NEWS Release - Governor Lael Brainard At the Chicago Council on Global Affairs, Chicago, Illinois September 12, 2016
The "New Normal" and What It Means for Monetary Policy
In the months ahead, my colleagues and I will continue to assess what policy path will best promote the sustained attainment of our goals. With that in mind, I would like to start by describing the contours of today's economy that will be particularly important in shaping the appropriate path of policy before reviewing recent developments.
These contours represent noteworthy departures from the "old normal" that prevailed in the decades prior to the financial crisis. I would argue that policy today must rely less on the old normal as a guidepost and instead be sensitive to the contours that shape today's "new normal."1
Key Features of the "New Normal"
Because monetary policy is forward looking, policymakers must assess how key features of the economic environment are most likely to influence the future path of the economy and shape policy accordingly. At a time when our assessment of the economy is evolving, several features of the "new normal"--some of which are interrelated--appear particularly noteworthy for our policy deliberations:
1. Inflation Has Been Undershooting, and the Phillips Curve Has Flattened
First, for the past several decades, policymakers relied on the empirical relationship between unemployment and inflation embodied in the Phillips curve as a key guidepost for monetary policy. The Phillips curve implied that as labor market slack diminished and the economy approached full employment, upward pressure on inflation would result. However, since 2012, inflation has tended to change relatively little--both absolutely and relative to earlier decades--as the unemployment rate has fallen considerably.2 At a time when the unemployment rate has fallen from 8.2 percent to 4.9 percent, inflation has undershot our 2 percent target now for 51 straight months.3 In other words, the Phillips curve appears to be flatter today than it was previously.
With the Phillips curve appearing to be a less reliable guidepost than it has been in the past, the anchoring role of inflation expectations remains critically important. On expected similar to realized inflation, recent developments suggest some reasons to be concerned more about undershooting than overshooting. Although some survey measures have remained well anchored at 2 percent, consumer surveys have moved to the lower end of their historical ranges and have not risen sustainably.4 Meanwhile, market‑based measures of inflation compensation have declined noticeably over the past two years at longer-term horizons, and have shown little improvement despite the recent stabilization in the price of oil and the exchange rate. Thus, we cannot rule out that the sustained period of undershooting the inflation target along with global disinflationary pressures are weighing on inflation expectations.
Recognition of these developments is reflected in the evolution of the forecasts of Federal Open Market Committee (FOMC) participants in the Summary of Economic Projections (SEP) from June 2012 to June 2016. The SEP forecasts have shown repeated mark downs of the central tendency of the projection for core PCE (personal consumption expenditures) inflation, and the attainment of 2 percent at the upper end of the range has been pushed out repeatedly from 2012 initially to 2017 most recently.
The apparent flatness of the Phillips curve together with evidence that inflation expectations may have softened on the downside and the persistent undershooting of inflation relative to our target should be important considerations in our policy deliberations. In particular, to the extent that the effect on inflation of further gradual tightening in labor market conditions is likely to be moderate and gradual, the case to tighten policy preemptively is less compelling.
2. Labor Market Slack Has Been Greater than Anticipated
Second, and related, although we have seen important progress on employment, this improvement has been accompanied by evidence of greater slack than previously anticipated. This uncertainty about the true state of the economy suggests we should be open to the possibility of material further progress in the labor market. Indeed, with payroll employment growth averaging 180,000 per month this year, many observers would have expected the unemployment rate to drop noticeably rather than moving sideways, as it has done. It is true that today's unemployment rate of 4.9 percent is only 0.1 percentage point from the median SEP participant's estimate of the longer-run level of unemployment. However, the natural rate of unemployment is uncertain and can vary over time. Indeed, in the SEP, the central tendency of the projection for the longer-run natural rate of unemployment has come down significantly, from a range of 5.2 to 6.0 percent in June 2012 to 4.7 to 5.0 percent in June 2016--a reduction of 1/2 to 1 percentage point.5We cannot rule out that estimates of the natural unemployment rate may move even lower.
In addition, the unemployment rate is not the only gauge of labor market slack, and other measures have been suggesting there is some room to go. The share of employees working part time for economic reasons, for example, has remained noticeably above its pre-crisis level. Of particular significance, the prime-age labor force participation rate, despite improvement this year, remains about 1‑1/2 percentage points below its pre-crisis level, suggesting room for further gains. While it is possible that the current low level of prime-age participation reflects ongoing pre-crisis trends, we cannot rule out that it reflects a lagged and still incomplete response to a very slow recovery in job opportunities and wages.6
This possibility is reinforced by the continued muted recovery in wage growth. Although wage growth has picked up to about a 2-1/2 percent pace in recent quarters, this pace is only modestly above that which prevailed over much of the recovery and well below growth rates seen prior to the financial crisis.7
My main point here is that in the presence of uncertainty and the absence of accelerating inflationary pressures, it would be unwise for policy to foreclose on the possibility of making further gains in the labor market.
3. Foreign Markets Matter, Especially because Financial Transmission is Strong
Third, disinflation pressure and weak demand from abroad will likely weigh on the U.S. outlook for some time, and fragility in global markets could again pose risks here at home.8 In Europe, recovery continues, but growth is slow and inflation is very low. Low growth and a flat yield curve are contributing to reduced profitability and a higher cost of equity financing for banks, which in turn could impair bank lending, one of the main transmission channels of monetary policy in the euro area's bank-centric financial system. A low growth, low inflation environment also makes progress on fiscal sustainability difficult and leaves countries with high debt-to-gross domestic product (GDP) ratios vulnerable to adverse demand shocks. Against this backdrop, uncertainty about Britain's future relationship with the European Union could damp business sentiment and investment in Europe.
Japan remains greatly challenged by weak growth and low inflation. Indeed, it is striking that despite active and creative monetary policies in both the euro area and Japan, inflation remains below target levels. The experiences of these economies highlight the risk of becoming trapped in a low-growth, low-inflation, low-inflation-expectations environment and suggest that policy should be oriented toward minimizing the risk of the U.S. economy slipping into such a situation.
Downside risks are also present in emerging market economies, where growth has slowed rapidly in recent years.9 Most importantly, China is undergoing a challenging transition from a growth model based on investment, exports, and debt-fueled state-owned enterprises to one driven by consumption, services, and dynamic private businesses. Because of the adjustment costs along this transition path and demographic trends, Chinese growth will likely continue to slow. Given that China has experienced very high growth in corporate debt, this downshift could pose risks. Importantly, Chinese authorities have made some progress on clarifying their policy stance, and capital outflows have slowed in recent months. Nonetheless, considerable uncertainty remains, and further volatility cannot be ruled out. The importance of Chinese growth and stability to many emerging market economies and to global markets more broadly implies that these risks have global implications.
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