Sullivan Sarasota 2017

Economic Outlook and Monetary Policy Global Interdependence Center and Financial Planning Association Sarasota, FL February 17, 2017

Daniel Sullivan Executive Vice President and Director of Research Federal Reserve Bank of Chicago The views I express here are my own and do not necessarily reflect the views of the Federal Reserve Bank of Chicago or the Federal Reserve System.

The Fed Has A Dual Mandate  Full employment

– (Rough) Meaning: Unemployment near its (time-varying) natural rate – with due allowance for other measures of slack – Current state: Likely very close to -- but perhaps not quite at -full employment  Stable prices

– (Exact) Meaning: Inflation as measured by PCE price index symmetrically near 2% over the medium term – Current state: Making progress, but continuing to fall short of target

Continued Moderate GDP Growth Real GDP Growth (Q4/Q4 percent change) 4 FRBCHI Potential

2017-2018 FRBCHI Forecast Average

Actual GDP

2

0 2016: 1.9%

-2

-4

2006

'08

'10

'12

'14

'16 H1/H2

'18

* Source: Data from the Bureau of Economic Analysis, accessed via Haver Analytics, and FRBCHI staff estimates.

Fed Nirvana?: Steady, Boring Growth

“Personally, I liked this roller coaster better before the Federal Reserve System got hold of it.�

4

Recent Spending Data  Consumption: Solid Growth  Home building: Continuing modest uptrend

 Business investment: Now showing modest increases

– But that’s an improvement over 2016:Q1-Q3  Net exports: Higher dollar will continue to slow exports  Adds up to moderate growth this quarter and likely the

next several quarters

Employment Growth Remains Robust Nonfarm Payroll Employment (change, thousands) 400 Data Growth Necessary To Absorb Increase In Labor Force* 300

Jan-2017 200

100

0

2011

'12

'13

'14

'15

'16

'17

Source: Data from the Bureau of Labor Statistics, accessed via Haver analytics. * Data based on Chicago Fed Letter, “Is There Still Slack in the Labor Market?�, by Daniel Aaronson, Scott A. Brave, and David Kelly.

Unemployment Likely Very Near Natural Rate Unemployment Rate (percent) 11

9

Actual Rate 7

Jan-2017

5 Natural Rate* FRBCHI Forecast* 3 2000

'02

'04

'06

'08

'10

'12

Source: Data from the Bureau of Labor Statistics, accessed via Haver Analytics. * Natural rate and forecasts taken from FRBCHI staff estimates.

'14

'16

'18

'20

Time To Take Away The Punch Bowl?  “The Federal Reserve’s role is to

take away the punch bowl just as the party gets going” – William McChesney Martin  Reasons to remove the punch bowl

only gradually – Uncertainty about whether we are truly at full employment – Inflation has been stubbornly low for a while; let’s not declare victory prematurely – Prudent risk management

Inflation Projected To Hit Target Soon PCE Price Index (12-month percent change)

Core PCE Inflation Oct

Nov

Dec

Monthly

0.1

0.0

0.1

Yr-to-Yr

1.8

1.7

1.7

5 4 Total

3

FOMC Projections* 2 1 Dec-2016

Core 0 -1 -2 2000

'02

'04

'06

'08

'10

'12

'14

'16

'18

Source: Data from the Bureau of Economic Analysis, accessed via Haver Analytics. * FOMC projections are the median values of the FOMC participants’ forecasts for core PCE inflation as reported in the December 14, 2016 Summary of Economic Projections.

9

But We’ve Been Disappointed Before Core PCE Inflation and Projections Over the Years (year-over-year percent change) 2.5 Actual Core PCE Inflation 2012*

2.0

2014*

2016*

Q4-2016 1.5

1.0

0.5 2006

'08

'10

'12

'14

'16

'18

Source: Data from the Bureau of Economic Analysis, accessed via Haver Analytics. * Projections are the median values from the September releases of the Summary of Economic Projections of the Federal Open Market Committee for every other year from 2012 to 2016.

10

Wage Growth Still Somewhat Slow Nominal 12-Month or 4-Qtr Wage Growth (percent) 5

4

Average Hourly Earnings: Production and Nonsupervisory

3

Jan-2017 Q4-2016

2 ECI Compensation

1 2006

'08

'10

'12

Source: Data from the Bureau of Labor Statistics, accessed via Haver Analytics.

'14

'16

11

Workers Reporting Higher Wage Rates 4-Qtr Growth in Average Reported Wage Rate in Current Population Survey (percent) 5

4

3 Average Wage Rate

Adjusted For Compositional Changes

2

Q4-2016

1

0 2006

'08

'10

'12

'14

'16

Source: Data based on Chicago Fed Economic Perspectives paper, “Growth in Work Quality”, by Dan Aaronson and Dan Sullivan. Utilizing CPS data, the average wage rate is predicted using individual characteristics (e.g., education).

The adjusted wage rate is the difference between individuals’ actual and predicted wages.

12

Post-Election Financial Developments S&P 500

10 Year Treasury Rate

(Index: Nov. 8, 2016 = 100)

(percent)

120

4

13-Feb-2017

100

3 13-Feb-2017

80

2

60 2013

1 2013

'14

'15

'16

Source: Data from the New York Times, accessed via Haver Analytics.

'17

'14

'15

'16

Source: Data from the U.S. Treasury, accessed via Haver Analytics.

'17

13

Post-Election Financial Developments Broad Trade-Weighted Dollar (Index: Jan-97=100)

CPI Inflation Compensation Embedded in TIPS

130

(percent) 3.0

13-Feb2017 2.5

120

5-10 Year 13-Feb-2017 110

2.0

100

1.5

90 2013

'14

'15

'16

'17

Source: Data from the Board of Governors of the Federal Reserve System, accessed via Haver Analytics.

1.0 2013

'14

'15

'16

'17

Source: Data based on “The U.S. Treasury Curve: 1961 to the Present” and “The TIPS Yield Curve and Inflation Compensation” (Gurkaynak, Sack, and Wright), accessed via Haver Analytics.

14

Inflation Expectations Recovering Survey of Professional Forecasters: CPI Inflation

University of Michigan Median Inflation Expectations

(percent) 2.50

(percent) 3.5 Q1-2017

10 Years Ahead

1 Year Ahead

2.25

3.0 Feb-2016

2.00

2.5 1 Year Ahead

1.75 2013

'14

'15

'16

Source: Data from the Federal Reserve Bank of Philadelphia, accessed via Haver Analytics.

'17

2.0 2013

'14

'15

'16

Source: Data from the University of Michigan Surveys of Consumers.

'17

15

Greater Consumer and Small Business Optimism Indices of Overall Consumer Sentiment

NFIB Optimism and Business Roundtable Indexes

(Michigan: Q1-1966=100; Conference Board: 1985=100)

(NFIB: 1986=100; CEO: 50+ = Expansion) 120

120

90

Feb-2017 Jan-2017

Conference Board Consumer Confidence

130 Jan-2017

110

90

Q4-2016 60

100

30

90

50

Business Roundtable NFIB Optimism

Michigan Consumer Sentiment

0 2006

'08

'10

'12

'14

'16

Source: Data from the University of Michigan Surveys of Consumers and The Conference Board, accessed via Haver Analytics.

80 2006

10

-30

'08

'10

'12

'14

'16

Source: Data from the National Federation of Independent Business and Business Roundtable, accessed via Haver Analytics.

16

Economy Close To Potential By Most Estimates Real and Potential GDP (Bil. Chained 2009 Dollars, SAAR)

16,000

 If estimates are correct, fiscal or

other stimulus can only boost GDP temporarily …

– And would likely be inflationary  … Unless it raises potential

8,000

– Increase available workers – Or make them more productive – Possible, but not easy

4,000 1970 '75 '80 '85 '90 '95 '00 '05 '10 '15 '20 Source: Data from the Bureau of Economic Analysis and the Congressional Budget Office, accessed via Haver Analytics.

Slower Potential GDP Growth Rate CBO Potential Real GDP (Q4/Q4 percentage change) 6

1960-1989 Average

1995-2000 Average

4

2001-2008 Average FRBCHI Estimate

2

2009-2016 Average

0 1960

1968

1976

1984

1992

2000

2008

2016

Source: Data from the Bureau of Economic Analysis and the Congressional Budget Office, accessed via Haver Analytics.

Estimates Of Potential Growth Have Fallen  Slower population growth and declining labor force participation

imply slower growth in available workers  Slower growth in capital investment and disappointing total

factor productivity growth imply slower labor productivity growth  Both could be affected by fiscal and regulatory changes

– But big increases are not easy to achieve Trend Growth In

1995-2000*

2009-2016**

Available Workers

1.2

0.5

Labor Productivity

2.6

0.9

GDP

3.8

1.4

* Source: CBO ** Source: FRBCHI staff estimates

19

Long-term Decline in Labor Force Participation (percent) 68

Fit Using Unemployment Gap*

67

Actual 65 Long-term Trend*

Jan-2017

64

62 1994

'98

'02

'06

Source: Data from the Bureau of Labor Statistics, accessed via Haver Analytics. * FRBCHI staff estimates.

'10

'14

20

Labor Force Participation Participation Rates for Ages 25 to 54 (percent) 100 Men

Women

Jan-2017

75

50

25 1950

'60

'70

'80

'90

Source: Data from the Bureau of Labor Statistics, accessed via Haver Analytics.

'00

'10

21

Productivity Growth Slowed Before Recession Real Output Per Hour (4-qtr annualized percent change) 8

6 1995-2003 4

2

Q4-2016

1948-1972 0 1973-1994

2004-current

-2

-4 1948

'58

'68

'78

'88

Source: Data from the Bureau of Labor Statistics, accessed via Haver Analytics.

'98

'08

22

Lower Equilibrium Real Interest Rates Laubach-Williams Equilibrium Real Fed Funds Rate Estimate (percent) 4

3

2

1 Q3-2016 0 1980

'84

'88

'92

'96

'00

'04

Source: Data from the Bureau of Labor Statistics, accessed via Haver Analytics. * FRBCHI staff estimates.

'08

'12

'16

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

4

3

2 Market Expectations (Feb. 24, 2017)

1

Market Expectations (Nov. 7, 2016) 0

2017

2018

2019

Long-run

Source: Interest rate projections are from the December 14, 2016 FOMC Summary of Economic Projections.

Red dots indicate the median projection. Market expectations are from OIS futures as of Nov. 7, 2016 and Feb. 13, 2017.

Less Room To Cut Rates In Future (percent)

20

16

12

8

4 Jan-2017 0 1980

'85

'90

'95

'00

'05

'10

Source: Data from the Board of Governors of the Federal Reserve System, accessed via Haver Analytics.

'15

Risk Management Considerations  Risks for inflation forecast weighted to downside  Policy options asymmetric

– Little room to loosen conventional policy to counter downside shocks – Ample room to tighten policy if inflationary pressures rise too much  Risk management thus prescribes accommodative policy

– Counter risk of inflation expectations becoming entrenched below target – Provide a buffer against possible future downside shocks that might otherwise drive us back to ZLB