Recent Economic Developments, Monetary Policy Considerations and Longer-term Prospects
Thank you for this opportunity to speak here today. The Chicago Council on Global Affairs has been a thought leader for nearly a century, encouraging public discourse, education, and research on important global issues. The Council's global focus is particularly important for understanding the challenges facing the U.S. economy today, as shown by last week's referendum on the United Kingdom's status in the European Union. In my remarks, I will review recent economic developments and the outlook for the economy. I will also discuss the economy's longer-term productive potential.
As always, the view I express here today are my own.
The Dual Mandate and State of the Economy
As you know, the Federal Reserve, through the Federal Open Market Committee (FOMC), is charged by the Congress with achieving maximum employment and stable prices--the dual mandate. For price stability, the FOMC has adopted a goal of 2 percent for inflation, as measured by the annual change in the price index for personal consumption expenditures. Many other central banks in developed economies have adopted inflation goals centered around 2 percent.
The FOMC has not set a numerical goal for maximum employment, because the long-run sustainable level of employment is determined mainly by non-monetary factors that are outside the Fed's control, such as demographics, social change, and fiscal and regulatory policies. Nonetheless, four times a year, FOMC participants write down their estimates of the longer-run sustainable level of the unemployment rate (which many interpret as the "natural rate"); at the recent June FOMC meeting the median estimate of that rate was 4.8 percent.
How should we evaluate our current performance against the dual mandate? I would say that we have made substantial progress toward maximum employment, although there is still some room for improvement. We have more work to do to assure that inflation moves back up to our 2 percent goal.
Let's start with the employment mandate. After several years of strong job growth, employment is now over 5 million higher than the pre-crisis peak in 2007. The unemployment rate has fallen from 10 percent in 2009 to 4.7 percent in May, essentially at the level that many observers identify as the natural rate. This rate is very far from a bright line--it cannot be observed directly, and estimates of its level are subject to great uncertainty.1 So we look to a wide range of labor market indicators to assess the overall health of the labor market. Many of those indicators suggest that the labor market is strong. To mention a few of these, job openings are at an all-time high by some measures. The "quits" rate--the rate at which employees voluntarily leave their jobs--is about at pre-crisis levels. Surveys of individuals and businesses suggest that the ease of finding and filling jobs is similar to that experienced in the mid-2000s.
Even though we are near the natural rate of unemployment, there is still room for improvement on several margins. Important among these is the labor force participation rate. If someone leaves the labor force for any reason, even temporarily, that person is not counted as unemployed. So the labor force participation rate is also a key determinant of the unemployment rate. Labor force participation is influenced by many factors, including the age structure of the population and individuals' perceptions of the availability of jobs.
Participation rose steadily from the 1970s through the 1990s as increasing numbers of women entered the formal workforce. That process ran its course, and, around the year 2000, participation began a gradual decline because of population aging and the continuation of other long-term trends, particularly the decline in participation among prime age males. From 2008 through 2013, participation dropped sharply by 3 percentage points, but has remained about flat, on net, since late 2013 in a context of strong job growth and declining unemployment. Economists estimate that, as the population ages, participation will naturally tend to decline at a trend rate of about 0.2 percentage point per year, so this period of flat participation actually represents an improvement against the post-crisis cyclical drop. Today, participation is near its longer-run trend as estimated by a group of Fed economists whose work is widely cited on these issues.2 Some other estimates suggest that there is still a shortfall in participation, and, of course, estimates of the trend participation rate are surrounded by fairly wide bands of uncertainty. I am inclined to believe that there are potential workers at the margins of the labor market who will return as the recovery continues, the labor market tightens further and wages increase. The U.S. participation rate for workers in the 25-54 age group is now below those of most other advanced economies, including the U.K., France and Germany, for example.
The number of part-time workers who want full time work remains above pre-crisis levels, which suggests that there may be some remaining slack there as well. In addition, we should expect to see stronger wage increases as the labor market tightens. There are welcome signs of a firming in wages, seen most clearly in the data on average hourly earnings, which are rising faster than the sum of inflation and productivity growth.
After several years of improving labor market conditions, recent data have been sending mixed signals on the level of momentum in the economy. Business investment has weakened, even outside the energy sector. Growth in gross domestic product (GDP) is estimated to have slowed to a rate of only 1-1/4 percent on an annualized basis over the fourth quarter of last year and the first quarter of this year. Incoming data do point to a rebound. For example, the Atlanta Fed's GDPNow model, which bases its projection on a range of incoming monthly data, estimates growth of 2.6 percent in the second quarter. In contrast, the labor market data, especially the monthly increase in payroll jobs, after displaying considerable strength for several years right through the first quarter of 2016, weakened significantly in April and May. While I would not want to make too much of two monthly observations, the strength of the labor market has been a key feature of the recovery, allowing us to look through quarterly fluctuations in GDP growth. So the possible loss of momentum in job growth is worrisome.
Turning to the inflation part of the mandate, the Fed's preferred measure of inflation has consistently run below our 2 percent objective since the end of the financial crisis, with the exception of the "Arab Spring" period in 2011, when oil prices temporarily spiked. For the 12 months ending in April, total inflation was only 1 percent, while core inflation (excluding food and energy prices) was 1-1/2 percent. Core inflation has been held down by falling import prices, owing in large part to the rise in the dollar, as well as the indirect effects of lower oil prices. If the dollar and oil prices remain broadly stable going forward, inflation should move up over time to our 2 percent objective.
When I was first exposed to macroeconomics in college, more than four decades ago, the view was that inflation was strongly influenced by the amount of slack in the economy. But the relationship between slack and inflation has weakened substantially over the years. In addition, inflation depends importantly on the inflation expectations of workers and firms. A widely shared view among economists today is that, unlike during the 1970s, expectations are no longer heavily influenced by fluctuations in inflation, but are fairly constant, or anchored. For both these reasons, inflation has become less responsive to cyclical changes in the economy. We measure inflation expectations through surveys of forecasters and the general public, and also through market readings on inflation swaps and "breakevens," which represent inflation compensation as measured by the difference between the return offered by nominal Treasury securities and that offered by TIPS. Since mid-2014, these market-based measures have declined significantly to historically low levels. Some of this decline probably represents lower risk of high inflation, or an elevated liquidity preference for much more heavily traded nominal Treasury securities, rather than expectations of lower inflation. Some survey measures of inflation expectations have also trended down. Given the importance of expectations for determining inflation, these developments deserve, and receive, careful attention. While inflation expectations seem to me to remain reasonably well anchored, it is essential that they remain so. The only way to assure that anchoring is to achieve actual inflation of 2 percent, and I am strongly committed to that objective.
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