Fed Reserve Governor Lael Brainard: Growing above Trend, Sustaining Full Employment and Inflation around Target

It is difficult to know how much slack remains. April's 3.9 percent unemployment rate was the lowest reading since December 2000. If the unemployment rate falls another couple of tenths — which seems likely, based on recent trends — it will be at its lowest level since 1969. Although the late 1960s marked the beginning of what is now called the Great Inflation, it is worth keeping in mind that there have been important shifts in the labor market since that time. For example, educational attainment is much higher today than it was in the 1960s, and college degree holders tend to have much lower unemployment rates, on average, than those with a high school degree or less.4

While the unemployment rate is now lower than before the financial crisis, the employment-to-population ratio for prime-age workers remains about 1 percentage point below its pre-crisis level. It is an open question what portion of the prime-age Americans who are out of the labor force may prove responsive to tight labor market conditions.

While it is difficult to know with precision how much slack still remains, I am seeing more evidence that labor markets are tightening, and wages are accelerating, although at a measured pace. The 12-month change in the employment cost index (ECI) for private industry workers in the first quarter was 2.8 percent, up from 2.3 percent in the year-earlier period. By way of comparison, in the period from 2005 to 2007, just before the financial crisis, the ECI rose a bit more than 3 percent at an annual rate, while core personal consumption expenditures (PCE) inflation was around 2-1/4 percent. I am hearing anecdotes of labor market shortages in particular occupations and sectors, echoing a theme in our recent Beige Book. Going forward, I will be looking for confirmation in other measures of wages that labor market tightness is feeding through to wage gains.

Sustainably Achieving Our Inflation Objective
Turning to the second leg of our dual mandate, in the most recent data, the trailing 12-month change in core PCE prices was 1.8 percent, up from a year earlier, when core PCE prices increased only 1.6 percent. Overall PCE prices, which include the volatile food and energy sectors, increased 2.0 percent, largely reflecting the recent run-up in crude oil prices. While the recent core PCE data are somewhat encouraging, we will want to see inflation coming in around target on a sustained basis after seven years of below-target readings.

As I have noted before, the persistence of subdued inflation, despite an unemployment rate that has moved below most estimates of its natural rate, suggests some risk that underlying inflation--the slow-moving trend that exerts a pull on wage and price setting--may have softened.5 For example, some survey measures of longer-run inflation expectations are currently lower than they were before the financial crisis, as are most estimates based on statistical filters. Inflation compensation has moved up recently but is still running somewhat below levels that prevailed before the crisis.

Re-anchoring underlying inflation at the Federal Open Market Committee's (FOMC) 2 percent objective is an important goal. Recent research has highlighted the downside risks to inflation and inflation expectations that are posed by the effective lower bound on nominal interest rates, and it underscores the importance of ensuring underlying inflation does not slip below target in today's new normal.6 In that regard, if we were to see a mild, temporary overshoot of the inflation target, this could well be consistent with the symmetry of the FOMC's target and may help nudge underlying inflation back to target.7

In short, it is reassuring to see core PCE inflation moving up, along with market-based measures of inflation compensation retracing earlier declines. After seven years of below-target inflation, it will be important to see inflation coming in around target on a sustained basis to be confident that underlying trend inflation is running at 2 percent.

The Yield Curve
Even though longer-term Treasury yields have moved up, on net, since the beginning of the year, there has been growing attention of late to the possibility of an inversion of the yield curve — that is, circumstances in which short-term interest rates exceed long-term interest rates on Treasury securities. Historically, yield curve inversions have had a reliable track record of predicting recessions in the United States.8 Since 1960, the 3-month Treasury yield has moved above the 10-year Treasury yield before every recession except the one in 1990, and, conversely, there has only been one case where the yield curve has inverted and a recession has not followed — in 1966.

This correlation between yield curve inversions and recessions might arise for a variety of reasons. First, let us take a case where short-term rates rise relative to long-term rates. When the FOMC is undertaking a deliberate tightening in policy, short-term interest rates typically rise, as do expectations of short-term interest rates in the medium term, while interest rates in the distant future may be less affected. For example, if short-term interest rates were raised to stabilize temporary swings in the economy, the logic of the expectations hypothesis would suggest that long rates would not rise as much. And if tighter monetary policy were to weaken the economy with a lag, this would lead to long rates not rising by as much or at all.

Second, let us take a case where long-term rates decline relative to short-term rates, perhaps reflecting a flight to safety. If market participants become concerned about a future macroeconomic risk that could lead to a weaker economy, this concern would tend to lower expected longer-term interest rates, both because monetary policy would be expected to become more accommodative in the future and because market participants may increase their relative holdings of safe assets, such as Treasury securities. In this case, longer-dated Treasury yields may fall, and if short-term interest rates do not adjust commensurately, the yield curve will invert ahead of a weaker economy.

Turning to current conditions, the spread between the 10-year and 3-month Treasury yields has declined from 375 basis points in early 2010 to about 125 basis points in the first quarter of this year. While that represents a considerable flattening, the current spread between the 10-year and 3-month yields is only about 20 basis points narrower than the average over the 45 years before the financial crisis.

As we try to assess the implications of this flattening of the yield curve, it is important to take into account the very low level of the current 10-year yield by historical standards. For the 20 years before the crisis, the 10-year Treasury yield averaged about 6‑1/4 percent, compared with recent readings around 3 percent. One reason the 10-year Treasury yield may be unusually low is that market expectations of interest rates in the longer run may be unusually low. A second reason may be that the term premium — the extra compensation an investor would demand for investing in a 10-year bond rather than rolling over a shorter-dated instrument repeatedly over a 10-year period--has fallen to levels that are very low by historical standards. According to one estimate from Federal Reserve Board staff, the term premium has tended to be slightly negative in recent years. By contrast, when the spread between the 10-year and 3-month Treasury yields was at its peak in early 2010, this measure of the term premium was close to 100 basis points.9

Other things being equal, a smaller term premium will make the yield curve flatter by lowering the long end of the curve. With the term premium today very low by historical standards, this may temper somewhat the conclusions that we can draw from a pattern that we have seen historically in periods with a higher term premium. With a very low term premium, any given amount of monetary policy tightening will lead to an inversion sooner so that even a modest tightening that might not have led to an inversion in the past could do so today.

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Fed Reserve Governor Lael Brainard: Growing above Trend, Sustaining Full Employment and Inflation around Target

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