And these revisions to u* and r* almost
certainly did have an important influence on the path for the policy rate that was actually
realized in recent years.7 I would expect to revise my estimates of r* and u* as
appropriate if incoming data on future inflation and unemployment diverge materially
and persistently from my baseline projections today.
Consequences for Monetary Policy
What does this mean for the conduct of monetary policy? As the economy has
moved to a neighborhood consistent with the Fed's dual-mandate objectives, risks have
become more symmetric and less skewed to the downside than when the current rate
cycle began three years ago. Raising rates too quickly could unnecessarily shorten the
economic expansion, while moving too slowly could result in rising inflation and
inflation expectations down the road that could be costly to reverse, as well as potentially
pose financial stability risks.
Although the real federal funds rate today is just below the range of longer-run
estimates presented in the September SEP, it is much closer to the vicinity of r* than it
was when the FOMC started to remove accommodation in December 2015. How close is
a matter of judgment, and there is a range of views on the FOMC. As I have already
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stressed, r* and u* are uncertain, and I believe we should continue to update our
estimates of them as new data arrive. This process of learning about r* and u* as new
data arrive supports the case for gradual policy normalization, as it will allow the Fed to
accumulate more information from the data about the ultimate destination for the policy
rate and the unemployment rate at a time when inflation is close to our 2 percent
objective.