The U.S. Economic Outlook & the Implications for Monetary Policy

The U.S. economy — supported by solid gains in household spending has expanded at a moderate rate in 2016. Job gains have been sturdy, and we have seen some firming in wage growth as the labor market has continued to tighten. Moreover, as the effects of earlier declines in energy prices have dissipated, the overall inflation rate has begun to move up closer to our 2 percent objective. As a consequence, economic conditions are not far from the Federal Reserve’s dual mandate of maximum sustainable employment and price stability. And, I expect that we will make further progress toward these goals in 2017. So, from a cyclical perspective, the economy is in reasonably good shape.

Over the longer term, however, the U.S. economy faces significant challenges. On the positive side, economic expansions don’t die of old age, and there appear to be few imbalances in the economy that could lead to the current expansion ending. But, for this to remain the case, it is important that fiscal policy and monetary policy are well-aligned going forward.

It is also important that the U.S. retains sufficient fiscal capacity so that fiscal policy can support the economy when the next cyclical downturn does occur. If fiscal policy can play a greater role in promoting macroeconomic stability, it would likely reduce the need for monetary authorities to take extraordinary actions to support economic activity.

There are other structural issues worth noting. Productivity growth has been anemic over the past few years, while income inequality has increased and income mobility remains low. Consequently, the gains in living standards generated by the current business expansion have been modest compared to previous expansions, and these gains have not been widely shared. Much more could be done both locally and nationally to increase the economy’s potential to perform better for a broader array of our citizens.

The outlook for growth and inflation
The U.S. economy has been expanding at a moderate rate. Growth has averaged about 1.8 percent this year and seems likely to continue at or slightly above this pace in 2017. The main driver of growth in 2016 has been the consumer, as real personal-consumption expenditures have increased at a 2.9 percent annual rate during the first three quarters. This solid consumption growth has been supported by sturdy job gains and rising nominal wages. Payroll gains have averaged about 180,000 per month this year. While this is down somewhat from 2015’s monthly pace of nearly 230,000, it is still considerably higher than the 75,000 to 110,000 monthly pace consistent with the likely long-term growth in the labor force. And wage gains, while still relatively muted, have begun to rise more rapidly as the labor market has continued to tighten.

Another positive factor for the economy is that household finances generally are in good shape. The household savings rate is 5.9 percent, which is a bit higher than one would expect based on historical relationships between household net worth and disposable income. And, after a long period of deleveraging, household debt has been growing, but very slowly. Over the last four quarters, household debt has risen by 2.4 percent. This slow pace, combined with low borrowing rates and an improving labor market, has pushed down the ratio of household debt service to income close to its lowest level since at least 1980. This suggests that households have the financial capacity to sustain their spending.

In contrast to consumer spending, many other areas of the economy have been considerably softer. Residential investment, after experiencing strong gains in 2015 and in the first quarter of 2016, fell during the past two quarters. However, increases in single-family housing starts and permits in October suggest that we are likely to see a reversal of this trend in the fourth quarter and into next year.

Business fixed investment has also been weak for some time. Part of this weakness reflects the collapse in oil and gas drilling activity following the plunge in crude oil prices during the second half of 2014. This adjustment now appears to be over, as oil and gas prices have recovered somewhat. But, even outside of this area, business fixed investment has been disappointing. Several factors may be at play here, including earlier uncertainty surrounding the presidential-election outcome and the fact that capacity-utilization rates remain unusually low at this point in the economic business cycle. While the election uncertainty has been resolved, I would expect business fixed investment to only rise slowly in the year ahead. 

In contrast, the trade sector has performed surprisingly well in 2016. This sector had to contend with headwinds created by weak growth in final demand by our major foreign trading partners, as well as the impact of earlier dollar strength on the nation’s export competitiveness. However, I’m not sure that I would take much signal from this performance. The improvement in trade seems to have been driven mainly by weakness in imports, particularly for capital goods, and by some one-off factors, such as the surge in soybean exports last quarter — both of which are unlikely to continue.

On inflation, we are making progress in pushing toward our 2 percent objective. Headline inflation has risen this year as the earlier declines in energy prices have dropped out of the year-over-year figures. And, core inflation has remained broadly steady, running at 1.7 percent over the past year — as measured by the personal consumption expenditures deflator that excludes food and energy. This stability is noteworthy, because one might have anticipated that lower energy prices and a firmer dollar would have pushed core inflation a bit lower. Also, household inflation expectations — which at times in 2015 appeared to be at risk of becoming unanchored to the downside — have been broadly stable. The University of Michigan long-term inflation expectations measure has generally remained in the 2.5 to 2.8 percent range of recent years. In addition, the New York Fed’s Survey of Consumer Expectations measure of 3-year median inflation expectations has stabilized in 2016 in a range of 2.5 to 2.8 percent, after declining modestly over the course of 2014 and 2015.

Implications for monetary policy
If the economy grows at a pace slightly above its sustainable long-term rate, as I expect, the labor market should gradually tighten further, and the resulting pressure on resources should help push inflation toward our 2 percent objective over the next year or two. Assuming the economy stays on this trajectory, I would favor making monetary policy somewhat less accommodative over time by gradually pushing up the level of short-term interest rates.

Following this year’s election, we have seen relatively large movements in financial asset prices. The stock market has firmed, bond yields have risen, and the dollar has appreciated. On balance, it appears that financial market conditions have tightened modestly. My personal interpretation of these developments is that market participants now anticipate that fiscal policy will turn more expansionary and that the Federal Open Market Committee (FOMC) will likely respond by tightening monetary policy a bit more quickly than previously anticipated. Assuming this expectation is realized, the recent modest tightening in financial-market conditions seems broadly appropriate.

Let me emphasize here that I do not view the recent shift in financial-market conditions as one that should prompt great concern. It is important to distinguish between a tightening of financial conditions that is driven by an increase in risk aversion from one that is driven by a greater likelihood of stronger near-term aggregate demand and less downside risk to the growth outlook. We experienced the former at the beginning of 2016, while the latter reflects current expectations of greater fiscal-policy stimulus.

Obviously, there is still considerable uncertainty about how fiscal policy will evolve over the next few years. At this juncture, it is premature to reach firm conclusions about what will likely occur. As we get greater clarity over the coming year, I will update my assessment of the economic outlook and, with that, my views about the appropriate stance of monetary policy.

William C. Dudley is president and CEO of the Federal Reserve Bank of New York. This viewpoint is an excerpt from his speech remarks, as prepared for delivery, at the Dec. 5 Association for a Better New York (ABNY) Breakfast at the Roosevelt Hotel in New York City. He said the remarks express his own views and not necessarily those of the FOMC or the Federal Reserve System. Jonathan McCarthy, Paolo Pesenti, and Joseph Tracy assisted in preparing these remarks.