Federal Reserve chair Janet Yellen thinks a rate hike later this year will be appropriate.
Yellen delivered a speech Thursday night at the University of Massachusetts titled, “Inflation Dynamics and Monetary Policy.”
Here’s the key line from Yellen’s speech on Thursday:
Most FOMC participants, including myself, currently anticipate that achieving these conditions will likely entail an initial increase in the federal funds rate later this year, followed by a gradual pace of tightening thereafter. But if the economy surprises us, our judgments about appropriate monetary policy will change.
Since the Fed’s meeting, we learned that the decision to keep interest rates pegged near 0% was a “close call,” and that while the Fed decided to hold off raising rates, Yellen believes that move will be made later this year.
That view is broadly consistent with the Fed’s “dot plot,” which indicated that the Fed funds rate would be closer to 0.5% at the end of this year.
But so in emphasising that the Fed will undertake a “gradual pace of tightening” after the first rate hike, Yellen is saying that when the Fed does raise rates, they will do so slowly — i.e., not raising rates at every meeting.
The overall tone of Thursday’s speech, however, is clear that Yellen expects that at either the October or December Fed meetings — or even both — the Fed will raise interest rates for the first time since 2006.
Yellen’s speech also addressed inflation, which she said in her latest press conference was running “way below” the Fed’s 2% target.
In that press conference, Yellen even went so far as to suggest that the Fed’s “credibility” rests on its ability to reach its 2% inflation target. But Yellen on Thursday echoed Fed vice chair Stanley Fischer, who in August suggested that the Fed could move to tighten monetary policy before inflation had moved all the way back to the Fed’s target.
To this end, Yellen said:
Given the highly uncertain nature of the outlook, one might ask: Why not hold off raising the federal funds rate until the economy has reached full employment and inflation is actually back at 2 per cent? The difficulty with this strategy is that monetary policy affects real activity and inflation with a substantial lag. If the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession.
The basic thing Yellen seems to want to avoid, then, is having to ratchet up monetary policy in the face of an economy that is seeing inflation “running too hot,” that must be headed off by action from the Fed.
As has been the case for most of the last several months, Yellen is reiterating that 2015 will be the year to raise interest rates while the number of months left in the year continues to dwindle. Those who believe the Fed will raise rates this year will see Yellen’s remarks as confirming that plan; those who believe the Fed will not raise rates will likely interpret Yellen’s comments as more empty talk out of the Fed.
Here’s the full text of Yellen’s speech:
I would like to thank Michael Ash for his kind introduction and the University of Massachusetts for the honour of being invited to deliver this year’s Philip Gamble Memorial Lecture.
In my remarks today, I will discuss inflation and its role in the Federal Reserve’s conduct of monetary policy. I will begin by reviewing the history of inflation in the United States since the 1960s, highlighting two key points: that inflation is now much more stable than it used to be, and that it is currently running at a very low level. I will then consider the costs associated with inflation, and why these costs suggest that the Federal Reserve should try to keep inflation close to 2 per cent. After briefly reviewing our policy actions since the financial crisis, I will discuss the dynamics of inflation and their implications for the outlook and monetary policy.
Historical Review of Inflation
A crucial responsibility of any central bank is to control inflation, the average rate of increase in the prices of a broad group of goods and services. Keeping inflation stable at a moderately low level is important because, for reasons I will discuss, inflation that is high, excessively low, or unstable imposes significant costs on households and businesses. As a result, inflation control is one half of the dual mandate that Congress has laid down for the Federal Reserve, which is to pursue maximum employment and stable prices.
The Federal Reserve has not always been successful in fulfilling the price stability element of its mandate. The dashed red line in figure 1 plots the four-quarter per cent change in the price index for personal consumption expenditures (PCE)–the measure of inflation that the Fed’s policymaking body, the Federal Open Market Committee, or FOMC, uses to define its longer-run inflation goal.1 Starting in the mid-1960s, inflation began to move higher. Large jumps in food and energy prices played a role in this upward move, but they were not the whole story, for, as illustrated here, inflation was already moving up before the food and energy shocks hit in the 1970s and the early 1980s.2 And if we look at core inflation, the solid black line, which excludes food and energy prices, we see that it too starts to move higher in the mid-1960s and rises to very elevated levels during the 1970s, which strongly suggests that something more than the energy and food price shocks must have been at work.
A second important feature of inflation over this period can be seen if we examine an estimate of its long-term trend, which is plotted as the dotted black line in figure 1. At each point in time, this trend is defined as the prediction from a statistical model of the level to which inflation is projected to return in the long run once the effects of any shocks to the economy have fully played out.3 As can be seen from the figure, this estimated trend drifts higher over the 1960s and 1970s, implying that during this period there was no stable “anchor” to which inflation could be expected to eventually return–a conclusion generally supported by other procedures for estimating trend inflation.
Today many economists believe that these features of inflation in the late 1960s and 1970s–its high level and lack of a stable anchor–reflected a combination of factors, including chronically overheated labour and product markets, the effects of the energy and food price shocks, and the emergence of an “inflationary psychology” whereby a rise in actual inflation led people to revise up their expectations for future inflation. Together, these various factors caused inflation–actual and expected–to ratchet higher over time. Ultimately, however, monetary policy bears responsibility for the broad contour of what happened to actual and expected inflation during this period because the Federal Reserve was insufficiently focused on returning inflation to a predictable, low level following the shocks to food and energy prices and other disturbances.
In late 1979, the Federal Reserve began significantly tightening monetary policy to reduce inflation. In response to this tightening, which precipitated a severe economic downturn in the early 1980s, overall inflation moved persistently lower, averaging less than 4 per cent from 1983 to 1990. Inflation came down further following the 1990-91 recession and subsequent slow recovery and then averaged about 2 per cent for many years. Since the recession ended in 2009, however, the United States has experienced inflation running appreciably below the FOMC’s 2 per cent objective, in part reflecting the gradual pace of the subsequent economic recovery.
Examining the behaviour of inflation’s estimated long-term trend reveals another important change in inflation dynamics. With the caveat that these results are based on a specific implementation of a particular statistical model, they imply that since the mid-1990s there have been no persistent movements in this predicted long-run inflation rate, which has remained very close to 2 per cent. Remarkably, this stability is estimated to have continued during and after the recent severe recession, which saw the unemployment rate rise to levels comparable to those seen during the 1981-82 downturn, when the trend did shift down markedly.4 As I will discuss, the stability of this trend appears linked to a change in the behaviour of long-run inflation expectations–measures of which appear to be much better anchored today than in the past, likely reflecting an improvement in the conduct of monetary policy. In any event, this empirical analysis implies that, over the past 20 years, inflation has been much more predictable over the longer term than it was back in the 1970s because the trend rate to which inflation was predicted to return no longer moved around appreciably. That said, inflation still varied considerably from year to year in response to various shocks.
As figure 2 highlights, the United States has experienced very low inflation on average since the financial crisis, in part reflecting persistent economic weakness that has proven difficult to fully counter with monetary policy. Overall inflation (shown as the dashed red line) has averaged only about 1-1/2 per cent per year since 2008 and is currently close to zero. This result is not merely a product of falling energy prices, as core inflation (the solid black line) has also been low on average over this period.
In 2012 the FOMC adopted, for the first time, an explicit longer-run inflation objective of 2 per cent as measured by the PCE price index.5 (Other central banks, including the European Central Bank and the Bank of England, also have a 2 per cent inflation target.) This decision reflected the FOMC’s judgment that inflation that persistently deviates–up or down–from a fixed low level can be costly in a number of ways. Persistent high inflation induces households and firms to spend time and effort trying to minimise their cash holdings and forces businesses to adjust prices more frequently than would otherwise be necessary. More importantly, high inflation also tends to raise the after-tax cost of capital, thereby discouraging business investment. These adverse effects occur because capital depreciation allowances and other aspects of our tax system are only partially indexed for inflation.6
Persistently high inflation, if unanticipated, can be especially costly for households that rely on pensions, annuities, and long-term bonds to provide a significant portion of their retirement income. Because the income provided by these assets is typically fixed in nominal terms, its real purchasing power may decline surprisingly quickly if inflation turns out to be consistently higher than originally anticipated, with potentially serious consequences for retirees’ standard of living as they age.7
An unexpected rise in inflation also tends to reduce the real purchasing power of labour income for a time because nominal wages and salaries are generally slow to adjust to movements in the overall level of prices. Survey data suggest that this effect is probably the number one reason why people dislike inflation so much.8 In the longer run, however, real wages–that is, wages adjusted for inflation–appear to be largely independent of the average rate of inflation and instead are primarily determined by productivity, global competition, and other nonmonetary factors. In support of this view, figure 3 shows that nominal wage growth tends to broadly track price inflation over long periods of time.
Inflation that is persistently very low can also be costly, and it is such costs that have been particularly relevant to monetary policymakers in recent years. The most important cost is that very low inflation constrains a central bank’s ability to combat recessions. Normally, the FOMC fights economic downturns by reducing the nominal federal funds rate, the rate charged by banks to lend to each other overnight. These reductions, current and expected, stimulate spending and hiring by lowering longer-term real interest rates–that is, nominal rates adjusted for inflation–and improving financial conditions more broadly. But the federal funds rate and other nominal interest rates cannot go much below zero, since holding cash is always an alternative to investing in securities.9 Thus, the lowest the FOMC can feasibly push the real federal funds rate is essentially the negative value of the inflation rate. As a result, the Federal Reserve has less room to ease monetary policy when inflation is very low. This limitation is a potentially serious problem because severe downturns such as the Great Recession may require pushing real interest rates far below zero for an extended period to restore full employment at a satisfactory pace.10 For this reason, pursuing too low an inflation objective or otherwise tolerating persistently very low inflation would be inconsistent with the other leg of the FOMC’s mandate, to promote maximum employment.11
An unexpected decline in inflation that is sizable and persistent can also be costly because it increases the debt burdens of borrowers. Consider homeowners who take out a conventional fixed-rate mortgage, with the expectation that inflation will remain close to 2 per cent and their nominal incomes will rise about 4 per cent per year. If the economy were instead to experience chronic mild deflation accompanied by flat or declining nominal incomes, then after a few years the homeowners might find it noticeably more difficult to cover their monthly mortgage payments than they had originally anticipated. Moreover, if house prices fall in line with consumer prices rather than rising as expected, then the equity in their home will be lower than they had anticipated. This situation, which is sometimes referred to as “debt deflation,” would also confront all households with outstanding student loans, auto loans, or credit card debt, as well as businesses that had taken out bank loans or issued bonds.12 Of course, in this situation, lenders would be receiving more real income. But the net effect on the economy is likely to be negative, in large part because borrowers typically have only a limited ability to absorb losses. And if the increased debt-service burdens and declines in collateral values are severe enough to force borrowers into bankruptcy, then the resultant hardship imposed on families, small business owners, and laid-off workers may be very severe.13
Monetary Policy Actions since the Financial Crisis
As I noted earlier, after weighing the costs associated with various rates of inflation, the FOMC decided that 2 per cent inflation is an appropriate operational definition of its longer-run price objective.14 In the wake of the 2008 financial crisis, however, achieving both this objective and full employment (the other leg of the Federal Reserve’s dual mandate) has been difficult, as shown in figure 4. Initially, the unemployment rate (the solid black line) soared and inflation (the dashed red line) fell sharply. Moreover, after the recession officially ended in 2009, the subsequent recovery was significantly slowed by a variety of persistent headwinds, including households with underwater mortgages and high debt burdens, reduced access to credit for many potential borrowers, constrained spending by state and local governments, and weakened foreign growth prospects. In an effort to return employment and inflation to levels consistent with the Federal Reserve’s dual mandate, the FOMC took a variety of unprecedented actions to help lower longer-term interest rates, including reducing the federal funds rate (the dotted black line) to near zero, communicating to the public that short-term interest rates would likely stay exceptionally low for some time, and buying large quantities of longer-term Treasury debt and agency-issued mortgage-backed securities.15
These actions contributed to highly accommodative financial conditions, thereby helping to bring about a considerable improvement in labour market conditions over time. The unemployment rate, which peaked at 10 per cent in 2009, is now 5.1 per cent, slightly above the median of FOMC participants’ current estimates of its longer-run normal level. Although other indicators suggest that the unemployment rate currently understates how much slack remains in the labour market, on balance the economy is no longer far away from full employment. In contrast, inflation has continued to run below the Committee’s objective over the past several years, and over the past 12 months it has been essentially zero. Nevertheless, the Committee expects that inflation will gradually return to 2 per cent over the next two or three years. I will now turn to the determinants of inflation and the factors that underlie this expectation.
Models used to describe and predict inflation commonly distinguish between changes in food and energy prices–which enter into total inflation–and movements in the prices of other goods and services–that is, core inflation. This decomposition is useful because food and energy prices can be extremely volatile, with fluctuations that often depend on factors that are beyond the influence of monetary policy, such as technological or political developments (in the case of energy prices) or weather or disease (in the case of food prices). As a result, core inflation usually provides a better indicator than total inflation of where total inflation is headed in the medium term.16 Of course, food and energy account for a significant portion of household budgets, so the Federal Reserve’s inflation objective is defined in terms of the overall change in consumer prices.
What, then, determines core inflation? Recalling figure 1, core inflation tends to fluctuate around a longer-term trend that now is essentially stable. Let me first focus on these fluctuations before turning to the trend. Economic theory suggests, and empirical analysis confirms, that such deviations of inflation from trend depend partly on the intensity of resource utilization in the economy–as approximated, for example, by the gap between the actual unemployment rate and its so-called natural rate, or by the shortfall of actual gross domestic product (GDP) from potential output. This relationship–which likely reflects, among other things, a tendency for firms’ costs to rise as utilization rates increase–represents an important channel through which monetary policy influences inflation over the medium term, although in practice the influence is modest and gradual. Movements in certain types of input costs, particularly changes in the price of imported goods, also can cause core inflation to deviate noticeably from its trend, sometimes by a marked amount from year to year.17 Finally, a nontrivial fraction of the quarter-to-quarter, and even the year-to-year, variability of inflation is attributable to idiosyncratic and often unpredictable shocks.18
What about the determinants of inflation’s longer-term trend? Here, it is instructive to compare the purely statistical estimate of the trend rate of future inflation shown earlier in figure 1 with survey measures of people’s actual expectations of long-run inflation, as is done in figure 5. Theory suggests that inflation expectations–which presumably are linked to the central bank’s inflation goal–should play an important role in actual price setting.19 Indeed, the contours of these series are strikingly similar, which suggests that the estimated trend in inflation is in fact related to households’ and firms’ long-run inflation expectations.20
To summarize, this analysis suggests that economic slack, changes in imported goods prices, and idiosyncratic shocks all cause core inflation to deviate from a longer-term trend that is ultimately determined by long-run inflation expectations. As some will recognise, this model of core inflation is a variant of a theoretical model that is commonly referred to as an expectations-augmented Phillips curve.21 Total inflation in turn reflects movements in core inflation, combined with changes in the prices of food and energy.
An important feature of this model of inflation dynamics is that the overall effect that variations in resource utilization, import prices, and other factors will have on inflation depends crucially on whether these influences also affect long-run inflation expectations. Figure 6 illustrates this point with a stylised example of the inflation consequences of a gradual increase in the level of import prices–perhaps occurring in response to stronger real activity abroad or a fall in the exchange value of the dollar–that causes the rate of change of import prices to be elevated for a time.22 First, consider the situation shown in panel A, in which households’ and firms’ expectations of inflation are not solidly anchored, but instead adjust in response to the rates of inflation that are actually observed.23 Such conditions–which arguably prevailed in the United States from the 1970s to the mid-1990s–could plausibly arise if the central bank has, in the past, allowed significant and persistent movements in inflation to occur. In this case, the temporary rise in the rate of change of import prices results in a permanent increase in inflation. This shift occurs because the initial increase in inflation generated by a period of rising import prices leads households and firms to revise up their expectations of future inflation. A permanent rise in inflation would also result from a sustained rise in the level of oil prices or a temporary increase in resource utilization.
By contrast, suppose that inflation expectations are instead well anchored, perhaps because the central bank has been successful over time in keeping inflation near some specified target and has made it clear to the public that it intends to continue to do so. Then the response of inflation to a temporary increase in the rate of change of import prices or any other transitory shock will resemble the pattern shown in panel B. In this case, inflation will deviate from its longer-term level only as long as import prices are rising. But once they level out, inflation will fall back to its previous trend in the absence of other disturbances.24
A key implication of these two examples is that the presence of well-anchored inflation expectations greatly enhances a central bank’s ability to pursue both of its objectives–namely, price stability and full employment. Because temporary shifts in the rate of change of import prices or other transitory shocks have no permanent influence on expectations, they have only a transitory effect on inflation. As a result, the central bank can “look through” such short-run inflationary disturbances in setting monetary policy, allowing it to focus on returning the economy to full employment without placing price stability at risk. Indeed, the Federal Reserve has done just that in setting monetary policy over the past decade or more. Moreover, as I will discuss shortly, these inflation dynamics are a key reason why the FOMC expects inflation to return to 2 per cent over the next few years.
On balance, the evidence suggests that inflation expectations are in fact well anchored at present. Figure 7 plots the two survey measures of longer-term expected inflation I presented earlier, along with a measure of longer-term inflation compensation derived as the difference between yields on nominal Treasury securities and inflation-indexed ones, called TIPS. Since the late 1990s, survey measures of longer-term inflation expectations have been quite stable; this stability has persisted in recent years despite a deep recession and concerns expressed by some observers regarding the potential inflationary effects of unconventional monetary policy. The fact that these survey measures appear to have remained anchored at about the same levels that prevailed prior to the recession suggests that, once the economy has returned to full employment (and absent any other shocks), core inflation should return to its pre-recession average level of about 2 per cent.
This conclusion is tempered somewhat by recent movements in longer-run inflation compensation, which in principle could reflect changes in investors’ expectations for long-run inflation. This measure is now noticeably lower than in the years just prior to the financial crisis.25 However, movements in inflation compensation are difficult to interpret because they can be driven by factors that are unique to financial markets–such as movements in liquidity or risk premiums–as well as by changes in expected inflation.26 Indeed, empirical work that attempts to control for these factors suggests that the long-run inflation expectations embedded in asset prices have in fact moved down relatively little over the past decade.27 Nevertheless, the decline in inflation compensation over the past year may indicate that financial market participants now see an increased risk of very low inflation persisting.
Although the evidence, on balance, suggests that inflation expectations are well anchored at present, policymakers would be unwise to take this situation for granted. Anchored inflation expectations were not won easily or quickly: Experience suggests that it takes many years of carefully conducted monetary policy to alter what households and firms perceive to be inflation’s “normal” behaviour, and, furthermore, that a persistent failure to keep inflation under control–by letting it drift either too high or too low for too long–could cause expectations to once again become unmoored.28 Given that inflation has been running below the FOMC’s objective for several years now, such concerns reinforce the appropriateness of the Federal Reserve’s current monetary policy, which remains highly accommodative by historical standards and is directed toward helping return inflation to 2 per cent over the medium term.29
Before turning to the implications of this inflation model for the current outlook and monetary policy, a cautionary note is in order. The Phillips-curve approach to forecasting inflation has a long history in economics, and it has usefully informed monetary policy decisionmaking around the globe. But the theoretical underpinnings of the model are still a subject of controversy among economists. Moreover, inflation sometimes moves in ways that empirical versions of the model, which necessarily are a simplified version of a complicated reality, cannot adequately explain. For this reason, significant uncertainty attaches to Phillips curve predictions, and the validity of forecasts from this model must be continuously evaluated in response to incoming data.
Assuming that my reading of the data is correct and long-run inflation expectations are in fact anchored near their pre-recession levels, what implications does the preceding description of inflation dynamics have for the inflation outlook and for monetary policy?
This framework suggests, first, that much of the recent shortfall of inflation from our 2 per cent objective is attributable to special factors whose effects are likely to prove transitory. As the solid black line in figure 8 indicates, PCE inflation has run noticeably below our 2 per cent objective on average since 2008, with the shortfall approaching about 1 percentage point in both 2013 and 2014 and more than 1-1/2 percentage points this year. The stacked bars in the figure give the contributions of various factors to these deviations from 2 per cent, computed using an estimated version of the simple inflation model I just discussed.30 As the solid blue portion of the bars shows, falling consumer energy prices explain about half of this year’s shortfall and a sizable portion of the 2013 and 2014 shortfalls as well. Another important source of downward pressure this year has been a decline in import prices, the portion with orange checkerboard pattern, which is largely attributable to the 15 per cent appreciation in the dollar’s exchange value over the past year. In contrast, the restraint imposed by economic slack, the green dotted portion, has diminished steadily over time as the economy has recovered and is now estimated to be relatively modest.31 Finally, a similarly small portion of the current shortfall of inflation from 2 per cent is explained by other factors (which include changes in food prices); importantly, the effects of these other factors are transitory and often switch sign from year to year.
Although an accounting exercise like this one is always imprecise and will depend on the specific model that is used, I think its basic message–that the current near-zero rate of inflation can mostly be attributed to the temporary effects of falling prices for energy and non-energy imports–is quite plausible. If so, the 12-month change in total PCE prices is likely to rebound to 1-1/2 per cent or higher in 2016, barring a further substantial drop in crude oil prices and provided that the dollar does not appreciate noticeably further.
To be reasonably confident that inflation will return to 2 per cent over the next few years, we need, in turn, to be reasonably confident that we will see continued solid economic growth and further gains in resource utilization, with longer-term inflation expectations remaining near their pre-recession level. Fortunately, prospects for the U.S. economy generally appear solid. Monthly payroll gains have averaged close to 210,000 since the start of the year and the overall economy has been expanding modestly faster than its productive potential. My colleagues and I, based on our most recent forecasts, anticipate that this pattern will continue and that labour market conditions will improve further as we head into 2016.
The labour market has achieved considerable progress over the past several years. Even so, further improvement in labour market conditions would be welcome because we are probably not yet all the way back to full employment. Although the unemployment rate may now be close to its longer-run normal level–which most FOMC participants now estimate is around 4.9 per cent–this traditional metric of resource utilization almost certainly understates the actual amount of slack that currently exists: On a cyclically adjusted basis, the labour force participation rate remains low relative to its underlying trend, and an unusually large number of people are working part time but would prefer full-time employment.32 Consistent with this assessment is the slow pace at which hourly wages and compensation have been rising, which suggests that most firms still find it relatively easy to hire and retain employees.
Reducing slack along these other dimensions may involve a temporary decline in the unemployment rate somewhat below the level that is estimated to be consistent, in the longer run, with inflation stabilizing at 2 per cent. For example, attracting discouraged workers back into the labour force may require a period of especially plentiful employment opportunities and strong hiring. Similarly, firms may be unwilling to restructure their operations to use more full-time workers until they encounter greater difficulty filling part-time positions. Beyond these considerations, a modest decline in the unemployment rate below its long-run level for a time would, by increasing resource utilization, also have the benefit of speeding the return to 2 per cent inflation. Finally, albeit more speculatively, such an environment might help reverse some of the significant supply-side damage that appears to have occurred in recent years, thereby improving Americans’ standard of living. 33
Consistent with the inflation framework I have outlined, the medians of the projections provided by FOMC participants at our recent meeting show inflation gradually moving back to 2 per cent, accompanied by a temporary decline in unemployment slightly below the median estimate of the rate expected to prevail in the longer run. These projections embody two key judgments regarding the projected relationship between real activity and interest rates. First, the real federal funds rate is currently somewhat below the level that would be consistent with real GDP expanding in line with potential, which implies that the unemployment rate is likely to continue to fall in the absence of some tightening. Second, participants implicitly expect that the various headwinds to economic growth that I mentioned earlier will continue to fade, thereby boosting the economy’s underlying strength. Combined, these two judgments imply that the real interest rate consistent with achieving and then maintaining full employment in the medium run should rise gradually over time. This expectation, coupled with inherent lags in the response of real activity and inflation to changes in monetary policy, are the key reasons that most of my colleagues and I anticipate that it will likely be appropriate to raise the target range for the federal funds rate sometime later this year and to continue boosting short-term rates at a gradual pace thereafter as the labour market improves further and inflation moves back to our 2 per cent objective.
By itself, the precise timing of the first increase in our target for the federal funds rate should have only minor implications for financial conditions and the general economy. What matters for overall financial conditions is the entire trajectory of short-term interest rates that is anticipated by markets and the public. As I noted, most of my colleagues and I anticipate that economic conditions are likely to warrant raising short-term interest rates at a quite gradual pace over the next few years. It’s important to emphasise, however, that both the timing of the first rate increase and any subsequent adjustments to our federal funds rate target will depend on how developments in the economy influence the Committee’s outlook for progress toward maximum employment and 2 per cent inflation.
The economic outlook, of course, is highly uncertain and it is conceivable, for example, that inflation could remain appreciably below our 2 per cent target despite the apparent anchoring of inflation expectations. Here, Japan’s recent history may be instructive: As shown in figure 9, survey measures of longer-term expected inflation in that country remained positive and stable even as that country experienced many years of persistent, mild deflation.34 The explanation for the persistent divergence between actual and expected inflation in Japan is not clear, but I believe that it illustrates a problem faced by all central banks: Economists’ understanding of the dynamics of inflation is far from perfect. Reflecting that limited understanding, the predictions of our models often err, sometimes significantly so. Accordingly, inflation may rise more slowly or rapidly than the Committee currently anticipates; should such a development occur, we would need to adjust the stance of policy in response.
Considerable uncertainties also surround the outlook for economic activity. For example, we cannot be certain about the pace at which the headwinds still restraining the domestic economy will continue to fade. Moreover, net exports have served as a significant drag on growth over the past year and recent global economic and financial developments highlight the risk that a slowdown in foreign growth might restrain U.S. economic activity somewhat further. The Committee is monitoring developments abroad, but we do not currently anticipate that the effects of these recent developments on the U.S. economy will prove to be large enough to have a significant effect on the path for policy. That said, in response to surprises affecting the outlook for economic activity, as with those affecting inflation, the FOMC would need to adjust the stance of policy so that our actions remain consistent with inflation returning to our 2 per cent objective over the medium term in the context of maximum employment.
Given the highly uncertain nature of the outlook, one might ask: Why not hold off raising the federal funds rate until the economy has reached full employment and inflation is actually back at 2 per cent? The difficulty with this strategy is that monetary policy affects real activity and inflation with a substantial lag. If the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. In addition, continuing to hold short-term interest rates near zero well after real activity has returned to normal and headwinds have faded could encourage excessive leverage and other forms of inappropriate risk-taking that might undermine financial stability. For these reasons, the more prudent strategy is to begin tightening in a timely fashion and at a gradual pace, adjusting policy as needed in light of incoming data.
To conclude, let me emphasise that, following the dual mandate established by the Congress, the Federal Reserve is committed to the achievement of maximum employment and price stability. To this end, we have maintained a highly accommodative monetary policy since the financial crisis; that policy has fostered a marked improvement in labour market conditions and helped check undesirable disinflationary pressures. However, we have not yet fully attained our objectives under the dual mandate: Some slack remains in labour markets, and the effects of this slack and the influence of lower energy prices and past dollar appreciation have been significant factors keeping inflation below our goal. But I expect that inflation will return to 2 per cent over the next few years as the temporary factors that are currently weighing on inflation wane, provided that economic growth continues to be strong enough to complete the return to maximum employment and long-run inflation expectations remain well anchored. Most FOMC participants, including myself, currently anticipate that achieving these conditions will likely entail an initial increase in the federal funds rate later this year, followed by a gradual pace of tightening thereafter. But if the economy surprises us, our judgments about appropriate monetary policy will change.
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