Janet L Yellen: The economic outlook and monetary policy
Speech by Ms Janet L Yellen, Chair of the Board of Governors of the Federal Reserve
System, to the Economic Club of Washington, Washington DC, 2 December 2015.
* * *
Thank you to the Economic Club of Washington for inviting me to speak to you today. I would
like to offer my assessment of the U.S. economy, nearly six and half years after the
beginning of the current economic expansion, and my view of the economic outlook. I will
describe the progress the economy has made toward the Federal Open Market Committee's
(FOMC) goals of maximum employment and stable prices and what the current situation and
the outlook imply for how monetary policy is likely to evolve to best foster the attainment of
those objectives.
The economic outlook
The U.S. economy has recovered substantially since the Great Recession. The
unemployment rate, which peaked at 10 percent in October 2009, declined to 5 percent in
October of this year. At that level, the unemployment rate is near the median of FOMC
participants' most recent estimates of its longer-run normal level.1 The economy has created
about 13 million jobs since the low point for employment in early 2010, and total nonfarm
payrolls are now almost 4-1/2 million higher than just prior to the recession. Most recently,
after a couple months of relatively modest payroll growth, employers added an estimated
271,000 jobs in October. This increase brought the average monthly gain since June to
about 195,000 - close to the monthly pace of around 210,000 in the first half of the year and
still sufficient to be consistent with continued improvement in the labor market.
Despite these substantial gains, we cannot yet, in my judgment, declare that the labor market
has reached full employment. Let me describe the basis for that view.
To begin with, I believe that a significant number of individuals now classified as out of the
labor force would find and accept jobs in an even stronger labor market. To be classified as
unemployed, working-age people must report that they have actively sought work within the
past four weeks. Most of those not seeking work are appropriately not counted as
unemployed. These include most retirees, teenagers and young adults in school, and those
staying home to care for children and other dependent family members. Even in a stronger
job market, it is likely that many of these individuals would choose not to work.
But some who are counted as out of the labor force might be induced to seek work if the
likelihood of finding a job rose or if the expected pay was higher. Examples here include
people who had become too discouraged to search for work when the prospects for
employment were poor and some who retired when their previous jobs ended. In October,
almost 2 million individuals classified as outside the labor force because they had not
searched for work in the previous four weeks reported that they wanted and were available
for work. This is a considerable number of people, and some of them undoubtedly would be
drawn back into the workforce as the labor market continued to strengthen. Likewise, some
of those who report they don't want to work now could change their minds in a stronger job
market.
Another margin of labor market slack not reflected in the unemployment rate consists of
individuals who report that they are working part time but would prefer a full-time job and
cannot find one - those classified as "part time for economic reasons." The share of such
workers jumped from 3 percent of total employment prior to the Great Recession to around
6-1/2 percent by 2010. Since then, however, the share of these part time workers has fallen
considerably and now is less than 4 percent of those employed. While this decline represents
considerable progress, particularly given secular trends that over time may have increased
the prevalence of part-time employment, I think some room remains for the hours of these
workers to increase as the labor market improves further.
The pace of increases in labor compensation provides another possible indicator, albeit an
imperfect one, of the degree of labor market slack. Until recently labor compensation had
grown only modestly, at average annual rates of around 2 to 2-1/2 percent. More recently,
however, we have seen a welcome pickup in the growth rate of average hourly earnings for
all employees and of compensation per hour in the business sector. While it is too soon to
conclude whether these more rapid rates of increase will continue, a sustained pickup would
likely signal a diminution of labor market slack.
Turning to overall economic activity, U.S. economic output - as measured by
inflationadjusted gross domestic product (GDP), or real GDP - has increased at a moderate pace,
on balance, during the expansion. Over the first three quarters of this year, real GDP is
currently estimated to have advanced at an annual rate of 2-1/4 percent, close to its average
pace over the previous five years. Many economic forecasters expect growth roughly along
those same lines in the fourth quarter.
Growth this year has been held down by weak net exports, which have subtracted more than
1/2 percentage point, on average, from the annual rate of real GDP growth over the past
three quarters. Foreign economic growth has slowed, damping increases in U.S. exports,
and the U.S. dollar has appreciated substantially since the middle of last year, making our
exports more expensive and imported goods cheaper.
By contrast, total real private domestic final purchases (PDFP) - which includes household
spending, business fixed investment, and residential investment, and currently represents
about 85 percent of aggregate spending - has increased at an annual rate of 3 percent this
year, significantly faster than real GDP. Household spending growth has been particularly
solid in 2015, with purchases of new motor vehicles especially strong. Job growth has
bolstered household income, and lower energy prices have left consumers with more to
spend on other goods and services. These same factors likely have contributed to consumer
confidence that is more upbeat this year than last year. Increases in home values and stock
market prices in recent years, along with reductions in debt, have pushed up the net worth of
households, which also supports consumer spending. Finally, interest rates for borrowers
remain low, due in part to the FOMC's accommodative monetary policy, and these low rates
appear to have been especially relevant for consumers considering the purchase of durable
goods.2
Other components of PDFP, including residential and business investment, have also
advanced this year. The same factors supporting consumer spending have supported further
gains in the housing sector. Indeed, gains in real residential investment spending have been
faster so far in 2015 than last year, although the level of new residential construction still
remains fairly low. And outside of the drilling and mining sector, where lower oil prices have
led to substantial cuts in outlays for new structures, business investment spending has
posted moderate gains.
On balance, the moderate average pace of real GDP growth so far this year and over the
entire expansion has been sufficient to help move the labor market closer to the FOMC's
goal of maximum employment. However, less progress has been made on the second leg of
our dual mandate - price stability - as inflation continues to run below the FOMC's longer-
run objective of 2 percent. Overall consumer price inflation - as measured by the change in
the price index for personal consumption expenditures - was only 1/4 percent over the
12 months ending in October. However, this number largely reflects the sharp fall in crude oil
prices since the summer of 2014 that, in turn, has pushed down retail prices for gasoline and
other consumer energy products. Because food and energy prices are volatile, it is often
helpful to look at inflation excluding those two categories - known as core inflation - which is
typically a better indicator of future overall inflation than recent readings of headline inflation.
But core inflation - which ran at 1-1/4 percent over the 12 months ending in October - is
also well below our 2 percent objective, partly reflecting the appreciation of the U.S. dollar.
The stronger dollar has pushed down the prices of imported goods, placing temporary
downward pressure on core inflation.3 The plunge in crude oil prices may also have had
some small indirect effects in holding down the prices of non-energy items in core inflation,
as producers passed on to their customers some of the reductions in their energy-related
costs. Taking account of these effects, which may be holding down core inflation by around
1/4 to 1/2 percentage point, it appears that the underlying rate of inflation in the United States
has been running in the vicinity of 1-1/2 to 1-3/4 percent.
Let me now turn to where I see the economy is likely headed over the next several years. To
summarize, I anticipate continued economic growth at a moderate pace that will be sufficient
to generate additional increases in employment, further reductions in the remaining margins
of labor market slack, and a rise in inflation to our 2 percent objective. I expect that the
fundamental factors supporting domestic spending that I have enumerated today will
continue to do so, while the drag from some of the factors that have been weighing on
economic growth should begin to lessen next year. Although the economic outlook, as
always, is uncertain, I currently see the risks to the outlook for economic activity and the
labor market as very close to balanced.
Turning to the factors that have been holding down growth, as I already noted, the higher
foreign exchange value of the dollar, as well as weak growth in some foreign economies, has
restrained the demand for U.S. exports over the past year. In addition, lower crude oil prices
have reduced activity in the domestic oil sector. I anticipate that the drag on U.S. economic
growth from these factors will diminish in the next couple of years as the global economy
improves and the adjustment to prior declines in oil prices is completed.
Although developments in foreign economies still pose risks to U.S. economic growth that we
are monitoring, these downside risks from abroad have lessened since late summer. Among
emerging market economies, recent data support the view that the slowdown in the Chinese
economy, which has received considerable attention, will likely continue to be modest and
gradual. China has taken actions to stimulate its economy this year and could do more if
necessary. A number of other emerging market economies have eased monetary and fiscal
policy this year, and economic activity in these economies has improved of late.
Accommodative monetary policy is also supporting economic growth in the advanced
economies. A pickup in demand in many advanced economies and a stabilization in
commodity prices should, in turn, boost the growth prospects of emerging market economies.
A final positive development for the outlook that I will mention relates to fiscal policy. This
year the effect of federal fiscal policy on real GDP growth has been roughly neutral, in
contrast to earlier years in which the expiration of stimulus programs and fiscal policy actions
to reduce the federal budget deficit created significant drags on growth.4 Also, the budget
situation for many state and local governments has improved as the economic expansion
has increased the revenues of these governments, allowing them to increase their hiring and
spending after a number of years of cuts in the wake of the Great Recession. Looking ahead,
I anticipate that total real government purchases of goods and services should have a
modest positive effect on economic growth over the next few years.5
Regarding U.S. inflation, I anticipate that the drag from the large declines in prices for crude
oil and imports over the past year and a half will diminish next year. With less downward
pressure on inflation from these factors and some upward pressure from a further tightening
in U.S. labor and product markets, I expect inflation to move up to the FOMC's 2 percent
objective over the next few years. Of course, inflation expectations play an important role in
the inflation process, and my forecast of a return to our 2 percent objective over the medium
term relies on a judgment that longer-term inflation expectations remain reasonably well
anchored. In this regard, recent measures from the Survey of Professional Forecasters, the
Blue Chip Economic Indicators, and the Survey of Primary Dealers have continued to be
generally stable. The measure of longer-term inflation expectations from the University of
Michigan Surveys of Consumers, in contrast, has lately edged below its typical range in
recent years. However, this measure often seems to respond modestly, though temporarily,
to large changes in actual inflation, and the very low readings on headline inflation over the
past year may help explain some of the recent decline in the Michigan measure.6
Marketbased measures of inflation compensation have moved up some in recent weeks after
declining to historically low levels earlier in the fall. While the low level of these measures
appears to reflect, at least in part, changes in risk and liquidity premiums, we will continue to
monitor this development closely. Convincing evidence that longer-term inflation
expectations have moved lower would be a concern because declines in consumer and
business expectations about inflation could put downward pressure on actual inflation,
making the attainment of our 2 percent inflation goal more difficult.
Monetary policy
Let me now turn to the implications of the economic outlook for monetary policy. Reflecting
progress toward the Committee's objectives, many FOMC participants indicated in
September that they anticipated, in light of their economic forecasts at the time, that it would
be appropriate to raise the target range for the federal funds rate by the end of this year.
Some participants projected that it would be appropriate to wait until later to raise the target
funds rate range, but all agreed that the timing of a rate increase would depend on what the
incoming data tell us about the economic outlook and the associated risks to that outlook.
In the policy statement issued after its October meeting, the FOMC reaffirmed its judgment
that it would be appropriate to increase the target range for the federal funds rate when we
had seen some further improvement in the labor market and were reasonably confident that
inflation would move back to the Committee's 2 percent objective over the medium term.
That initial rate increase would reflect the Committee's judgment, based on a range of
indicators, that the economy would continue to grow at a pace sufficient to generate further
labor market improvement and a return of inflation to 2 percent, even after the reduction in
policy accommodation. As I have already noted, I currently judge that U.S. economic growth
is likely to be sufficient over the next year or two to result in further improvement in the labor
market. Ongoing gains in the labor market, coupled with my judgment that longer-term
inflation expectations remain reasonably well anchored, serve to bolster my confidence in a
return of inflation to 2 percent as the disinflationary effects of declines in energy and import
prices wane.
Committee participants recognize that the future course of the economy is uncertain, and we
take account of both the upside and downside risks around our projections when judging the
appropriate stance of monetary policy. In particular, recent monetary policy decisions have
reflected our recognition that, with the federal funds rate near zero, we can respond more
readily to upside surprises to inflation, economic growth, and employment than to downside
shocks. This asymmetry suggests that it is appropriate to be more cautious in raising our
target for the federal funds rate than would be the case if short-term nominal interest rates
were appreciably above zero.7 Reflecting these concerns, we have maintained our current
policy stance even as the labor market has improved appreciably.
However, we must also take into account the well-documented lags in the effects of
monetary policy.8 Were the FOMC to delay the start of policy normalization for too long, we
would likely end up having to tighten policy relatively abruptly to keep the economy from
significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting
financial markets and perhaps even inadvertently push the economy into recession.
Moreover, holding the federal funds rate at its current level for too long could also encourage
excessive risk-taking and thus undermine financial stability.
On balance, economic and financial information received since our October meeting has
been consistent with our expectations of continued improvement in the labor market. And, as
I have noted, continuing improvement in the labor market helps strengthen confidence that
inflation will move back to our 2 percent objective over the medium term. That said, between
today and the next FOMC meeting, we will receive additional data that bear on the economic
outlook. These data include a range of indicators regarding the labor market, inflation, and
economic activity. When my colleagues and I meet, we will assess all of the available data
and their implications for the economic outlook in making our policy decision.
As you know, there has been considerable focus on the first increase in the federal funds
rate after nearly seven years in which that rate has been at its effective lower bound. We
have tried to be as clear as possible about the considerations that will affect that decision. Of
course, even after the initial increase in the federal funds rate, monetary policy will remain
accommodative. And it bears emphasizing that what matters for the economic outlook are
the public's expectations concerning the path of the federal funds rate over time: It is those
expectations that affect financial conditions and thereby influence spending and investment
decisions. In this regard, the Committee anticipates that even after employment and inflation
are near mandate-consistent levels, economic conditions may, for some time, warrant
keeping the target federal funds rate below levels the Committee views as normal in the
longer run.
This expectation is consistent with an implicit assessment that the neutral nominal federal
funds rate - defined as the value of the federal funds rate that would be neither expansionary
nor contractionary if the economy were operating near its potential - is currently low by
historical standards and is likely to rise only gradually over time. One indication that the
neutral funds rate is unusually low is that U.S. economic growth has been quite modest in
recent years despite the very low level of the federal funds rate and the Federal Reserve's
very large holdings of longer-term securities. Had the neutral rate been running closer to the
levels that are thought to have prevailed prior to the financial crisis, current monetary policy
settings would have been expected to foster a very rapid economic expansion, with inflation
likely rising significantly above our 2 percent objective.
Empirical support for the judgment that the neutral federal funds rate is low comes from both
academic research and Federal Reserve staff analysis. Figure 1 employs four
macroeconomic models used by Federal Reserve staff to estimate the "natural" real rate of
interest, a concept closely related to the neutral rate.9 The measures of the natural rate
shown in this figure represent the real short-term interest rate that would prevail in the
absence of frictions that slow the adjustment of wages and prices to changes in the
economy; under a variety of assumptions, this interest rate has been shown to promote full
employment.10 The shaded blue band represents the range of the estimates of the natural
real rate at each point in time. This analysis suggests that the natural real rate fell sharply
with the onset of the crisis and has recovered only partially. These findings are broadly
consistent with those reported in a paper by Thomas Laubach and John Williams, shown in
figure 2.11
The marked decline in the neutral federal funds rate after the crisis may be partially
attributable to a range of persistent economic headwinds that have weighed on aggregate
demand. These headwinds have included tighter underwriting standards and limited access
to credit for some borrowers, deleveraging by many households to reduce debt burdens,
contractionary fiscal policy at all levels of government, weak growth abroad coupled with a
significant appreciation of the dollar, slower productivity and labor force growth, and elevated
uncertainty about the economic outlook.12 As the restraint from these headwinds further
abates, I anticipate that the neutral federal funds rate will gradually move higher over time.
Indeed, in September, most FOMC participants projected that, in the long run, the nominal
federal funds rate would be near 3.5 percent, and that the actual federal funds rate would
rise to that level fairly slowly.13
9
Note that these estimates are in real terms; to obtain estimates of the nominal natural interest rate, one would
add a measure of expected inflation. The four models used are (1) a dynamic stochastic general equilibrium
(DSGE) model developed by the staff of the Federal Reserve Board and described in Kiley (2013); (2) a
DSGE model developed by the staff of the Federal Reserve Bank of New York and described in Del Negro
and others (2013); (3) a DSGE model developed by the staff of the Federal Reserve Board based on
Christiano, Motto, and Rostagno (2014); and (4) a DSGE model developed by the staff of the Federal Reserve
Board based on Guerrieri and Iacoviello (2013 [rev. 2014]).
10
The concept of the natural rate goes back to Wicksell, who defined it as the rate that "tends neither to raise
nor to lower" (1936 [1898], p. 102) commodity prices. Wicksell posited that the natural rate would be equal to
the real interest rate that would balance supply and demand absent monetary frictions. The recent academic
literature draws on this notion to define the natural rate as the real interest rate that would prevail in the
absence of sluggish adjustment in nominal prices and wages. In simple models, this interest rate would result
in stable prices and full employment; in some more complex models, this interest rate has been found to
promote stable inflation and appropriate economic activity, although monetary policymakers face important
tradeoffs in such settings. Importantly, the natural rate varies over time. For example, it generally rises with
expected productivity growth and with "preference shocks" that capture households' desire to consume today
rather than save. For further discussion of the potential usefulness of the natural rate for monetary policy, see,
for example, Barsky, Justiniano, and Melosi (2014) and Cúrdia and others (2015). By contrast, Laubach and
Williams (2015) employ a statistical approach that defines the natural rate as one consistent with the economy
operating at its full potential once transitory shocks to aggregate supply and demand have abated. These two
approaches to the measurement of the natural real rate are different but have important similarities.
Qualitatively, the two measures would be expected to move together in response to shocks to productivity
growth and preferences so long as those shocks were very persistent.
11
See Laubach and Williams (2015).
12
For analyses of how a sudden tightening in access to credit can lead to household deleveraging, pushing
down the neutral rate of interest, see Eggertsson and Krugman (2012) and Guerrieri and Lorenzoni (2015).
13
See figure 2 in the Summary of Economic Projections, an addendum to the minutes of the September 2015
FOMC meeting. See Board of Governors (2015b). The longer-run normal level of the federal funds rate
reported in the SEP presumably matches participants' assessment of the neutral nominal federal funds rate
that will prevail in the longer run. Between June 2012 and September 2015 the median of FOMC participants'
Because the value of the neutral federal funds rate is not directly measureable and must be
estimated based on our imperfect understanding of the economy and the available data, I
would stress that considerable uncertainty attends our estimates of its current level and even
more to its likely path going forward.14 That said, we will learn more from observing economic
developments in the period ahead. It is thereby important to emphasize that the actual path
of monetary policy will depend on how incoming data affect the evolution of the economic
outlook. Stronger growth or a more rapid increase in inflation than we currently anticipate
would suggest that the neutral federal funds rate is rising more quickly than expected,
making it appropriate to raise the federal funds rate more quickly as well; conversely, if the
economy disappoints, the federal funds rate would likely rise more slowly. Given the
persistent shortfall in inflation from our 2 percent objective, the Committee will, of course,
carefully monitor actual progress toward our inflation goal as we make decisions over time on
the appropriate path for the federal funds rate.
In closing, let me again thank the Economic Club of Washington for this opportunity to speak
about the economy and monetary policy. The economy has come a long way toward the
FOMC's objectives of maximum employment and price stability. When the Committee begins
to normalize the stance of policy, doing so will be a testament, also, to how far our economy
has come in recovering from the effects of the financial crisis and the Great Recession. In
that sense, it is a day that I expect we all are looking forward to.
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