Participants' Views on Current Conditions and the Economic Outlook
In their discussion of the economic situation and the outlook, meeting participants regarded the information received over the intermeeting period as indicating that economic activity had been expanding at a solid pace. Although growth likely slowed from the rapid rate recorded for the third quarter of 2014, a variety of indicators suggested that real GDP continued to grow faster than potential GDP late in the year and during January. Labor market conditions improved further, with strong job gains and a lower unemployment rate; participants judged that the underutilization of labor resources was continuing to diminish. Participants expected that, over the medium term, real economic activity would increase at a moderate pace sufficient to lead to further improvements in labor market conditions toward levels consistent with the Committee's objective of maximum employment. Inflation had declined further below the Committee's longer-run objective, largely reflecting declines in energy prices, and was anticipated to decline further in the near term. Market-based measures of inflation compensation 5 to 10 years ahead had registered a further decline, while survey-based measures of longer-term inflation expectations remained stable. Participants generally anticipated that inflation would rise gradually toward the Committee's 2 percent objective as the labor market improved further and the transitory effects of lower energy prices and other factors dissipated. The risks to the outlook for economic activity and the labor market were seen as nearly balanced. Participants generally regarded the net effect of the recent decline in energy prices as likely to be positive for economic activity and employment. Many participants continued to judge that a deterioration in the foreign economic situation could pose downside risks to the outlook for U.S. economic growth. Several saw those risks as having diminished over the intermeeting period, with lower oil prices and actions of foreign central banks both being supportive of growth abroad, but others pointed to heightened geopolitical and other risks.
With respect to the U.S. economy, participants noted that household spending was rising moderately. Recent declines in oil prices, which had boosted household purchasing power, were among the factors likely to underpin consumer spending in coming months; other factors cited as supporting household spending included low interest rates, easing credit standards, and continued gains in employment and income. However, it was noted that the recovery in the housing sector remained slow and that tepid nominal wage growth, if continued, could become a significant restraining factor for household spending.
Industry contacts pointed to generally solid business conditions, with businesses in many parts of the country continuing to express optimism about prospects for further improvement in 2015. Although manufacturing activity appeared to have slowed somewhat over the intermeeting period in some regions, business contacts suggested that this slowing was likely to prove temporary, and information from some parts of the country suggested that capital investment was poised to pick up. Several participants noted that there were signs of layoffs in the oil and gas industries, and that persistently low energy prices might prompt a larger retrenchment of employment in these industries. In addition, it was observed that if capital investment in energy-producing industries slowed significantly, it could damp the overall expansion of economic activity for a period, especially if the slowing took place after most of the positive effects of lower energy prices on growth in household spending had occurred. A few participants observed that government spending was unlikely to be a major contributor to the expansion of demand in the period ahead, with real federal purchases projected to be fairly flat over the medium term.
In their discussion of the foreign economic outlook, participants noted that a number of developments over the intermeeting period had likely reduced the risks to U.S. growth. Accommodative policy actions announced by a number of foreign central banks had likely strengthened the outlook abroad. The decline in energy prices was also seen as potentially exerting a stronger-than-anticipated positive effect on growth in the domestic economy and abroad. However, the increase in the foreign exchange value of the dollar was expected to be a persistent source of restraint on U.S. net exports, and a few participants pointed to the risk that the dollar could appreciate further. In addition, the slowdown of growth in China was noted as a factor restraining economic expansion in a number of countries, and several continuing risks to the international economic outlook were cited, including global disinflationary pressure, tensions in the Middle East and Ukraine, and financial uncertainty in Greece. Overall, the risks to the outlook for U.S. economic activity and the labor market were seen as nearly balanced.
Participants noted that inflation had moved further below the Committee's longer-run objective, largely reflecting declines in energy prices and other transitory factors. A number of participants observed that, with anchored inflation expectations, the fall in energy prices should not leave an enduring imprint on aggregate inflation. It was pointed out that the recent intensification of downward pressure on inflation reflected price movements that were concentrated in a narrow range of items in households' consumption basket, a pattern borne out by trimmed mean measures of inflation. Several participants remarked that inflation measures that excluded energy items had also moved down in recent months, but these declines partly reflected transitory factors, including downward pressure on import prices and the pass-through of lower energy costs to the prices of non- energy items. Nonetheless, several participants saw the continuing weakness of core inflation measures as a concern. In addition, a few participants suggested that the weakness of nominal wage growth indicated that core and headline inflation could take longer to return to 2 percent than the Committee anticipated. In contrast, a couple of participants suggested that nominal wage growth provides little information about the future behavior of price inflation. Participants also discussed the possibility that, because of the infrequent occurrence of reductions in nominal wages, wages may not have fully adjusted downward in the period of high unemployment, and therefore pent-up wage deflation might have weighed on wage gains for a time during the expansion. If this was the case, nominal wage growth could be expected to pick up in coming periods and to resume a more normal relationship with labor market slack. Most participants expected that continuing reductions in resource slack would be helpful in returning inflation over the medium term to the Committee's 2 percent longer-run objective, but a few participants voiced concern that nominal wage growth might rise rapidly and inflation might exceed 2 percent for a time.
Participants discussed the sizable decline in market-based measures of inflation compensation that had been observed over the past year and continued over the intermeeting period. A number of them judged that the decline mostly reflected a reduction in the risk premiums embedded in nominal interest rates rather than a decline in inflation expectations; this interpretation was supported by results of some analytical models used to decompose movements in market-based measures of inflation compensation and also by the continuing stability of survey-based measures of inflation expectations. However, other participants put some weight on the possibility that the decline in inflation compensation reflected a reduction in expected inflation. These participants further argued that the stability of survey-based measures of inflation expectations should not be taken as providing much reassurance; in particular, it was noted that in Japan in the late 1990s and early 2000s, survey-based measures of longer-term inflation expectations had not recorded major declines even as a disinflationary process had become entrenched. In addition, a few participants argued that even if the shift down in inflation compensation reflected lower inflation risk premiums rather than reductions in expected inflation, policymakers might still want to take that decline into account because it could reflect increased concern on the part of investors about adverse outcomes in which low inflation was accompanied by weak economic activity. Participants generally agreed that the behavior of market-based measures of inflation compensation needed to be monitored closely.
Participants also discussed other aspects of the substantial decline in nominal longer-term interest rates and its implications. The fall had occurred despite the strengthening U.S. economic outlook and market expectations that policy normalization could begin later this year. Some participants suggested that shifts of funds from abroad into U.S. Treasury securities may have put downward pressure on term premiums; the shifts, in turn, may have reflected in part a reaction to declines in foreign sovereign yields in response to actual and anticipated monetary policy actions abroad. A couple of participants noted that the reduction in longer-term real interest rates tended to make U.S. financial conditions more accommodative, potentially calling for a somewhat higher path for the federal funds rate going forward. Others observed that insofar as the shifts reflected concerns about growth prospects abroad or were accompanied by a stronger dollar, the implications for U.S. monetary policy were less clear. It was further noted that investment flows from abroad could also be contributing to the decline in TIPS-based measures of inflation compensation, as such flows tend to be concentrated in nominal Treasury securities rather than inflation-protected securities.
Participants saw broad-based improvement in labor market conditions over the intermeeting period, including strong gains in payroll employment and a further reduction in the unemployment rate. Some participants believed that considerable labor market slack remained, especially when indicators other than the unemployment rate were taken into account, including the unusually large fraction of the labor force working part time for economic reasons. A few observed that the combination of recent labor market improvements and continued softness in inflation had led them to lower their estimates of the longer-run normal rate of unemployment. However, a few others saw only a limited degree of remaining labor underutilization or anticipated that underutilization would be eliminated relatively soon.
Participants discussed considerations related to the choice of the appropriate timing of the initial firming in monetary policy and pace of subsequent rate increases. Ahead of this discussion, the staff gave a presentation that outlined some of the key issues likely to be involved, including the extent to which similar economic outcomes could be generated by different combinations of the date of the initial firming of policy and the pace of rate increases thereafter, how these combinations could affect the risks to economic outcomes, a review of past episodes in the United States and abroad in which monetary policy transitioned to a tightening phase after a lengthy period of low policy rates, and issues related to communications regarding the likely timing and pace of normalization.
Participants discussed the tradeoffs between the risks that would be associated with departing from the effective lower bound later and those that would be associated with departing earlier. Several participants noted that a late departure could result in the stance of monetary policy becoming excessively accommodative, leading to undesirably high inflation. It was also suggested that maintaining the federal funds rate at its effective lower bound for an extended period or raising it rapidly, if that proved necessary, could adversely affect financial stability. Some participants were concerned that a decision to delay the commencement of tightening could be perceived as indicating that an overly accommodative policy is likely to prevail during the firming phase. In connection with the risks associated with an early start to policy normalization, many participants observed that a premature increase in rates might damp the apparent solid recovery in real activity and labor market conditions, undermining progress toward the Committee's objectives of maximum employment and 2 percent inflation. In addition, an earlier tightening would increase the likelihood that the Committee might be forced by adverse economic outcomes to return the federal funds rate to its effective lower bound. Some participants noted the communications challenges associated with the prospect of commencing policy tightening at a time when inflation could be running well below 2 percent, and a few expressed concern that in some circumstances the public could come to question the credibility of the Committee's 2 percent goal. Indeed, one participant recommended that, in light of the outlook for inflation, the Committee consider ways to use its tools to provide more, not less, accommodation.
Many participants indicated that their assessment of the balance of risks associated with the timing of the beginning of policy normalization had inclined them toward keeping the federal funds rate at its effective lower bound for a longer time. Some observed that, even with these risks taken into consideration, the federal funds rate may have already been kept at its lower bound for a sufficient length of time, and that it might be appropriate to begin policy firming in the near term. Regardless of the particular strategy undertaken, it was noted that, provided that the data-dependent nature of the path for the federal funds rate after its initial increase could be communicated to financial markets and the general public in an effective manner, the precise date at which firming commenced would have a less important bearing on economic outcomes.
Participants discussed the economic conditions that they anticipate will prevail at the time they expect it will be appropriate to begin normalizing policy. There was wide agreement that it would be difficult to specify in advance an exhaustive list of economic indicators and the values that these indicators would need to take. Nonetheless, a number of participants suggested that they would need to see further improvement in labor market conditions and data pointing to continued growth in real activity at a pace sufficient to support additional labor market gains before beginning policy normalization. Many participants indicated that such economic conditions would help bolster their confidence in the likelihood of inflation moving toward the Committee's 2 percent objective after the transitory effects of lower energy prices and other factors dissipate. Some participants noted that their confidence in inflation returning to 2 percent would also be bolstered by stable or rising levels of core PCE inflation, or of alternative series, such as trimmed mean or median measures of inflation. A number of participants emphasized that they would need to see either an increase in market-based measures of inflation compensation or evidence that continued low readings on these measures did not constitute grounds for concern. Several participants indicated that signs of improvements in labor compensation would be an important signal, while a few others deemphasized the value of labor compensation data for judging incipient inflation pressures in light of the loose short-run empirical connection between wage and price inflation.
Participants discussed the communications challenges associated with signaling, when it becomes appropriate to do so, that policy normalization is likely to begin relatively soon while remaining clear that the Committee's actions would depend on incoming data. Many participants regarded dropping the "patient" language in the statement, whenever that might occur, as risking a shift in market expectations for the beginning of policy firming toward an unduly narrow range of dates. As a result, some expressed the concern that financial markets might overreact, resulting in undesirably tight financial conditions. Participants discussed some possible communications by which they might further underscore the data dependency of their decision regarding when to tighten the stance of monetary policy. A number of participants noted that while forward guidance had been a very useful tool under the extraordinary conditions of recent years, as the start of normalization approaches, there would be limits to the specificity that the Committee could provide about its timing. Looking ahead, some participants highlighted the potential benefits of streamlining the Committee's postmeeting statement once normalization has begun. More broadly, it was suggested that the Committee should communicate clearly that policy decisions will be data dependent, and that unanticipated economic developments could therefore warrant a path of the federal funds rate different from that currently expected by investors or policymakers.