In the Committee's most recent projections last December, most FOMC participants assessed the longer-run value of the neutral real federal funds rate to be in the vicinity of 1 percent. This level is quite low by historical standards, reflecting, in part, slow productivity growth and an aging population not only in the United States, but also in many advanced economies. Moreover, the current value of the neutral real federal funds rate appears to be even lower than this longer-run value because of several additional headwinds to the U.S. economy in the aftermath of the financial crisis, such as subdued economic growth abroad and perhaps a lingering sense of caution on the part of households and businesses in the wake of the trauma of the Great Recession.
It is difficult to say just how low the current neutral rate is because assessments of the effect of post-recession headwinds on the current level of the neutral real rate are subject to a great deal of uncertainty. Some recent estimates of the current value of the neutral real federal funds rate stand close to zero percent. With the actual value of the real federal funds rate currently near minus 1 percent, a near-zero estimate of the neutral real rate means that the stance of monetary policy remains moderately accommodative, an assessment that is consistent with the fact that employment has been growing at a pace — around 180,000 net new jobs per month — that is notably above the level estimated to be consistent with the longer-run trend in labor force growth — between 75,000 and 125,000 per month. As I will explain, this policy stance seems appropriate given that the underlying trend in inflation appears to be still running somewhat below 2 percent. But as that gap closes, with labor market conditions now in the vicinity of our maximum employment objective, the Committee considers it appropriate to move toward a neutral policy stance.
My colleagues and I generally anticipate that the neutral real federal funds rate will rise to its longer-run level over the next few years. This expectation partly underlies our view that gradual increases in the federal funds rate will likely be appropriate in the months and years ahead: Those increases would keep the economy from significantly overheating, thereby sustaining the expansion and maintaining price stability.
Post-Crisis Period: Same Strategy, New Tactics
I will now examine the strategic and tactical considerations that go into FOMC deliberations by discussing past monetary policy decisions in the context of our mandate from the Congress to pursue maximum employment and price stability.
The FOMC's monetary policy strategy is based on three basic principles. First, our monetary policy must be goal driven. We must take care to ensure that our decisions over time are consistent with our commitment to achieve the Federal Reserve's congressionally mandated goals of maximum employment and price stability, and that the public understands and has confidence in that commitment. Second, our monetary policy must be forward looking because our decisions tend to influence economic activity and inflation with a substantial lag. Among other things, this implies looking through short-term and transitory developments and focusing on the medium-term outlook--roughly two or three years out--when making policy decisions. Third, our monetary policy must be risk sensitive. Because the outlook is uncertain, we must assess appropriate policy with an eye toward the risk that our expectations about the economy turn out to be significantly wrong.
We have followed this basic strategy for decades and, in 2012, the FOMC formalized it in our "Statement on Longer-Run Goals and Monetary Policy Strategy." The Committee has reaffirmed this commitment annually. But the challenges brought about by the financial crisis, and the very deep recession and painfully slow recovery that followed, compelled us to adjust our tactics for carrying out our policy strategy. In particular, once the Committee had cut the federal funds rate to near zero in late 2008, it became necessary to deploy new tools to supply the considerable monetary accommodation required by the extremely weak state of the job market and persistently low inflation.Those tools — especially our large-scale securities purchases and increasingly explicit forward guidance pertaining to the likely future path of the federal funds rate — enabled the Federal Reserve to provide necessary additional support to the US economy by pushing down longer-term interest rates and easing financial conditions more generally.
Much has been written and said already about the provision of additional accommodation between 2008 and 2014, when the FOMC completed its latest round of large-scale securities purchases, so I will turn now to our policy stance since 2014, when the FOMC's main focus started to shift from providing additional accommodation to scaling it back.
2014: A Turning Point for Monetary Policy
By late 2013, the FOMC concluded that the economy had made sufficient progress, and the outlook was sufficiently favorable, that it should reduce the pace of its large-scale securities purchases. But we reiterated that these purchases would continue until the outlook for the labor market had improved substantially. The US economy made notable progress toward the FOMC's statutory goals during 2014, with the unemployment rate dropping to close to 6 percent by mid-year — well below its Great-Recession peak of 10 percent — and other measures of labor market conditions also showing improvement: Payroll gains were solid; job openings had risen significantly; and the number of workers voluntarily quitting their jobs — a sign of confidence in the labor market — was rising back toward pre-crisis levels. We were also seeing progress on achieving our price stability goal: Total inflation as measured by changes in the headline personal consumption expenditures (PCE) price index reached about 1-3/4 percent by mid-2014 after hovering around 1 percent in the fall of 2013. Inflation seemed to be moving toward the FOMC's 2 percent objective, a level that the FOMC judges to be consistent with price stability because it is low enough that it does not need to figure prominently into people's and businesses' economic decisions but high enough to serve as a buffer against deflation and provide greater scope for monetary policy to address economic weakness.
The progress seen during 2014 indicated to the FOMC that it was no longer necessary to provide increasing amounts of support to the US economy by continuing to add to the Federal Reserve's holdings of longer-term securities. Accordingly, the Committee continued to reduce the pace of asset purchases over the course of the year, ending its purchases in October. That step, however, did not mark an immediate shift toward tighter monetary policy because we also indicated then that we did not expect to raise interest rates for a considerable time after the end of our securities purchases. Moreover, as the Committee explained in a set of "normalization principles" issued that September, the intention was to maintain the overall size of the Federal Reserve's balance sheet at an elevated level until sometime after the FOMC had begun to raise its target for the federal funds rate. We decided that maintaining a highly accommodative stance of monetary policy remained appropriate because, while the US economy was stronger and closer to meeting our statutory goals, we saw significant room for improvement. In particular, the unemployment rate still stood above our assessment of its longer-run normal level — that is, the unemployment rate that we expect to prevail when the economy is operating at maximum employment — and inflation remained below the 2 percent objective.
Because my colleagues and I expected that labor market conditions would continue to improve and that inflation would move back to 2 percent over the medium term, we anticipated that the time was approaching when the economy would be strong enough that we should start to scale back our support. Indeed, the FOMC's June 2014 Summary of Economic Projections (SEP) reported that nearly all FOMC participants saw a higher federal funds rate as appropriate in the next calendar year. In contrast, only two participants in December 2013 thought that it would be appropriate to start raising that rate in the next calendar year.
Uneven Progress in 2015 and into 2016
In 2015, the unemployment rate fell significantly faster than we generally had anticipated in 2014. However, a series of unanticipated global developments beginning in the second half of 2014 — including a prolonged decline in oil prices, a sizable appreciation of the dollar, and financial market turbulence emanating from abroad — ended up having adverse implications for the outlook for inflation and economic activity in the United States, prompting the FOMC to remove monetary policy accommodation at a slower pace than we had anticipated in mid-2014.
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