The U.S. Economic Outlook And Monetary Policy

The U.S. Economic Outlook And Monetary Policy GIC Central Banking Series Madrid, Spain November 15, 2018 Daniel Sullivan Executive Vice President and Director of Research Federal Reserve Bank of Chicago Views expressed here are my own and do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System.

1

Roadmap  The U.S. economy has substantial momentum and dual mandate

goals have essentially been met, so it is natural to adjust monetary policy toward neutral  Big questions: – What is neutral policy?

– How much ‐‐ if at all ‐‐ should policy be adjusted beyond neutral?  Unusual features of the economic outlook – Late cycle fiscal stimulus – Significant trade tensions  Important analytical question: How to think about inflation expectations – Accelerationist nature of Phillips curve seems to have disappeared – Will inflation expectations stabilize at 2%?

2

Late Cycle Pick Up In Growth Real GDP Growth (percent change, annual rate) 6 Blue Chip Forecasts

Potential* 3

0 Actual GDP

Q3-2018

‐3

‐6

‐9 2007

'09

'11

'13

'15

Source: Blue Chip Consensus Forecasts and Bureau of Economic Analysis from Haver Analytics Potential from Chicago Fed staff estimates

'17

3

Job Gains Exceed Long-Term Labor Force Growth Monthly Payroll Employment Change (thousands) Data

400

3-month MA Long-Term Trend Necessary to Absorb Labor Force Growth*

300

Oct-2018 200

100

0 2011

'12

'13

'14

'15

'16

'17

'18

Source: Bureau of Labor Statistics from Haver Analytics *Based on Chicago Fed Letter, "Is there still slack in the labor market?“, No. 359, by Daniel Aaronson, Scott A. Brave, and David Kelly (2016)

4

Unemployment Is The Lowest Many Years Unemployment Rate (percent) 12

9

Oct-2018

CBO

6

FOMC Projections

Chicago Fed 3 1982

'86

'90

'94

'98

'02

'06

'10

'14

'18

FOMC projections are the median of the FOMC participants’ forecasts for core PCE inflation as reported in the September 26, 2018 Summary of Economic Projections.

Source: Bureau of Labor Statistics and Congressional Budget Office from Haver Analytics and internal Chicago Fed staff estimates

5

Wage and Compensation Growth Still Moderate Wage Growth (year over year percentage change) 5

4 2004 – 2006 Average 3

Oct-2018 Q3-2018

2

Employment Cost Index 1 2006

'08

Source: BLS from Haver Analytics

'10

'12

'14

'16

'18

6

Inflation Is At Target PCE Price Index (12-month percent change) 5 4 Total

3

FOMC Long-run Target 2 FOMC Projections* Sep-2018

1

Core

0 ‐1 ‐2 2004

'06

'08

'10

'12

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'18

'20

FOMC projections are the median of the FOMC participants’ forecasts for core PCE inflation as reported in the September 2018 Summary of Economic Projections.

Source: Federal Open Market Committee and Bureau of Economic Analysis from Haver Analytics

7

Policy Rate Heading Toward Neutral Federal Funds Rate and Natural Rate of Interest (percent, adjusted by 12 month growth in core PCE price index) 12 10 Real Federal Funds Rate

8 6 4

Laubach-Williams Neutral Real Funds Rate

2 0 ‐2 ‐4 ‐6 '70

'74

'78

'82

'86

'90

'94

'98

'02

Federal Reserve Board, Federal Reserve Bank of New York from Haver Analytics

'06

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Policy And The Neutral Rate  Natural rate of interest has fallen – True by many measures, including the “long‐term” natural rate

estimates from the model of Laubach and Williams – Interest rates on safe assets have fallen broadly over many years – Substantial uncertainty over exact current level  Reasons – Slower growth in productivity and labor force – Increased demand for safe assets – (Overall return on capital not much changed)  Fed has typically overshot neutral by 150 basis points or more – At least according to current thinking on neutral  Circumstances are different now – In past cycles, inflation expectations were often too high 9

Federal Expenditures and Receipts Actual and Projections (percent of GDP) 26

Expenditure: BBA Increases Extended* Expenditure: Current Baseline* Expenditure: Before BBA *

23 Actual (Expenditures)

20

17 Revenue: Before TCJA* Revenue: Current Baseline*

Actual (Revenues) 14 2000

'02

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* Calculations based on the CBO's April 2018 projections of Federal outlays, receipts, and gross domestic product.

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Government Deficit And Unemployment Government Deficit and Unemployment Rate (as a percentage of GDP; percent) 10

11 Unemployment Rate

8

6

CBO Projections

4

8

Q2-2018

2

5

0

�2 1980

2 '85

'90

'95

'00

'05

'10

'15

Source: Bureau of Economic Analysis and Congressional Budget Office from Haver Analytics

'20

11

U.S. Fiscal Policy  Tax cuts of late 2017 – Increased investment incentives for corporations – Lowered personal taxes  Spending increases of early 2018 – Relaxed caps on spending through fiscal 2019 – Many forecasters assume extensions  Supply effects: Small increases for several years – Greater capital investment should raise productivity – Somewhat greater labor supply  Demand effects: Concentrated in near term – Expect strong capital investment (Including capital inflows that imply

higher trade deficits)  Raises natural rate of interest in the short term 12

Absent Fiscal Stimulus Expect Slowing Growth Real GDP Growth (Q4/Q4 percent change) Forecast w/o Fiscal Changes*

4 FRBCHI Potential*

Actual GDP

2

0

‐2

‐4 2006

'08

'10

'12

Forecast from Chicago Fed staff estimates Source: Bureau of Economic Analysis from Haver Analytics

'14

'16

'18

'20

13

Now Near Term Expected Growth Stronger Real GDP Growth (Q4/Q4 percent change)

Effect of Fiscal Changes* Forecast w/o Fiscal Changes*

4 FRBCHI Potential*

Actual GDP

2

0

‐2

‐4 2006

'08

'10

'12

Forecast from Chicago Fed staff estimates Source: Bureau of Economic Analysis from Haver Analytics

'14

'16

'18

'20

14

Investment Private Nonresidential Fixed Investment (contribution to percentage change in GDP) 1.5 Total Structures (23%) Intellectual Property (32%) 1.0

Equipment (45%)

0.5

0.0

�0.5 2014

2015

2016

2017

2018

15

Trade Policy Effects I  Tariffs and retaliation – Washing machines, steel, aluminum, 50% of Chinese imports …

– Retaliation against soy beans, port, KY bourbon, WI motor cycles …  Sizable effects on several industries – Steel producers, steel users, several agriculture products  But direct effects on aggregate growth and inflation still small – (Imports are 20% of U.S. GDP) times (13% of imports from China)

times (50% have tariff) times (10% tariff) = something small  Similar to a modest supply shock – Lowers productivity as most efficient inputs become unavailable – Raises price level

16

Trade Policy Effects II  Monetary policy can’t eliminate the downside effects of tariffs on

productivity  One time increase in price level isn’t the same as a long‐running inflation – “Looking through” supply shocks is often an appropriate monetary

policy response  Possible larger effect I: Uncertainty could slow investment – Might call for more accommodation than otherwise  Possible larger effect II: First round price effects might push up inflation

expectations – Might call for less accommodation than otherwise

17

Rest Of World Slowing And Dollar Strengthening Global Purchasing Managers’ Index

U.S. Trade Weighted Dollar

(Index, 50 = no change )

(Index, Jan-97=100)

55

130 Oct-2018

54 120

53 Oct-2018

110

52

100 51

50 2016

90 '17

'18

'00

'03

'06

Source: Bureau of Economic Analysis and Federal Reserve Board from Haver Analytics

'09

'12

'15

'18

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Inflation Forecast Factors  Slack – e.g., unemployment relative to natural rate

– Currently suggests higher inflation, but: – Sensitivity seems to have decreased very substantially  Unemployment has to be much below natural rate to get large effects on inflation  Supply shocks

– E.g., oil prices, dollar, tariffs – Mixed effects on current inflation outlook  Inflation expectations

– Inflation expectations have been quite stable in recent decades – Some measures suggest inflation expectations are still lower than would be consistent with 2% inflation target

19

Inflation Expectations Still Somewhat Soft Inflation Surveys (percent)

TIPS 5-year, 5-year forward CPI Inflation Compensation

4

(percent) 4 University of Michigan Expected CPI Inflation: 5-10 years ahead

3

3 Nov-2018 9-Nov-18

2

2 Survey of Professional Forecasters for PCE: 10 years ahead

1 2006

'08

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1 2006

'08

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Source: University of Michigan Survey of Consumers, Survey of Professional Forecasters, and Federal Reserve Board

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Inflation Forecasting Framework Considerations  Accelerationist Phillips curve essentially equated inflation expectations

with the lagged history of inflation – If unemployment was below natural rate inflation rose – and kept rising as long as unemployment stayed too low – Unemployment above the natural rate was required to bring inflation and inflation expectations back down  Accelerationist phenomenon not visible in recent years

– Predicted that great recession would have caused significant deflation  With inflation expectations stable at 2%, inflation should returns to

target as long as slack returns to zero – No need for a period with high unemployment – Less reason to want to slow the economy with policy rates above neutral 21

Appropriate Pace of Policy Firming Target Federal Funds Rate at Year-End (percent) 5

4

3 Market Pricing 2

1

0 2018

2019

2020

2021

Source: September 2018 FOMC Summary of Economic Projections Red dots indicate median. Market pricing as derived from OIS futures as of November 1, 2018

Long�run

22

Summary  Dual mandate goals met

– Unemployment is below most estimates of its natural rate – Inflation is close to 2% and likely to rise only slightly higher – Implies monetary policy accommodation less needed  Sizable fiscal stimulus this year and next

– Unusual given tightness of labor markets – Possibly increases short‐run neutral rate of interest  Trade war worries, but only small effects on current aggregate outlook

– Several industries more heavily effected – Potential for larger effects – Monetary policy implications still unclear  Policy rates likely to continue to rise gradually – FOMC sees policy rates slightly above long‐run levels in 2020 and 2021 23