Recent volatile stock market movements are in reaction to the fear that central banks will begin to tighten monetary policy. Much attention is on the Federal Reserve. So, a significant speech from Fed Governor Lael Brainard is worth noting. She spoke at the Chicago Council on Global Affairs, Chicago, Illinois and outlined five factors in “the new normal”.
She concludes:
The five features of the current economic landscape that I have highlighted lean roughly in the same direction: In today’s new normal, the costs to the economy of greater-than-expected strength in demand are likely to be lower than the costs of significant unexpected weakness. In the case of unexpected strength, we have well-tried and tested tools and ample policy space in which to react. Moreover, because of Phillips curve flattening, the possibility of remaining labor market slack, the likely substantial response of the exchange rate and its depressing effect on inflation, the low neutral rate, and the fact that inflation expectations are well anchored to the upside, the response of inflation to unexpected strength in demand will likely be modest and gradual, requiring a correspondingly moderate policy response and implying relatively slight costs to the economy. In the face of an adverse shock, however, our conventional policy toolkit is more limited, and thus the risk of being unable to adequately respond to unexpected weakness is greater. The experience of the Japanese and euro-area economies suggest that prolonged weakness in demand is very difficult to correct, leading to economic costs that can be considerable.
This asymmetry in risk management in today’s new normal counsels prudence in the removal of policy accommodation. I believe this approach has served us well in recent months, helping to support continued gains in employment and progress on inflation. I look forward to assessing the evolution of the data in the months ahead for signs of further progress toward our goals, bearing in mind these considerations.
Watch her speech in full.
1. Inflation Has Been Undershooting, and the Phillips Curve Has Flattened
First, for the past several decades, policymakers relied on the empirical relationship between unemployment and inflation embodied in the Phillips curve as a key guidepost for monetary policy. The Phillips curve implied that as labor market slack diminished and the economy approached full employment, upward pressure on inflation would result. However, since 2012, inflation has tended to change relatively little–both absolutely and relative to earlier decades–as the unemployment rate has fallen considerably. At a time when the unemployment rate has fallen from 8.2 percent to 4.9 percent, inflation has undershot our 2 percent target now for 51 straight months. In other words, the Phillips curve appears to be flatter today than it was previously.
2. Labor Market Slack Has Been Greater than Anticipated
Second, and related, although we have seen important progress on employment, this improvement has been accompanied by evidence of greater slack than previously anticipated. This uncertainty about the true state of the economy suggests we should be open to the possibility of material further progress in the labor market. Indeed, with payroll employment growth averaging 180,000 per month this year, many observers would have expected the unemployment rate to drop noticeably rather than moving sideways, as it has done. It is true that today’s unemployment rate of 4.9 percent is only 0.1 percentage point from the median SEP participant’s estimate of the longer-run level of unemployment. However, the natural rate of unemployment is uncertain and can vary over time. Indeed, in the SEP, the central tendency of the projection for the longer-run natural rate of unemployment has come down significantly, from a range of 5.2 to 6.0 percent in June 2012 to 4.7 to 5.0 percent in June 2016–a reduction of 1/2 to 1 percentage point. We cannot rule out that estimates of the natural unemployment rate may move even lower.
3. Foreign Markets Matter, Especially because Financial Transmission is Strong
Third, disinflation pressure and weak demand from abroad will likely weigh on the U.S. outlook for some time, and fragility in global markets could again pose risks here at home. In Europe, recovery continues, but growth is slow and inflation is very low. Low growth and a flat yield curve are contributing to reduced profitability and a higher cost of equity financing for banks, which in turn could impair bank lending, one of the main transmission channels of monetary policy in the euro area’s bank-centric financial system. A low growth, low inflation environment also makes progress on fiscal sustainability difficult and leaves countries with high debt-to-gross domestic product (GDP) ratios vulnerable to adverse demand shocks. Against this backdrop, uncertainty about Britain’s future relationship with the European Union could damp business sentiment and investment in Europe.
4. The Neutral Rate Is Likely to Remain Very Low for Some Time
Fourth, perhaps most salient for monetary policy, it appears increasingly clear that the neutral rate of interest remains considerably and persistently lower than it was before the crisis. Over the current expansion, with a federal funds rate at, or near, zero and the additional support provided by asset purchases and reinvestment, GDP growth has averaged a very modest rate upward of 2 percent, and inflation has averaged only 1‑1/2 percent. Ten years ago, based on the underlying economic relationships that prevailed at the time, it would have seemed inconceivable that real activity and inflation would be so subdued given the stance of monetary policy. To reconcile these developments, it is difficult not to conclude that the current level of the federal funds rate is less accommodative today than it would have been 10 years ago. Put differently, the amount of aggregate demand associated with a given level of the interest rate is now much lower than before the crisis.
5. Policy Options Are Asymmetric
The four features just discussed that define the new normal make it likely that we will continue to grapple with a fifth new reality for some time: the ability of monetary policy to respond to shocks is asymmetric. With policy rates near the zero lower bound and likely to return there more frequently even if the economy only experiences shocks similar in magnitude to those experienced pre-crisis, due to the low level of the neutral rate, there is an asymmetry in the policy tools available to respond to adverse developments. Conventional changes in the federal funds rate, our most tested and best understood tool, cannot be used as readily to respond to downside shocks to aggregate demand as it can to upside shocks. While there are, of course, other policy options, these alternatives have constraints and uncertainties that are not present with conventional policy. From a risk-management perspective, therefore, the asymmetry in the conventional policy toolkit would lead me to expect policy to be tilted somewhat in favor of guarding against downside risks relative to preemptively raising rates to guard against upside risks.
