Although economic growth stalled in the first quarter, some slowing was expected and unseasonably harsh winter weather appears to have done the rest. The fundamental supports for a strengthening economy remain in place, and recent data seem to confirm that forecast. On the price front, I expect inflation to drift higher over the remainder of the year as the effects of some temporary factors that have been holding inflation down dissipate and the labor market continues to tighten.
If my forecast is correct, as growth strengthens and inflation drifts higher, the focus will turn to monetary policy. In particular, what will be the timing of lift-off? And when lift-off occurs, how quickly will the Federal Open Market Committee (FOMC) raise [interest] rates and to what level?
Also, with an exceptionally large balance sheet there will be considerable attention on the methods that the FOMC will likely use in order to exert control over the level of short-term rates. I can’t tell you yet how we will do it, but I am fully confident that we have the necessary tools to control the level of short-term rates and the credit-creation process. As always, what I have to say here reflects my own views and not necessarily those of the FOMC or the Federal Reserve System.
Turning first to economic activity, the trajectory of economic growth continues to disappoint. Since the downturn ended in mid-2009, real GDP growth has averaged only 2.2 percent per year despite a very accommodative monetary policy. This performance reflects three major factors — the significant headwinds resulting from the bursting of the housing bubble, the shift of fiscal policy from expansion toward restraint, especially in 2012 and 2013, and a series of shocks from abroad — most notably the European crisis.
The good news is that all three of these factors have abated. The headwinds resulting from the financial crisis are gradually becoming less severe. In particular, the sharp decline in household wealth due to the decline in housing prices and the weakness in equity prices has been largely reversed. As housing prices have climbed, the number of homes moving into the foreclosure process and the number of households with mortgages underwater have fallen sharply. Moreover, households have deleveraged their balance sheets. Debt levels have declined and lower interest rates have cut financing costs.
On the fiscal side, the amount of restraint has diminished sharply. For 2014, the projected drag is about ½ percent of GDP, roughly half the level of 2013. Moreover, much of this restraint was frontloaded into the beginning of the year, with the cessation of long-term unemployment compensation, the expiration of the bonus-depreciation provisions and the higher tax rates that applied to final tax settlements for the 2013 tax year. For the remainder of this year and next, the degree of fiscal restraint should be very modest.
In terms of the outlook abroad, the circumstances are more mixed. Although Europe is doing better, Japan is digesting the large hike in consumption taxes that was implemented on April 1, Chinese growth is slowing and some other emerging-market economies are coping with structural imbalances that are anticipated to lead to slower growth this year. One obvious wildcard is the situation in Ukraine and relations with Russia. How this will evolve is difficult to predict. The big risk is that conditions deteriorate and the ultimate outcome is a disruption to energy supplies from Russia. When all these cross-currents are considered, the impetus to growth from abroad appears little changed from last year.
Now a reasonable question would be: If the outlook is improving, then how does one explain the sharp slowdown in growth in the first quarter? My own view is that the principal factors behind the slowdown were transitory so we should not be overly concerned at this point. Some slowing in the first quarter was nearly inevitable. Foreign trade and inventories provided unsustainably large contributions to growth over the second half of last year and payback for those large gains was expected in the first quarter of this year. Also, the expiration of extended-unemployment compensation benefits and bonus depreciation at the end of the year was likely to take some of the starch out of consumer spending and business fixed investment. Beyond these anticipated factors, we had unusually harsh winter weather, which likely depressed housing activity, manufacturing production, and some aspects of household spending such as motor-vehicle purchases.
With the fundamentals of the economy improving and fiscal drag abating, I expect the economy to get back on to a roughly 3 percent growth trajectory over the remainder of this year, with some further strengthening likely in 2015. But, there remains considerable uncertainty about that forecast and, given the persistent over-optimism about the growth outlook by Federal Reserve officials and others in recent years, we shouldn’t count our chickens before they hatch.
Business fixed investment and housing are two key areas where activity has been disappointing. They need to kick in more forcefully for the economy to grow at an above trend rate for a sustained period.
Inflation
On the outlook for prices, I think that inflation will drift upwards over the next year, getting closer to the FOMC’s 2 percent objective for the personal-consumption expenditure (PCE) deflator. Some of the factors holding down inflation — such as the cut in Medicare-reimbursement rates last April — were one-offs and are now dropping out of the year-over-year figures. In some other areas, such as owners’ equivalent rent, price pressures look likely to firm somewhat.
That said, I see little prospect of inflation climbing sharply over the next year or two. There still are considerable margins of excess capacity available in the economy — especially in the labor market — that should moderate price pressures. Most notably, the trend of labor compensation is running at only about a 2 percent annualized pace. This is far below the roughly 3½ percent pace that would be consistent with trend productivity growth of 1 to 1½ percent and the FOMC’s 2 percent inflation objective.
I think there is some confusion as to whether the FOMC’s 2 percent inflation objective is a ceiling or not. My own view is that 2 percent is definitely not a ceiling. Once we reach 2 percent, I would expect that we would spend as much time slightly above 2 percent as below it, recognizing that we will hardly ever be exactly at 2 percent because of the inherent volatility in prices. If inflation were to drift above 2 percent, all else equal, then we would tend to resist such a rise. But, if inflation were slightly above 2 percent even as unemployment remained far above levels consistent with maximum employment, then the unemployment consideration would dominate because we would be further from the unemployment objective than we are from the inflation objective. This should not surprise anyone. This is what our “balanced approach” implies.
Given my outlook for above-trend growth and inflation gradually drifting higher, the inevitable question is what this means for the monetary-policy outlook. Over the near-term, if circumstances evolve relatively close to my forecast, I would continue to favor gradually reducing the pace of asset purchases [also called quantitative easing or QE] by staying on the same glide path of a $10 billion reduction in the monthly purchase pace following each FOMC meeting.
Assuming asset purchases end sometime this fall, the focus will shift to the timing of lift-off, the pace of [interest-rate] tightening once lift-off occurs and where short-term rates are ultimately headed over the longer-term. The issue of how the Fed will manage its balance sheet will also be relevant, as well as how monetary policy will be conducted during a period when the amount of excess reserves in the banking system is unusually large.
We currently anticipate that a considerable period will elapse between the end of asset purchases and lift-off, but precisely how long is difficult to say given the inherent uncertainties surrounding the outlook. If the economy is stronger than expected, causing the excess slack in the labor market to be absorbed sooner and inflation to rise more quickly than forecasted, then lift-off is likely to be pulled forward in time. If, instead, economic growth disappoints, inflation stays unusually low and the labor market continues to exhibit evidence of considerable excess slack, then lift-off will likely be pushed back.
Regarding the trajectory of rates after lift-off, this also is highly dependent on how the economy evolves. My current thinking is that the pace of tightening will probably be relatively slow. This depends, however, in large part, not only on the economy’s performance, but also on how financial conditions respond to tightening. After all, monetary policy works through financial conditions to affect aggregate demand and supply. If the response of financial conditions to tightening is very mild — say similar to how the bond and equity markets have responded to the tapering of asset purchases since last December — this might encourage a somewhat faster pace. In contrast, if bond yields were to move sharply higher, as was the case last spring, then a more cautious approach might be warranted.
In terms of the level of rates over the longer-term, I would expect them to be lower than historical averages for three reasons. First, economic headwinds seem likely to persist for several more years. While the wealth loss following the financial crisis has largely been reversed, the Great Recession has scarred households and businesses — this is likely to lead to greater precautionary saving and less investment for a long time. Also, as noted earlier, headwinds in the housing area seem likely to dissipate only slowly.
Second, slower growth of the labor force due to the aging of the population and moderate productivity growth imply a lower potential real GDP growth rate as compared to the 1990s and 2000s. Because the level of real equilibrium interest rates appears to be positively related to potential real GDP growth, this slower trend implies lower real equilibrium interest rates even after all the current headwinds fully dissipate.
Third, changes in bank regulation may also imply a somewhat lower long-term equilibrium rate. Consider that, all else equal, higher capital requirements for banks imply somewhat wider intermediation margins. While higher capital requirements are essential in order to make the financial system more robust, this is likely to push down the long-term equilibrium federal-funds rate somewhat.
Putting all these factors together, I expect that the level of the federal-funds rate consistent with 2 percent PCE inflation over the long run is likely to be well below the 4¼ percent average level that has applied historically when inflation was around 2 percent. Precisely how much lower is difficult to say at this point.
The fact that the equilibrium real federal-funds rate is likely to be lower for a long time underscores the need for caution in applying the benchmark Taylor Rule as a guide to the appropriate stance of monetary policy. As typically applied, the Taylor Rule assumes an equilibrium real rate of interest of 2 percent. This seems much too high in the current economic environment in which headwinds persist, and somewhat too high even when these headwinds fully dissipate.
[In conclusion,] we need an economy that is strong enough to more fully utilize the nation’s labor resources and to begin to push inflation back towards the Federal Reserve’s long-term objective. Only then can the monetary policy normalization process proceed. Although we are making progress towards our goals, we still have a considerable way to go.
William C. Dudley is president and CEO of the Federal Reserve Bank of New York. This viewpoint article is drawn and edited down from the prepared remarks for a speech that Dudley delivered on May 20 to the New York Association for Business Economics in New York City.