Source: https://www.newyorkfed.org/newsevents/speeches/2011/dud110228
Timestamp: 2018-06-21 04:40:39
Document Index: 304308181

Matched Legal Cases: ['art 11', 'art 12', 'art 22', 'art 29', 'art 30', 'art 31']

Prospects for the Economy and Monetary Policy - FEDERAL RESERVE BANK of NEW YORK
In my talk, I'll argue that the economic outlook has improved considerably. Despite this, we are still very far away from achieving our dual mandate of maximum sustainable employment and price stability. Faster progress toward these objectives would be very welcome and need not require an early change in the stance of monetary policy.
However, I'll also focus on some issues with respect to inflation that will merit careful monitoring. In particular, we need to keep a close watch on how households and businesses respond to commodity price pressures. The key issue here is whether the rise in commodity prices will unduly push up inflation expectations.
Indeed, the 2.8 percent annualized growth rate of real gross domestic product (GDP) in the fourth quarter may understate the economy's forward momentum. That is because real GDP growth in the quarter was held back by a sharp slowing in the pace of inventory accumulation. The revival in demand, production and confidence strongly suggests that we may be much closer to establishing a virtuous circle in which rising demand generates more rapid income and employment growth, which in turn bolsters confidence and leads to further increases in spending. The only major missing piece of the puzzle is the absence of strong payroll employment growth. We will need to see sustained strong employment growth in order to be certain that this virtuous circle has become firmly established.
Second, monetary policy and fiscal policy have provided support to the recovery. On the monetary policy side, the unusually low level of short-term interest rates and the Federal Reserve's large-scale asset purchase programs (LSAPs) have fostered a sharp improvement in financial market conditions. Since August 2010, for example, when market participants began to anticipate that the Federal Reserve would initiate another LSAP, U.S. equity prices have risen sharply and credit spreads have narrowed (Chart 11 and Chart 12). Long-term interest rates have moved higher after initially declining, but this does not appear troublesome as it primarily reflects the brightening economic outlook.
Given the emergence of such economies as China and India, can commodity price pressures be safely ignored as temporary “noise” in terms of the long-term inflation outlook or are these pressures likely to prove persistent? If commodity price pressures persisted, this could undercut one rationale for focusing on core measures of inflation—the argument that core measures are better predictors of future headline inflation than today's headline rate.
Second, the rise in unemployment has been associated with an increase in the degree of mismatch between unemployed workers' job skills and available job vacancies. Some cite the upward shift in the Beveridge curve, which illustrates the relationship between unemployment and job vacancies (Chart 22), as evidence of this effect.
Although this possibility shouldn't be ruled out, we should not be too worried about this, particularly if growth is broadly based. In particular, the economy is not growing quickly right now relative to past recoveries. For example, in the rebound from the comparably deep early 1980s recession, the annualized growth rate exceeded 7 percent for five consecutive quarters. Moreover, empirically there is little historical evidence that discontinuous “speed limit” effects play a significant role in influencing inflation in the United States.
Setting to one side the near-term effects of geopolitical developments, the rapid urbanization and industrialization of nations such as China and India could be generating an ongoing secular rise in commodity prices that might not be fully captured in today's spot and futures market prices. If so, this would undercut the role of core inflation as a good predictor of future headline inflation.
Fortunately, inflation expectations remain well-anchored. This can be seen in all three major measures of inflation expectations. First, market-based measures of inflation expectations are generally well-behaved. For example, the five-year forward measure of breakeven inflation generated from differences in the nominal Treasury yield curve and the TIPS yield curve has shown a modest rise since mid-2010 back into the range that has generally been in place for the past decade (Chart 29). Second, the long-term inflation expectations of professional forecasters have been very stable. As shown in Chart 30, the median long-term inflation forecast in the Professional Forecasters' survey remains around 2.1 percent for the PCE deflator. In terms of household expectations, there has been an increase in short-term expectations. This typically occurs when commodities such as gasoline go up sharply in price. However, even here longer-term expectations remain well-anchored. As shown in Chart 31, the University of Michigan median five-year inflation expectations measure remains around 2.9 percent—comfortably within its normal range and historically consistent with slightly lower realized inflation.
Although our ability to pay interest on excess reserves is sufficient to retain control of monetary policy, it is not bad policy to have both a “belt and suspenders” in place. As a result, we have developed means of draining reserves to provide reassurance that we will not—under any circumstance—lose control of monetary policy. These include reverse repo transactions with dealers and other counterparties, auctions of term deposits for banks, or securities sales from the Fed's portfolio.
A related concern is whether the Federal Reserve will be able to act sufficiently fast once it determines that it is time to raise the IOER. This concern reflects the view that the excess reserves sitting on banks' balance sheets are essentially “dry tinder” that could quickly fuel excessive credit creation and put the Fed behind the curve in tightening monetary policy.
In terms of imagery, this concern seems compelling—the banks sitting on piles of money that could be used to extend credit on a moment's notice. However, this reasoning ignores a very important point. Banks have always had the ability to expand credit whenever they like. They didn't need a pile of “dry tinder” in the form of excess reserves to do so. That is because the Federal Reserve's standard operating procedure for several decades has been a commitment to supply sufficient reserves to keep the fed funds rate at its target. If banks wanted to expand credit that would drive up the demand for reserves, the Fed would automatically meet that demand by supplying additional reserves as needed to maintain the fed funds rate at its target rate. In terms of the ability to expand credit rapidly, it makes no difference whether the banks have lots of excess reserves on their own balance sheets or can source whatever reserves they need from the fed funds market at the fed funds rate.3
In this regard, some have argued that Fed officials might be reluctant to raise short-term rates because such increases would squeeze the net interest margin on the Fed's System Open Market Account (SOMA) portfolio. Although it is true that a rise in short-term interest rates would reduce the Fed's net income from the extraordinary high levels seen in 2009 and 2010,4 this will not play a significant role in the Fed's monetary policy deliberations.
Fed policy is driven by the objectives set out in the dual mandate, and the net income earned by the Fed is the consequence of the policy choices that advance those objectives. The Federal Reserve's net income statement does not drive or constrain our policy actions. In short, we act as a central bank, not an investment manager.
It is also worth pointing out in passing that a failure to raise short-term interest rates at the appropriate moment based on our dual mandate objectives would also be a losing strategy with respect to net income. Inflation would climb, bond yields would rise and the Fed would ultimately be forced to raise short-term rates more aggressively, or to sell more assets at lower prices to regain control of inflation. This would almost certainly result in larger reductions in net income than a timelier exit from the current stance of monetary policy. So what does this all imply for monetary policy? First, barring a sustained period of economic growth so strong that the economy's substantial excess slack is quickly exhausted or a noteworthy rise in inflation expectations, the outlook implies that short-term interest rates are likely to remain unusually low for “an extended period.” The economy can be allowed to grow rapidly for quite some time before there is a real risk that shrinking slack will result in a rise in underlying inflation. We will learn more as we go, and, as always, should be prepared to adjust course in a timely manner if incoming information suggests a different strategy would better promote our objectives.