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 inflation-adjusted 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 Market-based 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.
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
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.