Question: What are the key challenges facing central bankers around the world today?

Narayana Kocherlakota: Thanks for the question. Before answering, I should point out that my remarks today will reflect only my own views and not necessarily those of anyone else in the Federal Reserve System.

In my view, the biggest challenge for central banks—especially here in the United States—is changes in the nature of asset demand and asset supply since 2007. Those changes are shaping current monetary policy—and are likely to shape policy for some time to come.

Let me elaborate. The demand for safe financial assets has grown greatly since 2007. This increased demand stems from many sources, but I’ll mention what I see as the most obvious one. As of 2007, the United States had just gone through nearly 25 years of macroeconomic tranquility. As a consequence, relatively few people in the United States saw a severe macroeconomic shock as possible. However, in the wake of the Great Recession and the Not-So-Great Recovery, the story is different. Workers and businesses want to hold more safe assets as a way to self-insure against this enhanced macroeconomic risk.

At the same time, the supply of the assets perceived to be safe has shrunk over the past six years. Americans—and many others around the world—thought in 2007 that it was highly unlikely that American residential land, and assets backed by land, could ever fall in value by 30 percent. They no longer think that. Similarly, investors around the world viewed all forms of European sovereign debt as a safe investment. They no longer think that either.

The increase in asset demand, combined with the fall in asset supply, implies that households and firms spend less at any level of the real interest rate—that is, the interest rate net of anticipated inflation. It follows that the Federal Open Market Committee (FOMC) can only meet its congressionally mandated objectives for employment and prices by taking actions that lower the real interest rate relative to its 2007 level. The FOMC has responded to this challenge by providing a historically unprecedented amount of monetary accommodation. But the outlook for prices and employment is that they will remain too low over the next two to three years relative to the FOMC’s objectives. Despite its actions, the FOMC has still not lowered the real interest rate sufficiently in light of the changes in asset demand and asset supply that I’ve described.

The passage of time will ameliorate these changes in the asset market, but only gradually. Indeed, the low real yields on long-term TIPS bonds suggest to me that these changes are likely to persist over a considerable period of time—possibly the next five to 10 years. If this forecast proves true, the FOMC will only meet its congressionally mandated objectives over that long time frame by taking policy actions that ensure that the real interest rate remains unusually low.

One challenge with this kind of policy environment—and this is closely linked to the overarching theme of this panel—is that low real interest rates are often associated with financial market phenomena that signify instability. There are many examples of such phenomena, but let me focus on a particularly important one: increased asset price volatility. When the real interest rate is unusually low, investors don’t discount the future by as much. Hence, an asset’s price becomes sensitive to information about dividends or risk premiums in what might usually have seemed like the distant future. These new sources of relevant information can lead to increased volatility, in the form of unusually large upward or downward movements in asset prices.

These kinds of financial market phenomena could pose macroeconomic risks. These potentialities are best addressed, I believe, by using effective supervision and regulation of the financial sector. It is possible, though, that these tools may fail to mitigate the relevant macroeconomic risks. The FOMC could respond to any residual risk by tightening monetary policy. However, it should only do so if the certain loss in terms of the associated fall in employment and prices is outweighed by the possible benefit of reducing the risk of an even larger fall in employment and prices caused by a financial crisis. Hence, the FOMC’s decision about how to react to signs of financial instability—now and in the years to come—will necessarily depend on a delicate probabilistic cost-benefit calculation.

Here’s an example of the kind of calculation that I have in mind. Last week, the Survey of Professional Forecasters reported that it saw less than one chance in 200 of the unemployment rate being higher than 9.5 percent in 2014, and an even smaller chance of the unemployment rate being that high in 2015.¹ One possible cause of this kind of a large upward movement in the unemployment rate is an untoward financial shock ultimately attributable to low real interest rates. Thus, the gain to tightening monetary policy is that the FOMC may—and I emphasize the word may—be able to reduce the already low probabilities of adverse unemployment outcomes.

To me, this kind of analysis suggests that, currently, the gains from tightening related to improving financial stability are both speculative and slight. In contrast, the losses from tightening—in terms of pushing employment and prices even further below the Federal Reserve’s goals—are both tangible and significant. I conclude that financial stability considerations provide little support for reducing accommodation at this time.

Thanks again for the question.

Endnote

My talk is about the decline in real—that is, net of inflation—interest rates since 2007. I begin by describing how, over the past six years, the demand for safe assets has grown, while the supply of those assets has shrunk. These changes in asset demand and asset supply imply that households and firms spend less at any level of real interest rates. It follows that the Federal Open Market Committee can only meet its congressionally mandated objectives for employment and prices by taking actions that greatly lower the real interest rate relative to its 2007 level. This is my first of three main messages: The FOMC should be thought of as having been forced to lower the real interest rate in order to respond appropriately to dramatic changes in asset market demand and supply.

I suggest that these dramatic changes in asset demand and asset supply are likely to persist over a considerable period of time—possibly the next five to 10 years. If that forecast holds true, it follows that the FOMC will only be able to meet its congressionally mandated objectives over that time frame by taking policy actions that ensure that the real interest rate remains unusually low. I point out that low real interest rates can be expected to be associated with financial market phenomena—like high asset price volatility—that are seen as signifying instability. This is my second main message: For many years to come, the FOMC will only be able to achieve its objectives by following policies that necessarily give rise to signs of financial market instability.

These financial market phenomena could pose macroeconomic risks. In my view, these potentialities are best addressed using effective supervision and regulation of the financial sector. It is possible, though, that these tools may only partly mitigate the relevant macroeconomic risks. The FOMC could respond to any residual risk by tightening monetary policy. However, it should only do so if the certain loss in terms of the associated fall in employment and prices is outweighed by the possible benefit of reducing the risk of an even larger fall in employment and prices caused by a financial crisis. Hence—and this is my third main message—the FOMC’s decision about how to react to signs of financial instability will necessarily depend on a delicate probabilistic cost-benefit calculation. The Committee is in a better position to make that calculation now than it was in 2007, and continues to make progress on this dimension.

Note

Introduction

Thanks for the invitation to speak at the 22nd annual Minsky conference. Professor Minsky devoted his career to emphasizing the connections between the financial sector and the real economy. It is safe to say that the events of the past decade have provided strong evidence in support of Professor Minsky’s basic belief in the importance of those connections. Indeed, as the economy continues to improve, we are beginning to hear new concerns being voiced about potential financial instability and associated risks to the macroeconomic risks. In my talk today, I will provide some perspectives on those issues.

I start by arguing that, over the past six years, we have seen dramatic changes in the demand for and supply of safe assets. Given those changes, the Federal Open Market Committee (FOMC) is only able to achieve its congressionally mandated objectives of maximum employment and price stability by keeping the real—that is, net of inflation—interest rate well below its 2007 level. I suggest that these changes in asset demand and asset supply are likely to persist over a considerable period of time—possibly the next five to 10 years. It follows that the FOMC will only be able to meet its objectives over that time frame by taking policy actions that ensure that the real interest rate remains unusually low.

I then point out that low real interest rates can be expected to be associated with financial market phenomena that are seen as signifying instability. It follows that, for many years to come, the FOMC will only be able to achieve its congressionally mandated objectives by following policies that result in signs of financial market instability.

Finally, I discuss how the FOMC should take those signs of instability into account when formulating monetary policy.

Before proceeding I need to stress that my remarks today reflect only my views and not necessarily those of any other FOMC participant.

Low Real Interest Rates (video)

Economists generally distinguish between nominal and real interest rates. The nominal interest rate is the interest rate reported on a typical savings account or mortgage. It tells you how many dollars a saver or a lender will get in the future for giving up a dollar today. The real interest rate adjusts those future dollars for the anticipated rate of price increases—that is, for the anticipated rate of inflation. This means that the real interest rate tells you how much purchasing power a saver or lender will get in the future for giving up a dollar of purchasing power today. Economists generally believe that household and businesses make savings and investment decisions based on real interest rates over the next five to 10 years.

When I was a student, back in the seventies and eighties, the real interest rate was a somewhat mysterious unobservable object. That’s no longer true. Treasury inflation-protected securities—bonds that are colloquially called TIPS—make coupon payments that are indexed to the inflation rate. This indexation means that TIPS coupon payments provide a fixed amount of purchasing power to the bondholder, not a fixed amount of dollars. As a result, TIPS yields provide a useful measure of the real interest rate.

When we look at TIPS yields, we see that real interest rates have fallen dramatically over the past six years. In the first half of 2007, five-year TIPS bonds had a real yield of about 2.5 percent and 10-year TIPS bonds also had a real yield of about 2.5 percent. Now jump forward to 2013. The five-year real TIPS yield is around negative 1.3 percent. Just to be clear: This means that the buyer of a five-year TIPS bond is giving up $100 of purchasing power today in exchange for around $94—six dollars less!—of purchasing power in five years. The 10-year real TIPS yield is also negative—around negative 0.7 percent.

Why have real interest rates fallen so much? At one level, the answer is obvious: monetary policy. The FOMC has announced its intention to keep the fed funds rate near zero at least until the unemployment rate falls below 6.5 percent. At the same time, the FOMC has bought over $3 trillion of longer-term assets issued or backed by the government. With inflationary expectations well anchored, these actions are designed to push downward on real interest rates and have been successful in doing so.

But I think that the obvious monetary policy answer is actually deeply misleading. Consider the following, very Minnesota, analogy. Some days during the year when I go outside, I wear a parka. Other days, I wear a light jacket. And—this will seem hard to believe—on some other days, I don’t need a coat at all.

Every morning, I have complete control over what kind of coat I wear—even more control than the FOMC has over real interest rates. But, of course, in making my choice of outerwear, I’m merely responding to the Minnesota weather, which is a force that is—sadly—well beyond my control. The FOMC is in exactly the same position of having to respond to strong forces well beyond its control when making its decisions about the real interest rate. Thus, when I decide what coat to wear, my goal is to keep myself at a temperature that I view as appropriate, given prevailing conditions that I cannot influence. Similarly, when the FOMC decides on a level of the real interest rate, its goal is to keep the macroeconomy at an appropriate “temperature,” given prevailing conditions that it cannot influence.¹

More concretely, the Committee is taking actions to adjust real interest rates so as to fulfill its congressional dual mandate of promoting price stability and maximum employment. Thus, suppose the economy is running too cold, in the sense that inflation is below the Committee’s 2 percent target and unemployment is elevated. Then, the FOMC can, metaphorically, put on a heavier coat—that is, lower the real interest rate to stimulate spending and economic activity.

In 2007, the FOMC had on about the right kind of coat, in the sense that the macroeconomic outlook was broadly consistent with the Committee’s objectives. The fall in TIPS yields over the past six years suggests that the FOMC has, in the language of my metaphor, put on a warmer coat by pushing down on real interest rates. Indeed, some observers have expressed the concern that the FOMC has put on too heavy a parka.

But the truth is that the FOMC’s choice of winter garb is actually insufficient to keep the U.S. economy appropriately warm. After all, the outlook for both employment and prices is too low relative to the FOMC’s goals. Unemployment is currently 7.6 percent and is expected to fall only slowly. At the same time, inflation pressures are muted: Both private sector forecasters and the FOMC expect that PCE inflation will be at or below 2 percent through 2013 and 2014. The Committee needs to put on some more serious winter gear if it is to get the economy back to the right temperature. More prosaically, the FOMC can only achieve its dual mandate objectives by lowering the real interest rate even further below its 2007 level.

What Happened? (video)

I’ve argued that the path of real interest rates that is consistent with the FOMC’s dual mandate objectives—what one might call the mandate-consistent path of real interest rates²—has fallen greatly since 2007. I now turn to a discussion of why this has happened. I see the decline in mandate-consistent real interest rates as grounded in an increase in the demand for, and a fall in the supply of, safe financial investment vehicles. Importantly, I see these changes as likely to be highly persistent.

There are many factors underlying the increased demand for safe assets. I’ll discuss three that strike me as particularly important: tighter credit access, heightened perceptions of macroeconomic risk and increased uncertainty about federal fiscal policy. In terms of credit access: I don’t think that it’s controversial to say that credit access is more limited than in 2007. What is less generally realized, I think, is that restrictions on households’ and businesses’ ability to borrow typically lead them to spend less and save more.

I can best illustrate this point through an example. Consider a household that wants to purchase a new home. In 2007, that household could have received a mortgage with a down payment of 10 percent of the purchase price, or even lower. In 2013, that same household is considerably more likely to need a down payment of 20 percent. These tighter mortgage standards mean that, to buy a similarly priced house, the household needs to first acquire more assets.

Thus, the demand for safe assets has risen because of tighter limits on credit access. It has also risen because of households’ and businesses’ assessments of macroeconomic risk. As of 2007, the United States had just gone through nearly 25 years of macroeconomic tranquility. As a consequence, relatively few workers or businesses (or macroeconomists!) in the United States saw a severe macroeconomic shock as possible.

However, in the wake of the Great Recession and the Not-So-Great Recovery, the story is different. Now, more workers see themselves as being exposed to the risk of persistent deterioration in labor incomes. More businesses see themselves as being exposed to the risk of a radical and persistent downshift in the demand for their products. These workers and businesses have an incentive to accumulate more safe assets as a way to self-insure against this enhanced macroeconomic risk.

The federal fiscal situation is another key source of elevated uncertainty. The federal government faces a long-run disconnect between its overt commitments and the baseline path of federal tax collections. This disconnect can only be resolved by raising taxes and/or cutting the long-run arc of spending.

Of course, this tension between revenues and expenditures pre-dated the 2007 downturn. However, it is at least arguable that the fiscal debates of the past few years have made more Americans aware of the uncertainties associated with resolving this long-run disconnect. And these uncertainties affect the demand for safe assets. The prospect of higher future corporate profits taxes gives businesses an incentive to demand safe short-term financial assets as opposed to engaging in long-term investments. The prospect of reductions in Medicare, Medicaid or Social Security gives some households an incentive to demand more safe assets as a way of replacing those lost potential benefits.

I’ve argued that, due in part to tighter credit access and higher uncertainty, the demand for safe financial assets has risen since 2007. At the same time, the global supply of assets perceived as safe has also fallen. Americans—and many others around the world—thought in 2007 that it was highly unlikely that American residential land, and assets backed by land, could ever fall in value by 30 percent. Not anymore. Similarly, investors around the world viewed all forms of European sovereign debt as a safe investment. Not anymore.

Thus, the FOMC is confronted with a greater demand for safe assets and tighter supply of safe assets than in 2007. These changes in asset markets mean that, at any given level of real interest rates, households and businesses spend less. Their decline in spending pushes down on both prices and employment. As a result, the FOMC has to lower the real interest rate to achieve its objectives.³

I often hear that the FOMC has created a low interest rate environment that is harmful for savers and others. But, to return to my winterwear analogy, that seems about as compelling as blaming me for creating winter in Minnesota by putting on my long johns. The FOMC has been confronted with wintry changes in asset demand and supply. It has lowered the real interest rate to keep the economy “warmer” in light of these changes. Indeed, as I argued earlier, the weak macroeconomic outlook suggests that the FOMC has in fact not put on a warm enough coat—that is, it has not lowered the real interest rate sufficiently.

What about the future? The passage of time will ameliorate these changes in the demand for and supply of safe assets—but only partially. Any long-run forecast has enormous attendant uncertainties. But I expect that for a considerable period of time—possibly the next five to 10 years—credit market access will remain limited relative to what borrowers had available in 2007. I expect that many workers and businesses will remain more concerned than in 2007 about the risk of a large adverse recessionary shock. And I also expect that businesses will continue to feel a heightened degree of uncertainty about taxes and households will continue to feel a heightened degree of uncertainty about the level of federal government benefits. These considerations suggest that, for many years to come, the FOMC will have to maintain low real interest rates to achieve its congressionally mandated goals.

Financial Market Outcomes Associated with Low Real Interest Rates (video)

I have argued that, for some time to come, the FOMC will only be able to achieve its dual mandate outcomes if the time path of real interest rates is lower than in 2007. Indeed, remember that in 2013, the mandate-consistent real interest rate over the next 10 years is at least three full percentage points lower than it was in 2007. It seems likely that the mandate-consistent time path of real interest rates could be unusually low for a considerable period of time.Moreover, these unusually low real interest rates will likely be associated with other unusual financial market outcomes. I’ll discuss three of these outcomes in some detail: inflated asset prices, unusually volatile asset returns and high merger activity.

The first consequence of low real interest rates that I mentioned—higher asset prices—is the most obvious. Long-lived assets are somewhat substitutable for each other. Hence, investors generally respond to low real TIPS yields by bidding up the price of other long-lived assets—including gold, land, stocks or machines. It follows that when real interest rates are unusually low by historical norms, asset prices will typically be unusually high relative to historical norms.

The second consequence of low real interest rates is that asset returns should be expected to be highly volatile. When the real interest rate is very high, only the near term matters to investors. Hence, variations in an asset’s price only reflect changes in investors’ information about the asset’s near-term dividends or risk premiums. But when the real interest rate is unusually low, then an asset’s price will become correspondingly sensitive to information about dividends or risk premiums in what might seem like the distant future. This new source of relevant information should be expected to induce more variability into asset prices and returns.⁴

Finally, I believe that when real interest rates are low, we should expect to see more mergers. Mergers typically involve enduring current costs in exchange for a flow of future benefits. For example, to initiate the merger, the acquiring firm has to search for an appropriate target, and that search can be costly. As well, after the merger, it may be necessary to undertake a one-time costly reorganization of people and materiel to achieve the anticipated gains in revenue. Businesses will be more willing to pay the upfront costs of a merger in exchange for the anticipated flow of future benefits associated with the merger if the real interest rate is low.⁵

In this way, unusually low real interest rates should be expected to be linked with inflated asset prices, high asset return volatility and heightened merger activity. All of these financial market outcomes are often interpreted as signifying financial market instability. And this observation brings me to a key conclusion. I’ve suggested that it is likely that, for a number of years to come, the FOMC will only achieve its dual mandate of maximum employment and price stability if it keeps real interest rates unusually low. I’ve also argued that when real interest rates are low, we are likely to see financial market outcomes that signify instability. It follows that, for a considerable period of time, the FOMC may only be able to achieve its macroeconomic objectives in association with signs of instability in financial markets.

Financial Stability and Monetary Policy (video)

These financial market phenomena could pose macroeconomic risks. In my view, these potentialities are best addressed through effective supervision and regulation of the financial sector. It is possible, though, that these tools may only partially mitigate the relevant macroeconomic risks. How, if at all, should the FOMC adapt monetary policy in response to any residual risk?

To answer this question, the Committee will need to confront an ongoing probabilistic cost-benefit calculation. On the one hand, raising the real interest rate will definitely lead to lower employment and prices. On the other hand, raising the real interest rate may reduce the risk of a financial crisis—a crisis which could give rise to a much larger fall in employment and prices. Thus, the Committee has to weigh the certainty of a costly deviation from its dual mandate objectives against the benefit of reducing the probability of an even larger deviation from those objectives.

This probabilistic cost-benefit calculation is conceptually challenging today and will remain so for some time to come. However, it is important to stress that the Committee is in a better position to address this challenge in 2013 than it was in 2007. The Federal Reserve System now dedicates a significant amount of our best staff resources to financial system surveillance. The Federal Reserve Bank of Minneapolis contributes to these efforts in a number of ways, including our ongoing monitoring of the risk-neutral probability distributions of future asset values.⁶ As a result of these efforts, the FOMC has a lot more information, on an ongoing basis, about the extent of financial system risks.

Nonetheless, as always, there is more to be learned. We need to understand better, in light of the current state of supervision and regulation, which residual financial system risks have the potential to translate into macroeconomic risks. And we need to understand better to what extent monetary policy tightening can in fact temper those residual financial system risks.

Conclusions

Let me wrap up.

Over the past six years, there have been big changes in the demand and supply of safe assets. These changes seem likely to be persistent ones, and they mean that the FOMC may keep real interest rates unusually low for years to achieve its objectives of maximum employment and price stability.

Thanks for listening. I look forward to taking your questions.

Note

Endnotes

References

Campbell, John Y., and Robert J. Shiller. 1988. The Dividend-Price Ratio and Expectations of Future Dividends and Discount Factors. Review of Financial Studies 1 (3): 195-228.

Cochrane, John H. 1992. Explaining the Variance of Price-Dividend Ratios. Review of Financial Studies 5 (2): 243-80.

Kocherlakota, Narayana R. 2012. Incomplete Labor Markets. Federal Reserve Bank of Minneapolis working paper.

Moran, P. 2013. Anticipation and Timing in Merger Waves. University of British Columbia working paper.

Thank you for that generous introduction, and thank you for the invitation to join you here today. It’s a pleasure to be here and to share my thoughts on the prospects for the economy and the role of monetary policy going forward. But as you will hear in a minute, I am also interested in your thoughts on the state of the economy and in your questions about Federal Reserve policy. So I look forward to our discussion following my talk.

In my remarks today, I’ll first provide some background about the Federal Reserve. I’ll then describe the current stance of monetary policy. I’ll discuss the macroeconomic outlook for the next couple of years implied by that monetary policy stance. Finally, I’ll offer my assessment of the appropriateness of monetary policy in light of that outlook.

But first—a disclaimer. I’m one of the 19 people who have the privilege and honor to participate in the meetings of what’s called the Federal Open Market Committee. FOMC meetings shape the course of monetary policy in the United States. But it’s very important to understand that my remarks today are only my views and not necessarily those of any other FOMC participant.

Federal Reserve Structure

Let me begin with some basics about the Federal Reserve System. The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our bank represents the ninth of the 12 Federal Reserve districts and includes Montana, the Dakotas, Minnesota, northwestern Wisconsin and the Upper Peninsula of Michigan.

Eight times per year, the Federal Open Market Committee—the FOMC—meets to set the path of short-term interest rates over the next six to seven weeks. All 12 presidents of the various regional Federal Reserve banks—including me—and the seven governors of the Federal Reserve Board contribute to these deliberations. However, the Committee itself consists only of the governors, the president of the Federal Reserve Bank of New York and a rotating group of four other presidents. I won’t be on the Committee in 2013, but will be next year. In this way, the structure of the FOMC mirrors the federalist structure of our government, because representatives from different regions of the country—the various presidents—have input into FOMC deliberations.

Congress requires the FOMC to make monetary policy so as to fulfill two mandates: promote price stability and promote maximum employment. Promoting maximum employment means that the Fed is charged with doing what it can to ensure that Americans who want to work can do so. Promoting price stability means that the Federal Reserve is charged with keeping inflation close to a pre-specified target. Price stability ensures that, when people write contracts in terms of dollars like student loans or annuities, they can have certainty about what those dollars will be able to buy in the future.

Now, in describing price stability, I’ve made reference to a pre-specified target for inflation. I haven’t said what the pre-specified inflation target is. In choosing its inflation target, the FOMC weighed the costs of overly high inflation against the need to guard against potentially destructive deflationary spirals. This assessment has led the FOMC to choose an inflation target of 2 percent. Similarly, most central banks around the world have opted for a low but still positive inflation target.

The FOMC acts to achieve its two mandates—maximum employment and price stability—by influencing interest rates through the purchase and sale of financial assets. When the FOMC raises interest rates, households and firms tend to spend less and save more. The fall in spending puts downward pressure on both employment and prices. Similarly, when the FOMC lowers interest rates, households and firms tend to spend more and save less. This puts upward pressure on employment and prices.

However, these pressures on employment and prices from lower interest rates are not felt immediately. Instead, it typically takes a year or two for the effects of monetary policy adjustments to manifest themselves in inflation and unemployment. Hence, the FOMC’s decisions about appropriate monetary policy necessarily hinge on the members’ forecasts of the evolution of prices and employment over the next year or two—what we typically call our medium-term outlooks for inflation and unemployment. I’ll discuss the interaction between my outlook and appropriate policy later in my remarks.

Current Stance of Monetary Policy

With that as background, let me move on to describe the current stance of monetary policy. The change in monetary policy over the past five years has been dramatic. At the end of 2007, the Federal Reserve had less than $900 billion of assets, mostly in the form of short-term Treasuries. It was targeting a fed funds rate—the short-term interbank lending rate—above 4 percent. As of now, the Federal Reserve owns over $3 trillion of assets, mostly in the form of long-term government-issued or government-backed securities. The Fed is currently targeting a fed funds rate of under a quarter percent.

Both of these changes in the stance of policy are designed to put upward pressure on employment and prices. In particular, the near-zero fed funds rate pushes downward on the interest rate that businesses and households can earn by saving money and downward on the interest rate to borrow money. These low interest rates encourage households to consume today rather than saving to consume in the future. Similarly, firms are encouraged to engage in capital expenditure rather than saving. This higher demand for consumption and investment pushes upward on both prices and employment.

Similarly, the Fed’s holdings of long-term assets mean that the private sector as a whole is less exposed to the interest rate risk that’s embedded in long-term investments. As a result, some private investors will demand a lower premium for holding other bonds that are exposed to interest rate risk, which puts downward pressure on other long-term yields. Again, faced with these lower yields, households and businesses should be more willing to spend now rather than later.

I’ve described the Fed’s current policy actions. But the impact of monetary policy on the macroeconomy also depends critically on the private sector’s beliefs about the Fed’s future actions. To take an obviously hypothetical extreme: Suppose the private sector believed today that the Fed would return permanently to its 2007 policy stance at its June meeting. Then, the macroeconomic impact of the Fed’s highly accommodative stance over the next couple of months would be negligible.

For this reason, the Federal Open Market Committee has gone to great lengths to provide what’s called “forward guidance”—communication to the public about the likely future evolution of its monetary policy decisions. Thus, the Committee is currently buying $85 billion of long-term assets each month. It has provided forward guidance about its future plans for asset purchases by saying that it intends to continue these asset purchases until there is substantial improvement in the labor market outlook. As Chairman Bernanke indicated in his recent press conference, the rate of these purchases may well vary in response to information about economic conditions.

The Committee has provided even more precision to the public about the likely future path of the fed funds rate. In its December statement, the FOMC announced that it anticipated keeping the fed funds rate at its current extraordinarily low level at least until the unemployment rate fell below a threshold of 6.5 percent, as long as the medium-term inflation outlook remained below 2.5 percent and longer-term inflation expectations remained well anchored. The unemployment rate is currently 7.6 percent, and most private sector forecasters see the unemployment rate staying above 6.5 percent well into 2015. The FOMC’s communication tells the public that it should expect the fed funds rate to stay extraordinarily low over that same time frame, and possibly longer.

I was delighted by the FOMC’s decision to offer this degree of precision about its forward guidance. I think that one important benefit of this kind of language is that it tells the public how the stance of monetary policy will evolve in response to changes in economic conditions. Thus, if the unemployment rate falls more slowly than expected, and the inflation outlook remains subdued, the fed funds rate will be extraordinarily low for a longer period of time. If the unemployment rate falls more rapidly than expected, the fed funds rate will be extraordinarily low for a shorter period of time. In this way, the FOMC has assured the public that the stance of monetary policy will automatically adjust in an appropriate fashion to the evolution of macroeconomic conditions. This automatic adjustment is an important benefit of the Fed’s thresholds.

I should be clear about a couple of aspects of the thresholds. First, the unemployment rate threshold is not a trigger for FOMC action. Thus, the FOMC may choose not to raise interest rates when the unemployment rate falls below 6.5 percent. Second, I see the FOMC’s guidance as providing a great deal of protection against undue inflationary pressures. In particular, the commitment to keep interest rates extraordinarily low is off the table if the medium-term inflation outlook ever rises above 2.5 percent. I’ll have more to say about this inflation protection later in my remarks.

My Two-Year Outlook

I’ve described the Fed’s current monetary policy stance in some detail, and I’ve emphasized that the Fed’s stance is much more accommodative than it was five years ago. That observation alone might suggest that the Fed’s policy is too accommodative. But there have been big changes in the economy since 2007. Over the past five years, Americans have lost jobs and a great deal of wealth. Relative to 2007, people remain uncertain about future employment and income. Businesses, too, are less certain about future demand for their goods. These changes and uncertainties make firms and households less willing to spend than in 2007, and so push downward on both employment and prices. This means that, in order to fulfill its dual mandate of promoting price stability and maximum employment, it is appropriate for the FOMC to adopt a more accommodative monetary policy than in 2007. So, the right question is a more subtle one: Is the FOMC overresponding to the changes in the economy since 2007 by providing too much accommodation?

As I noted earlier, the impact of monetary policy on the macroeconomy unfolds only slowly, over the course of a year or two. Hence, my answer to this question about whether the FOMC is providing too much accommodation depends on my outlook for the economy over the next year or two. With that in mind, I’ll turn now to describing that outlook, placed in the context of the evolution of the macroeconomy over the past five years. Let’s start by looking back at the evolution of national output—as measured by gross domestic product adjusted for inflation (real GDP). As you can see in this chart, national output fell dramatically during 2008 and the first half of 2009. Since the middle of 2009, the national economy has recovered, but only at a moderate rate.

Large chart

Given the sluggish recovery in national output, it is not surprising that labor markets are also healing slowly. This next chart shows the behavior of the unemployment rate over the past five years. The unemployment rate, which was 5 percent in December 2007, reached 10 percent in the second half of 2009 (October). As of March 2013, the national unemployment rate is at 7.6 percent.

Large chart

Finally, this next chart shows that inflation has also run below the Federal Reserve’s 2 percent target. Over the past five years, the personal consumption expenditure (PCE) price index has grown at an average annual rate of 1.6 percent. Here, I should emphasize that the PCE price index is an index that includes all goods and services, including food and energy. So, I’m not talking about so-called core inflation—I’m talking about what’s called headline inflation.

Large chart

That’s a brief review of the past five years. Real output has recovered only slowly from the depths of the 2007-09 recession. Unemployment remains well above 2007 levels. Inflation has averaged below the Fed’s target.

With that review as background, let me turn to my macroeconomic outlook for the next couple of years. That outlook is predicated on the assumption that the FOMC’s monetary policy choices over the next few years will be consistent with the forward guidance about asset purchases and the fed funds rate that the FOMC provided in its March statement. With that assumption about policy, my outlook for the next two years can be summarized as being an ongoing modest recovery. Let me quickly go through the charts again, only this time I will add my forecasts. I see output continuing to grow slowly—at around 2.5 percent in 2013 and around 3 percent in 2014. I expect unemployment to continue to fall only slowly, down to around 7.5 percent in late 2013 and around 7 percent in late 2014. This level of unemployment will continue to constrain wage growth. Consequently, inflation pressures will remain subdued, as I expect PCE inflation to be only 1.6 percent in 2013 and 1.9 percent in 2014.

Large chart

Large chart

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Using the Macroeconomic Outlook to Assess the Appropriateness of Monetary Policy

I’ve described my macroeconomic outlook for 2013 and 2014. Let me turn now to discussing how that outlook informs my judgment about monetary policy. As you will hear, my main conclusion is that my outlook implies that monetary policy is currently not accommodative enough.

Recall that the FOMC has a 2 percent inflation target. I do see inflation eventually returning to that 2 percent target under the FOMC’s current forward guidance. But I expect a slow rate of progress. As I’ve said, I anticipate that, conditional on the FOMC’s current forward guidance, the PCE inflation rate will be only 1.6 percent in 2013 and 1.9 percent in 2014. The FOMC could facilitate a faster return of the PCE inflation rate to the 2 percent target—that is, better promote price stability as mandated by Congress—by adopting a more accommodative monetary policy that puts more upward pressure on prices.

In reaching this conclusion that monetary policy should be more accommodative, I’ve only made reference to the price stability mandate. As I described earlier, the FOMC has a second mandate: to promote maximum employment. In March, most of the 19 FOMC participants believed that the unemployment rate will converge to a level between 5.2 percent and 6 percent within five to six years. But, under the current formulation of monetary policy, I see the rate of convergence to this long-run rate as likely to be slow. In particular, I expect that the unemployment rate will still be close to 7 percent by the end of 2014. The FOMC could facilitate a faster return of the unemployment rate to its lower long-run level by adopting a more accommodative monetary policy that puts more upward pressure on employment. Thus, I would say that my outlook for unemployment and my outlook for inflation both point to a need for more accommodation than is currently being provided by the FOMC.

One Way to Provide More Monetary Accommodation

Based on my outlook for the next two years, I’ve concluded that the FOMC would better fulfill both of its congressional mandates by adding more monetary policy accommodation. How could it do so? I think that there are several possible approaches available to the Committee. For example, the FOMC could reduce the public’s level of policy uncertainty by clarifying the nature of the economic conditions that would lead the Committee to reduce or stop its current asset purchases. Alternatively, the Committee could communicate to the public that, once the removal of monetary accommodation eventually commences, the rate of withdrawal will be slower than is currently anticipated.

Both of these kinds of changes in communication could potentially provide needed monetary accommodation. However, they would require the FOMC to make relatively complex changes to the language of its current communications. My own preferred approach is considerably simpler. In its current forward guidance, the FOMC has stated that it expects the fed funds rate to remain extraordinarily low at least until the unemployment rate falls below 6.5 percent. The FOMC could provide additional needed stimulus by lowering the threshold unemployment rate from 6.5 percent to 5.5 percent—that is, by changing one number in the existing statement.

To see why I say so, consider two possible scenarios. In the first, the public believes that the FOMC will begin raising the fed funds rate once the unemployment rate hits 6.5 percent. (To be clear: This belief is consistent with, but not necessarily implied by, the FOMC’s current forward guidance.) In the second, the public believes that the FOMC will defer the initial increase in the fed funds rate until the unemployment rate hits 5.5 percent. The higher unemployment rate in the first scenario means that monetary policy will be tightened sooner, which, in turn, will lead to the unemployment rate being higher for longer. Foreseeing that, people will save more in the first scenario than in the second, to protect themselves against these higher unemployment risks. Because they save more, they spend less, and there is less economic activity.¹

Thus, lowering the unemployment rate threshold to 5.5 percent would increase the demand for goods and thereby push upward on both employment and prices. Would this extra monetary stimulus result in an undue amount of inflation at some point in the future? Here, I find the recent historical evidence to be comforting. The following chart documents that the medium-term inflation outlook has not risen above 2 1/4 percent in the past 15 years, even though the unemployment rate was at times below 5 percent.² To me, this historical evidence suggests that, as long as the unemployment rate remains above 5.5 percent, the medium-term inflation outlook will stay close to 2 percent.

Large chart

The past is never a perfect guide to the future, of course. But I see the Committee’s estimates of future long-run unemployment as also being consistent with this historical evidence. Most FOMC participants expect that, over the long run, an unemployment rate of between 5.2 percent and 6 percent is consistent with an inflation rate of 2 percent. These estimates suggest that, as long as the unemployment rate remains above 5.5 percent, wage pressures will not be sufficiently strong to generate a medium-term inflation outlook much in excess of 2 percent.

Of course, these are estimates based on what we know now about current labor market conditions. The FOMC’s estimates of the unemployment rate consistent with maximum employment could evolve over time, in response to new information and new analyses. This is why the FOMC’s current forward guidance contains what I see as strong protection against undue inflation. As I described earlier, that guidance clearly states that the Committee’s commitment to a low fed funds rate is off the table if the medium-term inflation outlook ever rises above 2.5 percent.

I’ve said that I see it as unlikely that this inflation threshold would be breached, even if the Committee were to lower the unemployment threshold to 5.5 percent. Conversely, I would see a breach of this threshold as being a cause for significant concern. We have not seen a medium-term outlook for inflation as high as 2.25 percent over the past 15 years. In that context, a medium-term outlook of 2.5 percent or more should be seen as being highly unusual. In my view, such an unusually high inflation outlook should lead the FOMC to strongly consider an aggressive response.

Conclusions

Monetary policy affects the economy with a lag of one or two years. Hence, a policymaker’s views about the appropriate level of monetary policy accommodation depend on his or her forecast for how the economy will evolve over the next year or two. My outlook for inflation and unemployment implies that the FOMC should provide more monetary accommodation. The FOMC could provide that additional accommodation in several different ways. In my remarks today, I’ve described one particularly simple approach: lowering the unemployment rate threshold in the Committee’s forward guidance to 5.5 percent from the current setting of 6.5 percent.

Some might be concerned that this move would give rise to undue inflationary pressures. I see that possibility as unlikely—and, even if I’m wrong in my assessment, the Committee’s forward guidance provides tight inflation safeguards.

Thanks for listening, and I look forward to taking your questions.

Note

Endnotes

Reference

Werning, Iván. 2012. “Managing a Liquidity Trap: Monetary and Fiscal Policy.” Working paper. Massachusetts Institute of Technology.

Thank you for that generous introduction, and thank you too for the invitation to join you here today. Since becoming president of the Federal Reserve Bank of Minneapolis, I’ve learned a great deal by visiting cities and towns throughout our district. For example, I visited this morning with community leaders to gain a better understanding of challenges and successes in local labor markets. Following this talk, I will take a whirlwind tour of the city, culminating in a meeting with business leaders about the state of the local economy.

Speaking of local business leaders, I would like to mention two in particular, Randy Newman and Brian Johnson. Randy, of course, is chairman and CEO of Alerus Financial, but he is also a new member of the Minneapolis Fed’s board of directors. And Brian, the CEO of Choice Financial, is a member of our advisory council representing community depository institutions. I extend a special thank you to Brian for his invitation to come to Grand Forks and for all the work he has done to make my visit so successful. The Federal Reserve System deeply appreciates the public service of Randy and Brian, and of others here today who have served on our board and advisory councils in the past.

In my remarks today, I’ll first provide some background about the Federal Reserve. I’ll then describe the current stance of monetary policy. I’ll discuss the macroeconomic outlook for the next couple of years implied by that monetary policy stance. Finally, I’ll offer my assessment of the appropriateness of monetary policy in light of that outlook.

But first—a disclaimer. As you will hear shortly, I’m one of the 19 people who have the privilege and honor to participate in the meetings of what’s called the Federal Open Market Committee. FOMC meetings shape the course of monetary policy in the United States. But it’s very important to understand that my remarks today are only my views and not necessarily those of any other FOMC participant.

Federal Reserve Structure

Let me begin with some basics about the Federal Reserve System. The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our bank represents the ninth of the 12 Federal Reserve districts and includes Montana, the Dakotas, Minnesota, northwestern Wisconsin and the Upper Peninsula of Michigan.

Eight times per year, the Federal Open Market Committee—the FOMC—meets to set the path of short-term interest rates over the next six to seven weeks. All 12 presidents of the various regional Federal Reserve banks—including me—and the seven governors of the Federal Reserve Board contribute to these deliberations. However, the Committee itself consists only of the governors, the president of the Federal Reserve Bank of New York and a rotating group of four other presidents. I won’t be on the Committee in 2013, but will be next year. In this way, the structure of the FOMC mirrors the federalist structure of our government, because representatives from different regions of the country—the various presidents—have input into FOMC deliberations.

Congress requires the FOMC to make monetary policy so as to fulfill two mandates: promote price stability and promote maximum employment. Promoting maximum employment means that the Fed is charged with doing what it can to ensure that Americans who want to work can do so. Promoting price stability means that the Federal Reserve is charged with keeping inflation close to a pre-specified target. Price stability ensures that, when people write contracts in terms of dollars like student loans or annuities, they can have certainty about what those dollars will be able to buy in the future.

Now, in describing price stability, I’ve made reference to a pre-specified target for inflation. I haven’t said what the pre-specified inflation target is. In choosing its inflation target, the FOMC weighed the costs of overly high inflation against the need to guard against potentially destructive deflationary spirals. This assessment has led the FOMC to choose an inflation target of 2 percent. Similarly, most central banks around the world have opted for a low but still positive inflation target.

The FOMC acts to achieve its two mandates—maximum employment and price stability—by influencing interest rates through the purchase and sale of financial assets. When the FOMC raises interest rates, households and firms tend to spend less and save more. The fall in spending puts downward pressure on both employment and prices. Similarly, when the FOMC lowers interest rates, households and firms tend to spend more and save less. This puts upward pressure on employment and prices.

However, these pressures on employment and prices from lower interest rates are not felt immediately. Instead, it typically takes a year or two for the effects of monetary policy adjustments to manifest themselves in inflation and unemployment. Hence, the FOMC’s decisions about appropriate monetary policy necessarily hinge on the members’ forecasts of the evolution of prices and employment over the next year or two—what we typically call our medium-term outlooks for inflation and unemployment. I’ll discuss the interaction between my outlook and appropriate policy later in my remarks.

Current Stance of Monetary Policy

With that as background, let me move on to describe the current stance of monetary policy. The change in monetary policy over the past five years has been dramatic. At the end of 2007, the Federal Reserve had less than $900 billion of assets, mostly in the form of short-term Treasuries. It was targeting a fed funds rate—the short-term interbank lending rate—above 4 percent. As of now, the Federal Reserve owns over $3 trillion of assets, mostly in the form of long-term government-issued or government-backed securities. The Fed is currently targeting a fed funds rate of under a quarter percent.

Both of these changes in the stance of policy are designed to put upward pressure on employment and prices. In particular, the near-zero fed funds rate pushes downward on the interest rate that businesses and households can earn by saving money and downward on the interest rate to borrow money. These low interest rates encourage households to consume today rather than saving to consume in the future. Similarly, firms are encouraged to engage in capital expenditure rather than saving. This higher demand for consumption and investment pushes upward on both prices and employment.

Similarly, the Fed’s holdings of long-term assets mean that the private sector as a whole is less exposed to the interest rate risk that’s embedded in long-term investments. As a result, some private investors will demand a lower premium for holding other bonds that are exposed to interest rate risk, which puts downward pressure on other long-term yields. Again, faced with these lower yields, households and businesses should be more willing to spend now rather than later.

I’ve described the Fed’s current policy actions. But the impact of monetary policy on the macroeconomy also depends critically on the private sector’s beliefs about the Fed’s future actions. To take an obviously hypothetical extreme: Suppose the private sector believed today that the Fed would return permanently to its 2007 policy stance at its June meeting. Then, the macroeconomic impact of the Fed’s highly accommodative stance over the next couple of months would be negligible.

For this reason, the Federal Open Market Committee has gone to great lengths to provide what’s called “forward guidance”—communication to the public about the likely future evolution of its monetary policy decisions. Thus, the Committee is currently buying $85 billion of long-term assets each month. It has provided forward guidance about its future plans for asset purchases by saying that it intends to continue these asset purchases until there is substantial improvement in the labor market outlook. As Chairman Bernanke indicated in his recent press conference, the rate of these purchases may well vary in response to information about economic conditions.

The Committee has provided even more precision to the public about the likely future path of the fed funds rate. In its December statement, the FOMC announced that it anticipated keeping the fed funds rate at its current extraordinarily low level at least until the unemployment rate fell below a threshold of 6.5 percent, as long as the medium-term inflation outlook remained below 2.5 percent and longer-term inflation expectations remained well anchored. The unemployment rate is currently 7.7 percent, and most private sector forecasters see the unemployment rate staying above 6.5 percent well into 2015. The FOMC’s communication tells the public that it should expect the fed funds rate to stay extraordinarily low over that same time frame, and possibly longer.

I was delighted by the FOMC’s decision to offer this degree of precision about its forward guidance. I think that one important benefit of this kind of language is that it tells the public how the stance of monetary policy will evolve in response to changes in economic conditions. Thus, if the unemployment rate falls more slowly than expected, and the inflation outlook remains subdued, the fed funds rate will be extraordinarily low for a longer period of time. If the unemployment rate falls more rapidly than expected, the fed funds rate will be extraordinarily low for a shorter period of time. In this way, the FOMC has assured the public that the stance of monetary policy will automatically adjust in an appropriate fashion to the evolution of macroeconomic conditions. This automatic adjustment is an important benefit of the Fed’s thresholds.

I should be clear about a couple of aspects of the thresholds. First, the unemployment rate threshold is not a trigger for FOMC action. Thus, the FOMC may choose not to raise interest rates when the unemployment rate falls below 6.5 percent. Second, I see the FOMC’s guidance as providing a great deal of protection against undue inflationary pressures. In particular, the commitment to keep interest rates extraordinarily low is off the table if the medium-term inflation outlook ever rises above 2.5 percent. I’ll have more to say about this inflation protection later in my remarks.

My Two-Year Outlook

I’ve described the Fed’s current monetary policy stance in some detail, and I’ve emphasized that the Fed’s stance is much more accommodative than it was five years ago. That observation alone might suggest that the Fed’s policy is too accommodative. But there have been big changes in the economy since 2007. Over the past five years, Americans have lost jobs and a great deal of wealth. Relative to 2007, people remain uncertain about future employment and income. Businesses, too, are less certain about future demand for their goods. These changes and uncertainties make firms and households less willing to spend than in 2007, and so push downward on both employment and prices. This means that, in order to fulfill its dual mandate of promoting price stability and maximum employment, it is appropriate for the FOMC to adopt a more accommodative monetary policy than in 2007. So, the right question is a more subtle one: Is the FOMC overresponding to the changes in the economy since 2007 by providing too much accommodation?

As I noted earlier, the impact of monetary policy on the macroeconomy unfolds only slowly, over the course of a year or two. Hence, my answer to this question about whether the FOMC is providing too much accommodation depends on my outlook for the economy over the next year or two. With that in mind, I’ll turn now to describing that outlook, placed in the context of the evolution of the macroeconomy over the past five years. Let’s start by looking back at the evolution of national output—as measured by gross domestic product adjusted for inflation (real GDP). As you can see in this chart, national output fell dramatically during 2008 and the first half of 2009. Since the middle of 2009, the national economy has recovered, but only at a moderate rate.

Large chart

Given the sluggish recovery in national output, it is not surprising that labor markets are also healing slowly. This next chart shows the behavior of the unemployment rate over the past five years. The unemployment rate, which was 5 percent in December 2007, reached 10 percent in the second half of 2009 (October). As of February 2013, the national unemployment rate is at 7.7 percent.

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Finally, this next chart shows that inflation has also run below the Federal Reserve’s 2 percent target. Over the past five years, the personal consumption expenditure (PCE) price index has grown at an average annual rate of 1.6 percent. Here, I should emphasize that the PCE price index is an index that includes all goods and services, including food and energy. So, I’m not talking about so-called core inflation—I’m talking about what’s called headline inflation.

Large chart

That’s a brief review of the past five years. Real output has recovered only slowly from the depths of the 2007-09 recession. Unemployment remains well above 2007 levels. Inflation has averaged below the Fed’s target.

With that review as background, let me turn to my macroeconomic outlook for the next couple of years. That outlook is predicated on the assumption that the FOMC’s monetary policy choices over the next few years will be consistent with the forward guidance about asset purchases and the fed funds rate that the FOMC provided in its March statement. With that assumption about policy, my outlook for the next two years can be summarized as being an ongoing modest recovery. Let me quickly go through the charts again, only this time I will add my forecasts. I see output continuing to grow slowly—at around 2.5 percent in 2013 and around 3 percent in 2014. I expect unemployment to continue to fall only slowly, down to around 7.5 percent in late 2013 and around 7 percent in late 2014. This level of unemployment will continue to constrain wage growth. Consequently, inflation pressures will remain subdued, as I expect PCE inflation to be only 1.6 percent in 2013 and 1.9 percent in 2014.

Large chart

Large chart

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Using the Macroeconomic Outlook to Assess the Appropriateness of Monetary Policy

I’ve described my macroeconomic outlook for 2013 and 2014. Let me turn now to discussing how that outlook informs my judgment about monetary policy. As you will hear, my main conclusion is that my outlook implies that monetary policy is currently not accommodative enough.

Recall that the FOMC has a 2 percent inflation target. I do see inflation eventually returning to that 2 percent target under the FOMC’s current forward guidance. But I expect a slow rate of progress. As I’ve said, I anticipate that, conditional on the FOMC’s current forward guidance, the PCE inflation rate will be only 1.6 percent in 2013 and 1.9 percent in 2014. The FOMC could facilitate a faster return of the PCE inflation rate to the 2 percent target—that is, better promote price stability as mandated by Congress—by adopting a more accommodative monetary policy that puts more upward pressure on prices.

In reaching this conclusion that monetary policy should be more accommodative, I’ve only made reference to the price stability mandate. As I described earlier, the FOMC has a second mandate: to promote maximum employment. In March, most of the 19 FOMC participants believed that the unemployment rate will converge to a level between 5.2 percent and 6 percent within five to six years. But, under the current formulation of monetary policy, I see the rate of convergence to this long-run rate as likely to be slow. In particular, I expect that the unemployment rate will still be close to 7 percent by the end of 2014. The FOMC could facilitate a faster return of the unemployment rate to its lower long-run level by adopting a more accommodative monetary policy that puts more upward pressure on employment. Thus, I would say that my outlook for unemployment and my outlook for inflation both point to a need for more accommodation than is currently being provided by the FOMC.

One Way to Provide More Monetary Accommodation

Based on my outlook for the next two years, I’ve concluded that the FOMC would better fulfill both of its congressional mandates by adding more monetary policy accommodation. How could it do so? I think that there are several possible approaches available to the Committee. For example, the FOMC could reduce the public’s level of policy uncertainty by clarifying the nature of the economic conditions that would lead the Committee to reduce or stop its current asset purchases. Alternatively, the Committee could communicate to the public that, once the removal of monetary accommodation eventually commences, the rate of withdrawal will be slower than is currently anticipated.

Both of these kinds of changes in communication could potentially provide needed monetary accommodation. However, they would require the FOMC to make relatively complex changes to the language of its current communications. My own preferred approach is considerably simpler. In its current forward guidance, the FOMC has stated that it expects the fed funds rate to remain extraordinarily low at least until the unemployment rate falls below 6.5 percent. The FOMC could provide additional needed stimulus by lowering the threshold unemployment rate from 6.5 percent to 5.5 percent—that is, by changing one number in the existing statement.

Thus, lowering the unemployment rate threshold to 5.5 percent would increase the demand for goods and thereby push upward on both employment and prices. Would this extra monetary stimulus result in an undue amount of inflation at some point in the future? Here, I find the recent historical evidence to be comforting. The following chart documents that the medium-term inflation outlook has not risen above 2 1/4 percent in the past 15 years, even though the unemployment rate was at times below 5 percent.² To me, this historical evidence suggests that, as long as the unemployment rate remains above 5.5 percent, the medium-term inflation outlook will stay close to 2 percent.

Large chart

The past is never a perfect guide to the future, of course. But I see the Committee’s estimates of future long-run unemployment as also being consistent with this historical evidence. Most FOMC participants expect that, over the long run, an unemployment rate of between 5.2 percent and 6 percent is consistent with an inflation rate of 2 percent. These estimates suggest that, as long as the unemployment rate remains above 5.5 percent, wage pressures will not be sufficiently strong to generate a medium-term inflation outlook much in excess of 2 percent.

Of course, these are estimates based on what we know now about current labor market conditions. The FOMC’s estimates of the unemployment rate consistent with maximum employment could evolve over time, in response to new information and new analyses. This is why the FOMC’s current forward guidance contains what I see as strong protection against undue inflation. As I described earlier, that guidance clearly states that the Committee’s commitment to a low fed funds rate is off the table if the medium-term inflation outlook ever rises above 2.5 percent.

I’ve said that I see it as unlikely that this inflation threshold would be breached, even if the Committee were to lower the unemployment threshold to 5.5 percent. Conversely, I would see a breach of this threshold as being a cause for significant concern. We have not seen a medium-term outlook for inflation as high as 2.25 percent over the past 15 years. In that context, a medium-term outlook of 2.5 percent or more should be seen as being highly unusual. In my view, such an unusually high inflation outlook should lead the FOMC to strongly consider an aggressive response.

Conclusions

Monetary policy affects the economy with a lag of one or two years. Hence, a policymaker’s views about the appropriate level of monetary policy accommodation depend on his or her forecast for how the economy will evolve over the next year or two. My outlook for inflation and unemployment implies that the FOMC should provide more monetary accommodation. The FOMC could provide that additional accommodation in several different ways. In my remarks today, I’ve described one particularly simple approach: lowering the unemployment rate threshold in the Committee’s forward guidance to 5.5 percent from the current setting of 6.5 percent.

Some might be concerned that this move would give rise to undue inflationary pressures. I see that possibility as unlikely—and, even if I’m wrong in my assessment, the Committee’s forward guidance provides tight inflation safeguards.

Thanks for listening, and I look forward to taking your questions.

Note

Endnotes

Reference

Werning, Iván. 2012. “Managing a Liquidity Trap: Monetary and Fiscal Policy.” Working paper. Massachusetts Institute of Technology.

Thank you for that generous introduction. Good afternoon everyone, and thank you for the invitation to join you here today. It’s a pleasure to be here and to share my thoughts on the prospects for the economy and the role of monetary policy going forward. But as you will hear in a minute, I am also interested in your thoughts on the state of the economy and on your questions about Federal Reserve policy. So I look forward to our discussion following my talk.

In my remarks today, I’ll first provide some background about the Federal Reserve. I’ll then describe the current stance of monetary policy. I’ll discuss the macroeconomic outlook for the next couple of years implied by that monetary policy stance. Finally, I’ll offer my assessment of the appropriateness of monetary policy in light of that outlook.

But first—a disclaimer. As you will hear shortly, I’m one of the 19 people who have the privilege and honor to participate in the meetings of what’s called the Federal Open Market Committee. FOMC meetings shape the course of monetary policy in the United States. But it’s very important to understand that my remarks today are only my views and not necessarily those of any other FOMC participant.

Federal Reserve Structure

Let me begin with some basics about the Federal Reserve System. I like to tell people that the Fed is a uniquely American institution. What do I mean by that? Well, relative to its counterparts around the world, the U.S. central bank is highly decentralized. The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our bank represents the ninth of the 12 Federal Reserve districts and includes Montana, the Dakotas, Minnesota, northwestern Wisconsin and the Upper Peninsula of Michigan.

Eight times per year, the Federal Open Market Committee—the FOMC—meets to set the path of short-term interest rates over the next six to seven weeks. All 12 presidents of the various regional Federal Reserve banks—including me—and the seven governors of the Federal Reserve Board contribute to these deliberations. However, the Committee itself consists only of the governors, the president of the Federal Reserve Bank of New York and a rotating group of four other presidents. I won’t be on the Committee in 2013, but will be next year. In this way, the structure of the FOMC mirrors the federalist structure of our government, because representatives from different regions of the country—the various presidents—have input into FOMC deliberations.

Congress requires the FOMC to make monetary policy so as to fulfill two mandates: promote price stability and promote maximum employment. It should be clear that these are both Main Street objectives. Promoting maximum employment means that the Fed is charged with doing what it can to ensure that Americans who want to work can do so. Promoting price stability means that the Federal Reserve is charged with keeping inflation close to a pre-specified target. Price stability ensures that, when people write contracts in terms of dollars like student loans or annuities, they can have certainty about what those dollars will be able to buy in the future.

Now, in describing price stability, I’ve made reference to a pre-specified target for inflation. I haven’t said what the pre-specified inflation target is. In choosing its inflation target, the FOMC weighed the costs of overly high inflation against the need to guard against potentially destructive deflationary spirals. This assessment has led the FOMC to choose an inflation target of 2 percent. Similarly, most central banks around the world have opted for a low but still positive inflation target.

The FOMC acts to achieve its two mandates—maximum employment and price stability—by influencing interest rates through the purchase and sale of financial assets. When the FOMC raises interest rates, households and firms tend to spend less and save more. The fall in spending puts downward pressure on both employment and prices. Similarly, when the FOMC lowers interest rates, households and firms tend to spend more and save less. This puts upward pressure on employment and prices.

However, these pressures on employment and prices from lower interest rates are not felt immediately. Instead, it typically takes a year or two for the effects of monetary policy adjustments to manifest themselves in inflation and unemployment. Hence, the FOMC’s decisions about appropriate monetary policy necessarily hinge on the members’ forecasts of the evolution of prices and employment over the next year or two—what we typically call our medium-term outlooks for inflation and unemployment. I’ll discuss the interaction between my outlook and appropriate policy later in my remarks.

Current Stance of Monetary Policy

With that as background, let me move on to describe the current stance of monetary policy. The change in monetary policy over the past five years has been dramatic. At the end of 2007, the Federal Reserve had less than $900 billion of assets, mostly in the form of short-term Treasuries. It was targeting a fed funds rate—the short-term interbank lending rate—above 4 percent. As of now, the Federal Reserve owns over $3 trillion of assets, mostly in the form of long-term government-issued or government-backed securities. The Fed is currently targeting a fed funds rate of under a quarter percent.

Both of these changes in the stance of policy are designed to put upward pressure on employment and prices. In particular, the near-zero fed funds rate pushes downward on the interest rate that businesses and households can earn by saving money and downward on the interest rate to borrow money. These low interest rates encourage households to consume today rather than saving to consume in the future. Similarly, firms are encouraged to engage in capital expenditure rather than saving. This higher demand for consumption and investment pushes upward on both prices and employment.

Similarly, the Fed’s holdings of long-term assets mean that the private sector as a whole is less exposed to the interest rate risk that’s embedded in long-term investments. As a result, some private investors will demand a lower premium for holding other bonds that are exposed to interest rate risk, which puts downward pressure on other long-term yields. Again, faced with these lower yields, households and businesses should be more willing to spend now rather than later.

I’ve described the Fed’s current policy actions. But the impact of monetary policy on the macroeconomy also depends critically on the private sector’s beliefs about the Fed’s future actions. To take an obviously hypothetical extreme: Suppose the private sector believed today that the Fed would return permanently to its 2007 policy stance at its June meeting. Then, the macroeconomic impact of the Fed’s highly accommodative stance over the next couple of months would be negligible.

For this reason, the Federal Open Market Committee has gone to great lengths to provide what’s called “forward guidance”—communication to the public about the likely future evolution of its monetary policy decisions. Thus, the Committee is currently buying $85 billion of long-term assets each month. It has provided forward guidance about its future plans for asset purchases by saying that it intends to continue these asset purchases until there is substantial improvement in the labor market outlook. As Chairman Bernanke indicated in his recent press conference, the rate of these purchases may well vary in response to information about economic conditions.

The Committee has provided even more precision to the public about the likely future path of the fed funds rate. In its December statement, the FOMC announced that it anticipated keeping the fed funds rate at its current extraordinarily low level at least until the unemployment rate fell below a threshold of 6.5 percent, as long as the medium-term inflation outlook remained below 2.5 percent and longer-term inflation expectations remained well-anchored. The unemployment rate is currently 7.7 percent, and most private sector forecasters see the unemployment rate staying above 6.5 percent well into 2015. The FOMC’s communication tells the public that it should expect the fed funds rate to stay extraordinarily low over that same time frame, and possibly longer.

I was delighted by the FOMC’s decision to offer this degree of precision about its forward guidance. I think that one important benefit of this kind of language is that it tells the public how the stance of monetary policy will evolve in response to changes in economic conditions. Thus, if the unemployment rate falls more slowly than expected, and the inflation outlook remains subdued, the fed funds rate will be extraordinarily low for a longer period of time. If the unemployment rate falls more rapidly than expected, the fed funds rate will be extraordinarily low for a shorter period of time. In this way, the FOMC has assured the public that the stance of monetary policy will automatically adjust in an appropriate fashion to the evolution of macroeconomic conditions. This automatic adjustment is an important benefit of the Fed’s thresholds.

I should be clear about a couple of aspects of the thresholds. First, the unemployment rate threshold is not a trigger for FOMC action. Thus, the FOMC may choose not to raise interest rates when the unemployment rate falls below 6.5 percent. Second, I see the FOMC’s guidance as providing a great deal of protection against undue inflationary pressures. In particular, the commitment to keep interest rates extraordinarily low is off the table if the medium-term inflation outlook ever rises above 2.5 percent. I’ll have more to say about this inflation protection later in my remarks.

My Two-Year Outlook (video)

I’ve described the Fed’s current monetary policy stance in some detail, and I’ve emphasized that the Fed’s stance is much more accommodative than it was five years ago. That observation alone might suggest that the Fed’s policy is too accommodative. But there have been big changes in the economy since 2007. Over the past five years, Americans have lost jobs and a great deal of wealth. Relative to 2007, people remain uncertain about future employment and income. Businesses, too, are less certain about future demand for their goods. These changes and uncertainties make firms and households less willing to spend than in 2007, and so push downward on both employment and prices. This means that, in order to fulfill its dual mandate of promoting price stability and maximum employment, it is appropriate for the FOMC to adopt a more accommodative monetary policy than in 2007. So, the right question is a more subtle one: Is the FOMC overresponding to the changes in the economy since 2007 by providing too much accommodation?

As I noted earlier, the impact of monetary policy on the macroeconomy unfolds only slowly, over the course of a year or two. Hence, my answer to this question about whether the FOMC is providing too much accommodation depends on my outlook for the economy over the next year or two. With that in mind, I’ll turn now to describing that outlook, placed in the context of the evolution of the macroeconomy over the past five years. Let’s start by looking back at the evolution of national output—as measured by gross domestic product adjusted for inflation (real GDP). As you can see in this chart, national output fell dramatically during 2008 and the first half of 2009. Since the middle of 2009, the national economy has recovered, but only at a moderate rate.

Large chart

Given the sluggish recovery in national output, it is not surprising that labor markets are also healing slowly. This next chart shows the behavior of the unemployment rate over the past five years. The unemployment rate, which was 5 percent in December 2007, reached 10 percent in the second half of 2009 (October). As of February 2013, the national unemployment rate is at 7.7 percent.

Large chart

Finally, this next chart shows that inflation has also run below the Federal Reserve’s 2 percent target. Over the past five years, the personal consumption expenditure (PCE) price index has grown at an average annual rate of 1.6 percent. Here, I should emphasize that the PCE price index is an index that includes all goods and services, including food and energy. So, I’m not talking about so-called core inflation—I’m talking about what’s called headline inflation.

Large chart

That’s a brief review of the past five years. Real output has recovered only slowly from the depths of the 2007-09 recession. Unemployment remains well above 2007 levels. Inflation has averaged below the Fed’s target.

With that review as background, let me turn to my macroeconomic outlook for the next couple of years. That outlook is predicated on the assumption that the FOMC’s monetary policy choices over the next few years will be consistent with the forward guidance about asset purchases and the fed funds rate that the FOMC provided in its March statement. With that assumption about policy, my outlook for the next two years can be summarized as being an ongoing modest recovery. Let me quickly go through the charts again, only this time I will add my forecasts. I see output continuing to grow slowly—at around 2.5 percent in 2013 and around 3 percent in 2014. I expect unemployment to continue to fall only slowly, down to around 7.5 percent in late 2013 and around 7 percent in late 2014. This level of unemployment will continue to constrain wage growth. Consequently, inflation pressures will remain subdued, as I expect PCE inflation to be only 1.6 percent in 2013 and 1.9 percent in 2014.

Large chart

Large chart

Large chart

Using the Macroeconomic Outlook to Assess the Appropriateness of Monetary Policy

I’ve described my macroeconomic outlook for 2013 and 2014. Let me turn now to discussing how that outlook informs my judgment about monetary policy. As you will hear, my main conclusion is that my outlook implies that monetary policy is currently not accommodative enough.

Recall that the FOMC has a 2 percent inflation target. I do see inflation eventually returning to that 2 percent target under the FOMC’s current forward guidance. But I expect a slow rate of progress. As I’ve said, I anticipate that, conditional on the FOMC’s current forward guidance, the PCE inflation rate will be only 1.6 percent in 2013 and 1.9 percent in 2014. The FOMC could facilitate a faster return of the PCE inflation rate to the 2 percent target—that is, better promote price stability as mandated by Congress—by adopting a more accommodative monetary policy that puts more upward pressure on prices.

In reaching this conclusion that monetary policy should be more accommodative, I’ve only made reference to the price stability mandate. As I described earlier, the FOMC has a second mandate: to promote maximum employment. In March, most of the 19 FOMC participants believed that the unemployment rate will converge to a level between 5.2 percent and 6 percent within five to six years. But, under the current formulation of monetary policy, I see the rate of convergence to this long-run rate as likely to be slow. In particular, I expect that the unemployment rate will still be close to 7 percent by the end of 2014. The FOMC could facilitate a faster return of the unemployment rate to its lower long-run level by adopting a more accommodative monetary policy that puts more upward pressure on employment. Thus, I would say that my outlook for unemployment and my outlook for inflation both point to a need for more accommodation than is currently being provided by the FOMC.

One Way to Provide More Monetary Accommodation (video)

Based on my outlook for the next two years, I’ve concluded that the FOMC would better fulfill both of its congressional mandates by adding more monetary policy accommodation. How could it do so? I think that there are several possible approaches available to the Committee. For example, the FOMC could reduce the public’s level of policy uncertainty by clarifying the nature of the economic conditions that would lead the Committee to reduce or stop its current asset purchases. Alternatively, the Committee could communicate to the public that, once the removal of monetary accommodation eventually commences, the rate of withdrawal will be slower than is currently anticipated.

Both of these kinds of changes in communication could potentially provide needed monetary accommodation. However, they would require the FOMC to make relatively complex changes to the language of its current communications. My own preferred approach is considerably simpler. In its current forward guidance, the FOMC has stated that it expects the fed funds rate to remain extraordinarily low at least until the unemployment rate falls below 6.5 percent. The FOMC could provide additional needed stimulus by lowering the threshold unemployment rate from 6.5 percent to 5.5 percent—that is, by changing one number in the existing statement.

To see why I say so, consider two possible scenarios. In the first, the public believes that the FOMC will begin raising the fed funds rate once the unemployment rate hits 6.5 percent. (To be clear: This belief is consistent with, but not necessarily implied by, the FOMC’s current forward guidance.) In the second, the public believes that the FOMC will defer the initial increase in the fed funds rate until the unemployment rate hits 5.5 percent. The higher unemployment rate in the first scenario means that monetary policy will be tightened sooner, which, in turn, will lead to the unemployment rate being higher for longer. Foreseeing that, people will save more in the first scenario than in the second, to protect themselves against these higher unemployment risks. Because they save more, they spend less, and there is less economic activity.¹

Thus, lowering the unemployment rate threshold to 5.5 percent would increase the demand for goods and thereby push upward on both employment and prices. Would this extra monetary stimulus result in an undue amount of inflation at some point in the future? Here, I find the recent historical evidence to be comforting. The following chart documents that the medium-term inflation outlook has not risen above 2 1/4 percent in the past 15 years, even though the unemployment rate was at times below 5 percent.² To me, this historical evidence suggests that, as long as the unemployment rate remains above 5.5 percent, the medium-term inflation outlook will stay close to 2 percent.

Large chart

The past is never a perfect guide to the future, of course. But I see the Committee’s estimates of future long-run unemployment as also being consistent with this historical evidence. Most FOMC participants expect that, over the long run, an unemployment rate of between 5.2 percent and 6 percent is consistent with an inflation rate of 2 percent. These estimates suggest that, as long as the unemployment rate remains above 5.5 percent, wage pressures will not be sufficiently strong to generate a medium-term inflation outlook much in excess of 2 percent.

Of course, these are estimates based on what we know now about current labor market conditions. The FOMC’s estimates of the unemployment rate consistent with maximum employment could evolve over time, in response to new information and new analyses. This is why the FOMC’s current forward guidance contains what I see as strong protection against undue inflation. As I described earlier, that guidance clearly states that the Committee’s commitment to a low fed funds rate is off the table if medium-term inflation outlook ever rises above 2.5 percent.

I’ve said that I see it as unlikely that this inflation threshold would be breached, even if the Committee were to lower the unemployment threshold to 5.5 percent. Conversely, I would see a breach of this threshold as being a cause for significant concern. We have not seen a medium-term outlook for inflation as high as 2.25 percent over the past 15 years. In that context, a medium-term outlook of 2.5 percent or more should be seen as being highly unusual. In my view, such an unusually high inflation outlook should lead the FOMC to strongly consider an aggressive response.

To sum up: My outlook for both inflation and unemployment means that the FOMC should provide more monetary accommodation. In March, the FOMC said that it anticipates keeping the fed funds rate extraordinarily low at least until the unemployment rate falls below 6.5 percent. In my view, it would be appropriate for the Committee to increase the level of monetary accommodation by lowering the unemployment rate threshold to 5.5 percent. Some might be concerned that this move would give rise to undue inflationary pressures. I see that possibility as unlikely—and, even if I’m wrong in my assessment, the Committee’s forward guidance provides tight inflation safeguards.

Conclusions

Monetary policy affects the economy with a lag of one or two years. Hence, a policymaker’s views about the appropriate level of monetary policy accommodation depend on his or her forecast for how the economy will evolve over the next year or two. My own outlook is that growth will remain moderate over the next two years. As a result, under current policy, my outlook for inflation is that it will run below the Fed’s target of 2 percent over the next two years and that the unemployment rate will be above 7 percent over that same period. That outlook suggests that the FOMC can better promote price stability and promote maximum employment, as mandated by Congress, by adopting a more accommodative policy stance. The FOMC could provide that additional accommodation in several different ways. In my remarks today, I’ve described one particularly simple approach: lowering the unemployment rate threshold in its forward guidance to 5.5 percent from the current setting of 6.5 percent.

Thanks for listening and I look forward to taking your questions.

Note

Endnotes

Reference

Werning, Iván. 2012. “Managing a Liquidity Trap: Monetary and Fiscal Policy.” Working paper. Massachusetts Institute of Technology.

Note^*

Thank you for that generous introduction. Good evening everyone, and thank you for the invitation to join you here today. It’s a pleasure to be here at the start of a new year and to share my thoughts on the prospects for the economy and the role of monetary policy going forward. But as you will hear in a minute, I am also interested in your thoughts on the state of the economy and on your questions about Federal Reserve policy. So I look forward to our discussion following my talk.

In my remarks today, I’ll first provide some background about the Federal Reserve. I’ll then describe the current stance of monetary policy. I’ll discuss the macroeconomic outlook for the next couple of years implied by that monetary policy stance. Finally, I’ll offer my assessment of the appropriateness of monetary policy in light of that outlook.

But first—a disclaimer. As you will hear shortly, I’m one of the 19 people who have the privilege and honor to participate in the meetings of what’s called the Federal Open Market Committee. FOMC meetings shape the course of monetary policy in the United States. But it’s very important to understand that my remarks today are only my views and not necessarily those of any other FOMC participant.

Federal Reserve Structure

Let me begin with some basics about the Federal Reserve System. I like to tell people that the Fed is a uniquely American institution. What do I mean by that? Well, relative to its counterparts around the world, the U.S. central bank is highly decentralized. The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our bank represents the ninth of the 12 Federal Reserve districts and includes Montana, the Dakotas, Minnesota, northwestern Wisconsin and the Upper Peninsula of Michigan.

Eight times per year, the Federal Open Market Committee—the FOMC—meets to set the path of short-term interest rates over the next six to seven weeks. All 12 presidents of the various regional Federal Reserve banks—including me—and the seven governors of the Federal Reserve Board contribute to these deliberations. However, the Committee itself consists only of the governors, the president of the Federal Reserve Bank of New York and a rotating group of four other presidents. I won’t be on the Committee in 2013, but will be next year. In this way, the structure of the FOMC mirrors the federalist structure of our government, because representatives from different regions of the country—the various presidents—have input into FOMC deliberations.

This federalist structure is important because it fosters valuable two-way communication between Americans and their central bank—exactly the kind of two-way communication that we’re engaging in today. Of course, one direction of communication is from regional Fed presidents to the residents of their districts, like when we give speeches, write articles for our bank publications or present material on our websites. But the other direction matters a lot too. The input from the presidents to the FOMC relies critically on information we receive about local economic performance in our districts. We obtain this information through the work of our research staffs—but we also obtain it through ongoing conversations with local business and community leaders. And, after I’m done talking, your questions and comments will be another important input into my thinking about policy. In my view, this two-way communication between the residents of Main Street and the Federal Reserve System, mediated by the presidents of the regional Feds, is a critical ingredient to the System’s ongoing effectiveness.

Congress requires the FOMC to make monetary policy so as to fulfill two mandates: promote price stability and promote maximum employment. It should be clear that these are both Main Street objectives. Promoting maximum employment means that the Fed is charged with doing what it can to ensure that Americans who want to work can do so. Promoting price stability means that the Federal Reserve is charged with keeping inflation close to a pre-specified target. Price stability ensures that, when people write contracts in terms of dollars like student loans or annuities, they can have certainty about what those dollars will be able to buy in the future.

Now, in describing price stability, I’ve made reference to a pre-specified target for inflation. I haven’t said what the pre-specified inflation target is. In choosing its inflation target, the FOMC weighed the costs of overly high inflation against the need to guard against potentially destructive negative inflation—so-called deflation. This assessment has led the FOMC to choose an inflation target of 2 percent. Similarly, most central banks around the world have opted for a low but still positive inflation target.

The FOMC acts to achieve its two mandates—maximum employment and price stability—by influencing interest rates through the purchase and sale of financial assets. When the FOMC raises interest rates, households and firms tend to spend less and save more. The fall in spending puts downward pressure on both employment and prices. Similarly, when the FOMC lowers interest rates, households and firms tend to spend more and save less. This puts upward pressure on employment and prices.

However, these pressures on employment and prices from lower interest rates are not felt immediately. Instead, it typically takes a year or two for the effects of monetary policy adjustments to manifest themselves in inflation and unemployment. Hence, the FOMC’s decisions about appropriate monetary policy necessarily hinge on the members’ forecasts of the evolution of prices and employment over the next year or two—what we typically call our medium-term outlooks for inflation and unemployment. I’ll discuss the interaction between my outlook and appropriate policy later in my remarks.

Current Stance of Monetary Policy

With that as background, let me move on to describe the current stance of monetary policy. The change in monetary policy over the past five years has been dramatic. At the end of 2007, the Federal Reserve had less than $900 billion of assets, mostly in the form of short-term Treasuries. It was targeting a fed funds rate—the short-term interbank lending rate—above 4 percent. As of the end of 2012, the Federal Reserve owns nearly $3 trillion of assets, mostly in the form of long-term government-issued or government-backed securities. The Fed is currently targeting a fed funds rate of under a quarter percent.

Both of these changes in the stance of policy are designed to put upward pressure on employment and prices. In particular, the near-zero fed funds rate pushes downward on the interest rate that businesses and households can earn by saving money and downward on the interest rate to borrow money. These low interest rates encourage households to consume today rather than saving to consume in the future. Similarly, firms are encouraged to engage in capital expenditure rather than saving. This higher demand for consumption and investment pushes upward on both prices and employment.

Similarly, the Fed’s holdings of long-term assets mean that the private sector as a whole is less exposed to the interest rate risk that’s embedded in long-term investments. As a result, some private investors will demand a lower premium for holding other bonds that are exposed to interest rate risk, which puts downward pressure on other long-term yields. Again, faced with these lower yields, households and businesses should be more willing to spend now rather than later.

I’ve described the Fed’s current policy actions. But the impact of monetary policy on the macroeconomy also depends critically on the private sector’s beliefs about the Fed’s future actions. To take an obviously hypothetical extreme: Suppose the private sector believed today that the Fed would return permanently to its 2007 policy stance at its March meeting. Then, the macroeconomic impact of the Fed’s highly accommodative stance over the next two months would be negligible.

For this reason, the Federal Open Market Committee has gone to great lengths to provide what’s called “forward guidance”—communication to the public about the likely future evolution of its monetary policy decisions. Thus, the Committee is currently buying $85 billion of long-term assets each month. It has provided forward guidance about its future plans for asset purchases by saying that it intends to continue these asset purchases until there is substantial improvement in the labor market outlook.

The Committee has provided even more precision to the public about the likely future path of the fed funds rate. In its December statement, the FOMC announced that it anticipated keeping the fed funds rate at its current extraordinarily low level at least until the unemployment rate fell below a threshold of 6.5 percent, as long as the medium-term inflation outlook remained below 2.5 percent and longer-term inflation expectations remained well-anchored. The unemployment rate is currently 7.8 percent, and most private sector forecasters see the unemployment rate staying above 6.5 percent well into 2015. The FOMC’s communication tells the public that it should expect the fed funds rate to stay extraordinarily low over that same time frame, and possibly longer.

The FOMC’s communication about interest rates also tells the public how the stance of monetary policy will evolve in response to changes in economic conditions. Thus, if the unemployment rate falls more slowly than expected, the fed funds rate will be extraordinarily low for a longer period of time. If the unemployment rate falls more rapidly than expected, the fed funds rate will be extraordinarily low for a shorter period of time. In this way, the FOMC has assured the public that the stance of monetary policy will automatically adjust in an appropriate fashion to the evolution of macroeconomic conditions. This automatic adjustment is an important benefit of the Fed’s thresholds.

My Two-Year Outlook

I’ve described the Fed’s current monetary policy stance in some detail, and I’ve emphasized that the Fed’s stance is much more accommodative than it was five years ago. That observation alone might suggest that the Fed’s policy is too accommodative. But there have been big changes in the economy since 2007. Over the past five years, Americans have lost jobs and a great deal of wealth. Relative to 2007, people remain uncertain about future employment and income. Businesses, too, are less certain about future demand for their goods. These changes and uncertainties make firms and households less willing to spend than in 2007, and so push down on both employment and prices. This means that, in order to fulfill its dual mandate of promoting price stability and maximum employment, it is appropriate for the FOMC to adopt a more accommodative monetary policy than in 2007. So, the right question is a more subtle one: Is the FOMC overresponding to the changes in the economy since 2007 by providing too much accommodation?

As I noted earlier, the impact of monetary policy on the macroeconomy unfolds only slowly, over the course of a year or two. Hence, my answer to this question about whether the FOMC is providing too much accommodation depends on my outlook for the economy over the next year or two. With that in mind, I’ll turn now to describing that outlook, placed in the context of the evolution of the macroeconomy over the past five years. Let’s start by looking back at the evolution of national output—as measured by gross domestic product adjusted for inflation (real GDP). As you can see in this chart, national output fell dramatically during 2008 and the first half of 2009. Since the middle of 2009, the national economy has recovered at a moderate rate. Note, though, that output remains about 9 percent below where it would be if it had grown over the past five years in line with historical averages.

Large chart

Given the sluggish recovery in national output, it is not surprising that labor markets are also healing slowly. This next chart shows the behavior of the unemployment rate over the past five years. The unemployment rate, which was 5 percent in December 2007, reached 10 percent in the second half of 2009 (October). At the end of 2012, the national unemployment rate remained at 7.8 percent.

Large chart

Finally, this next chart shows that inflation has also run below the Federal Reserve’s 2 percent target. Over the past five years, the personal consumption expenditure (PCE) price index has grown at an average annual rate of 1.7 percent. Here, I should emphasize that the PCE price index is an index that includes all goods and services, including food and energy. So, I’m not talking about so-called core inflation—I’m talking about what’s called headline inflation.

Large chart

That’s a brief review of the past five years. Real output remains well below what one would expect it to be in light of historical growth patterns in the United States. Unemployment remains well above 2007 levels. Inflation has averaged below the Fed’s target.

With that review as background, let me turn to my macroeconomic outlook for the next couple of years. That outlook is predicated on the assumption that the FOMC’s monetary policy choices over the next few years will be consistent with the forward guidance about asset purchases and the fed funds rate that the FOMC provided in its December statement. With that assumption about policy, my outlook for the next two years can be summarized as being an ongoing modest recovery. Let me quickly go through the charts again, only this time I will add my forecasts. First, I see output continuing to grow slowly—at around 2.5 percent in 2013 and around 3 percent in 2014. Note that this growth will do little in terms of returning the economy to the historical trend. Consistent with this slow output growth, I expect unemployment to continue to fall only slowly, down to around 7.5 percent in late 2013 and around 7 percent in late 2014. This level of unemployment will continue to constrain wage growth. Consequently, inflation pressures will remain subdued, as I expect PCE inflation to be only 1.6 percent in 2013 and 1.9 percent in 2014.

Large chart

Large chart

Large chart

Using the Macroeconomic Outlook to Assess the Appropriateness of Monetary Policy

I’ve described my macroeconomic outlook for 2013 and 2014. Let me turn now to discussing how that outlook informs my judgment about monetary policy. As you will hear, my main conclusion is that my outlook implies that monetary policy is currently not accommodative enough.

Recall that the FOMC has a 2 percent inflation target. I do see inflation eventually returning to that 2 percent target under the FOMC’s current forward guidance. But I expect a slow rate of progress. As I’ve said, I anticipate that, conditional on the FOMC’s current forward guidance, the PCE inflation rate will be only 1.6 percent in 2013 and 1.9 percent in 2014. The FOMC could facilitate a faster return of the PCE inflation rate to the 2 percent target—that is, better promote price stability as mandated by Congress—by adopting a more accommodative monetary policy that puts more upward pressure on prices.

In reaching this conclusion that monetary policy should be more accommodative, I’ve only made reference to the price stability mandate. As I described earlier, the FOMC has a second mandate: to promote maximum employment. In December, most of the 19 FOMC participants believed that the unemployment rate will converge to a level between 5.2 percent and 6 percent within five to six years. But, under the current formulation of monetary policy, I see the rate of convergence to this long-run rate as likely to be slow. In particular, I expect that the unemployment rate will still be close to 7 percent by the end of 2014. The FOMC could facilitate a faster return of the unemployment rate to its lower long-run level by adopting a more accommodative monetary policy that puts more upward pressure on employment. Thus, I would say that my outlook for unemployment and my outlook for inflation both point to a need for more accommodation than is currently being provided by the FOMC.

One Way to Provide More Monetary Accommodation

Based on my outlook for the next two years, I’ve concluded that the FOMC would better fulfill both of its congressional mandates by adding more monetary policy accommodation. But how best to do so? In its current forward guidance, the FOMC has stated that it expects the fed funds rate to remain extraordinarily low at least until the unemployment rate falls below 6.5 percent. In my view, it would be appropriate for the FOMC to provide more needed stimulus by lowering the threshold unemployment rate from 6.5 percent to 5.5 percent.

To see why I say so, consider two possible scenarios. In the first, the public believes that the FOMC will begin raising the fed funds rate once the unemployment rate hits 6.5 percent. (To be clear: This belief is consistent with, but not necessarily implied by, the FOMC’s current forward guidance.) In the second, the public believes that the FOMC will defer the initial increase in the fed funds rate until the unemployment rate hits 5.5 percent. The higher unemployment rate in the first scenario means that monetary policy will be tightened sooner, which, in turn, will lead to the unemployment rate being higher for longer. Foreseeing that, people will save more in the first scenario than in the second, to protect themselves against these higher unemployment risks. Because they save more, they spend less, and there is less economic activity.¹

Thus, lowering the unemployment rate threshold to 5.5 percent would increase the demand for goods and thereby push upward on both employment and prices. Would this extra monetary stimulus result in an undue amount of inflation at some point in the future? Here, I find the recent historical evidence to be comforting. The following chart documents that the medium-term inflation outlook has not risen above 2¼ percent in the past 15 years, even though the unemployment rate was at times below 5 percent.² To me, this historical evidence suggests that, as long as the unemployment rate remains above 5.5 percent, the medium-term inflation outlook will stay close to 2 percent.

Large chart

The past is never a perfect guide to the future, of course. But I see the Committee’s estimates of future long-run unemployment as also being consistent with this historical evidence. Most FOMC participants expect that, over the long run, an unemployment rate of between 5.2 percent and 6 percent is consistent with an inflation rate of 2 percent. These estimates suggest that, as long as the unemployment rate remains above 5.5 percent, wage pressures will not be sufficiently strong to generate a medium-term inflation outlook much in excess of 2 percent.

Of course, these are estimates based on what we know now about labor market conditions. New information and new analyses could lead the FOMC’s estimates of the long-run unemployment rate to evolve over time. This is why the FOMC’s current forward guidance contains what I see as strong protection against undue inflation. As I described earlier, that guidance clearly states that the Committee’s commitment to a low fed funds rate is off the table if the medium-term inflation outlook ever rises above 2.5 percent. Having said that, let me repeat that I see it as unlikely that this threshold would ever be breached, even if the Committee were to lower the unemployment threshold to 5.5 percent.

To sum up: My outlook for both inflation and unemployment means that the FOMC should provide more monetary accommodation. In December, the FOMC said that it anticipates keeping the fed funds rate extraordinarily low at least until the unemployment rate falls below 6.5 percent. In my view, it would be appropriate for the Committee to increase the level of monetary accommodation by lowering the unemployment rate threshold to 5.5 percent. Some might be concerned that this move would give rise to undue inflationary pressures. I see that possibility as unlikely—and, even if I’m wrong in my assessment, the Committee’s forward guidance provides tight inflation safeguards.

Conclusions

Monetary policy affects the economy with a lag of one or two years. Hence, a policymaker’s views about the appropriate level of monetary policy accommodation depend on his or her forecast for how the economy will evolve over the next year or two. My own outlook is that growth will remain moderate over the next two years. As a result, under current policy, my outlook for inflation is that it will run below the Fed’s target of 2 percent over the next two years and that the unemployment rate will be above 7 percent over that same period. Hence, the FOMC can better promote price stability and promote maximum employment, as mandated by Congress, by adopting a more accommodative policy stance. It can provide that extra accommodation by lowering the unemployment rate threshold in its forward guidance to 5.5 percent from the current setting of 6.5 percent.

Note

Endnotes

Reference

Werning, Iván. 2012. “Managing a Liquidity Trap: Monetary and Fiscal Policy.” Working paper. Massachusetts Institute of Technology.

Note^*

Thank you for that generous introduction. Good morning everyone, and thank you for the invitation to join you here today. It’s a pleasure to be here at the start of a new year and to share my thoughts on the prospects for the economy and the role of monetary policy going forward. But as you will hear in a minute, I am also interested in your thoughts on the state of the economy and on your questions about Federal Reserve policy. So I look forward to our discussion following my talk.

In my remarks today, I’ll first provide some background about the Federal Reserve. I’ll then describe the current stance of monetary policy. I’ll discuss the macroeconomic outlook for the next couple of years implied by that monetary policy stance. Finally, I’ll offer my assessment of the appropriateness of monetary policy in light of that outlook.

But first—a disclaimer. As you will hear shortly, I’m one of the 19 people who have the privilege and honor to participate in the meetings of what’s called the Federal Open Market Committee. FOMC meetings shape the course of monetary policy in the United States. But it’s very important to understand that my remarks today are only my views and not necessarily those of any other FOMC participant.

Federal Reserve Structure

Let me begin with some basics about the Federal Reserve System. I like to tell people that the Fed is a uniquely American institution. What do I mean by that? Well, relative to its counterparts around the world, the U.S. central bank is highly decentralized. The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our bank represents the ninth of the 12 Federal Reserve districts and includes Montana, the Dakotas, Minnesota, northwestern Wisconsin and the Upper Peninsula of Michigan.

Eight times per year, the Federal Open Market Committee—the FOMC—meets to set the path of short-term interest rates over the next six to seven weeks. All 12 presidents of the various regional Federal Reserve banks—including me—and the seven governors of the Federal Reserve Board contribute to these deliberations. However, the Committee itself consists only of the governors, the president of the Federal Reserve Bank of New York and a rotating group of four other presidents. I won’t be on the Committee in 2013, but will be next year. In this way, the structure of the FOMC mirrors the federalist structure of our government, because representatives from different regions of the country—the various presidents—have input into FOMC deliberations.

This federalist structure is important because it fosters valuable two-way communication between Americans and their central bank—exactly the kind of two-way communication that we’re engaging in today. Of course, one direction of communication is from regional Fed presidents to the residents of their districts, like when we give speeches, write articles for our bank publications or present material on our websites. But the other direction matters a lot too. The input from the presidents to the FOMC relies critically on information we receive about local economic performance in our districts. We obtain this information through the work of our research staffs—but we also obtain it through ongoing conversations with local business and community leaders. And, after I’m done talking, your questions and comments will be another important input into my thinking about policy. In my view, this two-way communication between the residents of Main Street and the Federal Reserve System, mediated by the presidents of the regional Feds, is a critical ingredient to the System’s ongoing effectiveness.

Congress requires the FOMC to make monetary policy so as to fulfill two mandates: promote price stability and promote maximum employment. It should be clear that these are both Main Street objectives. Promoting maximum employment means that the Fed is charged with doing what it can to ensure that Americans who want to work can do so. Promoting price stability means that the Federal Reserve is charged with keeping inflation close to a pre-specified target. Price stability ensures that, when people write contracts in terms of dollars like student loans or annuities, they can have certainty about what those dollars will be able to buy in the future.

Now, in describing price stability, I’ve made reference to a pre-specified target for inflation. I haven’t said what the pre-specified inflation target is. In choosing its inflation target, the FOMC weighed the costs of overly high inflation against the need to guard against potentially destructive negative inflation—so-called deflation. This assessment has led the FOMC to choose an inflation target of 2 percent. Similarly, most central banks around the world have opted for a low but still positive inflation target.

The FOMC acts to achieve its two mandates—maximum employment and price stability—by influencing interest rates through the purchase and sale of financial assets. When the FOMC raises interest rates, households and firms tend to spend less and save more. The fall in spending puts downward pressure on both employment and prices. Similarly, when the FOMC lowers interest rates, households and firms tend to spend more and save less. This puts upward pressure on employment and prices.

However, these pressures on employment and prices from lower interest rates are not felt immediately. Instead, it typically takes a year or two for the effects of monetary policy adjustments to manifest themselves in inflation and unemployment. Hence, the FOMC’s decisions about appropriate monetary policy necessarily hinge on the members’ forecasts of the evolution of prices and employment over the next year or two—what we typically call our medium-term outlooks for inflation and unemployment. I’ll discuss the interaction between my outlook and appropriate policy later in my remarks.

Current Stance of Monetary Policy

With that as background, let me move on to describe the current stance of monetary policy. The change in monetary policy over the past five years has been dramatic. At the end of 2007, the Federal Reserve had less than $900 billion of assets, mostly in the form of short-term Treasuries. It was targeting a fed funds rate—the short-term interbank lending rate—above 4 percent. As of the end of 2012, the Federal Reserve owns nearly $3 trillion of assets, mostly in the form of long-term government-issued or government-backed securities. The Fed is currently targeting a fed funds rate of under a quarter percent.

Both of these changes in the stance of policy are designed to put upward pressure on employment and prices. In particular, the near-zero fed funds rate pushes downward on the interest rate that businesses and households can earn by saving money and downward on the interest rate to borrow money. These low interest rates encourage households to consume today rather than saving to consume in the future. Similarly, firms are encouraged to engage in capital expenditure rather than saving. This higher demand for consumption and investment pushes upward on both prices and employment.

Similarly, the Fed’s holdings of long-term assets mean that the private sector as a whole is less exposed to the interest rate risk that’s embedded in long-term investments. As a result, some private investors will demand a lower premium for holding other bonds that are exposed to interest rate risk, which puts downward pressure on other long-term yields. Again, faced with these lower yields, households and businesses should be more willing to spend now rather than later.

I’ve described the Fed’s current policy actions. But the impact of monetary policy on the macroeconomy also depends critically on the private sector’s beliefs about the Fed’s future actions. To take an obviously hypothetical extreme: Suppose the private sector believed today that the Fed would return permanently to its 2007 policy stance at its March meeting. Then, the macroeconomic impact of the Fed’s highly accommodative stance over the next two months would be negligible.

For this reason, the Federal Open Market Committee has gone to great lengths to provide what’s called “forward guidance”—communication to the public about the likely future evolution of its monetary policy decisions. Thus, the Committee is currently buying $85 billion of long-term assets each month. It has provided forward guidance about its future plans for asset purchases by saying that it intends to continue these asset purchases until there is substantial improvement in the labor market outlook.

The Committee has provided even more precision to the public about the likely future path of the fed funds rate. In its December statement, the FOMC announced that it anticipated keeping the fed funds rate at its current extraordinarily low level at least until the unemployment rate fell below a threshold of 6.5 percent, as long as the medium-term inflation outlook remained below 2.5 percent and longer-term inflation expectations remained well-anchored. The unemployment rate is currently 7.8 percent, and most private sector forecasters see the unemployment rate staying above 6.5 percent well into 2015. The FOMC’s communication tells the public that it should expect the fed funds rate to stay extraordinarily low over that same time frame, and possibly longer.

The FOMC’s communication about interest rates also tells the public how the stance of monetary policy will evolve in response to changes in economic conditions. Thus, if the unemployment rate falls more slowly than expected, the fed funds rate will be extraordinarily low for a longer period of time. If the unemployment rate falls more rapidly than expected, the fed funds rate will be extraordinarily low for a shorter period of time. In this way, the FOMC has assured the public that the stance of monetary policy will automatically adjust in an appropriate fashion to the evolution of macroeconomic conditions. This automatic adjustment is an important benefit of the Fed’s thresholds.

My Two-Year Outlook

I’ve described the Fed’s current monetary policy stance in some detail, and I’ve emphasized that the Fed’s stance is much more accommodative than it was five years ago. That observation alone might suggest that the Fed’s policy is too accommodative. But there have been big changes in the economy since 2007. Over the past five years, Americans have lost jobs and a great deal of wealth. Relative to 2007, people remain uncertain about future employment and income. Businesses, too, are less certain about future demand for their goods. These changes and uncertainties make firms and households less willing to spend than in 2007, and so push down on both employment and prices. This means that, in order to fulfill its dual mandate of promoting price stability and maximum employment, it is appropriate for the FOMC to adopt a more accommodative monetary policy than in 2007. So, the right question is a more subtle one: Is the FOMC overresponding to the changes in the economy since 2007 by providing too much accommodation?

As I noted earlier, the impact of monetary policy on the macroeconomy unfolds only slowly, over the course of a year or two. Hence, my answer to this question about whether the FOMC is providing too much accommodation depends on my outlook for the economy over the next year or two. With that in mind, I’ll turn now to describing that outlook, placed in the context of the evolution of the macroeconomy over the past five years. Let’s start by looking back at the evolution of national output—as measured by gross domestic product adjusted for inflation (real GDP). As you can see in this chart, national output fell dramatically during 2008 and the first half of 2009. Since the middle of 2009, the national economy has recovered at a moderate rate. Note, though, that output remains about 9 percent below where it would be if it had grown over the past five years in line with historical averages.

Large chart

Given the sluggish recovery in national output, it is not surprising that labor markets are also healing slowly. This next chart shows the behavior of the unemployment rate over the past five years. The unemployment rate, which was 5 percent in December 2007, reached 10 percent in the second half of 2009 (October). At the end of 2012, the national unemployment rate remained at 7.8 percent.

Large chart

Finally, this next chart shows that inflation has also run below the Federal Reserve’s 2 percent target. Over the past five years, the personal consumption expenditure (PCE) price index has grown at an average annual rate of 1.7 percent. Here, I should emphasize that the PCE price index is an index that includes all goods and services, including food and energy. So, I’m not talking about so-called core inflation—I’m talking about what’s called headline inflation.

Large chart

That’s a brief review of the past five years. Real output remains well below what one would expect it to be in light of historical growth patterns in the United States. Unemployment remains well above 2007 levels. Inflation has averaged below the Fed’s target.

With that review as background, let me turn to my macroeconomic outlook for the next couple of years. That outlook is predicated on the assumption that the FOMC’s monetary policy choices over the next few years will be consistent with the forward guidance about asset purchases and the fed funds rate that the FOMC provided in its December statement. With that assumption about policy, my outlook for the next two years can be summarized as being an ongoing modest recovery. Let me quickly go through the charts again, only this time I will add my forecasts. First, I see output continuing to grow slowly—at around 2.5 percent in 2013 and around 3 percent in 2014. Note that this growth will do little in terms of returning the economy to the historical trend. Consistent with this slow output growth, I expect unemployment to continue to fall only slowly, down to around 7.5 percent in late 2013 and around 7 percent in late 2014. This level of unemployment will continue to constrain wage growth. Consequently, inflation pressures will remain subdued, as I expect PCE inflation to be only 1.6 percent in 2013 and 1.9 percent in 2014.

Large chart

Large chart

Large chart

Using the Macroeconomic Outlook to Assess the Appropriateness of Monetary Policy

I’ve described my macroeconomic outlook for 2013 and 2014. Let me turn now to discussing how that outlook informs my judgment about monetary policy. As you will hear, my main conclusion is that my outlook implies that monetary policy is currently not accommodative enough.

Recall that the FOMC has a 2 percent inflation target. I do see inflation eventually returning to that 2 percent target under the FOMC’s current forward guidance. But I expect a slow rate of progress. As I’ve said, I anticipate that, conditional on the FOMC’s current forward guidance, the PCE inflation rate will be only 1.6 percent in 2013 and 1.9 percent in 2014. The FOMC could facilitate a faster return of the PCE inflation rate to the 2 percent target—that is, better promote price stability as mandated by Congress—by adopting a more accommodative monetary policy that puts more upward pressure on prices.

In reaching this conclusion that monetary policy should be more accommodative, I’ve only made reference to the price stability mandate. As I described earlier, the FOMC has a second mandate: to promote maximum employment. In December, most of the 19 FOMC participants believed that the unemployment rate will converge to a level between 5.2 percent and 6 percent within five to six years. But, under the current formulation of monetary policy, I see the rate of convergence to this long-run rate as likely to be slow. In particular, I expect that the unemployment rate will still be close to 7 percent by the end of 2014. The FOMC could facilitate a faster return of the unemployment rate to its lower long-run level by adopting a more accommodative monetary policy that puts more upward pressure on employment. Thus, I would say that my outlook for unemployment and my outlook for inflation both point to a need for more accommodation than is currently being provided by the FOMC.

One Way to Provide More Monetary Accommodation

Based on my outlook for the next two years, I’ve concluded that the FOMC would better fulfill both of its congressional mandates by adding more monetary policy accommodation. But how best to do so? In its current forward guidance, the FOMC has stated that it expects the fed funds rate to remain extraordinarily low at least until the unemployment rate falls below 6.5 percent. In my view, it would be appropriate for the FOMC to provide more needed stimulus by lowering the threshold unemployment rate from 6.5 percent to 5.5 percent.

To see why I say so, consider two possible scenarios. In the first, the public believes that the FOMC will begin raising the fed funds rate once the unemployment rate hits 6.5 percent. (To be clear: This belief is consistent with, but not necessarily implied by, the FOMC’s current forward guidance.) In the second, the public believes that the FOMC will defer the initial increase in the fed funds rate until the unemployment rate hits 5.5 percent. The higher unemployment rate in the first scenario means that monetary policy will be tightened sooner, which, in turn, will lead to the unemployment rate being higher for longer. Foreseeing that, people will save more in the first scenario than in the second, to protect themselves against these higher unemployment risks. Because they save more, they spend less, and there is less economic activity.¹

Thus, lowering the unemployment rate threshold to 5.5 percent would increase the demand for goods and thereby push upward on both employment and prices. Would this extra monetary stimulus result in an undue amount of inflation at some point in the future? Here, I find the recent historical evidence to be comforting. The following chart documents that the medium-term inflation outlook has not risen above 2¼ percent in the past 15 years, even though the unemployment rate was at times below 5 percent.² To me, this historical evidence suggests that, as long as the unemployment rate remains above 5.5 percent, the medium-term inflation outlook will stay close to 2 percent.

Large chart

The past is never a perfect guide to the future, of course. But I see the Committee’s estimates of future long-run unemployment as also being consistent with this historical evidence. Most FOMC participants expect that, over the long run, an unemployment rate of between 5.2 percent and 6 percent is consistent with an inflation rate of 2 percent. These estimates suggest that, as long as the unemployment rate remains above 5.5 percent, wage pressures will not be sufficiently strong to generate a medium-term inflation outlook much in excess of 2 percent.

Of course, these are estimates based on what we know now about labor market conditions. New information and new analyses could lead the FOMC’s estimates of the long-run unemployment rate to evolve over time. This is why the FOMC’s current forward guidance contains what I see as strong protection against undue inflation. As I described earlier, that guidance clearly states that the Committee’s commitment to a low fed funds rate is off the table if the medium-term inflation outlook ever rises above 2.5 percent. Having said that, let me repeat that I see it as unlikely that this threshold would ever be breached, even if the Committee were to lower the unemployment threshold to 5.5 percent.

To sum up: My outlook for both inflation and unemployment means that the FOMC should provide more monetary accommodation. In December, the FOMC said that it anticipates keeping the fed funds rate extraordinarily low at least until the unemployment rate falls below 6.5 percent. In my view, it would be appropriate for the Committee to increase the level of monetary accommodation by lowering the unemployment rate threshold to 5.5 percent. Some might be concerned that this move would give rise to undue inflationary pressures. I see that possibility as unlikely—and, even if I’m wrong in my assessment, the Committee’s forward guidance provides tight inflation safeguards.

Conclusions

Monetary policy affects the economy with a lag of one or two years. Hence, a policymaker’s views about the appropriate level of monetary policy accommodation depend on his or her forecast for how the economy will evolve over the next year or two. My own outlook is that growth will remain moderate over the next two years. As a result, under current policy, my outlook for inflation is that it will run below the Fed’s target of 2 percent over the next two years and that the unemployment rate will be above 7 percent over that same period. Hence, the FOMC can better promote price stability and promote maximum employment, as mandated by Congress, by adopting a more accommodative policy stance. It can provide that extra accommodation by lowering the unemployment rate threshold in its forward guidance to 5.5 percent from the current setting of 6.5 percent.

Note

Endnotes

Reference

Werning, Iván. 2012. “Managing a Liquidity Trap: Monetary and Fiscal Policy.” Working paper. Massachusetts Institute of Technology.

Thank you for that generous introduction. Good morning everyone, and thank you for the invitation to join you here today. It’s a pleasure to be here at the start of a new year and to share my thoughts on the prospects for the economy and the role of monetary policy going forward. But as you will hear in a minute, I am also interested in your thoughts on the state of the economy and on your questions about Federal Reserve policy. So I look forward to our discussion following my talk.

In my remarks today, I’ll first provide some background about the Federal Reserve. I’ll then describe the current stance of monetary policy. I’ll discuss the macroeconomic outlook for the next couple of years implied by that monetary policy stance. Finally, I’ll offer my assessment of the appropriateness of monetary policy in light of that outlook.

But first—a disclaimer. As you will hear shortly, I’m one of the 19 people who have the privilege and honor to participate in the meetings of what’s called the Federal Open Market Committee. FOMC meetings shape the course of monetary policy in the United States. But it’s very important to understand that my remarks today are only my views and not necessarily those of any other FOMC participant.

Federal Reserve Structure

Let me begin with some basics about the Federal Reserve System. I like to tell people that the Fed is a uniquely American institution. What do I mean by that? Well, relative to its counterparts around the world, the U.S. central bank is highly decentralized. The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our bank represents the ninth of the 12 Federal Reserve districts and includes Montana, the Dakotas, Minnesota, northwestern Wisconsin and the Upper Peninsula of Michigan.

Eight times per year, the Federal Open Market Committee—the FOMC—meets to set the path of short-term interest rates over the next six to seven weeks. All 12 presidents of the various regional Federal Reserve banks—including me—and the seven governors of the Federal Reserve Board contribute to these deliberations. However, the Committee itself consists only of the governors, the president of the Federal Reserve Bank of New York and a rotating group of four other presidents. I won’t be on the Committee in 2013, but will be next year. In this way, the structure of the FOMC mirrors the federalist structure of our government, because representatives from different regions of the country—the various presidents—have input into FOMC deliberations.

This federalist structure is important because it fosters valuable two-way communication between Americans and their central bank—exactly the kind of two-way communication that we’re engaging in today. Of course, one direction of communication is from regional Fed presidents to the residents of their districts, like when we give speeches, write articles for our bank publications or present material on our websites. But the other direction matters a lot too. The input from the presidents to the FOMC relies critically on information we receive about local economic performance in our districts. We obtain this information through the work of our research staffs—but we also obtain it through ongoing conversations with local business and community leaders. And, after I’m done talking, your questions and comments will be another important input into my thinking about policy. In my view, this two-way communication between the residents of Main Street and the Federal Reserve System, mediated by the presidents of the regional Feds, is a critical ingredient to the System’s ongoing effectiveness.

Congress requires the FOMC to make monetary policy so as to fulfill two mandates: promote price stability and promote maximum employment. It should be clear that these are both Main Street objectives. Promoting maximum employment means that the Fed is charged with doing what it can to ensure that Americans who want to work can do so. Promoting price stability means that the Federal Reserve is charged with keeping inflation close to a pre-specified target. Price stability ensures that, when people write contracts in terms of dollars like student loans or annuities, they can have certainty about what those dollars will be able to buy in the future.

Now, in describing price stability, I’ve made reference to a pre-specified target for inflation. I haven’t said what the pre-specified inflation target is. In choosing its inflation target, the FOMC weighed the costs of overly high inflation against the need to guard against potentially destructive negative inflation—so-called deflation. This assessment has led the FOMC to choose an inflation target of 2 percent. Similarly, most central banks around the world have opted for a low but still positive inflation target.

The FOMC acts to achieve its two mandates—maximum employment and price stability—by influencing interest rates through the purchase and sale of financial assets. When the FOMC raises interest rates, households and firms tend to spend less and save more. The fall in spending puts downward pressure on both employment and prices. Similarly, when the FOMC lowers interest rates, households and firms tend to spend more and save less. This puts upward pressure on employment and prices.

However, these pressures on employment and prices from lower interest rates are not felt immediately. Instead, it typically takes a year or two for the effects of monetary policy adjustments to manifest themselves in inflation and unemployment. Hence, the FOMC’s decisions about appropriate monetary policy necessarily hinge on the members’ forecasts of the evolution of prices and employment over the next year or two—what we typically call our medium-term outlooks for inflation and unemployment. I’ll discuss the interaction between my outlook and appropriate policy later in my remarks.

Current Stance of Monetary Policy

With that as background, let me move on to describe the current stance of monetary policy. The change in monetary policy over the past five years has been dramatic. At the end of 2007, the Federal Reserve had less than $900 billion of assets, mostly in the form of short-term Treasuries. It was targeting a fed funds rate—the short-term interbank lending rate—above 4 percent. As of the end of 2012, the Federal Reserve owns nearly $3 trillion of assets, mostly in the form of long-term government-issued or government-backed securities. The Fed is currently targeting a fed funds rate of under a quarter percent.

Both of these changes in the stance of policy are designed to put upward pressure on employment and prices. In particular, the near-zero fed funds rate pushes downward on the interest rate that businesses and households can earn by saving money and downward on the interest rate to borrow money. These low interest rates encourage households to consume today rather than saving to consume in the future. Similarly, firms are encouraged to engage in capital expenditure rather than saving. This higher demand for consumption and investment pushes upward on both prices and employment.

Similarly, the Fed’s holdings of long-term assets mean that the private sector as a whole is less exposed to the interest rate risk that’s embedded in long-term investments. As a result, some private investors will demand a lower premium for holding other bonds that are exposed to interest rate risk, which puts downward pressure on other long-term yields. Again, faced with these lower yields, households and businesses should be more willing to spend now rather than later.

I’ve described the Fed’s current policy actions. But the impact of monetary policy on the macroeconomy also depends critically on the private sector’s beliefs about the Fed’s future actions. To take an obviously hypothetical extreme: Suppose the private sector believed today that the Fed would return permanently to its 2007 policy stance at its March meeting. Then, the macroeconomic impact of the Fed’s highly accommodative stance over the next two months would be negligible.

For this reason, the Federal Open Market Committee has gone to great lengths to provide what’s called “forward guidance”—communication to the public about the likely future evolution of its monetary policy decisions. Thus, the Committee is currently buying $85 billion of long-term assets each month. It has provided forward guidance about its future plans for asset purchases by saying that it intends to continue these asset purchases until there is substantial improvement in the labor market outlook.

The Committee has provided even more precision to the public about the likely future path of the fed funds rate. In its December statement, the FOMC announced that it anticipated keeping the fed funds rate at its current extraordinarily low level at least until the unemployment rate fell below a threshold of 6.5 percent, as long as the medium-term inflation outlook remained below 2.5 percent and longer-term inflation expectations remained well-anchored. The unemployment rate is currently 7.8 percent, and most private sector forecasters see the unemployment rate staying above 6.5 percent well into 2015. The FOMC’s communication tells the public that it should expect the fed funds rate to stay extraordinarily low over that same time frame, and possibly longer.

The FOMC’s communication about interest rates also tells the public how the stance of monetary policy will evolve in response to changes in economic conditions. Thus, if the unemployment rate falls more slowly than expected, the fed funds rate will be extraordinarily low for a longer period of time. If the unemployment rate falls more rapidly than expected, the fed funds rate will be extraordinarily low for a shorter period of time. In this way, the FOMC has assured the public that the stance of monetary policy will automatically adjust in an appropriate fashion to the evolution of macroeconomic conditions. This automatic adjustment is an important benefit of the Fed’s thresholds.

My Two-Year Outlook

I’ve described the Fed’s current monetary policy stance in some detail, and I’ve emphasized that the Fed’s stance is much more accommodative than it was five years ago. That observation alone might suggest that the Fed’s policy is too accommodative. But there have been big changes in the economy since 2007. Over the past five years, Americans have lost jobs and a great deal of wealth. Relative to 2007, people remain uncertain about future employment and income. Businesses, too, are less certain about future demand for their goods. These changes and uncertainties make firms and households less willing to spend than in 2007, and so push down on both employment and prices. This means that, in order to fulfill its dual mandate of promoting price stability and maximum employment, it is appropriate for the FOMC to adopt a more accommodative monetary policy than in 2007. So, the right question is a more subtle one: Is the FOMC overresponding to the changes in the economy since 2007 by providing too much accommodation?

As I noted earlier, the impact of monetary policy on the macroeconomy unfolds only slowly, over the course of a year or two. Hence, my answer to this question about whether the FOMC is providing too much accommodation depends on my outlook for the economy over the next year or two. With that in mind, I’ll turn now to describing that outlook, placed in the context of the evolution of the macroeconomy over the past five years. Let’s start by looking back at the evolution of national output—as measured by gross domestic product adjusted for inflation (real GDP). As you can see in this chart, national output fell dramatically during 2008 and the first half of 2009. Since the middle of 2009, the national economy has recovered at a moderate rate. Note, though, that output remains about 9 percent below where it would be if it had grown over the past five years in line with historical averages.

Large chart

Given the sluggish recovery in national output, it is not surprising that labor markets are also healing slowly. This next chart shows the behavior of the unemployment rate over the past five years. The unemployment rate, which was 5 percent in December 2007, reached 10 percent in the second half of 2009 (October). At the end of 2012, the national unemployment rate remained at 7.8 percent.

Large chart

Finally, this next chart shows that inflation has also run below the Federal Reserve’s 2 percent target. Over the past five years, the personal consumption expenditure (PCE) price index has grown at an average annual rate of 1.7 percent. Here, I should emphasize that the PCE price index is an index that includes all goods and services, including food and energy. So, I’m not talking about so-called core inflation—I’m talking about what’s called headline inflation.

Large chart

That’s a brief review of the past five years. Real output remains well below what one would expect it to be in light of historical growth patterns in the United States. Unemployment remains well above 2007 levels. Inflation has averaged below the Fed’s target.

With that review as background, let me turn to my macroeconomic outlook for the next couple of years. That outlook is predicated on the assumption that the FOMC’s monetary policy choices over the next few years will be consistent with the forward guidance about asset purchases and the fed funds rate that the FOMC provided in its December statement. With that assumption about policy, my outlook for the next two years can be summarized as being an ongoing modest recovery. Let me quickly go through the charts again, only this time I will add my forecasts. First, I see output continuing to grow slowly—at around 2.5 percent in 2013 and around 3 percent in 2014. Note that this growth will do little in terms of returning the economy to the historical trend. Consistent with this slow output growth, I expect unemployment to continue to fall only slowly, down to around 7.5 percent in late 2013 and around 7 percent in late 2014. This level of unemployment will continue to constrain wage growth. Consequently, inflation pressures will remain subdued, as I expect PCE inflation to be only 1.6 percent in 2013 and 1.9 percent in 2014.

Large chart

Large chart

Large chart

Using the Macroeconomic Outlook to Assess the Appropriateness of Monetary Policy

I’ve described my macroeconomic outlook for 2013 and 2014. Let me turn now to discussing how that outlook informs my judgment about monetary policy. As you will hear, my main conclusion is that my outlook implies that monetary policy is currently not accommodative enough.

Recall that the FOMC has a 2 percent inflation target. I do see inflation eventually returning to that 2 percent target under the FOMC’s current forward guidance. But I expect a slow rate of progress. As I’ve said, I anticipate that, conditional on the FOMC’s current forward guidance, the PCE inflation rate will be only 1.6 percent in 2013 and 1.9 percent in 2014. The FOMC could facilitate a faster return of the PCE inflation rate to the 2 percent target—that is, better promote price stability as mandated by Congress—by adopting a more accommodative monetary policy that puts more upward pressure on prices.

In reaching this conclusion that monetary policy should be more accommodative, I’ve only made reference to the price stability mandate. As I described earlier, the FOMC has a second mandate: to promote maximum employment. In December, most of the 19 FOMC participants believed that the unemployment rate will converge to a level between 5.2 percent and 6 percent within five to six years. But, under the current formulation of monetary policy, I see the rate of convergence to this long-run rate as likely to be slow. In particular, I expect that the unemployment rate will still be close to 7 percent by the end of 2014. The FOMC could facilitate a faster return of the unemployment rate to its lower long-run level by adopting a more accommodative monetary policy that puts more upward pressure on employment. Thus, I would say that my outlook for unemployment and my outlook for inflation both point to a need for more accommodation than is currently being provided by the FOMC.

One Way to Provide More Monetary Accommodation

Based on my outlook for the next two years, I’ve concluded that the FOMC would better fulfill both of its congressional mandates by adding more monetary policy accommodation. But how best to do so? In its current forward guidance, the FOMC has stated that it expects the fed funds rate to remain extraordinarily low at least until the unemployment rate falls below 6.5 percent. In my view, it would be appropriate for the FOMC to provide more needed stimulus by lowering the threshold unemployment rate from 6.5 percent to 5.5 percent.

To see why I say so, consider two possible scenarios. In the first, the public believes that the FOMC will begin raising the fed funds rate once the unemployment rate hits 6.5 percent. (To be clear: This belief is consistent with, but not necessarily implied by, the FOMC’s current forward guidance.) In the second, the public believes that the FOMC will defer the initial increase in the fed funds rate until the unemployment rate hits 5.5 percent. The higher unemployment rate in the first scenario means that monetary policy will be tightened sooner, which, in turn, will lead to the unemployment rate being higher for longer. Foreseeing that, people will save more in the first scenario than in the second, to protect themselves against these higher unemployment risks. Because they save more, they spend less, and there is less economic activity.¹

Thus, lowering the unemployment rate threshold to 5.5 percent would increase the demand for goods and thereby push upward on both employment and prices. Would this extra monetary stimulus result in an undue amount of inflation at some point in the future? Here, I find the recent historical evidence to be comforting. The following chart documents that the medium-term inflation outlook has not risen above 2¼ percent in the past 15 years, even though the unemployment rate was at times below 5 percent.² To me, this historical evidence suggests that, as long as the unemployment rate remains above 5.5 percent, the medium-term inflation outlook will stay close to 2 percent.

Large chart

The past is never a perfect guide to the future, of course. But I see the Committee’s estimates of future long-run unemployment as also being consistent with this historical evidence. Most FOMC participants expect that, over the long run, an unemployment rate of between 5.2 percent and 6 percent is consistent with an inflation rate of 2 percent. These estimates suggest that, as long as the unemployment rate remains above 5.5 percent, wage pressures will not be sufficiently strong to generate a medium-term inflation outlook much in excess of 2 percent.

Of course, these are estimates based on what we know now about labor market conditions. New information and new analyses could lead the FOMC’s estimates of the long-run unemployment rate to evolve over time. This is why the FOMC’s current forward guidance contains what I see as strong protection against undue inflation. As I described earlier, that guidance clearly states that the Committee’s commitment to a low fed funds rate is off the table if the medium-term inflation outlook ever rises above 2.5 percent. Having said that, let me repeat that I see it as unlikely that this threshold would ever be breached, even if the Committee were to lower the unemployment threshold to 5.5 percent.

To sum up: My outlook for both inflation and unemployment means that the FOMC should provide more monetary accommodation. In December, the FOMC said that it anticipates keeping the fed funds rate extraordinarily low at least until the unemployment rate falls below 6.5 percent. In my view, it would be appropriate for the Committee to increase the level of monetary accommodation by lowering the unemployment rate threshold to 5.5 percent. Some might be concerned that this move would give rise to undue inflationary pressures. I see that possibility as unlikely—and, even if I’m wrong in my assessment, the Committee’s forward guidance provides tight inflation safeguards.

Conclusions

Monetary policy affects the economy with a lag of one or two years. Hence, a policymaker’s views about the appropriate level of monetary policy accommodation depend on his or her forecast for how the economy will evolve over the next year or two. My own outlook is that growth will remain moderate over the next two years. As a result, under current policy, my outlook for inflation is that it will run below the Fed’s target of 2 percent over the next two years and that the unemployment rate will be above 7 percent over that same period. Hence, the FOMC can better promote price stability and promote maximum employment, as mandated by Congress, by adopting a more accommodative policy stance. It can provide that extra accommodation by lowering the unemployment rate threshold in its forward guidance to 5.5 percent from the current setting of 6.5 percent.

Note

Endnotes

Reference

Werning, Iván. 2012. “Managing a Liquidity Trap: Monetary and Fiscal Policy.” Working paper. Massachusetts Institute of Technology.

Thank you, Chris, for that introduction and thanks, especially, to all of you for coming tonight to this event. It is great to see so much interest in the Federal Reserve. I’ll open things up with some brief remarks about the Fed and my macroeconomic outlook for 2013 and 2014. However, I’m very much looking forward to what I see as the main event this evening: answering your questions about the Federal Reserve and the economy.

But first—a disclaimer. As you will hear shortly, I’m one of the 19 people who have the privilege and honor to participate in the meetings of what’s called the Federal Open Market Committee. FOMC meetings shape the course of monetary policy in the United States. But it’s very important to understand that, in my remarks today, I’m telling you only my own views, and those perspectives are not necessarily those of any other FOMC participant.

Federal Reserve Structure and the Making of Monetary Policy

As I mentioned, the Federal Open Market Committee—the FOMC—is the Fed’s monetary policymaking body. It meets eight times per year. All 12 presidents of the various regional Federal Reserve banks travel from their home districts to Washington to contribute to monetary policy deliberations, along with the seven governors of the Federal Reserve Board. In this way, representatives from different regions of the country have direct input into the setting of American monetary policy.

Congress requires the FOMC to make monetary policy so as to fulfill two mandates: promote price stability and promote maximum employment. It should be clear that these are both Main Street objectives. Promoting maximum employment means that the Fed is charged with doing what it can to ensure that Americans who want to work can do so. Promoting price stability means that the Federal Reserve is charged with keeping inflation close to a pre-specified target. Households and businesses engage in a large number of transactions—like mortgages or IRAs—that involve the exchange of dollars today for dollars in the future. Price stability ensures that they can have certainty about what those future dollars will be able to buy.

Now, in describing price stability, I’ve made reference to a “pre-specified target” for inflation. I haven’t said what the pre-specified inflation target is. In choosing its inflation target, the FOMC weighed the costs of overly high inflation against the need to guard against potentially destructive negative inflation—so-called deflation. This assessment has led the FOMC to pick an inflation target of 2 percent. Similarly, most central banks around the world have opted for a low but still positive inflation target.

The FOMC acts to achieve its two mandates—maximum employment and price stability—by influencing interest rates through the purchase and sale of financial assets. When the FOMC raises interest rates, households and firms tend to spend less and save more. The fall in spending puts downward pressure on both employment and prices. Similarly, when the FOMC lowers interest rates, households and firms tend to spend more and save less. This puts upward pressure on employment and prices.

However, these pressures on employment and prices from lower interest rates are not felt immediately. Instead, it typically takes a year or two for the effects of monetary policy adjustments to manifest themselves in inflation and unemployment. Hence, the FOMC’s decisions about appropriate monetary policy necessarily hinge on the members’ forecasts of the evolution of prices and employment over the next year or two—what we typically call our medium-term outlooks for inflation and unemployment.

So, a key part of my job as a monetary policymaker is to formulate a medium-term outlook for the U.S. economy. In the remainder of my remarks, I’ll describe my two-year outlook for inflation, unemployment and economic output. I’ll begin, though, by placing that outlook in the context of the evolution of these same variables over the past five years.

Past Five Years

Let’s start by looking back at the evolution of national output—as measured by gross domestic product adjusted for inflation (real GDP). As you can see in this chart, national output fell dramatically during 2008 and the first half of 2009. Since the middle of 2009, the national economy has recovered at a moderate rate. Note, though, that output remains about 9 percent below where it would be if it had grown over the past five years in line with historical averages.

Given the sluggish recovery in national output, it is not surprising that labor markets are also healing slowly. This next chart shows the behavior of the unemployment rate over the past five years. The unemployment rate, which was 5 percent in December 2007, reached 10 percent in the second half of 2009 (October). At the end of 2012, the national unemployment rate remained at 7.8 percent.

Finally, this next chart shows that inflation has also run below the Federal Reserve’s 2 percent target. Over the past five years, the personal consumption expenditure (PCE) price index has grown at an average annual rate of 1.7 percent. Here, I should emphasize that the PCE price index is an index that includes all goods and services, including food and energy. So, I’m not talking about so-called core inflation—I’m talking about what’s called headline inflation.

That’s a brief review of the past five years. Real output remains well below what one would expect it to be in light of historical growth patterns in the United States. Unemployment remains well above 2007 levels. Inflation has averaged below the Fed’s target.

With that review as background, let me turn to my macroeconomic outlook for the next couple of years. That outlook is predicated on the assumption that the FOMC’s monetary policy choices over the next few years will be consistent with the forward guidance about asset purchases and the fed funds rate that the FOMC provided in its December statement. With that assumption about policy, my outlook for the next two years can be summarized as being an ongoing modest recovery. Let me quickly go through the charts again, only this time I will add my forecasts. First, I see output as continuing to grow slowly—at around 2.5 percent in 2013 and around 3 percent in 2014. Note that this growth will do little in terms of returning the economy to the historical trend. Consistent with this slow output growth, I expect unemployment to continue to fall only slowly, down to around 7.5 percent in late 2013 and around 7 percent in late 2014. This level of unemployment will continue to constrain wage growth. Consequently, inflation pressures will remain subdued, as I expect PCE inflation to be only 1.6 percent in 2013 and 1.9 percent in 2014.

Conclusions

Let me wrap up.

Congress has charged the Fed with making monetary policy to achieve two Main Street objectives: keep inflation close to 2 percent and unemployment low. Monetary policy tools operate with a lag of a year or two. These lags mean that the FOMC’s policy decisions are based on how it expects the economy to perform over the medium term. My own forecast, conditional on the FOMC’s current monetary policy stance, is that inflation will run below the Fed’s target of 2 percent over the next two years and the unemployment rate will remain elevated. This forecast suggests that, if anything, monetary policy is currently too tight, not too easy.

Thanks for listening. And I look forward to your questions.

Conversations with the Fed [PDF]

Endnote

For many policymakers, the lesson of the financial crisis of 2007-09—and other similar events in the past—is that the disorderly failure of an important financial institution could have large macroeconomic costs. Faced with these costs, governments might well provide resources to an important financial institution to enable it to continue to repay its creditors in full. Such firms are often referred to as being “too big to fail,” or TBTF.

The Dodd-Frank Act says that one of its goals is to end “too big to fail.” To achieve that goal, the act makes a number of changes in the regulatory landscape. Regulatory agencies are beginning to implement these changes.

But how will we know if these changes in laws and regulations are working? I think that there is no way to answer this question without a measure—or preferably a range of measures—of the size of the TBTF problem. If these metrics remain high, then we know that we need further supervisory, regulatory or possibly legislative changes. If those measures are low, then the TBTF problem is small, and we can conclude that the current approach to dealing with TBTF is, in fact, an effective one.

At the Federal Reserve Bank of Minneapolis, we are highly interested in developing and tracking these kinds of measures of the TBTF problem. This interest follows naturally from the line of thinking about the TBTF problem emphasized by my predecessor, Gary Stern, and my current head of supervision, Ron Feldman. Our preferred approach is to use market indicators as the basis for our metrics, along the lines that Chairman Bernanke sketched earlier this year.²

In my remarks today, I’ll describe two current market-based approaches that gauge the size of the TBTF problem. Then I’ll discuss a limitation of these two market-based approaches—a limitation that seems to be shared by other available market-based approaches as well. I’ll close by highlighting this limitation as a key area for future research. Before I continue, I need to remind you that all views expressed in these remarks and during the discussion are my own, and not necessarily those of others in the Federal Reserve.

Measurement

I’ll begin by describing two of the currently available market-based approaches for measuring the size of the TBTF problem.

The first approach relies on a combination of credit ratings and market prices. The method examines the difference—typically called the “uplift” —between two types of credit ratings: one that accounts for potential external support and one that does not. Market data can then be used to translate the uplift—the difference in credit ratings—into a difference in borrowing costs. By scaling this borrowing cost by the size of the bank’s risk-sensitive liabilities, a measure of the TBTF problem can be obtained for that bank. Andrew Haldane of the Bank of England has exploited this approach to great effect. Based on this analysis, he argues that the size of the TBTF problem—both here in the United States and globally—remains substantial.³

The second approach is typical of a more complex method that relies on market prices, specifically the relationship between market prices, measures of TBTF status and measures of risk. We’ve done some work using this approach here at the Federal Reserve Bank of Minneapolis. We examine pricing on credit default swaps for large bank debt likely considered TBTF and for debt issued by other financial firms not likely considered TBTF. We use a standard model to estimate the likelihood of firm default. We calculate the statistical relationship between the measure of default and the credit default swaps prices. We compare that relationship for the likely TBTF firms to the firms not considered TBTF. The connection between credit default swaps prices and estimated default probabilities should be relatively lower for the TBTF firms that are seen as being more likely to receive government support. Our preliminary work using this approach indicates that the size of the TBTF problem has fallen over the past couple of years but remains large.

A Conceptual Limitation

Let me turn to describing what I think we can and cannot learn from the approaches that I’ve described and from other currently available market-based metrics. In my description, I’ll ignore some possible sources of error, like the use of potentially flawed credit ratings or statistical models of default. It’s not that I don’t see those possible sources of error as important—it’s more that I’m sure that they will be the subject of intense scrutiny in future research.⁴ In contrast, I’ll focus on what I see as an intrinsic conceptual limitation of the existing metrics that I believe also merits attention.

In describing this conceptual limitation, I think that it’s helpful for me to start with a recent speech about “too big to fail” by William Dudley, president of the Federal Reserve Bank of New York.⁵

In his speech, President Dudley describes two kinds of policy approaches designed to treat the problem of TBTF. Some approaches—like higher capital requirements—attempt to reduce the likelihood of distress in an important financial institution. Other approaches—like living wills—attempt to reduce the social costs associated with that distress. I see this reduction in social costs as valuable because it reduces the incentive for a government to provide support to the relevant distressed financial institution.

The metrics that I’ve described are gauges of the joint impact of both kinds of policies. In particular, when the metrics are low for a given financial institution, it can be for one of two reasons. It could be that creditors believe that there is little likelihood of that financial institution becoming distressed. This would be a sign that the first kind of policies identified by President Dudley are working. Or it could be that creditors believe that it is unlikely that the government will provide support to the institution if it ever becomes distressed. This would be a sign that the second kind of policy measures are working.

Measures of the joint impact of the two kinds of policy approaches are, I think, valuable. It is clear that the TBTF problem is small if living wills work so well that there is little or no likelihood of a distressed financial institution ever receiving support. But I would suggest too that the TBTF problem is also small if creditors perceive that, because of either economic conditions or capital requirements, there is little likelihood of important financial institutions becoming distressed. To use an analogy, some observers have expressed concern about emergency federal flood assistance creating a moral hazard problem. But, even if the government stands ready to provide full assistance to all in the event of a flood, I would expect the impact of the relevant moral hazard problem to be low for a house in the 10,000 year flood zone.

So I do see the current metrics as being of use. Nonetheless, it would be desirable to augment them with metrics that could distinguish the impacts of the two kinds of policy measures. Similarly, TBTF metrics could improve simply because creditors’ assessments of future macroeconomic conditions improve. It would be desirable too to have a way to strip out the effects of this particular factor on our metrics. Technically, we would like to be able to use market-based information, and other data sources, to obtain projected levels of TBTF support that are conditional on specific economic events. The current measures average across these events to obtain an expected level of TBTF support.⁶

Conclusions

Let me wrap up.

Congress has mandated that the Federal Reserve make monetary policy so as to promote price stability and maximum employment. In recent remarks that I made in Duluth, Minnesota, I stressed the importance of using metrics about the inflation and unemployment outlooks to gauge the appropriateness of monetary policy in light of those congressionally mandated objectives. Without these metrics, it is challenging to know whether monetary policy is overly accommodative or not.

This same general point applies to supervision and regulation. The Dodd-Frank Act mandates an end to “too big to fail.” But the public can only hold Congress and its delegees responsible for achieving this mandate if there are quantitative measures of the size of the TBTF problem. The Minneapolis Fed continues to work toward constructing, and publicizing, such measures.

Endnotes

References

Dudley, William C. 2012. “Solving the Too Big to Fail Problem.” Remarks at the Clearing House’s Second Annual Business Meeting and Conference, New York City, Nov. 15.

Haldane, Andrew. 2012. “On Being the Right Size.” Speech at the Institute of Economic Affairs’ 22nd Annual Series, the 2012 Beesley Lectures at the Institute of Directors, Pall Mall, Oct. 25.

Kocherlakota, Narayana. 2010. “Taxing Risk and the Optimal Regulation of Financial Institutions.” Economic Policy Paper, Federal Reserve Bank of Minneapolis.

But first—a disclaimer. As you will hear shortly, I’m one of the 19 people who have the privilege and honor to participate in the meetings of what’s called the Federal Open Market Committee (FOMC). FOMC meetings shape the course of monetary policy in the United States. But it’s very important to understand that, in my remarks today, I’m telling you only my own views, and those perspectives are not necessarily those of any other FOMC participant.

Federal Reserve Structure and the Making of Monetary Policy

Let me begin with some background about the Fed. Relative to its counterparts around the world, the U.S. central bank is decentralized. The Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our bank represents the ninth of the 12 Federal Reserve districts, and our district includes Montana, the Dakotas, Minnesota, northwestern Wisconsin and the Upper Peninsula of Michigan.

As I mentioned, the Federal Open Market Committee—the FOMC—is the Fed’s monetary policymaking body. It meets eight times per year to set the course of monetary policy. All 12 presidents of the various regional Federal Reserve banks travel from their home districts to Washington to contribute to these deliberations, along with the seven governors of the Federal Reserve Board. In this way, representatives from different regions of the country have direct input into the setting of U.S. monetary policy.

Congress requires the FOMC to make monetary policy so as to fulfill two mandates: to promote price stability and to promote maximum employment. It should be clear that these are both Main Street objectives that benefit all Americans. Promoting maximum employment means that the Fed is charged with doing what it can to ensure that Americans who want to work can do so. Promoting price stability means that the Federal Reserve is charged with keeping inflation close to a pre-specified target. Price stability ensures that, when people write contracts in terms of dollars, like student loans or annuities, they can have certainty about what those dollars will be able to buy in the future.

Now, in describing price stability, I’ve made reference to a “pre-specified target” for inflation. I haven’t said what the pre-specified inflation target is. In choosing its inflation target, the FOMC weighed the costs of overly high inflation against the need to guard against potentially destructive negative inflation—so-called deflation. This assessment has led the FOMC to pick an inflation target of 2 percent. Similarly, most central banks around the world have opted for a low but still positive inflation target.

The FOMC acts to achieve its two mandates—maximum employment and price stability—by influencing interest rates through the purchase and sale of financial assets. When interest rates rise, households and firms tend to spend less and save more. The fall in spending puts downward pressure on both employment and prices. When interest rates fall, households and firms tend to spend more and save less. This puts upward pressure on employment and prices.

Of course, there are many interest rates in the economy—mortgage rates, student loan rates, corporate borrowing rates and so on. The Fed does not directly intervene in all, most or even many of these markets. Instead, Congress has restricted the Fed to trade in a small number of financial markets. Nonetheless, most economists agree that the Fed is able to influence almost all interest rates. The forces of competition in financial markets imply that the prices in one financial market necessarily influence prices in most or all financial markets. This interconnectedness levers the Fed’s interventions in a small number of financial markets into an influence on the economy as a whole.

As I’ve said, the Fed’s mandated goals are clearly Main Street ones—to promote maximum employment and price stability. But, as I’ve also described, the Federal Reserve acts to achieve those goals by engaging in trades in financial markets. The public discourse about the Fed often focuses on our financial transactions in isolation, and the links back to our Main Street objectives are not always apparent. This disconnect is always problematic, but in the remainder of my remarks, I’ll argue that it is especially so today.

Current Monetary Policy Stance

Let me turn then to the current stance of monetary policy. Five years ago, in October 2007, the Federal Reserve had under $900 billion of assets, mostly in the form of short-term Treasuries. It was targeting a fed funds rate—the short-term interbank lending rate—of just under 5 percent. Five years later, the Federal Reserve owns nearly $3 trillion of assets, mostly in the form of long-term government-issued or government-backed securities. It plans to buy still more over the remainder of 2012. It has also been targeting a fed funds rate of under a quarter percent for nearly four years—and anticipates continuing to do so through mid-2015. In the language of central banking, the Fed’s policy stance is considerably more accommodative than it was five years ago.

Some observers argue that the Fed has done too much, has been too accommodative. I strongly disagree. These critics are certainly right that the Fed’s actions—tripling its balance sheet and keeping the fed funds rate near zero for years—are historically unprecedented. But it is also clear that the economy has been hit by the worst shock in 80 years. Over the past five years, Americans have lost jobs and a great deal of wealth. Relative to 2007, people remain uncertain about future employment and income. Businesses, too, are less certain about future demand for their goods. These changes and uncertainties make firms and households less willing to spend, and so push down on both employment and prices. In order to fulfill its dual mandate of promoting price stability and promoting maximum employment, the FOMC must offset these adverse shocks by making monetary policy more accommodative.

In light of the unusually large macroeconomic shock, I believe that it is misleading to assess the FOMC’s actions by comparing its current choices to policy steps taken over the past 30 years. Instead, we have to assess monetary policy by comparing the economy’s performance relative to the FOMC’s goals of price stability and maximum employment. In particular, if the FOMC’s policy is too accommodative, that should manifest itself in inflation above the Fed’s target of 2 percent. This has not been true over the past year: Personal consumption expenditure inflation—including food and energy—is running closer to 1.5 percent than the Fed’s target of 2 percent.¹

But this comparison using inflation over the past year is at best incomplete. Current monetary policy is typically thought to affect inflation with a one- to two-year lag. This means that we should always judge the appropriateness of current monetary policy using our best possible forecast of inflation, not current inflation. Along those lines, most FOMC participants expect that inflation will remain at or below 2 percent over the next one to two years. Given how high unemployment is expected to remain over the next few years, these inflation forecasts suggest that monetary policy is, if anything, too tight, not too easy.

Conclusions

Let me wrap up. In my discussion about the Federal Reserve, I’ve described our decentralized structure, and I’ve emphasized our Main Street objectives of price stability and maximum employment. I see our structure and our goals as entirely complementary. In my view, having people from around the country—the presidents of the various regional Reserve banks—participate in monetary policy deliberations is valuable in ensuring that those discussions always put our Main Street goals at center stage.

Unfortunately, public discussion about the Fed often centers on the financial transactions that we undertake to achieve our goals. I think that this focus on our actions, as opposed to our goals, is always misleading and is especially so right now. The FOMC has provided a historically unprecedented amount of monetary accommodation. But the U.S. economy is recovering from the largest adverse shock in 80 years—and a historically unprecedented shock should lead to a historically unprecedented monetary policy response. We should always judge the appropriateness of the Fed’s policies in terms of how the economy is doing relative to the two Main Street goals that Congress has set for the FOMC. Such a comparison does not suggest that monetary policy is currently too easy.

Thank you for your time and attention. I’ll be happy to take your questions.

View a Storify composed of tweets from this event.

Endnotes

Thank you for that introduction, Tim. It’s a great pleasure to be here in Great Falls to commemorate your service on the board of directors of the Helena Branch of the Federal Reserve Bank of Minneapolis. From what you have described, people can get a good sense of the contributions that our directors make to the Federal Reserve System. However, as the president of the Federal Reserve Bank of Minneapolis, I would just stress the value of this citizen participation in our nation’s central bank. It is important for people to realize that the Federal Reserve is represented and served by dedicated citizens like Tim, from places like Great Falls, Helena, Billings, and from many towns like them all across the country. The time that Tim has contributed to the Federal Reserve is truly public service. So thank you, Tim, for your commitment and dedication; and thanks also to the other members of the Helena branch board of directors, all of whom are here today.

I plan to talk for about a half hour, and then I look forward to your questions and comments. I always find those to be great learning opportunities. However, before we proceed any further, I need to remind you that the following views are my own, and not necessarily those of others in the Federal Reserve.

In my remarks today, I’ll begin by briefly discussing the objectives of the Federal Open Market Committee, or FOMC, which is the monetary policymaking arm of the Federal Reserve. With that as background, I will then turn to a discussion of monetary policy. My jumping-off point is a phrase in the FOMC statement issued on September 13. In that statement, the Committee said that it “expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.”

My main message today is that the FOMC can provide additional monetary stimulus by making this sentence more precise in the form of what I’m going to call a liftoff plan: a description of the economic conditions that would lead the Committee to contemplate the initial increase in the fed funds rate above its current extraordinarily low level.²

I will suggest the following specific contingency plan for liftoff:

As long as the FOMC satisfies its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent.

The fed funds rate is a short-term interbank lending rate that is the FOMC’s usual vehicle for influencing credit conditions. I’ll be much more precise later about the meaning of the phrase “satisfies its price stability mandate.” Briefly, though, I mean that longer-term inflation expectations are stable and that the Committee’s medium-term outlook for the annual inflation rate is within a quarter of a percentage point of its target of 2 percent. The substance of this liftoff plan is that, as long as longer-term inflation expectations remain stable, the Committee will not raise the fed funds rate unless the medium-term outlook for the inflation rate exceeds a threshold value of 2 1/4 percent or the unemployment rate falls below a threshold value of 5.5 percent. Note that neither of these thresholds should be viewed as triggers—that is, once the relevant cutoffs are crossed, the Committee retains the option of either keeping the fed funds rate extraordinarily low or raising the fed funds rate.

Thus, my proposed liftoff plan contains a specific definition of the phrase “a considerable time after the economic recovery strengthens.” In my talk, I will argue that this specificity—about an event that may not take place for four or more years—will provide needed current stimulus to the economy.

FOMC Objectives

Let me begin by describing the monetary policy objectives of the FOMC. Congress has specified in the Federal Reserve Act that the FOMC should make monetary policy so as to promote price stability and maximum employment. These two objectives—price stability and maximum employment—are typically termed the FOMC’s dual mandate. In January, the FOMC issued an important consensus statement of long-run principles and strategies. The statement provides a specific definition of price stability as representing a goal, over the longer run, of 2 percent inflation.

But there are a couple of reasons why this definition of price stability is not as operational as one might like. One issue is that monetary policy affects inflation with lags. Policymakers are generally thinking about making current choices so as to influence the annual inflation rate in about two years’ time. Thus, monetary policy choices made toward the end of 2012 should be evaluated in terms of their impact on the annual inflation rate in the calendar year 2014. As a result, policymakers’ choices are shaped by what I will call the medium-term outlook for the inflation rate—that is, the forecast for the annual inflation rate in two years.³

A second operational issue is that in some circumstances, it may be appropriate to follow policies that lead the medium-term outlook for inflation to deviate from the long-run target. Indeed, most central banks—including ones that do not have an employment mandate—find that this kind of flexibility is desirable. Of course, the public may cease to regard 2 percent as a meaningful long-run target if it sees too much of a gap between 2 percent and the Committee’s medium-term outlook for inflation. A key question is: How much leeway around 2 percent is appropriate?

The Committee has made no formal decision about this issue, and my own thinking continues to evolve. But I currently believe that allowing the medium-term outlook for inflation to deviate from 2 percent by a quarter of a percentage point in either direction would provide sufficient flexibility to the Committee, while posing no threat to the credibility of the long-run target. My thinking is informed by the following chart. It documents that, even though the unemployment rate was at times below 5 percent, the medium-term inflation outlook based on material prepared for FOMC meetings has not risen above 2 1/4 percent in the past 15 years.⁴

Large Image

To sum up, the FOMC defines its price stability mandate as a 2 percent inflation target over the longer run. When making this definition operational, though, it is necessary to take into account the lags associated with monetary policy and to allow for some medium-term flexibility around the long-run target. Given these considerations, in my view, the FOMC can be said to be satisfying its price stability mandate as long as its medium-term outlook for inflation is between 1 3/4 percent and 2 1/4 percent, and longer-term inflation expectations remain stable.

In formulating my preferred operational definition of price stability, I’ve made reference to a Committee medium-term outlook for inflation. What I have in mind here is not my own outlook, or some average of FOMC participants’ individual outlooks. Rather, I have in mind a collective outlook for inflation that has been determined by the Committee as a whole. The Committee currently does formulate such an outlook and communicates that outlook through its statement. However, these communications are typically purely qualitative. My proposed operational definition of price stability hinges on the Committee’s formulating, and communicating, a quantitative collective outlook. Regardless of what one thinks of the liftoff plan that I will elaborate on shortly, monetary policy would be clearer and more accountable if the Committee followed the practice of other central banks and reported this kind of quantitative collective medium-term outlook for inflation at least quarterly.

So far, I’ve focused on the FOMC’s price stability mandate. As I mentioned earlier, the FOMC has a second mandate, which is to promote maximum employment. Whenever an organization has two goals, it is logically possible that it might face a tension between those two goals. But recent macroeconomic data and public communications from the FOMC’s September 13 meeting reveal that there is no such tension at this time. The unemployment rate is elevated above a level that the Committee sees as consistent with its employment mandate. Most FOMC participants’ medium-term outlooks for PCE inflation are at 2 percent or below. These observations imply that, by increasing monetary accommodation, the Committee can better meet its employment mandate while still satisfying its price stability mandate.

The FOMC’s public communications also suggest that this lack of tension between its two mandates is likely to continue for some time. Most FOMC participants currently project that, in the long run, an unemployment rate less than 6 percent is consistent with 2 percent inflation. These forecasts suggest that violations of price stability are unlikely to occur until the unemployment rate is considerably lower than its current level of 7.8 percent.

A Liftoff Plan (video)

I now turn to the development of a liftoff plan: an economic contingency plan for the initial increase in the fed funds rate above its current extraordinarily low level. I’ve described how the FOMC currently sees little tension between its two mandates and how its public communications suggest that this lack of tension between the mandates seems likely to continue. This current, and future, lack of tension between the two mandates will be a critical foundation for the plan that I describe.

I’ll start with some background. Right now, the FOMC has two types of accommodation in place. First, it is targeting the federal funds rate at between 0 and 0.25 percent. The Committee expects to keep that interest rate extraordinarily low at least through mid-2015. Second, the FOMC has bought a large amount of long-term government-issued and government-backed assets—indeed, in September, the Committee announced its intention to expand its holdings of these assets over the coming months. Both of these forms of accommodation are designed to put downward pressure on interest rates. This downward pressure is intended to discourage firms and households from saving or buying financial assets, and instead encourage them to spend. When firms and households spend, their extra demand for goods and services pushes upward on employment and upward on prices.

I think it is safe to say that, relative to historical norms, the current stance of monetary policy is quite unusual. In June 2011, the FOMC released a statement describing its exit strategy—that is, the sequence of steps involved in returning monetary policy to a more normal stance. However, that 2011 statement said nothing about the conditions that would trigger the initiation of this exit strategy. This omission is problematic. The current economic impact of both forms of accommodation—low interest rates and asset purchases—depends on when the public believes that accommodation will be removed.

To understand this critical point, consider two possible scenarios. In the first, the public believes that the FOMC will initiate liftoff once the unemployment rate hits 7 percent. In the second, the public believes that the FOMC will defer initiation of liftoff until the unemployment rate hits 6 percent. The higher unemployment rate in the first scenario means that monetary policy will be tightened sooner, which, in turn, will lead to the unemployment rate being higher for longer. Foreseeing that, people will save more in the first scenario than in the second, to protect themselves against these higher unemployment risks. Because they save more, they spend less, and there is less economic activity. In other words, the FOMC can provide more current stimulus if people believe that liftoff will be triggered by a lower unemployment rate.

With this observation in mind, the remainder of my remarks will describe what I see as an appropriate liftoff plan.⁵ The proposed plan is the following:

As long as the FOMC is continuing to satisfy its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent.

As discussed earlier, by “satisfy its price stability mandate,” I mean that longer-term inflation expectations are stable, and the Committee’s outlook is that the annual inflation rate in two years will be within a quarter of a percentage point of the target inflation rate of 2 percent.

Why is this liftoff plan an appropriate one? I argued earlier that the FOMC can provide more current stimulus by using a lower unemployment rate threshold for liftoff. Of course, additional monetary stimulus will give rise to more inflationary pressures, and those pressures are problematic because they could lead the FOMC to violate its price stability mandate. However, the Committee should choose the lowest unemployment rate threshold that it sees as unlikely to generate a violation of the price stability mandate.

Along those lines, most FOMC participants currently project that a long-run unemployment rate less than 6 percent will be consistent with 2 percent inflation. Given these projections, and given usual estimates of the impact of the unemployment rate on the medium-term inflation outlook, the medium-term outlook for the inflation rate is unlikely to be above 2 1/4 percent when the unemployment rate is higher than 5.5 percent.⁶ Hence, over the longer run, an unemployment rate threshold of 5.5 percent is likely to be consistent with price stability, although slightly higher or slightly lower thresholds should not materially affect the impact of this plan.

Some observers have suggested that, by committing to keep the fed funds rate low until the unemployment rate is as low as 5.5 percent, the FOMC risks “getting behind the inflationary curve.” As I’ve discussed, this contingency seems unlikely given the FOMC’s current assessments of the long-run unemployment rate consistent with 2 percent inflation. But, in any event, the proposed liftoff plan provides an escape clause designed specifically to mitigate this risk. The plan allows the FOMC to raise the fed funds rate if long-term inflation expectations deviate too much from historical norms, or if the medium-term outlook for the inflation rate ever exceeds 2 1/4 percent. In this fashion, this plan explicitly maintains price stability as an objective while also promoting a more robust recovery.

It is true that the liftoff plan does not say that the Committee will raise the fed funds rate when the medium-term inflation outlook exceeds 2 1/4 percent—only that it could. The Committee’s decision in this context would hinge on a delicate cost-benefit calculation that would weigh the inflation increases against the employment gains. In my view, that policy conversation should contemplate a reassessment of the long-run unemployment rate that the Committee sees as being consistent with 2 percent inflation.7

In the same vein, the unemployment rate of 5.5 percent should be viewed as only a threshold to initiate a policy conversation, not as a trigger for action. For example, it is possible that macroeconomic shocks could lead the Committee’s medium-term outlook for inflation to be below 2 percent when the unemployment rate falls below 5.5 percent. At that point, the Committee might want to defer initiating exit, and the liftoff plan allows the Committee to consider doing so.

I should be clear about how the proposed liftoff plan generates current stimulus. The basic economics underlying the plan is that if people’s expectations about their future prospects improve, they will save less. As economists like to do, I think that I can best illustrate this through an extreme example. Suppose that a worker were given a new contract that contained a no-layoff provision. That person would not have to save as much to guard against the possibility of involuntary job loss. The reduced need for savings would translate directly into spending more today.

Of course, the proposed liftoff plan does not promise anyone lifetime protection against layoffs! What it does promise is that the FOMC will fully support much higher levels of economic activity. Thus, the plan commits to keeping the fed funds rate extraordinarily low until the unemployment rate is much nearer historical norms, as long as inflation remains under control. With that commitment, households can anticipate that the unemployment rate will fall more quickly, meaning more job security and more jobs available for those who are looking. With that brighter future in store, they will save less and spend more today. That will drive up economic activity.⁸

The liftoff plan that I’ve discussed is distinct from proposals that recommend that the FOMC attempt to stimulate the economy by generating inflation that is well above target. The idea of those proposals is that, faced with higher inflation, people will spend more today to avoid the higher future prices. As I’ve just described, the liftoff plan proposed in this speech does not operate that way. Instead, my plan maintains price stability as a cornerstone while also promoting a quicker recovery.

Indeed, I’m highly skeptical about the feasibility of the inflation-based approach, given current economic conditions. The FOMC has said that it views the current unemployment rate as being elevated, relative to levels that it sees as being consistent with its mandate to promote maximum employment. With such high unemployment, labor is not scarce. Wage pressures are muted—and that will translate directly into the medium-term outlook for inflation’s being consistent with price stability.

This reasoning argues that it is difficult for the FOMC to foster above-target inflation given current circumstances. Admittedly, the reasoning was based on a key implicit presumption: longer-term inflation expectations remain stable. The FOMC could potentially generate significantly higher inflation in the near term by using words and deeds to shift longer-term expectations upward. I would see any such action as being inconsistent with the FOMC’s January 2012 statement of longer-run goals that I mentioned earlier.

Conclusions (video)

I’ve spent much of my time describing what I see as an appropriate liftoff plan. I’ve proposed that, given current Committee thinking about the economy’s productive capacity, the Committee should plan on deferring exit until the unemployment rate falls below 5.5 percent. Critically, there are important inflation safeguards embedded in the plan: The Committee could consider initiating liftoff if its medium-term inflation outlook ever exceeds 2 1/4 percent. The evidence from the past 15 years suggests that this event is unlikely to occur.

I first described the ideas in this speech about three weeks ago, in Ironwood, Michigan. It evinced mixed reactions. Some observers felt that the proposed liftoff plan was dovish, in the sense that it seemed to put a lot of weight on the employment mandate. Others argued that the plan was hawkish, in the sense that it put a lot of weight on the price stability mandate.

I think that this dispersion of views reflects a simple fact: The plan is neither hawkish nor dovish. The terms “hawkish” and “dovish” presume that the Committee faces a tension between its two mandates. But the Committee does not see any tension between its two mandates now. And its long-run unemployment forecasts suggest that it does not anticipate any tension between the two mandates until the unemployment rate is considerably lower. The liftoff plan in this speech essentially says that as long as the Committee continues to perceive no tension between its mandates, it should not begin to raise the fed funds rate. I see this plan as providing an appropriate policy framework regardless of how the data evolve over time or how one approaches the two mandates of the FOMC.

Thanks for listening, and I look forward to taking your questions.

Endnotes

References

Kocherlakota, Narayana. 2011a. “Further Thoughts on Making Monetary Policy.” Speech at Harvard Club of Minnesota. Minneapolis, Minn., Oct. 21.

Kocherlakota, Narayana. 2011b. “Making Monetary Policy: Public Contingency Planning Using a Mandate Dashboard.” Speech at Stanford Institute for Economic Policy Research. Stanford, Calif., Nov. 29.

Werning, Iván. 2012. “Managing a Liquidity Trap: Monetary and Fiscal Policy.” Working paper. Massachusetts Institute of Technology.

View All Presentation Slides [PDF]

Note¹

Thank you very much for that generous introduction, and thank you for the opportunity to join all of you here today. It is a pleasure to be back in the Upper Peninsula. I was in Marquette two years ago, and Bob Jacquart insisted that I come to Ironwood on my next trip to the U.P. And I have to say—he was right. This is a beautiful part of the world. Speaking of Bob, I would like to thank him for all of his work in helping put this event together, along with James Lorenson and Linda Gustafson here at Gogebic Community College. I would also like to thank everyone who joined us at Bob’s factory this morning to discuss economic issues facing businesses in the region. It was an informative meeting, and also a very instructive tour; so thanks again, Bob, for making all of that happen.

As Bob knows from his service on the Bank’s Advisory Council on Small Business and Labor, discussions about current conditions and people’s business plans are important for monetary policymakers. As you can imagine, I have access to reams of data about the economy, but data don’t always tell the whole story. That’s why opportunities like this are valuable to me. Likewise, I look forward to your questions and comments at the end of my talk, as I always find those to be great learning opportunities. However, before we proceed any further, I need to remind you that the following views are my own, and not necessarily those of others in the Federal Reserve.

In my remarks today, I’ll briefly discuss the objectives of the Federal Open Market Committee, or FOMC, which is the monetary policymaking arm of the Federal Reserve. Next, I’ll present a pictorial review of the evolution of macroeconomic data over the past five years.

With that background, I will then turn to a discussion of monetary policy. My jumping-off point is a phrase in the FOMC statement issued last Thursday. In that statement, the Committee said that it “expects that a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” My main message today is that the FOMC can provide additional monetary stimulus by making this sentence more precise in the form of what I’m going to call a liftoff plan: a description of the economic conditions that would lead the Committee to contemplate the initial increase in the fed funds rate above its currently extraordinarily low level.²

I will suggest the following specific contingency plan for liftoff:

As long as the FOMC satisfies its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent.

The fed funds rate is a short-term interbank lending rate that is the FOMC’s usual vehicle for influencing credit conditions. I’ll be much more precise later about the meaning of the phrase “satisfies its price stability mandate.” Briefly, though, I mean that longer-term inflation expectations are stable and that the Committee’s medium-term outlook for the annual inflation rate is within a quarter of a percentage point of its target of 2 percent. The substance of this liftoff plan is that, as long as longer-term inflation expectations remain stable, the Committee will not raise the fed funds rate unless the medium-term outlook for the inflation rate exceeds a threshold value of 2 1/4 percent or the unemployment rate falls below a threshold value of 5.5 percent. Note that neither of these thresholds should be viewed as triggers—that is, once the relevant cutoffs are crossed, the Committee retains the option of either keeping the fed funds rate extraordinarily low or raising the fed funds rate.

Thus, my proposed liftoff plan contains a specific definition of the phrase “a considerable time after the economic recovery strengthens.” In my talk, I will argue that this specificity—about an event that may not take place for four or more years—will provide needed current stimulus to the economy.

FOMC Objectives

Let me begin by describing the monetary policy objectives of the FOMC. Congress has specified in the Federal Reserve Act that the FOMC should make monetary policy so as to promote price stability and maximum employment. These two objectives—price stability and maximum employment—are typically termed the FOMC’s dual mandate. In January, the FOMC issued an important consensus statement of long-run principles and strategies. In that statement, the FOMC pointed out that it is difficult to fashion a quantitative definition of “maximum employment.”

In contrast, the January statement does provide a specific definition of price stability as representing a goal, over the longer run, of 2 percent inflation. But there are a couple of reasons why this definition of price stability is not as operational as one might like. One issue is that monetary policy affects inflation with lags. Policymakers are generally thinking about making current choices so as to influence the annual inflation rate in about two years’ time. Thus, monetary policy choices made toward the end of 2012 should be evaluated in terms of their impact on the annual inflation rate in the calendar year 2014. As a result, policymakers’ choices are shaped by what I will call the medium-term outlook for the inflation rate—that is, the forecast for the annual inflation rate in two years.³

A second operational issue is that in some circumstances, it may be appropriate to follow policies that lead the medium-term outlook for inflation to deviate from the long-run target. Indeed, most central banks—including ones that do not have an employment mandate—find that this kind of flexibility is desirable. Of course, the public may cease to regard 2 percent as a meaningful long-run target if it sees too much of a gap between 2 percent and the Committee’s medium-term outlook for inflation. A key question is: How much leeway around 2 percent is appropriate?

The Committee has made no formal decision about this issue, and my own thinking continues to evolve. But I currently believe that allowing the medium-term outlook for inflation to deviate from 2 percent by a quarter of a percentage point in either direction would provide sufficient flexibility to the Committee, while posing no threat to the credibility of the long-run target. I’ll provide more details on my thinking about this issue later in the talk.

To sum up, the FOMC defines its price stability mandate as a 2 percent inflation target over the longer run. When operationalizing this definition, though, it is necessary to take into account the lags associated with monetary policy and to allow for some medium-term flexibility around the long-run target. Given these considerations, in my view, the FOMC can be said to be satisfying its price stability mandate as long as its medium-term outlook for inflation is between 1 3/4 percent and 2 1/4 percent, and longer-term inflation expectations remain stable.

A Look Back and Associated Monetary Policy Considerations

I’ve described the FOMC’s objectives in making monetary policy. Let me turn now to describing the evolution of the economy over the past few years. I will focus on three variables that are of great interest to the FOMC: output, unemployment and inflation. I’ll then briefly discuss the implications of this recent macroeconomic history for monetary policy decision-making.

Economists typically measure the output of a country through its gross domestic product, adjusted for inflation—what’s called real GDP. This graph shows the behavior of real GDP over the past 10 years. The gray area on the graph marks the time that was dated as the Great Recession by the National Bureau of Economic Research. During this time, real GDP fell by about 5 percent. The gray bar tells us that the economy is considered to have been in recovery since the middle of 2009—that is, for over three years.

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But the recovery has been, at best, a slow one. The black line on the chart depicts how, as of December 2007, we would have typically expected real GDP to grow, given long-run averages. Over the course of the recession, a gap emerged between real GDP and this black line. By the middle of 2009, that gap was about 10 percent. This is not surprising—pretty much by definition, we expect a gap of this kind to open up during recessions. But, historically, large declines in real GDP have been followed by sufficiently strong output growth to close this gap within a few years. During the recent recovery, though, the gap has actually widened noticeably.

Given the sluggish recovery in national output, it is not surprising that labor markets are also healing slowly. This is often described in terms of the behavior of the national unemployment rate, which we can see on this graph. The unemployment rate was 5 percent in December 2007 and peaked at 10 percent in late 2009. It has since fallen to 8.1 percent—still well above historical norms.

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The next graph shows the evolution of the inflation rate, based on the personal consumption expenditures price index. The black line is headline inflation, which includes food and energy goods and services. It is quite variable, in large part because of substantial transitory shocks to oil prices. The red line is core inflation, which strips away food and energy goods and services. This series is much smoother—hence, it is generally thought to do a better job of tracking underlying inflation pressures in the economy than headline inflation does. Inflation fluctuated notably in 2008 and 2009, in large part due to movements in energy prices. Currently, both core and headline inflation rates are below the FOMC’s target inflation rate of 2 percent.

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That’s a brief review of the past five years. Real output has grown over the past three years, but remains well below what one would expect in light of historical growth patterns in the United States. Unemployment remains well above 2007 levels. Inflation is below the Fed’s target inflation rate of 2 percent.

What do these data imply about the appropriate stance of monetary policy? The FOMC has two mandates—to promote price stability and to promote maximum employment. Whenever an organization has two goals, it is logically possible that those goals may conflict. Indeed, many observers have expressed exactly this concern about the FOMC’s current position.

But these data and public communications from last week’s FOMC meeting reveal that there is no such tension at this time. The unemployment rate is elevated above a level that the Committee sees as consistent with its employment mandate. Most FOMC participants’ medium-term outlooks for PCE inflation are at 2 percent or below. These observations imply that, by increasing monetary accommodation, the Committee can better meet its employment mandate while still satisfying its price stability mandate.

The FOMC’s public communications also suggest that this lack of tension between its two mandates is likely to continue for some time to come. Most FOMC participants currently project that, in the long run, an unemployment rate less than 6 percent is consistent with 2 percent inflation. These forecasts suggest that violations of price stability are unlikely to occur until the unemployment rate is considerably lower than its current level of 8.1 percent.

A Liftoff Plan

I’ve described the evolution of macroeconomic data over the past five years, how the FOMC currently sees little tension between its two mandates and how this lack of tension between the mandates seems likely to continue. I now return to the key message that I introduced at the beginning of this talk: the importance of developing a liftoff plan—that is, an economic contingency plan for the initial increase in the fed funds rate above its current extraordinarily low level.

I’ll start with some background. Right now, the FOMC has two types of accommodation in place. First, it is targeting the federal funds rate at between 0 and 0.25 percent. The Committee expects to keep that interest rate extraordinarily low at least through mid-2015. Second, the FOMC has bought a large amount of long-term government-issued and government-backed assets—indeed, last week the Committee announced its intention to expand its holdings of these assets over the coming months. Both of these forms of accommodation are designed to put downward pressure on interest rates. This downward pressure is intended to discourage firms and households from saving or buying financial assets, and instead encourage them to spend. When firms and households spend, their extra demand for goods and services pushes upward on employment and upward on prices.

I think that it is safe to say that, relative to historical norms, the current stance of monetary policy is quite unusual. In June 2011, the FOMC released a statement describing its exit strategy—that is, the sequence of steps involved in returning monetary policy to a more normal stance. However, that 2011 statement said nothing about the conditions that would trigger the initiation of this exit strategy. This omission is problematic. The current economic impact of both forms of accommodation—low interest rates and asset purchases—depends on when the public believes that accommodation will be removed.

To understand this critical point, consider two possible scenarios. In the first, the public believes that the FOMC will initiate liftoff once the unemployment rate hits 7 percent. In the second, the public believes that the FOMC will defer initiation of liftoff until the unemployment rate hits 6 percent. The higher unemployment rate in the first scenario means that monetary policy will be tightened sooner, which, in turn, will lead to the unemployment rate being higher for longer. Foreseeing that, people will save more in the first scenario than in the second, to protect themselves against these higher unemployment risks. Because they save more, they spend less, and there is less economic activity. In other words, the FOMC can provide more current stimulus if people believe that liftoff will be triggered by a lower unemployment rate.

With this observation in mind, the remainder of my remarks will describe what I see as an appropriate liftoff plan.⁴ The proposed plan is the following:

As long as the FOMC is continuing to satisfy its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent.

As discussed earlier, by “satisfy its price stability mandate,” I mean that longer-term inflation expectations are stable, and the Committee’s outlook is that the annual inflation rate in two years will be within a quarter of a percentage point of the target inflation rate of 2 percent.

Why is this liftoff plan an appropriate one? I argued earlier that the FOMC can provide more current stimulus by using a lower unemployment rate threshold for liftoff. Of course, additional monetary stimulus will give rise to more inflationary pressures, and those pressures are problematic because they could lead the FOMC to violate its price stability mandate. However, in my view, the Committee should choose the lowest unemployment rate threshold that it sees as unlikely to generate a violation of the price stability mandate.

I noted earlier that the FOMC’s current projections for the long-run unemployment rate are well below 8.1 percent. These projections suggest that there will be little upward pressure on inflation until the recovery is sufficiently robust that the unemployment rate has fallen back to a level that is more consistent with historical norms. I see an unemployment threshold of 5.5 percent as being readily rationalized under this perspective, although slightly higher or slightly lower thresholds should not materially affect the impact of this plan.⁵

The proposed liftoff plan does allow the FOMC to contemplate raising the fed funds rate if the Committee’s medium-term inflation outlook rises above 2 1/4 percent. However, the following chart shows that recent historical evidence suggests that this possibility is unlikely to occur. It documents that the medium-term inflation outlook has not risen above 2 1/4 percent in the last 15 years.⁶ Thus, this historical evidence suggests that, as long as the unemployment rate remains above 5.5 percent, it seems unlikely that the price stability mandate would be violated.

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In any event, the liftoff plan does not say that the Committee will raise the fed funds rate when the medium-term inflation outlook exceeds 2 1/4 percent—only that it could. The Committee’s decision in this context would hinge on a delicate cost-benefit calculation that would weigh the inflation increases against the employment gains. That policy conversation would, I conjecture, be a challenging one. Among other issues, it could well involve a reassessment of the long-run unemployment rate that is consistent with 2 percent inflation.⁷

In the same vein, the unemployment rate of 5.5 percent should be viewed as only a threshold to initiate a policy conversation, not as a trigger for action. For example, it is possible that macroeconomic shocks could lead the Committee’s medium-term outlook for inflation to be below 2 percent when the unemployment rate falls below 5.5 percent. At that point, the Committee might want to defer initiating exit, and the liftoff plan allows the Committee to consider doing so.

Before concluding, I want to be clear about the economic mechanism by which the proposed liftoff plan generates stimulus. First, it does not generate stimulus by having the FOMC tolerate higher rates of inflation, as has been espoused by many observers. I am doubtful about the efficacy of the inflation-based approach. I suspect that many households would believe that their wage increases would not keep up with the higher anticipated inflation rates. Those households would save more and spend less—exactly the opposite of the policy’s aim. In any event, I think that this approach is a risky one for central banks to use, because it requires them to raise inflation expectations—but not too much.

Thus, the liftoff plan that I’ve discussed only applies when the FOMC satisfies its price stability mandate. How then does the proposed liftoff plan generate stimulus? The plan recommends that the FOMC clearly communicate its intention to pursue policies that are fully supportive of much higher levels of economic activity. Thus, the plan commits to keeping the fed funds rate extraordinarily low until the unemployment rate is much nearer historical norms, as long as inflation remains under control. With that commitment, households can anticipate a lower path for unemployment, and they can save less to guard against the risk of job loss. People will spend more today, and that will drive up economic activity.⁸

Conclusions

I’ve spent much of my time describing what I see as an appropriate liftoff plan. I’ve proposed that, given current Committee thinking about the economy’s productive capacity, the Committee should plan on deferring exit until the unemployment rate falls below 5.5 percent. Critically, there are important inflation safeguards embedded in the plan: The Committee could consider initiating liftoff if its medium-term inflation outlook ever exceeds 2 1/4 percent. The evidence from the past 15 years suggests that this event is unlikely to occur.

President Charles Evans of the Federal Reserve Bank of Chicago has also proposed what I’m calling a liftoff plan. As I said last year in answer to a media query, I very much liked his approach to thinking about the problem. Those familiar with his plan will see that my thinking has been greatly influenced by his. This is perhaps hardly surprising, since he sits next to me at every FOMC meeting!

My building on President Evans’ creative proposal in this fashion is, I think, indicative of how the Federal Open Market Committee operates. The making of monetary policy under Chairman Ben Bernanke’s leadership is a distinctly collaborative process. Obviously, we don’t always agree with one another. It would be surprising if we did in such unusual economic conditions. But we learn continually from each other’s points of view. In that way, I believe that we can start to make progress on the challenging economic problems we face.

Thanks for listening, and I look forward to taking your questions.

Endnotes

References

Kocherlakota, Narayana. 2011a. “Further Thoughts on Making Monetary Policy.” Speech at Harvard Club of Minnesota. Minneapolis, Minn., Oct. 21.

Kocherlakota, Narayana. 2011b. “Making Monetary Policy: Public Contingency Planning Using a Mandate Dashboard.” Speech at Stanford Institute for Economic Policy Research. Stanford, Calif., Nov. 29.

Werning, Iván. 2012. “Managing a Liquidity Trap: Monetary and Fiscal Policy.” Working paper. Massachusetts Institute of Technology.

View All Presentation Slides [PDF]

In its statement following the Sept. 13, 2012, meeting, the Federal Open Market Committee, or FOMC, stated that “a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” I argue that the FOMC can provide additional monetary stimulus by making this sentence more precise in the form of what I call a liftoff plan: a description of the economic conditions that would lead the Committee to contemplate the initial increase in the fed funds rate above its currently extraordinarily low level.

I suggest the following specific contingency plan for liftoff:

As long as the FOMC satisfies its price stability mandate, it should keep the fed funds rate extraordinarily low until the unemployment rate has fallen below 5.5 percent.

By “satisfies its price stability mandate,” I mean that longer-term inflation expectations remain stable, and the medium-term outlook for inflation is within a quarter of a percentage point of the Fed’s long-run target of 2 percent.

The substance of this liftoff plan is that the Committee will not raise the fed funds rate unless the medium-term outlook for the inflation rate exceeds a threshold value of 2 1/4 percent or the unemployment rate falls below a threshold value of 5.5 percent. Most FOMC participants project that the long-run unemployment rate consistent with 2 percent inflation is between 5.2 percent and 6 percent. These estimates, along with the historical evidence from the past 15 years, suggest that the unemployment rate can fall considerably without violating the proposed inflation threshold.

The proposed liftoff plan does not generate stimulus by promising higher inflation. Rather, the proposed plan recommends that the FOMC clearly communicate that it will not begin the process of cooling off the economy by raising rates until it sees much higher levels of economic activity. With that commitment, households can anticipate a lower path for unemployment, and they can save less to guard against the risk of job loss. People will spend more today, and that will drive up economic activity.

I mentioned that the Minneapolis Fed’s work in Indian Country goes back many years. My own presidency is much newer, but I have to say that I’ve been excited about our Indian Country work for almost all of that time. This excitement dates to a visit to our Helena Branch in the fall of 2009, shortly after I became president. On that trip, I spoke with Branch Director Joe McDonald, then the head of Salish-Kootenai Tribal College, and with Helena staff member Sue Woodrow, who was and is deeply involved in our Community Development Department’s work with tribes and tribal communities. They helped me grasp both the need for faster economic development in Indian Country and the opportunities for Federal Reserve Banks to contribute, such as through Sue’s efforts to help develop tribal commercial codes.

Today’s agenda—appropriately—highlights both progress and challenges in the journey of Indian Country economic development. As several of the authors note, the gap in income and wealth between reservation residents and Americans overall has closed some in recent decades, but remains disturbingly wide. Most of us here today are economists, lawyers or policy analysts or advocates. Thus, when we think about closing the income and wealth gaps in Indian Country, we tend to focus on how social institutions and policies affect behavior and economic outcomes, through their effects on incentives and resource constraints. Specifically, we look at institutions and policies with respect to responsive and effective governance, the impartial rule of law and resolution of disputes, clear property ownership and property rights, efficient resolution of externalities, sound decisions regarding public goods, and efficient taxation and redistribution. Today we will be hearing about many of these topics, in papers that discuss the optimal assignment of powers to tribal versus other governments, the effects of constitutionally determined tribal electoral systems, and domestic and international perspectives on the importance of tribal business environments, including the nature of laws regarding the use of personal property as collateral for loans. New evidence on these topics will be presented and discussed, giving all of us—including the Federal Reserve Bank of Minneapolis—a clearer understanding of how to enhance economic growth in Indian Country.

Nonetheless, we have much more to do and learn. It is fitting, therefore, that we will close the conference with a discussion of the future direction of research on Indian Country economic development. The Minneapolis Fed’s Community Development Department is currently updating its strategic plan, including for its work and research in Indian Country, so this discussion is very timely for us. Let me briefly share a few of my own thoughts about how we can deepen our understanding of Indian Country economic development. I see opportunities in both empirical work and theoretical modeling. On the empirical side, we need better reservation-specific measurement of business inputs and outputs, as well as of land ownership and business-relevant policies and regulations. These data would help us better evaluate specific program initiatives and generally understand how and why economic performance differs between reservations and nearby off-reservation economies.

But improved data are not enough. Indian Country researchers can make additional progress by drawing upon the advances in economic theory and modeling in related fields such as the economics of institutions, economic development and regional science. Ideas from those fields are already present in the papers at this conference. Still, I see opportunities to more thoroughly apply the models and model evaluation techniques widely used in those fields. Finally, I look forward to the further involvement of tribal scholars and policymakers in the conduct and use of Indian Country economic development research. In that light, I am pleased that we have a mix of American Indian and other professionals on the program and in the room today.

Over lunch you will hear from Dorothy Bridges, our senior vice president for Community Development and Outreach. She will explain how we currently have a very full slate of Indian Country initiatives and that we are committed to continuing to help develop and better understand Indian Country economies. To be effective, we will need to stay in touch with the people in this room and the rest of the Indian Country economic research community. I look forward to learning from you and with you as we work together to bring prosperity to America’s Indian nations. Thank you.

So you’ve heard from Mary, and I’ve mentioned Howard. Let me begin by making quick introductions of the rest of the members of our board. As you listen to my intros, you might find it useful to keep in mind that the Minneapolis Federal Reserve district includes the states of Montana, North and South Dakota, Minnesota, and parts of Wisconsin and Michigan. Without further ado, then, here are the directors:

Mary Brainerd, president and CEO of HealthPartners, as you know, is our chair.

Randy Hogan, chairman and CEO of Pentair in Minneapolis, is our deputy chair.

And MayKao Hang is president and CEO of the Amherst H. Wilder Foundation in St. Paul.

Those three directors are what we call Class C directors, which means that they are appointed by the Board of Governors in Washington, D.C., to represent the public.

And then we have Howard Dahl, president and CEO of Amity Technology in Fargo.

Bill Shorma, president of Rush-Co/Strategic Rail Services in Springfield, South Dakota.

And Larry Simkins, chairman, president, and CEO of the Washington Companies in Missoula, Montana.

Those three are what’s known as Class B directors. Like the Class C directors, Class B directors are representatives of the public. However, they are not chosen by the Board of Governors in Washington. Instead, they are elected by banks in the Minneapolis Federal Reserve district who are members of the Federal Reserve System.

And you’ve probably already guessed that our next group of three directors is termed Class A. These directors are elected by member banks in our district to represent those banks. And our Class A directors are:

Julie Causey, chair of Western Bank in St. Paul.

Ken Palmer, chairman, president, and CEO of Range Financial Corporation and Range Bank in Negaunee, Michigan, which is in the Upper Peninsula.

And, finally, Dick Westra, president and CEO of Dacotah Bank in Aberdeen, South Dakota.

Also present today is Jake Marvin, chairman and CEO of Marvin Windows, and our former board chair who served our board for six years ending last December.

I would like to publicly thank all of these people for their public service. Being a board director is a job that demands much and returns little beyond the fulfillment associated with important public service. And this event is a great illustration of what I’m talking about. Like all of you, these are busy people with important responsibilities back home, so for them to take time from their schedules to tour a region of our district speaks volumes about their commitment. I should also mention that we are joined by members of our bank senior management team as well as other bank staff today. While I won’t take the time to introduce each of them, suffice it to say that this too is a group of highly dedicated public servants. They provide outstanding leadership and support to the Federal Reserve Bank of Minneapolis and the Federal Reserve System. I do want to particularly acknowledge Barb Pierce and Patti Lorenzen for their tremendous help in setting up the logistics for this visit. We are also quite fortunate to have two expert local tour guides for tomorrow: Loren Kospeng and Ron Ness. Before I go on, let me remind you that the following views are my own, and not necessarily those of others in the Federal Reserve.

As Mary described in her remarks, one of the strengths of the Federal Reserve System that Congress designed nearly 100 years ago, in 1913, is its system of regional banks and branches that ensures representation from citizens in towns and cities throughout the country, including relatively small communities like Springfield, Aberdeen, and Negaunee. What I’m going to do in the remainder of my remarks is describe the decentralized nature of the Federal Reserve, especially as it pertains to monetary policy, and then discuss the role of the directors. After that, I will be happy to take your questions on these subjects or other issues on your mind this evening. In addition, as Mary noted, if you would like to direct a question to her about her role on the board of directors, she also stands ready.

So, to begin, the Federal Reserve Bank of Minneapolis is one of 12 regional Reserve banks that, along with the Board of Governors in Washington, D.C., make up the Federal Reserve System. Our bank represents the ninth of the 12 Federal Reserve districts, and, by area, we’re the second largest. As I mentioned earlier, our district also includes the Dakotas, Minnesota, northwestern Wisconsin, and the Upper Peninsula of Michigan.

What do we do at the Federal Reserve Bank? Well, within the Federal Reserve we have clever ways of describing the work we do; for example, we use the highly technical term “three-legged stool” to describe our primary roles. Those three legs include payment services, supervision and regulation of financial institutions, and monetary policy. Very briefly, that first leg means that the Federal Reserve Bank of Minneapolis, along with the other 11 Federal Reserve banks, works to ensure the smooth movement of funds between banks, savings and loans, and credit unions through a nationwide electronic payments system. As for the second leg, the Federal Reserve Bank of Minneapolis supports the Federal Reserve System in ensuring a safe, sound, and accessible banking system, and stable financial markets through supervision and regulation of the nation’s banking, financial, and payments systems. This means that we implement rules and regulations as mandated by Congress. In doing so, we work with other federal and state agencies and regulators to promote safety and soundness in the operations of the financial services industry.

Obviously, I could spend a great deal of time speaking about those two responsibilities, especially supervision and regulation, which has grown in prominence since the financial crisis and the passage of the Dodd-Frank Act. However, I want to move now to the third leg of the stool, monetary policy, as this role is the one that most directly impacts the lives of Americans and is also where the role of our directors is most prominent.

Monetary policy is established by the Federal Open Market Committee, or FOMC. The FOMC meets at least eight times per year and consists of the seven governors of the Federal Reserve Board in Washington, the president of the Federal Reserve Bank of New York, and a group of four other Reserve bank presidents that rotates annually. For example, I was on the FOMC in 2011 and will be a member of the Committee again in 2014. However, all 12 Reserve Bank presidents—whether they vote or not—participate in FOMC deliberations. This is an important point, as it highlights the decentralized nature of the Federal Reserve’s policymaking. All of the presidents bring their perspectives on the economy to every meeting, and those perspectives are shaped, in part, by what we learn from our local districts. Our directors play a big role in that information-gathering process. At every board of directors meeting, a number of directors are charged with answering questions about trends in the economy. For example, are firms planning to hire? What are their capital expenditure projections? Are input prices changing? What are firms’ expectations for growth in the near and medium term? Our directors don’t just answer those questions from the perspective of their own companies; rather, they contact a number of businesses in their regions and industries to gauge broader business sentiment.

This type of information is very valuable to policymakers. As you might imagine, the Federal Reserve is very good at aggregating and analyzing data, but data often lag and do not give a complete description of what is currently happening in the economy. The information that I receive from our directors is important in helping me complete that economic picture. I should also note that the Federal Reserve Bank of Minneapolis has three advisory councils to seek further input from citizens in our district. These councils have members from the agricultural industry, small business and labor, and the financial services industry. As well, we have a branch office based in Helena, and we receive valuable economic intelligence from the members of that branch’s board of directors.

So I have described the Federal Reserve’s decentralized structure, especially as it pertains to monetary policymaking, and I have also begun to explain the directors’ role by illustrating how they contribute to that policymaking. Now I would like to briefly describe some of the other roles of the directors. Directors, as you would imagine, do more than just provide economic intelligence—in particular, they also provide oversight of bank management. In some respects, this is similar to any board of directors. For example, through committees and board deliberations, directors review and approve the bank’s annual budget, review the bank’s annual performance, and oversee the internal audit program and the bank’s control environment. This oversight helps ensure that Federal Reserve banks are run as effectively and efficiently as possible. I know that I speak for all of our management team when I say that we benefit on an ongoing basis from the collective wisdom that gathers in our board room.

I began these remarks by introducing our board and describing the various classifications under which they serve. Those classes—A, B, and C—may seem rather mundane, but they are really quite meaningful. Again, Congress had a good idea about how the Federal Reserve should be structured when it formed the System a century ago, and it has stood the test of time. That first group I mentioned, the Class C directors who serve to represent the public, are appointed by the Board of Governors in Washington, D.C. That last point is key because it ensures that the Board of Governors, which is appointed by the president and approved by the Senate, has a say in the makeup of our board of directors. So in that respect, our local board of directors has a direct connection to the federal government in Washington, which is important. The second group, the Class B directors, are also chosen to represent the public, but they are elected by member banks from each district. This too is important because it ensures that the public is represented by directors who are chosen locally, and not by Washington. In this way, the framers of the Federal Reserve Act carefully balanced national and local interests in the composition of bank boards of directors.

The last group, the Class A directors, who are elected by member banks to represent those banks, are the ones that have received some attention of late. Since the financial crisis and the extraordinary measures that the Federal Reserve has taken to prevent the collapse of our financial system, some have questioned whether it is appropriate for bankers to sit on the boards of Federal Reserve banks. Isn’t it wrong, these critics say, to give bankers power over those who are supposed to supervise them? It would be wrong if that were the case, but members of the board of directors—bankers or not—have no say in how Federal Reserve banks conduct their supervisory operations. Supervisory matters are handled directly between bank staff and the Board of Governors in Washington, D.C. Supervisory matters are not a part of the business of the board of directors.

However, what is a part of board business is the important information that bankers relate about credit conditions in the economy, about issues pertaining to the payments system, and about general business conditions. This is precisely the kind of information that policymakers need to do their job, whether under extraordinary or normal economic conditions.

Our board of directors and our senior management team have made this trip out to western North Dakota to learn more about what makes your economy tick. But I’m glad, too, to have had this opportunity to tell you a little about our board of directors—a group of dedicated public servants whose role is often misunderstood by many. Now, I am sure that you have a number of questions. And I will do my best to answer the easy ones—the tough ones I’ll leave for Mary. Thank you very much for your time.

The speech listed below was given by Mary Brainerd before Narayana Kocherlakota's remarks.

The Fed’s commitment to financial education is as much a personal one for me as it is an institutional one, as is true for many others in the System. Like the chairman, and like all of you, I have spent a large part of my working life in front of classrooms, and so I come to my current position with a deep appreciation for the importance of economic and financial literacy. Entering the world of policymaking has only reinforced that belief, with the lessons of the recent financial crisis a strong case in point.

Of course, the Minneapolis Fed’s efforts in this area have long pre-dated my own relatively brief tenure as president. To give but one of many examples, our Community Development staff have spearheaded the Bank’s participation in personal financial education through their involvement with the Jump$tart Coalition. It’s worth emphasizing that, at the broader System level, the Fed plays a role in developing materials for teachers of economics and personal finance to use in the classroom, all the way from kindergarten through college. Anyone interested in seeing the materials created by staff here and at other district Reserve Banks can go to federalreserveeducation.org to see what is available.

I don’t have much more to say—but I feel that I would be enormously remiss if I didn’t acknowledge the outsized contributions of Claudia Parliament. Economic and financial educators in Minnesota and around the country have had no better ally than Claudia and the Minnesota Council for Economic Education. Everyone attending this week’s conference can see how tirelessly she has worked for years to promote economic and financial education. She recently retired but is still active, as evidenced by her presence today. Let’s all take a moment to express our gratitude. Thanks, Claudia.

I’m ready to start taking questions.

What I would like to do now is broadly describe that service. Federal Reserve branch directors have two main responsibilities: They serve as branch advisers and as reporters of economic conditions, and I’ll take them in that order.

Branch directors do not serve the kind of direct oversight role that you might expect from a more typical board of directors. That oversight role, including approval of budgets and audit authority for the entire Ninth District, comes from our board of directors in Minneapolis. Rather, the role of branch directors in the management of the branch is more of an advisory responsibility. To fulfill that advisory responsibility, they review the branch’s objectives, budget and performance, and also provide regular and valuable feedback to branch management. Of course, as chair of the Helena Branch board for portions of his tenure, Joe has led many of the branch board meetings and those discussions.

Also, branch directors can serve an advisory role to their colleagues on the Minneapolis board of directors. Branch directors meet eight times a year at our branch office in Helena and once in Minneapolis in a joint meeting with the Minneapolis board. Additionally, each director individually travels to Minneapolis twice a year to attend meetings with the Minneapolis board and participates as a nonvoting member in discussions relative to budget, performance and other director responsibilities.

This brings us to the second primary responsibility of a Federal Reserve branch director—economic reporting, which the directors do at each of their meetings. The bottom line is that Joe contributed to the making of monetary policy. Now, I want to be clear, Joe had no direct say in the making of monetary policy, nor does any member of any Federal Reserve board of directors. The job of making monetary policy is the responsibility of the Federal Open Market Committee. The FOMC, as many of you know, is the monetary policymaking group that meets every six to eight weeks to set the path of short-term interest rates. All of the presidents of the 12 Federal Reserve Banks, including myself, and the seven members of the Board of Governors of the Federal Reserve System participate in the FOMC meetings. And as an FOMC meeting participant, I need to ensure that I am getting the information necessary to arrive at the best decision regarding monetary policy.

Now, it may seem that we in the Federal Reserve System do not lack for such information. Indeed, thanks to our excellent research staff, the Federal Reserve is very good at collecting and analyzing data. But data often lag and sometimes do not give us a complete and immediate picture of what is happening in the economy. This means that, in addition to the national economic models and analysis produced by economists on my staff and at the Board of Governors, I rely on information that I receive about local economic performance. I get that kind of local economic intelligence from people who attend meetings that we hold across the Ninth District or who come to my speeches and share their views with me. In addition, each Federal Reserve Bank has a number of advisory councils representing Main Street businesses, agricultural producers, labor groups and community banks and thrifts, among other constituencies. The input from all these citizens plays an important role in the development of monetary policy.

But among all of these sources of local economic information, branch directors like Joe are certainly among the most vital. When it comes to Joe’s input, his measured response to questions pertaining to Montana’s business environment helped us better understand the forces shaping the state’s economy. His reports included perspectives from the education and business communities, and also those unique to communities in Indian Country. In addition, he brought feedback from the working class and from many of those facing considerable challenges in today’s economy. In short, he provided the kind of input that reflects the diversity that is required for me to be effective at Federal Open Market Committee meetings.

Thank you, Joe, once again, for your service to the Federal Reserve. We hope you stay in touch after your term expires at year-end, and we wish you all the best. Also, thanks to all of you for coming out to help celebrate Joe’s career as a Helena Branch director. I look forward to meeting you and, as I’ve just described, to hearing your stories about your work and the Montana economy. Thanks again.

Good afternoon, everyone. It is my great pleasure to welcome all of you to the Federal Reserve Bank of Minneapolis for this important discussion about a topic that directly or indirectly impacts the lives of all Minnesotans—secure trade and travel between this state and our neighbor to the north, Canada.

It struck me when reviewing the list of attendees that I should extend a special welcome to certain guests and to acknowledge those important agencies and institutions represented here today. But then I realized I would have to name practically everyone on the attendee list. This is truly an impressive gathering, and I commend all of you for joining us here today. Having said that, however, I hope you will indulge me as I offer a particular welcome to Senator Amy Klobuchar and to Consul General Martin Loken. We are very pleased that Senator Klobuchar has made time in her busy schedule to be with us today by video, and we look forward to her remarks. And thank you, Martin, for reaching out to the Federal Reserve Bank as a partner for this conference. Our bank and the consulate general have had a good working relationship in the past, and we look forward to strengthening that relationship in the future.

Before I say more about the bank’s interest in the issues on hand today, I should note that I have a personal interest in issues relating to Canada. I was born in Baltimore, but from the age of 1 to 15, I grew up in Canada. (I don’t recall my parents asking for my permission before they moved me from my native country, but perhaps they did.) Most of that time I spent in Winnipeg—which means that I’m one of the few people who live in the Twin Cities who is more worried about how hot the summers are as opposed to how cold the winters are.

I think that my time in Canada gave me a better understanding of the special relationship that Canada has with the United States. Now, the Canadians in this room know that one peculiarity about that special relationship is that many people in the United States are unaware of it. Canadian students grow up learning about the United States and, subsequently, paying attention to the United States in ways that are not typically reciprocated by their southern neighbors. But—having lived most of the past 15 years here in Minnesota—I have found that Minnesotans are, in fact, much more engaged with Canada than is true of the denizens of more southern climes. Minnesotans understand the value of the relationship between our state and Canada, and we take a keen interest in the evolving economic partnership between our two countries.

Some of you are perhaps aware of one of this bank’s publications, the fedgazette, a newspaper dedicated to business and economic news in our Ninth District. Most of the Ninth District borders Canada, and over the years our writers and analysts have reported on important economic issues affecting trade. Indeed, the inaugural issue of the fedgazette in 1989 devoted considerable space to the Canada/U.S. Trade Agreement, or CUSTA, a precursor to its more famous acronym, NAFTA, or the North American Free Trade Agreement, which also included Mexico. In one of those fedgazette articles, then Canadian Consul General John Blackwood said that such agreements would replace the economics of tariffs with the economics of transportation. The cost/benefit of cross-border business will be influenced more by proximity, Blackwood said, and not by penalties.

If Minnesota’s experience is any indication, that was certainly the case here. Trade between Minnesota and Canada, adjusted for inflation, increased approximately fourfold between 1990 and 2011. Of course, all of that increase was not due solely to trade agreements, but it is important to recall that most goods crossing the border between Minnesota and Canada were subject to tariffs prior to those agreements. And you don’t have to be an economist to know that tariffs deter trade.

Today we are here to discuss the latest in the long and successful history of trade negotiations between the United States and Canada, and to focus specifically on its impact on the state of Minnesota. Once again, I would like to thank Martin for bringing this important conversation to the Federal Reserve Bank of Minneapolis. Part of our charge as a district Federal Reserve Bank is to monitor our district’s economy, and a key part of our economy’s strength is the amount of business that our district does with Canada. So I welcome all of you here today and look forward to our discussion. Thank you.

Endnote

Basic economics says that a policymaker should set a policy instrument so that, on the margin, there is no net benefit to altering it. But while the policymaker’s decision is necessarily made today, the resultant costs and benefits are realized only in the future. Therefore, the policymaker’s optimal choice is to set the policy instrument so that the outlook for the future marginal net benefit is zero. In this talk, I address the following question: How can the policymaker formulate the needed outlook for marginal net benefits? Policymakers often attempt to do so by using statistical models to forecast future marginal net benefits. I argue that policymakers can achieve better outcomes by basing their outlooks on risk-neutral probabilities derived from the prices of financial derivatives.

The benefit of using risk-neutral probabilities arises from the observation that resources may be more valuable in one state of the world relative to another, equally likely, state of the world. (For example, the economy might be in a deep recession in the former state and in a boom in the latter.) In weighing future costs and benefits, the policymaker should take account of this differential valuation of resources in different states. Because they are derived from market prices, risk-neutral probabilities provide the needed information about the relative values of resources in different states of the world in a way that purely statistical forecasts cannot.

After presenting my general argument, I illustrate it using the example of a central bank that has a single mandate of targeting an inflation rate of pi_bar. Monetary policy operates with lags, and inflation is affected by shocks other than the central bank’s decision. Hence, the best that the central bank can do is to ensure that its medium-term outlook for inflation always equals pi_bar. My general argument implies that the appropriate outlook for the central bank is not a statistical forecast of inflation, but rather the risk-neutral expectation of inflation, calculated using risk-neutral probabilities. This risk-neutral expectation can be measured using inflation break-evens on assets like zero coupon inflation swaps or TIPS bonds. Hence, it is optimal for an inflation-targeting central bank to follow policies that ensure that inflation break-evens remain close to pi_bar.

The Federal Reserve Bank of Minneapolis reports measures of risk-neutral probabilities on its website. These reports are based on a variety of option prices and are updated every two weeks.

Endnotes

Optimal Outlooks - Presentation Slides [PDF]

Optimal Outlooks
June 3, 2012

President Kocherlakota previously gave a similar speech at the Financial Intermediation Research Society Conference on June 3rd, 2012. View the video of that speech and the Q & A that followed.

Thank you very much for that generous introduction. It is an honor and a pleasure to speak before a group that plays an instrumental role in the formation and growth of new and young businesses. As many of you likely know, those types of businesses are key to employment growth, especially in periods following recessions. As you also know, employment growth has been disappointing, to say the least, coming out of the period known as the Great Recession. I will have more to say about this in a few minutes, but I want to add that I look forward to your questions and comments at the close of my remarks. I like to remind audiences that monetary policymakers have no end of data at their fingertips, but data lag by weeks and sometimes months, and policymakers need to make decisions in real time. Input from groups like this—just like that which I receive from our Bank’s Board of Directors, our Advisory Councils, and from people across the Ninth District on my travels—is important in helping to shape my understanding of the economy. So thank you for inviting me here today, both to share my views and also to hear your own.

I became president of the Federal Reserve Bank of Minneapolis in October 2009. One of my main objectives since then has been to make both the Minneapolis Fed and the Federal Reserve System more open and transparent. And I’ve been delighted to learn that I’m not at all alone in this pursuit of greater openness. I see many positive developments along these lines throughout the System, and especially on the part of the Federal Open Market Committee. The FOMC, as you no doubt know, is the monetary policymaking arm of the Federal Reserve. It meets every six to seven weeks to chart the course of monetary policy. The members of the Board of Governors and the presidents of the 12 regional Feds, including me, all take part in these meetings.

Today, I will talk about a significant improvement in the FOMC’s communication about monetary policy: In January 2012, the FOMC released a consensus statement describing its long-run framework. Congress has given the Federal Reserve a dual mandate: to promote maximum employment and to promote price stability. The January framework statement is important because it outlines the strategy that the FOMC follows in order to implement the FOMC’s dual mandate.

As you will hear, the framework statement provides a quantitative definition for price stability, through a numerical target for inflation. It does not do the same for maximum employment. I will spend a considerable amount of time discussing this latter aspect of the statement and its relevance for current policy.

Before proceeding, I’ll remind you that my remarks reflect my thoughts, and not necessarily those of others in the Federal Reserve System.

A brief history of Fed transparency

I’ll begin with some historical context. Over the past 30 years, central banks all over the world have become much more transparent about their objectives and how their current actions allow them to achieve those objectives. This transparency is widely viewed—by both policymakers and scholars—as an important means of enhancing the effectiveness of monetary policy.

Most central banks aim to keep medium-term inflation low and stable—at around 2 percent annually. They have been quite successful in achieving that goal over the past 20 or 25 years. They view that success as being due in part to their communicating on an ongoing basis how their current policy actions are consistent with that goal.

There are at least two benefits of transparency. The first is broadly appreciated: By being clear about their objectives, central banks are better able to achieve those objectives. For example, if the central bank’s announced inflation target is 2 percent per year, firms and employees know that wages need to grow by 2 percent to keep up with the cost of living. That knowledge helps prevent wages from growing so fast that firms have to raise prices by more than 2 percent to cover their costs—and that in turn contributes to keeping inflation under control. In brief, then, transparency helps anchor inflation expectations.

The second benefit of transparency is less appreciated, but no less important. A transparent central bank is more accountable to the public because it is forced to be more disciplined in ensuring that its policy actions are in fact consistent with its policy objectives. The central bank knows the public will be able to track its performance. When performance matches words, the public will have an even stronger belief in the central bank, which serves to anchor inflation expectations more solidly.

So, there has been a trend toward central bank transparency internationally. What about here in the United States? I think we can all take pride in the fact that under Chairman Bernanke and his predecessor, Chairman Greenspan, the Fed has made enormous strides in transparency. It is easy to forget that, as recently as 1993, the FOMC would act and not tell anyone for 90 days! It was not until 2000 that the FOMC began issuing the statement that many of us now take for granted. And it was a decade ago that the roll call vote of FOMC members was added to the statement. Thus, there has been substantial progress in monetary policy transparency over the past 15 or so years.

As of the beginning of 2011, the Committee had arrived at three main forms of communication. First, immediately after every meeting, the Committee issues a carefully worded, but brief, statement intended to describe the current state of the economy and the current stance of monetary policy. Second, three weeks after each meeting, the Committee issues a carefully worded set of minutes that provides a longer, but still relatively high-level, description of interactions within the meeting. Third, after the January, April, June, and October/November meetings, the FOMC releases a summary of economic projections. Among other things, these quarterly releases contain information about FOMC meeting participants’ goals for medium-run inflation and unemployment (roughly, over the next five to six years).

The framework statement

There have been several changes in FOMC communications over the past year, including the introduction of regular press conferences by the chairman and the regular release of FOMC participants’ individual assessments of the appropriate path of short-term interest rates. But I want to spend my time today discussing the change that I view as the most important: the FOMC’s release in January 2012 of a five-paragraph statement describing its long-run framework.

What I will do instead is describe four aspects of the framework statement that I view as especially important. The first key aspect of the framework is that it specifically translates the term “price stability” into a 2 percent target for inflation. The American public need guess no longer about the Federal Reserve’s inflation intentions—either on the upside or on the downside: 2 percent is our goal.

Second, the framework describes how the Committee weighs the two mandates— promoting maximum employment and promoting price stability—against one another. Importantly, it stresses that the two mandates are typically complementary, in the sense that keeping unemployment from rising too high also keeps inflation from falling too low. I think that this point is often under-emphasized in popular discussions of monetary policy.

Third, the framework enjoyed broad consensus support among meeting participants. This suggests that any changes in the framework will require the same level of broad consensus support. In this sense, one can think of the framework as being like a constitution.

I have moved quickly through the first three of these key elements of the framework statement—inflation target of 2 percent, the typical complementarity of the two mandates, and the quasi-constitutionality of the statement. This fourth key feature of the statement is that while it provides a numerical target for inflation, it does not provide a similar explicit quantitative interpretation of the second mandate: “maximum employment.” I want to spend the rest of my time discussing why it does not do so.

Estimating maximum employment

I’ll start with a quote from the framework statement itself: “The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the job market.” What are these nonmonetary factors? There are many, including population trends, the incentives built into the tax system, the incentives built into social insurance safety nets, the returns to human capital accumulation for young people, and simply social norms. The FOMC has no control over these nonmonetary factors. Its job is to attain the maximum level of employment attainable through monetary policy, taking these other nonmonetary factors as given.

It is important to note that the long list of nonmonetary factors includes nonmonetary policies. It follows that, even if employment is close to the maximum level that is achievable using monetary policy, there may well be nonmonetary policy levers that could be used to raise employment still higher. For example, suppose that Congress and the president choose to reduce the payroll tax paid by employers. Such a move would provide an additional incentive to employers to hire more workers (albeit at the cost of increasing the deficit), and increase employment and reduce unemployment.

All of these nonmonetary factors, policy or otherwise, fluctuate over time. Their changes in turn generate fluctuations in the level of maximum employment achievable through monetary policy—fluctuations that are often hard to gauge on a real-time basis. In what follows, I will spend some time describing why I believe that the Committee currently faces an especially large amount of uncertainty about the level of maximum employment that it can hope to achieve.

I’ll start by showing you graphs of four measures of the recent adverse changes in U.S. labor market performance. To understand the graphs, it’s helpful to recall that economists define the labor force to include all of those over 16 years of age who have a job or who have looked for a job in the past four weeks. All of the charts depict annual data through 2011.

The first graph depicts the evolution of the unemployment rate over time—the fraction of people in the labor force who have looked for a job in the past four weeks. The graph shows that after rising sharply from 2007 to 2009 (the shaded area indicates the recession period), the unemployment rate has been falling slowly.³

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The next graph shows the evolution of the employment/population ratio over time—the fraction of people who have a job. To eliminate some of the possible demographic shifts that might otherwise influence this picture, the graph focuses on people between 25 and 54 years old, the so-called prime age population for the job market. We can see a sharp decline in this ratio from 2007 to 2009. And, in contrast to the unemployment rate, there has been no noticeable recovery in this measure.

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The third graph is a depiction of the fraction of the population between ages 25 and 54 who are in the labor force—that is, they either have a job or have looked for one in the past month. Economists refer to this as the labor force participation rate. An interesting aspect of this graph is that this fraction has tended downward since the late 1990s. This downward path has accelerated since 2008.

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The final graph depicts the relationship of unfilled job openings and unemployment over time. The horizontal axis shows the unemployment rate. The vertical axis is the job openings or vacancy rate—the ratio of job openings to the sum of employment and job openings. Each point on this graph corresponds to a different year, and represents the average unemployment rate and the average vacancy rate in that year.

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When the economy is doing well, firms usually hire more workers and they find it more challenging to fill their available openings. Hence, the unemployment rate is low, and the vacancy rate is high. So, typically, as the economy improves, the plotted points move toward the upper left in this picture. Conversely, when economic times get worse, the plotted points move to the southeast. This creates a curve that runs from the northwest to the southeast—a curve that’s known as the Beveridge curve.

However, in the Great Recession and its aftermath, we have seen something different: The Beveridge curve itself has shifted out toward the upper right. Economists see this kind of outward shift as representing a decline in the ability of the labor market to form mutually beneficial matches between workers and firms. In that sense, the labor market is less efficient. The outward shift means that firms can’t fill their available job openings as readily as we would have expected in light of the high unemployment rate.

To summarize: Labor market outcomes do remain notably worse than prior to the recession. The good news is that the unemployment rate has been declining since the end of the recession. But there is also countervailing evidence: The labor force participation rate has been falling steadily, and the employment/population ratio remains near its low point. The Beveridge curve shows considerable deterioration in labor market matching efficiency.

How persistent will these changes in U.S. labor markets prove to be? Economists hold at least two views on this question. The first is guided by the patterns in post-World War II data for the United States. These patterns suggest that the current deterioration in U.S. labor market performance is indeed reversible under appropriate policy.

The second view is less sanguine. It says that the post-World War II data do not contain an economic crisis of the kind or magnitude that hit the United States in 2008. Such a crisis could well have a different kind of impact on labor markets than the earlier postwar recessions.

The Swedish experience

This latter view is also informed by data from other countries—not just the United States. My staff and I have recently taken a close look at data from Sweden.⁴ Why Sweden? In the early 1990s, Sweden was hit by a financial, banking, and currency crisis—what one might term a triple crisis. Of course, other industrialized countries—perhaps most notably Japan—have experienced these kinds of crises. My staff and I have focused on Sweden because it is generally viewed as having dealt with this triple crisis in a highly effective fashion. For example, in 2007, OECD economists wrote, “Sweden’s economy has made a remarkable recovery from the major crisis of the early 1990s,” in emphasizing Sweden’s rapid productivity growth in the previous two decades.⁵

Despite this success, the triple crisis had a profound and highly persistent effect on the Swedish labor market. To see this, let’s look at graphs for the same four variables in Sweden that I showed you earlier for the United States.⁶ I’ve shaded the period 1991-93 in these graphs to indicate the heart of the triple crisis period in Sweden.

The first graph depicts the Swedish unemployment rate. From 1980 to 1990, the unemployment rate had never been above 4 percent and was typically closer to 2 percent. After 1993, the unemployment rate was never much below 6 percent.

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The second graph depicts the Swedish employment/population ratio, again for those between ages 25 and 54. From 1980 to 1990, the employment/population ratio grew steadily in Sweden and peaked at over 91 percent. After 1993, the ratio trended upward slightly but remained below 86 percent for most of the period.

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Next, we see the evolution of the fraction of Swedes aged 25-54 years who are in the labor force. From 1980 to 1990, this fraction rose to a high of over 92 percent. After 1993, it was typically around 88 percent and never much above 90 percent.

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Finally, we can look at the Beveridge curve—the joint evolution of unfilled job openings and unemployment. The Swedish Beveridge curve shifted outward from 1990 to 1995—and that shift has endured through at least 2010.

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To sum up: These four measures of Swedish labor market performance declined markedly after the triple crisis of the early 1990s. At least up until now, this decline has proved to be permanent. I should note too that these changes happened over a remarkably short span. In its February 1995 inflation report, the Riksbank, the Swedish central bank, suggests that the rate of unemployment that they viewed as sustainable over the long run had risen from 2-3 percent to 6 percent in less than five years.⁷ Their assessment—again, made in 1995—has proven to be a remarkably accurate characterization of how Swedish labor markets functioned over the next 15 years.

It is important to emphasize that, of course, there are many institutional differences between Sweden and the United States, especially in terms of tax systems and social safety nets. It would be a mistake to conclude from the Swedish data alone that the recent decline in U.S. labor market measures is inevitably a permanent one. But Sweden is not atypical. Cross-country research from Reinhart and Reinhart (2010) has found that financial crises tend to be followed by sustained increases in unemployment.⁸

Hence, I do think that the Swedish data—given that they come from a country generally regarded as an exemplar of how to handle a financial crisis—have to be viewed as informative. At a minimum, Sweden’s experience forces us to contemplate the possibility that the erosion in labor market performance that we’ve seen in the United States over the past five years may be highly persistent, even under appropriate monetary policy.

Policy implications

Over the past ten minutes or so, I have talked about the recent adverse changes in U.S. labor market performance. I have discussed two sharply different possible ways to view those changes: first, that they are largely reversible under appropriate monetary policy and, second, that they are likely to be highly persistent. These two possibilities suggest that the FOMC is confronted with an unusually high degree of uncertainty about the level of “maximum employment” it can achieve. This uncertainty translates directly into a corresponding uncertainty about the appropriate approach to policy. In particular, policymakers who see the deterioration in labor market performance as reversible using monetary policy will typically favor more accommodative policy than those who view the deterioration as more protracted.

Fortunately, we can use other sources of information to reduce the level of uncertainty about the maximum level of employment achievable through monetary policy. “Maximum employment” for monetary policy is widely interpreted as the level of employment that is sustainable through monetary policy actions without an acceleration in inflation. While we cannot directly observe “maximum employment,” we do observe inflation, and its behavior is a useful signal of how close we are to the maximum level of employment achievable by the FOMC.

So, what has been happening with inflation? Inflation was distinctly higher in 2011 than in 2010. Even core measures of inflation, which strip out energy goods and services, and food, went up notably. I see these changes as a signal that our country’s current labor market performance is closer to “maximum employment,” given the tools available to the FOMC, than the post-World War II U.S. data alone would suggest. As I’ve argued in the past, appropriate monetary policy should be responsive to such signals.

It is worth reiterating a point that I made earlier. “Maximum employment” for monetary policy is not the same as “maximum employment” for all policymakers. Congress and the president can choose to provide direct subsidies to employers for hiring. Such subsidies will increase the federal deficit, but they do have the power to increase “maximum employment” for the FOMC.

Conclusions

Let me wrap up. The overarching theme of my speech has been monetary policy transparency. I pointed out that the FOMC has made major strides toward greater transparency in recent decades, and especially over the past two years. These steps mean that we are more accountable to the public and more effective as policymakers. It is especially noteworthy that in our January framework statement, the Committee has set a clear quantitative objective for our price stability mandate: 2 percent inflation per year.

I believe that all Americans can take great pride in the improvements in FOMC communication over the past 15 or so years. But there is still more that can be done (of course!). Too often, our communications about the future course of the economy imply considerably more certainty than we can possible have. We should be more transparent about the uncertainties that we face as policymakers. We can and should use scenario analyses to describe how our policy will respond to new information about those uncertainties.

Along these lines, we can learn from the practices of other central banks. For example, in today’s talk, I spent a great deal of time discussing the uncertainties associated with formulating a quantitative measure of “maximum employment” for the FOMC. An interested Swedish citizen would have been able to read many rich and detailed discussions of exactly this issue in the Swedish central bank’s monetary policy reports in the mid-1990s.

Thanks for listening to my remarks. I’ll be happy to take your questions now on these or any other topic that might occur to you.

Endnotes

View All Presentation Slides [PDF]

Monetary Policy Transparency: Changes and Challenges
May 10, 2012

President Kocherlakota previously gave a similar speech at the Economic Club of Minnesota on May 10th, 2012. View the video of that speech and the Q & A that followed.

Basic economics says that a policymaker should set a policy instrument so that, on the margin, there is no net benefit to altering it. But while the policymaker’s decision is necessarily made today, the resultant costs and benefits are realized only in the future. Therefore, the policymaker’s optimal choice is to set the policy instrument so that the outlook for the future marginal net benefit is zero. In this talk, I address the following question: How can the policymaker formulate the needed outlook for marginal net benefits? Policymakers often attempt to do so by using statistical models to forecast future marginal net benefits. I argue that policymakers can achieve better outcomes by basing their outlooks on risk-neutral probabilities derived from the prices of financial derivatives.

The benefit of using risk-neutral probabilities arises from the observation that resources may be more valuable in one state of the world relative to another, equally likely, state of the world. (For example, the economy might be in a deep recession in the former state and in a boom in the latter.) In weighing future costs and benefits, the policymaker should take account of this differential valuation of resources in different states. Because they are derived from market prices, risk-neutral probabilities provide the needed information about the relative values of resources in different states of the world in a way that purely statistical forecasts cannot.

After presenting my general argument, I illustrate it using the example of a macro-prudential supervisor who is considering whether to allow systemically important financial institutions to pay dividends. A current dividend payment may generate future social losses if financial markets are strained in that future. Hence, the supervisor’s decision must be based on an outlook for future financial market stress. The above argument implies that the requisite outlook should incorporate the relative costs of resource losses in different states of the world.

The Federal Reserve Bank of Minneapolis reports measures of risk-neutral probabilities on its website. These reports are based on a variety of option prices and are updated every two weeks.

Optimal Outlooks - Presentation Slides [PDF]

Endnotes

Thank you very much for that generous introduction. It is a great pleasure to join all of you today as part of your regional data forum. As an economist and, almost by definition, a data geek, it is especially heartwarming to be here during this event. So thank you for the invitation. I would also like to especially thank those of you who took time from your busy schedules to meet with me and members of my staff this morning to discuss the Black Hills area economy and its challenges and opportunities. It is especially important for monetary policymakers to have a deep understanding of how the economy works, and one of the ways that we attain that understanding is through opportunities like this. The comments and questions that you all share, whether in meetings, over lunch, or in our question-and-answer session following this talk, all help to shape my thinking about the economy and policy.

I became president of the Federal Reserve Bank of Minneapolis in October 2009. One of my main objectives since then has been to make both the Minneapolis Fed and the Federal Reserve System more open and transparent. And I’ve been delighted to learn that I’m not at all alone in this pursuit of greater openness. I see many positive developments along these lines throughout the System, and especially on the part of the Federal Open Market Committee. The FOMC, as you no doubt know, is the monetary policymaking arm of the Federal Reserve. It meets every six to seven weeks to chart the course of monetary policy. The members of the Board of Governors and the presidents of the 12 regional Feds, including me, all take part in these meetings.

Today, I will talk about a significant improvement in the FOMC’s communication about monetary policy: In January 2012, the FOMC released a consensus statement describing its long-run framework. Congress has given the Federal Reserve a dual mandate: to promote maximum employment and to promote price stability. The January framework statement is important because it outlines the strategy that the FOMC follows in order to implement the FOMC’s dual mandate.

As you will hear, the framework statement provides a quantitative definition for price stability, through a numerical target for inflation. It does not do the same for maximum employment. I will spend a considerable amount of time discussing this latter aspect of the statement and its relevance for current policy.

Before proceeding, I’ll remind you that my remarks reflect my thoughts, and not necessarily those of others in the Federal Reserve System.

A brief history of Fed transparency

I’ll begin with some historical context. Over the past 30 years, central banks all over the world have become much more transparent about their objectives and how their current actions allow them to achieve those objectives. This transparency is widely viewed—by both policymakers and scholars—as an important means of enhancing the effectiveness of monetary policy.

Most central banks aim to keep medium-term inflation low and stable—at around 2 percent annually. They have been quite successful in achieving that goal over the past 20 or 25 years. They view that success as being due in part to their communicating on an ongoing basis how their current policy actions are consistent with that goal.

There are at least two benefits of transparency. The first is broadly appreciated: By being clear about their objectives, central banks are better able to achieve those objectives. For example, if the central bank’s announced inflation target is 2 percent per year, firms and employees know that wages need to grow by 2 percent to keep up with the cost of living. That knowledge helps prevent wages from growing so fast that firms have to raise prices by more than 2 percent to cover their costs—and that in turn contributes to keeping inflation under control. In brief, then, transparency helps anchor inflation expectations.

The second benefit of transparency is less appreciated, but no less important. A transparent central bank is more accountable to the public because it is forced to be more disciplined in ensuring that its policy actions are in fact consistent with its policy objectives. The central bank knows the public will be able to track its performance. When performance matches words, the public will have an even stronger belief in the central bank, which serves to anchor inflation expectations more solidly.

So, there has been a trend toward central bank transparency internationally. What about here in the United States? I think we can all take pride in the fact that under Chairman Bernanke and his predecessor, Chairman Greenspan, the Fed has made enormous strides in transparency. It is easy to forget that, as recently as 1993, the FOMC would act and not tell anyone for 90 days! It was not until 2000 that the FOMC began issuing the statement that many of us now take for granted. And it was a decade ago that the roll call vote of FOMC members was added to the statement. Thus, there has been substantial progress in monetary policy transparency over the past 15 or so years.

As of the beginning of 2011, the Committee had arrived at three main forms of communication. First, immediately after every meeting, the Committee issues a carefully worded, but brief, statement intended to describe the current state of the economy and the current stance of monetary policy. Second, three weeks after each meeting, the Committee issues a carefully worded set of minutes that provides a longer, but still relatively high-level, description of interactions within the meeting. Third, after the January, April, June, and October/November meetings, the FOMC releases a summary of economic projections. Among other things, these quarterly releases contain information about FOMC meeting participants’ goals for medium-run inflation and unemployment (roughly, over the next five to six years).

The framework statement

There have been several changes in FOMC communications over the past year, including the introduction of regular press conferences by the chairman and the regular release of FOMC participants’ individual assessments of the appropriate path of short-term interest rates. But I want to spend my time today discussing the change that I view as the most important: the FOMC’s release in January 2012 of a five-paragraph statement describing its long-run framework.

What I will do instead is describe four aspects of the framework statement that I view as especially important. The first key aspect of the framework is that it specifically translates the term “price stability” into a 2 percent target for inflation. The American public need guess no longer about the Federal Reserve’s inflation intentions—either on the upside or on the downside: 2 percent is our goal.

Second, the framework describes how the Committee weighs the two mandates— promoting maximum employment and promoting price stability—against one another. Importantly, it stresses that the two mandates are typically complementary, in the sense that keeping unemployment from rising too high also keeps inflation from falling too low. I think that this point is often under-emphasized in popular discussions of monetary policy.

Third, the framework enjoyed broad consensus support among meeting participants. This suggests that any changes in the framework will require the same level of broad consensus support. In this sense, one can think of the framework as being like a constitution.

I have moved quickly through the first three of these key elements of the framework statement—inflation target of 2 percent, the typical complementarity of the two mandates, and the quasi-constitutionality of the statement. This fourth key feature of the statement is that while it provides a numerical target for inflation, it does not provide a similar explicit quantitative interpretation of the second mandate: “maximum employment.” I want to spend the rest of my time discussing why it does not do so.

Estimating maximum employment

I’ll start with a quote from the framework statement itself: “The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the job market.” What are these nonmonetary factors? There are many, including population trends, the incentives built into the tax system, the incentives built into social insurance safety nets, the returns to human capital accumulation for young people, and simply social norms. The FOMC has no control over these nonmonetary factors. Its job is to attain the maximum level of employment attainable through monetary policy, taking these other nonmonetary factors as given.

It is important to note that the long list of nonmonetary factors includes nonmonetary policies. It follows that, even if employment is close to the maximum level that is achievable using monetary policy, there may well be nonmonetary policy levers that could be used to raise employment still higher. For example, suppose that Congress and the president choose to reduce the payroll tax paid by employers. Such a move would provide an additional incentive to employers to hire more workers (albeit at the cost of increasing the deficit), and increase employment and reduce unemployment.

All of these nonmonetary factors, policy or otherwise, fluctuate over time. Their changes in turn generate fluctuations in the level of maximum employment achievable through monetary policy—fluctuations that are often hard to gauge on a real-time basis. In what follows, I will spend some time describing why I believe that the Committee currently faces an especially large amount of uncertainty about the level of maximum employment that it can hope to achieve.

I’ll start by showing you graphs of four measures of the recent adverse changes in U.S. labor market performance. To understand the graphs, it’s helpful to recall that economists define the labor force to include all of those over 16 years of age who have a job or who have looked for a job in the past four weeks. All of the charts depict annual data through 2011.

The first graph depicts the evolution of the unemployment rate over time—the fraction of people in the labor force who have looked for a job in the past four weeks. The graph shows that after rising sharply from 2007 to 2009 (the shaded area indicates the recession period), the unemployment rate has been falling slowly.³

Large Image

The next graph shows the evolution of the employment/population ratio over time—the fraction of people who have a job. To eliminate some of the possible demographic shifts that might otherwise influence this picture, the graph focuses on people between 25 and 54 years old, the so-called prime age population for the job market. We can see a sharp decline in this ratio from 2007 to 2009. And, in contrast to the unemployment rate, there has been no noticeable recovery in this measure.

Large Image

The third graph is a depiction of the fraction of the population between ages 25 and 54 who are in the labor force—that is, they either have a job or have looked for one in the past month. Economists refer to this as the labor force participation rate. An interesting aspect of this graph is that this fraction has tended downward since the late 1990s. This downward path has accelerated since 2008.

Large Image

The final graph depicts the relationship of unfilled job openings and unemployment over time. The horizontal axis shows the unemployment rate. The vertical axis is the job openings or vacancy rate—the ratio of job openings to the sum of employment and job openings. Each point on this graph corresponds to a different year, and represents the average unemployment rate and the average vacancy rate in that year.

Large Image

When the economy is doing well, firms usually hire more workers and they find it more challenging to fill their available openings. Hence, the unemployment rate is low, and the vacancy rate is high. So, typically, as the economy improves, the plotted points move toward the upper left in this picture. Conversely, when economic times get worse, the plotted points move to the southeast. This creates a curve that runs from the northwest to the southeast—a curve that’s known as the Beveridge curve.

However, in the Great Recession and its aftermath, we have seen something different: The Beveridge curve itself has shifted out toward the upper right. Economists see this kind of outward shift as representing a decline in the ability of the labor market to form mutually beneficial matches between workers and firms. In that sense, the labor market is less efficient. The outward shift means that firms can’t fill their available job openings as readily as we would have expected in light of the high unemployment rate.

To summarize: Labor market outcomes do remain notably worse than prior to the recession. The good news is that the unemployment rate has been declining since the end of the recession. But there is also countervailing evidence: The labor force participation rate has been falling steadily, and the employment/population ratio remains near its low point. The Beveridge curve shows considerable deterioration in labor market matching efficiency.

How persistent will these changes in U.S. labor markets prove to be? Economists hold at least two views on this question. The first is guided by the patterns in post-World War II data for the United States. These patterns suggest that the current deterioration in U.S. labor market performance is indeed reversible under appropriate policy.

The second view is less sanguine. It says that the post-World War II data do not contain an economic crisis of the kind or magnitude that hit the United States in 2008. Such a crisis could well have a different kind of impact on labor markets than the earlier postwar recessions.

The Swedish experience

This latter view is also informed by data from other countries—not just the United States. My staff and I have recently taken a close look at data from Sweden.⁴ Why Sweden? In the early 1990s, Sweden was hit by a financial, banking, and currency crisis—what one might term a triple crisis. Of course, other industrialized countries—perhaps most notably Japan—have experienced these kinds of crises. My staff and I have focused on Sweden because it is generally viewed as having dealt with this triple crisis in a highly effective fashion. For example, in 2007, OECD economists wrote, “Sweden’s economy has made a remarkable recovery from the major crisis of the early 1990s,” in emphasizing Sweden’s rapid productivity growth in the previous two decades.⁵

Despite this success, the triple crisis had a profound and highly persistent effect on the Swedish labor market. To see this, let’s look at graphs for the same four variables in Sweden that I showed you earlier for the United States.⁶ I’ve shaded the period 1991-93 in these graphs to indicate the heart of the triple crisis period in Sweden.

The first graph depicts the Swedish unemployment rate. From 1980 to 1990, the unemployment rate had never been above 4 percent and was typically closer to 2 percent. After 1993, the unemployment rate was never much below 6 percent.

Large Image

The second graph depicts the Swedish employment/population ratio, again for those between ages 25 and 54. From 1980 to 1990, the employment/population ratio grew steadily in Sweden and peaked at over 91 percent. After 1993, the ratio trended upward slightly but remained below 86 percent for most of the period.

Large Image

Next, we see the evolution of the fraction of Swedes aged 25-54 years who are in the labor force. From 1980 to 1990, this fraction rose to a high of over 92 percent. After 1993, it was typically around 88 percent and never much above 90 percent.

Large Image

Finally, we can look at the Beveridge curve—the joint evolution of unfilled job openings and unemployment. The Swedish Beveridge curve shifted outward from 1990 to 1995—and that shift has endured through at least 2010.

Large Image

To sum up: These four measures of Swedish labor market performance declined markedly after the triple crisis of the early 1990s. At least up until now, this decline has proved to be permanent. I should note too that these changes happened over a remarkably short span. In its February 1995 inflation report, the Riksbank, the Swedish central bank, suggests that the rate of unemployment that they viewed as sustainable over the long run had risen from 2-3 percent to 6 percent in less than five years.⁷ Their assessment—again, made in 1995—has proven to be a remarkably accurate characterization of how Swedish labor markets functioned over the next 15 years.

It is important to emphasize that, of course, there are many institutional differences between Sweden and the United States, especially in terms of tax systems and social safety nets. It would be a mistake to conclude from the Swedish data alone that the recent decline in U.S. labor market measures is inevitably a permanent one. But Sweden is not atypical. Cross-country research from Reinhart and Reinhart (2010) has found that financial crises tend to be followed by sustained increases in unemployment.⁸

Hence, I do think that the Swedish data—given that they come from a country generally regarded as an exemplar of how to handle a financial crisis—have to be viewed as informative. At a minimum, Sweden’s experience forces us to contemplate the possibility that the erosion in labor market performance that we’ve seen in the United States over the past five years may be highly persistent, even under appropriate monetary policy.

Policy implications

Over the past ten minutes or so, I have talked about the recent adverse changes in U.S. labor market performance. I have discussed two sharply different possible ways to view those changes: first, that they are largely reversible under appropriate monetary policy and, second, that they are likely to be highly persistent. These two possibilities suggest that the FOMC is confronted with an unusually high degree of uncertainty about the level of “maximum employment” it can achieve. This uncertainty translates directly into a corresponding uncertainty about the appropriate approach to policy. In particular, policymakers who see the deterioration in labor market performance as reversible using monetary policy will typically favor more accommodative policy than those who view the deterioration as more protracted.

Fortunately, we can use other sources of information to reduce the level of uncertainty about the maximum level of employment achievable through monetary policy. “Maximum employment” for monetary policy is widely interpreted as the level of employment that is sustainable through monetary policy actions without an acceleration in inflation. While we cannot directly observe “maximum employment,” we do observe inflation, and its behavior is a useful signal of how close we are to the maximum level of employment achievable by the FOMC.

So, what has been happening with inflation? Inflation was distinctly higher in 2011 than in 2010 and continues to run above the FOMC’s target of 2 percent. Even core measures of inflation, which strip out energy goods and services, and food, went up notably. I see these changes as a signal that our country’s current labor market performance is much closer to “maximum employment,” given the tools available to the FOMC, than the post-World War II U.S. data alone would suggest. As I’ve argued in the past, appropriate monetary policy should be responsive to such signals.

It is worth reiterating a point that I made earlier. “Maximum employment” for monetary policy is not the same as “maximum employment” for all policymakers. Congress and the president can choose to provide direct subsidies to employers for hiring. Such subsidies will increase the federal deficit, but they do have the power to increase “maximum employment” for the FOMC.

Conclusions

Let me wrap up. The overarching theme of my speech has been monetary policy transparency. I pointed out that the FOMC has made major strides toward greater transparency in recent decades, and especially over the past two years. These steps mean that we are more accountable to the public and more effective as policymakers. It is especially noteworthy that in our January framework statement, the Committee has set a clear quantitative objective for our price stability mandate: 2 percent inflation per year.

I believe that all Americans can take great pride in the improvements in FOMC communication over the past 15 or so years. But there is still more that can be done (of course!). Too often, our communications about the future course of the economy imply considerably more certainty than we can possible have. We should be more transparent about the uncertainties that we face as policymakers. We can and should use scenario analyses to describe how our policy will respond to new information about those uncertainties.

Along these lines, we can learn from the practices of other central banks. For example, in today’s talk, I spent a great deal of time discussing the uncertainties associated with formulating a quantitative measure of “maximum employment” for the FOMC. An interested Swedish citizen would have been able to read many rich and detailed discussions of exactly this issue in the Swedish central bank’s monetary policy reports in the mid-1990s.

Thanks for listening to my remarks. I’ll be happy to take your questions now on these or any other topic that might occur to you.

Endnotes

View All Presentation Slides [PDF]

Monetary Policy Transparency: Changes and Challenges
May 10, 2012

View video of the speech and the
Q & A that followed.