US gross domestic product (GDP) growth generally surprised to the downside in 2015, reflecting, in part, weak economic activity abroad, the earlier appreciation of the dollar, and the effect of falling oil prices on business fixed investment. This unanticipated slowing in the pace of the economic recovery caused us to worry about the sustainability of ongoing improvements in employment and, thus, of likely progress toward our maximum employment goal. Our worry was reinforced by our assessment that, with the federal funds rate still near zero, there would likely be only limited scope for us to respond by lowering short-term rates if the weakening in economic activity turned out to be persistent. In contrast, if the weakening proved transitory and the economy instead began to overheat, threatening to push inflation to an undesirably high level, the FOMC would have ample scope to respond through tighter monetary policy.
Inflation also was lower than expected, with headline PCE prices rising less than 1 percent over the course of 2015, instead of around 1-3/4 percent as we had anticipated in June 2014. Much of this shortfall reflected the effects of falling oil prices and the appreciation of the dollar. My colleagues and I typically look through the effects on inflation of fluctuations in oil prices and the dollar because these effects tend to be transitory. However, we became concerned in 2015 about the risk that part of the decline in inflation could prove to be longer lasting, especially given that inflation had already been running below our 2 percent objective for quite some time. These various considerations, along with our reassessment of longer-run economic conditions — which I will discuss shortly — explain why the Committee ended up raising the target range for the federal funds rate only 1/4 percentage point in 2015, substantially less than the full percentage point increase suggested by the median projection of FOMC participants reported in June 2014.
2016 also brought some unexpected economic developments that led us to proceed cautiously. During the first half of the year, mixed readings on the job market, along with additional disappointing data on real GDP growth, suggested again that progress toward the achievement of our maximum employment goal could be slowing markedly. Meanwhile, inflation hovered just below 1 percent as dollar appreciation continued to exert downward pressure on import prices, and financial market turbulence emanating from abroad —associated with concerns about the Chinese economy and the Brexit referendum — posed new risks to US economic activity and inflation. Moreover, even as payroll gains turned solid again in the second half of 2016, the unemployment rate remained relatively flat, suggesting that perhaps there was more room for improvement in the job market than we had previously thought. Those unanticipated developments were part of the reason why the Committee again opted to proceed more slowly in removing accommodation than had been anticipated at the start of the year. We ended up increasing the target range for the federal funds rate by only 1/4 percentage point over the course of 2016, rather than the full percentage point suggested by our December 2015 projections.
Reassessing Longer-Run Conditions
The slower-than-anticipated increase in our federal funds rate target in 2015 and 2016 reflected more than just the inflation, job market, and foreign developments I mentioned. During that period, the FOMC and most private forecasters generally lowered their assessments of the longer-run neutral level of the real federal funds rate. Indeed, at our October 2015 meeting, the FOMC had a comprehensive discussion of neutral real interest rates and was impressed by the breadth of evidence suggesting that those rates had declined both here and abroad, and that the decline had been going on for some time. In response to this growing evidence, the median assessment by FOMC participants of the longer-run level of the real federal funds rate fell from 1-3/4 percent in June 2014 to 1-1/2 percent in December 2015 and then to 1 percent in December 2016. These reassessments reflected, in part, the persistence of surprisingly sluggish productivity growth — both in the United States and abroad — and suggested that fewer federal funds rate increases would be necessary than previously thought to scale back accommodation.
Partly in response to persistently slow wage growth, FOMC participants and private forecasters have in recent years lowered their estimates of the normal longer-run rate of unemployment. The median projection of FOMC participants of the longer-run level of the unemployment rate fell from about 5-1/4 percent in June 2014 to approximately 4-3/4 percent in December 2016. Other things being equal, a lower longer-run level of the unemployment rate suggests that the economy has greater scope to create jobs without generating too much inflation. Thus, the downward revisions to FOMC participants' views on the unemployment rate over the longer run contributed to our assessment that monetary policy could stay accommodative longer than we had anticipated in 2014.
Further Progress since Mid-2016
The US economy has exhibited remarkable resilience in the face of adverse shocks in recent years, and economic developments since mid-2016 have reinforced the Committee's confidence that the economy is on track to achieve our statutory goals. Job gains have remained quite solid, and the unemployment rate, at 4.8 percent in January, is now in line with the median of FOMC participants' estimates of its longer-run normal level. On the whole, the prospects for further moderate economic growth look encouraging, particularly as risks emanating from abroad appear to have receded somewhat. The Committee currently assesses that the risks to the outlook are roughly balanced.
Moreover, after remaining disappointingly low through mid-2016, inflation moved up during the second half of 2016, mainly because of the diminishing effects of the earlier declines in energy prices and import prices. More recently, higher energy prices appear to have temporarily boosted inflation, with the total PCE price index rising nearly 2 percent in the 12 months ending in January. Core PCE inflation — which excludes volatile energy and food prices and, therefore, tends to be a better indicator of future inflation — has been running near 1-3/4 percent. Market-based measures of inflation compensation have moved up, on net, in recent months, although they remain low.
With the job market strengthening and inflation rising toward our target, the median assessment of FOMC participants as of last December was that a cumulative 3/4 percentage point increase in the target range for the federal funds rate would likely be appropriate over the course of this year. In light of current economic conditions, such an increase would be consistent with the Committee's expectation that it will raise the target range for the federal funds rate at a gradual pace and would bring the real federal funds rate close to some estimates of its current neutral level. However, partly because my colleagues and I expect the neutral real federal funds rate to rise somewhat over the longer run, we projected additional gradual rate hikes in 2018 and 2019.
Our individual projections for the appropriate path for the federal funds rate reflect economic forecasts that generally envision that economic activity will expand at a moderate pace in coming years, labor market conditions will strengthen somewhat further, and inflation will be at or near 2 percent over the medium term. In short, we currently judge that it will be appropriate to gradually increase the federal funds rate if the economic data continue to come in about as we expect. Indeed, at our meeting later this month, the Committee will evaluate whether employment and inflation are continuing to evolve in line with our expectations, in which case a further adjustment of the federal funds rate would likely be appropriate.
Nonetheless, as we have said many times — and as my discussion today demonstrates — monetary policy cannot be and is not on a preset course. As in 2015 and 2016, the Committee stands ready to adjust its assessment of the appropriate path for monetary policy if unanticipated developments materially change the economic outlook.
Monetary Policy Is Not a Panacea
The US economy has shown great improvement and is close to meeting our congressionally mandated goals of maximum employment and price stability, but we of course recognize that important challenges remain. For instance, as we noted in our latest Monetary Policy Report to the Congress, the ongoing expansion has been the slowest since World War II, with real GDP growth averaging only about 2 percent per year. This subdued pace reflects, in part, slower growth in the labor force in recent years — compared with much of the post-World War II period — and disappointing productivity growth both in the United States and abroad.
Our report also noted that, despite a notable pickup in 2015, real incomes for the median family were still a bit lower than they were prior to the Great Recession, and the gains during this economic recovery have been skewed toward the top of the income distribution, as has been the case for quite some time. Families at the 10th percentile of the income distribution earned about 4 percent less in 2015 than they did in 2007, whereas families at the 90th percentile earned about 4 percent more. In addition, the economic circumstances of blacks and Hispanics, while improved since the depths of the recession, remain worse, on average, that those of whites or Asians.
These unwelcome developments, unfortunately, reflect structural challenges that lie substantially beyond the reach of monetary policy. Monetary policy cannot, for instance, generate technological breakthroughs or affect demographic factors that would boost real GDP growth over the longer run or address the root causes of income inequality. And monetary policy cannot improve the productivity of American workers. Fiscal and regulatory policies — which are of course the responsibility of the Administration and the Congress — are best suited to address such adverse structural trends.
To conclude, we at the Federal Reserve must remain squarely focused on our congressionally mandated goals. The economy has essentially met the employment portion of our mandate and inflation is moving closer to our 2 percent objective. This outcome suggests that our goal-focused, outlook-dependent approach to scaling back accommodation over the past couple of years has served the US economy well.
This same approach will continue to drive our policy decisions in the months and years ahead. With that in mind, our policy aims to support continued growth of the American economy in pursuit of our congressionally mandated objectives. We do that, as I have noted, with an eye always on the risks. To that end, we realize that waiting too long to scale back some of our support could potentially require us to raise rates rapidly sometime down the road, which in turn could risk disrupting financial markets and pushing the economy into recession. Having said that, I currently see no evidence that the Federal Reserve has fallen behind the curve, and I therefore continue to have confidence in our judgment that a gradual removal of accommodation is likely to be appropriate. However, as I have noted, unless unanticipated developments adversely affect the economic outlook, the process of scaling back accommodation likely will not be as slow as it was during the past couple of years.
- "Operating Under A Cloud of Uncertainty": Janet Yellen's FOMC Press Conference About Raising the Target Range for Federal Funds Rate to 1/2 to 3/4 %
- Trump's Infrastructure Plan Dwarfed by Estimates of Need: Civil Engineers Group Ranked the Country at a D-Plus on Infrastructure
- Remarks by Fed Vice Chairman Stanley Fischer: The Behavior of Employment Has Been Remarkably Resilient
- Chair Janet L. Yellen: "My Message Will Be Largely Favorable, Although Recent Developments Have Been Mixed"
- The Outlook, Uncertainty, and Monetary Policy; Janet Yellen's Speech to the Economic Club of New York
- The Federal Reserve Raises Federal Funds Rate For the First Time in Nine Years
- Federal Reserve: Keeping the Target Fderal Funds Rate Below Levels the Committee Views as Normal in the Longer Run
- Bernanke: Facing Significant Headwinds
- Bernanke's First Press Conference
- Ben Speaks: The Economic Outlook and Monetary and Fiscal Policy