The Fed, Monetary Policy, and The U.S. Economic …...The Fed, Monetary Policy, and The U.S. Economic Outlook Maria Luengo-Prado Senior Economist and Policy Advisor Federal Reserve

The Fed, Monetary Policy, and The U.S. EconomicOutlook

Maria Luengo-PradoSenior Economist and Policy Advisor

Federal Reserve Bank of Boston

August 4, 2017

Presentation prepared for the Valve Manufacturers Association

Disclaimer

These views are my own and do not necessarily represent theviews of the Federal Reserve Bank of Boston or the FederalReserve System.

Outline

1 Background on the Federal Reserve and Monetary Policy.

2 Current Economic Conditions and the Outlook.

3 Final Remarks.

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The Fed and Monetary Policy Current Conditions and Outlook Final Remarks

What is the Federal Reserve System

The Federal Reserve is the U.S. Central Bank

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What does the Federal Reserve do?

The Federal Reserve is the central bank of the US and has severalresponsibilities:

Monetary policy (set by the FOMC).

Lender of last resort.

Bank regulation.

Payments system.

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The Federal Open Market Committee (FOMC)

The FOMC meets 8 times per year to:

Review economic and financial conditions.Assess the risks to its long-run goals.Determine the appropriate stance of monetary policy.

Each meeting is followed immediately by a written statementexplaining policy decisions. Minutes of the meeting arepublished three weeks later. Full transcripts are available afterfive years.

Meetings in March, June, September, and December arefollowed by press conferences and accompanied with a releaseof economic projections of the FOMC.

The Chairman and others make regular reports to Congress onmonetary policy and the economy.

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What is Monetary Policy?

“Actions undertaken by a central bank, such as the FederalReserve, to influence the availability and cost of money andcredit to help promote national economic goals.”(Source: http://www.federalreserve.gov/monetarypolicy/fomc.htm)

One of the primary “actions” taken by the FOMC is to set thetarget for the federal funds rate (FFR).

This is the interest rate that banks pay to borrow reservesfrom other banks overnight.

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What are “National Economic Goals”?

Required by Congress: “maximum employment, stable prices,and moderate long-term interest rates” (Federal Reserve Act,as amended in 1977).

The first two goals are known as the dual mandate.

More specifically:

Employment goal: Not fixed, but policymakers determine along-term goal based largely on factors relating to thestructure of the labor market.(For example, the unemployment rate is measured relative to an

equilibrium full-employment rate called the NAIRU.)

Inflation goal: 2 percent per year.

Other Objectives?

Output growth, financial stability.

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How can Monetary Policy Achieve these Goals?Monetary Policy Transmission

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Implementing Monetary Policy (Normal Times)

Banks make money by lending deposits.

The Federal Reserve requires banks to hold a minimum levelof reserves based on their deposits, which can influence banks’funds available for lending.

Reserve requirement ratio

Banks sometimes will have excess reserves, and sometimesthey will not have enough. Banks who need reserves canborrow from banks with excess reserves (federal fundsmarket).

Federal funds rate

Banks can also borrow reserves directly from the FederalReserve (discount window).

Discount rate

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Implementing Monetary Policy (Normal Times)

The Fed cannot force banks to alter their lending directly,BUT...

The FOMC sets the overnight interest rate (price) used bybanks to trade reserve balances—the Federal Funds Rate(FFR).

Everything else equal, the less banks pay (receive) forborrowing (lending) reserves to (from) other banks, the lowerthe opportunity cost of funds and the more willing they are tolend funds to consumers and firms.

How does the Fed change the FFR?Through open market operations, the FOMC manages thesupply of reserve balances in the banking system and hencethe price of reserves:

The Fed purchases treasuries to increase reserves and ↓ FFR.The Fed sells treasuries to remove reserves and ↑ FFR.

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The Transmission of Monetary Policy

More reserves through purchases of treasuries by the Fed,lower the short-term interbank rates (FFR), which reducesother interest rates (including longer-term rates) in theeconomy.

The stimulative effect of lower rates works through housing,consumer durables, and business investment.

Removing reserves from the banking system (by sellingtreasuries) raises the FFR and reduces consumer spending andbusiness investment.

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Monetary Policy: Choosing the FFR

The Fed’s policy actions, in recent history, are well characterizedby the following:

If inflation exceeds target, the FOMC raises the federal fundsrate (FFR) (tightens policy).

If the unemployment rate exceeds the long run goal, theFOMC lowers the FFR (eases policy).

You can think of the Fed’s reaction function as a monetary policyrule:

ifft = iNt + α

(πt − π

targett

)− β

(Ut − UFull Employment

t

)where :

ifft = federal funds rate

πt = inflation rate

Ut = unemployment rate

Monetary Policy in Different PeriodsDual Mandate: Objectives typically complementary. If not, a balanced approach in

promoting them is followed.

Fighting Inflation Fighting Unemployment

−5

0

5

10

15

20

Per

cent

, ann

ual r

ate

1960q1 1970q1 1980q1 1990q1 2000q1 2010q1

Fed Funds Effective Rate Core PCE Inflation Unemployment Gap

Source: Federal Reserve Board/CBO/BLS/Haver Analytics.

Monetary Policy: The Volcker Disinflation Episode

0

5

10

15

20

Per

cent

1975 1977 1979 1981 1983 1985 1987 1989

Core PCE Federal Funds Rate Unemployment Rate

Source: Federal Reserve Board/BLS/BEA/Haver Analytics

When Volcker became chairman in 1979, inflation was high and peaked in 1981 at

13.5%. The inflation rate dropped to 3.2% by 1983. Volcker raised the FFR from

11.2% in 1979 to 20% in June of 1981 but the unemployment rate became higher

than 10% during this time as well.

Monetary Policy: The Great Recession and the Zero Lower Bound (ZLB)

0

2

4

6

8

10P

erce

nt

2007 2009 2011 2013 2015 2017

Core PCE Federal Funds Rate

Unemployment Rate

Source: Federal Reserve Board/BLS/BEA/Haver Analytics

No conflicting objectives, but the FFR hit zero!

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Other Tools of Monetary Policy

In recent years, with the FFR at the ZLB, the FOMC has relied on alternative(unconventional) tools for implementing monetary policy.

1 Large-scale Asset Purchases (LSAP) or Quantitative Easing (QE) to:

Increase the money supply and lower long-term interest rates.Improve liquidity for banks.Support asset prices.

2 Alter the composition of Fed balance sheet (Operation Twist):

Buy long-term and sell short-term Treasury securities.Further push down long-term interest rates.

3 Communication/Forward Guidance:

Long-term interest rates move with expectations about futureshort-term interest rates.Policymaker statements about future policy actions affectthese expectations.

4 (Some countries have experimented with negative (FFR) rates.)

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The Fed’s Balance Sheet

0

1

2

3

4

5

Trill

ions

of U

SD

Jan07 Jan09 Jan11 Jan13 Jan15 Jan17

Treasuries MBS

Agency debt Other (Repos + Loans)

Source: Federal Reserve Board /Haver Analytics

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Success? The Transmission of Monetary Policy toLong-Term Rates

0

5

10

15

Per

cent

1985m1 1990m1 1995m1 2000m1 2005m1 2010m1 2015m1

Fed Funds (effective) Rate10−Year Treasury Yield at Constant Maturity

Source: Federal Reserve Board/Haver Analytics

Current Conditions

1 The Dual Mandate:

1. The Labor Market.2. Inflation.

2 Other Objectives:

3. GDP Growth.4. Financial Stability.

1. The Labor Market

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The labor market has improved substantially since the Great Recession.

The unemployment rate is now below the CBO’s estimate of the full employment rate.

3

4

5

6

7

8

9

10

11 %

8

9

10

11

12

13

14

15

16

17

18%

2005 2007 2009 2011 2013 2015 2017 2019

U-6 Underemployment Rate (left axis) Unemployment Rate (right axis)

NAIRU (CBO, right axis) FOMC Median Forecast (right Axis)

Source: BLS/CBO/Federal Reserve Board/Haver Analytics

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The labor force participation has remained relatively stable over the last few years at

roughly 63%. This points to a very strong labor market given the aging of the population.

1012

1416

1820 %

6263

6465

6667

%

90 92 94 96 98 00 02 04 06 08 10 12 14 16

Labor Force Participation Rate, 16+ (left axis)

Labor Force Participation Rate, 65+ (right axis)

Population Aged 65+ as a Share of Total Population (right axis)

Source : BLS/Census Bureau/Haver Analytics

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Employment growth has remained strong pointing to further improvement in the

labor market this year.

0

50

100

150

200

250

300

350

Jobs

(tho

us.)

Jan15 Apr15 Jul15 Oct15 Jan16 Apr16 Jul16 Oct16 Jan17 Apr17

Moving Average (6-mo)

Equilibrium Job Growth*

Monthly Change

*Job growth needed to keep pace with population growth.Source: Bureau of Labor Statistics/Haver Anayltics

Change in Total Nonfarm Payroll Employment

2. Inflation

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Core inflation remains relatively subdued, but is expected to rise toward the FOMC’s 2

percent target.

0

.5

1

1.5

2

2.5

Per

cent

2005 2007 2009 2011 2013 2015 2017 2018 2019

Core PCE Inflation FOMC June Projections

FOMC Target as of 2012

Source: Bureau of Economic Analysis/Federal Reserve Board/Haver Analytics

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Healthy wage growth should put pressure on inflation going forward.

1.2

1.6

2

2.4

2.8

3.2

3.6

Per

cent

(yea

r-ov

er-y

ear)

2007q1 2009q1 2011q1 2013q1 2015q1 2017q1

ECI: Wages and Salaries Average Hourly Earnings: Total Pvt. Industries

Source: Bureau of Labor Statistics/Haver Analytics

3. Output Growth

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GDP growth in the first quarter slowed to 1.2 percent, but growth in the second

quarter was strong and expected to continue the rest of the year.

2.62.9

1.51.2

2.6

-4

-3

-2

-1

0

1

2

3

4

5

Per

cent

2014 2015 2016 2017: Q1 2017: Q2

Real GDP Growth

-4

-3

-2

-1

0

1

2

3

4

5

Per

cent

age

Poi

nts

2014 2015 2016 2017: Q1 2017: Q2

Contributions of Components

Consumption

Fixed Investment Inventory Investment

Government Purchases Net Exports

Source: Bureau of Economic Analysis/Haver Analytics

A first quarter slowdown is not unusual, and we should paymore attention to the signal from the labor market.

The consumption numbers for the second quarter areencouraging.

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Secular Stagnation?

From a longer term perspective, several prominent economists worry that GDP

growth has been low since the change of the century.

0

1

2

3

4

Per

cent

1960s 1970s 1980s 1990s 2000s 2010-2016*Annualized growth rateSource: Haver Analytics

Real GDP Per Capita Growth by Decade*

Fiscal policy is better suited than monetary policy to address this issue.

4. Financial Stability

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Financial markets are doing well for now.

U.S. Presidential Election July FOMC

2100

2200

2300

2400

2500

01Oct2016 01Jan2017 01Apr2017 01Jul2017Source: Haver Analytics

S&P 500 Stock Price Index U.S. Presidential Election July 2017 FOMC

10

15

20

25

01Oct2016 01Jan2017 01Apr2017 01Jul2017Source: Wall Street Journal/Haver Analytics

Market Volatility Index, VIX

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House prices have recovered since the Great Recession.

50

100

150

200

HP

I: Ja

n 20

00 =

100

Jan95 Jan98 Jan01 Jan04 Jan07 Jan10 Jan13 Jan16

Source: CoreLogic/Haver Analytics

National House Price Index

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Consumer credit continues to grow and defaults are down.

-40

-20

0

20

40

Per

cent

2005q1 2008q1 2011q1 2014q1 2017q1Source: FRB Senior Loan Officer Opinion Survey/Haver Analytics

Banks' Willingness to Lend to Consumers

1.00

2.00

3.00

4.00

5.00

6.00

Per

cent

Jan07 Jan09 Jan11 Jan13 Jan15 Jan17Source: Standard & Poor's

S&P/Experian Consumer Credit Default Composite Index

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Lending standards are easing somewhat recently.

-20

0

20

40

60

80

Per

cent

2005q1 2008q1 2011q1 2014q1 2017q1Source: FRB Senior Loan Officer Opinion Survey/Haver Analytics

Lending Standards for Commercial & Industrial Loans to Large & Medium Firms

Note: This graph shows the net percentage of domestic banks responding that lending standards have tightened

over the past three months.

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This is helping investment pick some momentum

2000

2200

2400

2600

2800

3000

Bil.

Cha

ined

200

9$

2005q1 2008q1 2011q1 2014q1 2017q1Source: Bureau of Economic Analysis/Haver Analytics

Real Private Fixed Investment, SAAR

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Where are we in terms of the dual mandate?

What did the Fed do?

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Last Statement from the FOMC. July 26, 2017.

About the economy:

The labor market has continued to strengthen and economic activity has been

rising moderately so far this year.

On a 12-month basis, inflation has declined recently: the core measure is

running somewhat below 2 percent.

The decision:

The stance of monetary policy remains accommodative, and the Committee

decided to maintain the FFR at [1 to 1-1/4] percent.

Forward guidance:

“The Committee expects that economic conditions will evolve in a manner that

will warrant gradual increases in the FFR; the FFR is likely to remain, for some

time, below levels that are expected to prevail in the longer run. However, the

actual path of the federal funds rate will depend on the economic outlook as

informed by incoming data.”

On the balance sheet: “The Committee is maintaining its existing policy of

reinvesting principal payments [...] The Committee currently expects to begin

implementing a balance sheet normalization program relatively soon, provided

that the economy evolves broadly as anticipated.”

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The Oulook

Table 1: Economic Forecast

2017 2018 2019 Long Run

Change in Real GDPFOMC (June Projections, Median) 2.2 2.1 1.9 1.8Survey of Professional Forecasters 2.1 2.5 2.1

Unemployment RateFOMC (June Projections, Median) 4.3 4.2 4.2 4.6Survey of Professional Forecasters 4.5 4.3 4.4

PCE InflationFOMC (June Projections, Median) 1.6 2.0 2.0 2.0Survey of Professional Forecasters 1.9 2.0 2.0

Federal Funds RateFOMC (June Projections, Median) 1.4 2.1 2.9 3.0

Note: The Survey of Professional Forecasters (SPF) forecasts real GDP growth in annual averages while theFOMC projects Q4/Q4 growth. SPF forecasts the unemployment rate in annual averages while the FOMCprojects the Q4 value. Both forecasts for core PCE are for Q4/Q4 inflation. Sources: Federal Open MarketCommittee, Survey of Professional Forecasters

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Future Policy?

FOMC participants assessments of appropriate monetary policy: Midpoint of

target range or target level for the federal funds rate.

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Summary

The main transmission mechanism for monetary policy worksthrough the long-term rate. In normal times, we just affect itby actively managing a very short-term rate.

Monetary policy is not an exact science. It has long andvariable lags.

We need to always be open as the economy, or ourunderstanding of it as policymakers, can change profoundly.

The recovery from the Great Recession is ongoing andpolicymakers will continue working toward achieving (andmaintaining) maximum employment and price stability.

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Federal Reserve Independence is Important

The goal of monetary policy is determined by Congress (dualmandate), but the Fed has freedom on how to implementpolicy.

“Implementation independence” allows flexibility for monetarypolicy to react quickly and not to be used as a bargaining chipfor other political issues.

Allows monetary policy to evolve with our understanding ofthe economy.

Independence does NOT mean “no accountability”.

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If you want to learn more

Keywords: fractional reserve banking system, federal fundsrate, open market operations, dual mandate, Federal Reserveindependence, zero lower bound.

Some Links:

http://www.federalreserve.gov/

http://www.bostonfed.org

http://www.bostonfed.org/economic/research.htm

http://www.federalreserve.gov/

http://www.bostonfed.org

http://www.bostonfed.org/economic/research.htm

Documents

The Fed, Monetary Policy, and The U.S. Economic …...The Fed, Monetary Policy, and The U.S. Economic Outlook Maria Luengo-Prado Senior Economist and Policy Advisor Federal Reserve