EMBARGOED UNTIL MONDAY, NOVEMBER 10, 2014 AT 5:10 P.M. EASTERN TIME OR UPON DELIVERY Implications of Low Inflation Rates for Monetary Policy Eric S. Rosengren President & CEO Federal Reserve Bank of Boston November 10, 2014 The H. Parker Willis Lecture in Political Economy Washington and Lee University Lexington, Virginia bostonfed.org
Major Central Banks Missing Their Inflation Targets Inflation rate is too low rather than too high U.S. economy has been improving FOMC stopped the asset-purchase program in October Significant improvement in labor markets Persistently below the Fed s 2 percent inflation target since the financial crisis 2
Why is Too Low Inflation a Problem? Low inflation risks actual deflation if the economy experiences a negative shock Deflation: Falling aggregate prices Households and firms postpone expenditures Debtors real value of loan payment rises over time Associated with slow economic growth Japan experienced an extended period of slow growth while it experienced mild deflation Some have concerns that Europe could potentially experience a mild deflation 3
Why are Very Low Real Interest Rates a Problem? Economy with significant slack may require low real interest rates Low nominal rates and low inflation rates make it difficult for monetary policy to offset negative shocks Particularly a problem when short-term nominal interest rates are at the zero lower bound as we have experienced since 2008 4
Figure 1: Nominal and Real Federal Funds Effective Rate January 2008 - September 2014 5 4 3 Percent Nominal Real 2 1 0-1 -2-3 Jan-2008 Jan-2010 Jan-2012 Jan-2014 Note: The real federal funds effective rate is calculated by subtracting the core PCE inflation rate from the nominal federal funds effective rate. Source: BEA, Federal Reserve Board, Haver Analytics 5
Labor Market Adjustments Can Be More Difficult With Low Inflation Workers and firms resist decreasing nominal wages downward nominal wage rigidity In recessions, when demand for workers falls, real wages tend to fall At low inflation rates it is difficult for real wages to fall Makes labor market recovery more protracted and painful 6
Central Bank Credibility Confidence that a central bank can achieve its goals helps to keep expectations well anchored Persistent undershooting of the inflation goal could cause expectations to drift down Makes it more difficult to achieve inflation target 7
Importance of a Symmetric Inflation Target Persistently higher or lower inflation requires a monetary policy response Total and core inflation have been below target Falling oil and other commodity prices are likely to postpone return to target Reason for monetary policymakers to be patient in removing accommodation (lifting off from the zero lower bound) Such patience provides the opportunity to better determine how much labor market slack remains 8
Figure 2: Median Inflation Forecasts for 2014 of Federal Reserve Board Members and Federal Reserve Bank Presidents June 2012 - September 2014 2.5 Percent 2.0 1.5 1.0 0.5 2014 PCE 2014 Core PCE 0.0 Jun-2012 Dec-2012 Jun-2013 Dec-2013 Jun-2014 Date of Forecast Note: Forecasts for both measures of inflation are for the percent change from the fourth quarter of 2013 to the fourth quarter of 2014. Source: FOMC, Summary of Economic Projections (SEP), Minutes of FOMC Meetings 9
Figure 3: Median Inflation Forecasts for 2014 from the Survey of Professional Forecasters May 2012 - August 2014 2.5 Percent 2.0 1.5 1.0 0.5 2014 PCE 2014 Core PCE 0.0 May-2012 Nov-2012 May-2013 Nov-2013 May-2014 Date of Forecast Note: Forecasts for both measures of inflation are for the percent change from the fourth quarter of 2013 to the fourth quarter of 2014. Source: Federal Reserve Bank of Philadelphia 10
Figure 4: Measures of Labor Market Slack January 1994 - October 2014 18 15 Percent U-6: U-3 Plus Workers who are Part Time for Economic Reasons or Marginally Attached U-3: Civilian Unemployment Rate 12 9 6 3 0 Jan-1994 Jan-1999 Jan-2004 Jan-2009 Jan-2014 Recession Source: BLS, NBER, Haver Analytics 11
Figure 5: Employment Gap and Inflation 1980:Q1-2014:Q3 8 Percentage Points 1 4 1 0 1-4 0-8 Employment Gap 12-Quarter Change in Core CPI Inflation 0-12 1980:Q1 1988:Q1 1996:Q1 2004:Q1 2012:Q1 Recession 0 Note: The employment gap is the difference between the unemployment rate and the CBO estimate of the natural rate of unemployment. Source: BLS, CBO, NBER, Haver Analytics 12
Figure 6: Ten-Year Treasury Yield Minus Ten- Year Inflation-Indexed Treasury Yield January 3, 2012 - November 6, 2014 Percent 3.0 2.5 2.0 1.5 1.0 03-Jan-2012 18-Sep-2012 04-Jun-2013 18-Feb-2014 04-Nov-2014 Note: Yields at Constant Maturity Source: Federal Reserve Board, Haver Analytics 13
Figure 7: Inflation Expectations January 2012 - October 2014 4 Percent 3 2 1 Median Expected Inflation Over Next 5 to to 10 Years 0 Jan-2012 Jul-2012 Jan-2013 Jul-2013 Jan-2014 Jul-2014 Source: Thomson Reuters, University of Michigan 14
Figure 8: Spot Oil Price: West Texas Intermediate Crude Oil January 3, 2012 - November 6, 2014 120 Dollars Per Barrel 110 100 90 80 70 60 03-Jan-2012 18-Sep-2012 04-Jun-2013 18-Feb-2014 04-Nov-2014 Source: Energy Information Administration (EIA), WSJ, Haver Analytics 15
Figure 9: U.S. Field Production of Crude Oil January 2000 - August 2014 300 Millions of Barrels 250 200 150 100 50 0 Jan-2000 Jan-2004 Jan-2008 Jan-2012 Source: Energy Information Administration (EIA) 16
Figure 10: S&P Goldman Sachs Commodity Price Indices (January 2012 = 100) January 2012 - October 2014 S&P GSCI Commodity Nearby Index 120 120 Energy (69.77% of GSCI) Industrial Metals (6.74% of GSCI) 120 110 110 110 100 100 100 90 90 90 80 80 80 70 Jan-12 Jan-13 Jan-14 70 Jan-12 Jan-13 Jan-14 70 Jan-12 Jan-13 Jan-14 Precious Metals (3.25% of GSCI) Agriculture (15.28% of GSCI) Livestock (4.96% of GSCI) 120 120 130 110 110 120 100 100 110 90 90 100 80 80 90 70 Jan-12 Jan-13 Jan-14 70 Jan-12 Jan-13 Jan-14 80 Jan-12 Jan-13 Jan-14 Source: S&P, Haver Analytics 17
Figure 11: JP Morgan Nominal Broad Trade- Weighted Effective Exchange Rate Index for the U.S. Dollar January 3, 2012 - November 6, 2014 96 Index, 2000 = 100 92 88 84 80 76 03-Jan-2012 18-Sep-2012 04-Jun-2013 18-Feb-2014 04-Nov-2014 Source: JP Morgan, Haver Analytics 18
Figure 12: Employment Cost Index for Total Compensation for Private Industry Workers by Occupational Group 2003:Q1-2014:Q3 5 Percent Change from Year Earlier 4 3 2 Natural Resources, Construction and Maintenance Production, Transportation and Material Moving Management and Professional Sales and Office 1 Service Occupations 0 2003:Q1 2008:Q1 2013:Q1 Recession Source: BLS, NBER, Haver Analytics 19
Figure 13: Employment Cost Index for Total Compensation for Private Industry Workers by Census Region 2003:Q1-2014:Q3 6 Percent Change from Year Earlier 5 4 3 Northeast West Midwest 2 South 1 0 2003:Q1 2008:Q1 2013:Q1 Recession Source: BLS, NBER, Haver Analytics 20
Figure 14: Measures of Inflation Targeted by Central Banks January 2012 - September 2014 4 Percent Change from Year Earlier U.S. 3 Japan Euro Area 2 1 0-1 Jan-2012 Jul-2012 Jan-2013 Jul-2013 Jan-2014 Jul-2014 Note: The U.S. series is the PCE. The Euro Area series is the Harmonized Index of Consumer Prices. Japan s series is the CPI, All Items less Fresh Food, and adjusted for Japan s April 2014 consumption tax increase. Source: BEA, Eurostat, Japan s Ministry of Internal Affairs and Communications, Bank of Japan, Haver Analytics 21
Figure 15: Overnight/Policy Rates for the Euro Area, Japan, and the U.S. January 3, 2012 - November 6, 2014 1.2 1.0 0.8 Percent Euro Area Main Refinancing Operation on Effective Date U.S. Federal Funds Effective Rate Japan's Uncollateralized Overnight Call Rate 0.6 0.4 0.2 0.0 03-Jan-2012 18-Sep-2012 04-Jun-2013 18-Feb-2014 04-Nov-2014 Source: Bank of Japan, European Central Bank, Federal Reserve Board, Haver Analytics 22
Figure 16: Ten-Year Government Bond Yields January 3, 2012 - November 6, 2014 4 Percent U.S. France Germany Japan 3 2 1 0 03-Jan-2012 18-Sep-2012 04-Jun-2013 18-Feb-2014 04-Nov-2014 Source: U.S. Treasury, Financial Times, Haver Analytics 23
Concluding Observations Central banks around the world have persistently missed their stated inflation targets Experiences in Japan and Europe increasingly indicate that it can be costly to be complacent when inflation gets too low It is important for the Federal Reserve to achieve the 2 percent target it has set for itself Until there is stronger evidence that inflation will return to 2 percent, monetary policymakers should remain patient about removing accommodation 24