The Fed and The U.S. Economic Outlook

The Fed and The U.S. Economic Outlook Maria Luengo-Prado Senior Economist and Policy Advisor Federal Reserve Bank of Boston May 13, 2016 Presentation prepared for the Telergee Alliance CFO & Controllers Conference

Disclaimer These views are my own and do not necessarily represent the views of the Federal Reserve System.

Outline 1 Background on the Federal Reserve and monetary policy. 2 Current U.S. economic indicators and the outlook. 3 The road ahead.

The Fed

The Federal Reserve System The Federal Reserve is the U.S. Central Bank

The Federal Reserve System There are 12 Federal Reserve Banks that operate under the general supervision of the Board of Governors in Washington. The Fed is responsible for U.S. monetary policy which is set by the 12-member Federal Open Market Committee (FOMC). 7 members of the Board of Governors (BOG) and 5 Federal Reserve Bank Presidents (rotating). Current chairman Janet Yellen. Eight regularly scheduled meetings during the year, and other meetings as needed.

What does the Federal Reserve do? The Federal Reserve is the central bank of the U.S. and has several responsibilities: Monetary policy Lender of last resort Bank regulation Payments system

What is Monetary Policy?

What is Monetary Policy? Actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. (Source: http://www.federalreserve.gov/monetarypolicy/fomc.htm)

What is Monetary Policy? Actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. (Source: http://www.federalreserve.gov/monetarypolicy/fomc.htm) Economic Goals (required by Congress): maximum employment, stable prices, and moderate long-term interest rates (Federal Reserve Act, as amended in 1977).

What is Monetary Policy? Actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. (Source: http://www.federalreserve.gov/monetarypolicy/fomc.htm) Economic Goals (required by Congress): maximum employment, stable prices, and moderate long-term interest rates (Federal Reserve Act, as amended in 1977). First two goals known as dual mandate.

What is Monetary Policy? Actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. (Source: http://www.federalreserve.gov/monetarypolicy/fomc.htm) Economic Goals (required by Congress): maximum employment, stable prices, and moderate long-term interest rates (Federal Reserve Act, as amended in 1977). First two goals known as dual mandate. More specifically: Price stability: 2 percent per year inflation. Maximum sustainable employment: Unemployment rate measured relative to the NAIRU (non-accelerating inflation rate of unemployment).

What is Monetary Policy? Actions undertaken by a central bank, such as the Federal Reserve, to influence the availability and cost of money and credit to help promote national economic goals. (Source: http://www.federalreserve.gov/monetarypolicy/fomc.htm) Economic Goals (required by Congress): maximum employment, stable prices, and moderate long-term interest rates (Federal Reserve Act, as amended in 1977). First two goals known as dual mandate. More specifically: Price stability: 2 percent per year inflation. Maximum sustainable employment: Unemployment rate measured relative to the NAIRU (non-accelerating inflation rate of unemployment). Other goals? Output growth, financial stability.

The Banking System and Fed Policy Instruments The Federal Reserve requires banks to hold a minimum level of reserves based on their deposits, which can influence banks funds available for lending.

The Banking System and Fed Policy Instruments The Federal Reserve requires banks to hold a minimum level of reserves based on their deposits, which can influence banks funds available for lending. Banks can also borrow reserves directly from the Federal Reserve (discount window).

The Banking System and Fed Policy Instruments The Federal Reserve requires banks to hold a minimum level of reserves based on their deposits, which can influence banks funds available for lending. Banks can also borrow reserves directly from the Federal Reserve (discount window). Banks who need reserves can borrow from banks with excess reserves (federal funds market).

The Banking System and Fed Policy Instruments The Federal Reserve requires banks to hold a minimum level of reserves based on their deposits, which can influence banks funds available for lending. Reserve requirement ratio Banks can also borrow reserves directly from the Federal Reserve (discount window). Banks who need reserves can borrow from banks with excess reserves (federal funds market).

The Banking System and Fed Policy Instruments The Federal Reserve requires banks to hold a minimum level of reserves based on their deposits, which can influence banks funds available for lending. Reserve requirement ratio Banks can also borrow reserves directly from the Federal Reserve (discount window). Discount rate Banks who need reserves can borrow from banks with excess reserves (federal funds market).

The Banking System and Fed Policy Instruments The Federal Reserve requires banks to hold a minimum level of reserves based on their deposits, which can influence banks funds available for lending. Reserve requirement ratio Banks can also borrow reserves directly from the Federal Reserve (discount window). Discount rate Banks who need reserves can borrow from banks with excess reserves (federal funds market). Federal funds rate

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 by banks to trade reserve balances the Federal Funds Rate (FFR). Through open market operations, the FOMC manages the supply of reserve balances in the banking system and hence the price of reserves: Fed purchases of bonds increase reserves (lowers FFR). Fed sales of bonds remove reserves (raises FFR). Everything else equal, the less banks receive (pay) for lending (borrowing) reserves to (from) other banks, the lower the opportunity cost of funds and the more willing they are to lend funds to consumers and firms.

The Transmission of Monetary Policy Lower (higher) short-term interbank rates reduce (increase) other interest rates, including longer-term rates, in the economy. The stimulative effect of lower rates work through housing, consumer durables, and business investment. Removing reserves from the banking system raises the FFR and reduces consumer spending and business investment.

Unemployment Rate 12 Percent of Labor Force 10 8 6 4 1980m1 1985m1 1990m1 1995m1 2000m1 2005m1 2010m1 2015m1 Source: Haver Analytics United States

Headline and Core Inflation 12 mo. Percent Change 16 14 12 10 8 6 4 2 0 2 1955m1 1965m1 1975m1 1985m1 1995m1 2005m1 2015m1 Core CPI Source: BLS/Haver Analytics. Headline CPI

Monetary Policy in Different Periods 20 Percent, annual rate 15 10 5 0 Fighting Inflation Fighting Unemployment 5 1960q1 1970q1 1980q1 1990q1 2000q1 2010q1 Fed Funds Effective Rate Core PCE Inflation Unemployment Gap Source: Federal Reserve Board/CBO/BLS/Haver Analytics.

The Great Recession Deep recession and slow recovery. Recessions tend to be deeper and the recoveries slower when a recession is combined with a financial crisis. Required substantial monetary policy intervention. (Aggressive) conventional policy response: lowering the FFR. Alternative monetary policy at the Zero-Lower Bound.

Index (January 2000 = 100) 120 140 160 180 200 National House Price Index (Seasonally Adjusted) 2003m1 2005m1 2007m1 2009m1 2011m1 2013m1 2015m1 Source: CoreLogic/Haver Analytics Percent Consumers with New Foreclosures (%).25.2.15.1.05 2000q1 2005q1 2010q1 2015q1 Source: FRBNY Consumer Credit Panel/Haver Analytics Percent 0 5 10 15 20 25 30 35 40 45 50 Long Term Unemployment (%, Seasonally Adjusted) Percent 10 8 6 4 2 Federal Funds Rate (%) 1990m1 1995m1 2000m1 2005m1 2010m1 2015m1 Unemployed Job Losers: Out 27 Weeks & Over Source: Bureau of Labor Statistics /Haver Analytics 0 1985m1 1990m1 1995m1 2000m1 2005m1 2010m1 2015m1 Source: Federal Reserve Board/Haver Analytics

Alternative Monetary Policy at the Zero-Lower Bound In recent years, with the FFR near the zero lower bound (ZLB), the FOMC has relied on alternative (unconventional) tools for implementing monetary policy. 1 Asset Purchases: Large-scale purchases (LSAP) or Quantitative Easing (QE) 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 Lender of Last Resort 4 Communication/Forward Guidance

Success? The Transmission of Monetary Policy in Action 15 Percent, annual rate 10 5 0 1985q1 1990q1 1995q1 2000q1 2005q1 2010q1 2016q2 Federal Funds (effective) Rate 10 Year Treasury Note Yield at Constant Maturity Source: Federal Reserve Board/Haver Analytics

Challenges Facing Monetary Policy Monetary policy has long and variable lags. The FOMC makes a decision about the FFR or other monetary policy tools today based on current economic conditions, but also based on a forecast of future economic conditions and how they might be impacted by a rate change (given long and variable lags). Forecasts are a best guess of future conditions. Our models and understanding of the economy are imperfect. Shocks happen (e.g. U.S. Government shutdown, European instability, natural disasters, military conflicts). Much FOMC debate over the last 50 years has centered around the evolving model of the macroeconomy.

Federal Reserve Independence is Important The goal of monetary policy is determined by Congress (dual mandate), but the Fed has freedom on how to implement policy. Implementation independence allows flexibility for monetary policy to react quickly and not to be used as a bargaining chip for other political issues. Allows monetary policy to evolve with our understanding of the economy. Independence does NOT mean: No effects of fiscal policy on monetary policy. No accountability.

Recent Indicators and the Outlook 1. GDP and Consumption Growth

Real Gross Domestic Product GDP=Consumption+Investment+Government Spending + Net Exports 9.5 9 Log Scale 8.5 8 7.5 1955q1 1965q1 1975q1 1985q1 1995q1 2005q1 2015q1 Source: Haver Analytics

GDP growth slowed further in 2016:Q1. The drag on output spread beyond net exports and changing inventories. Key contributors: consumption and nonresidential investment. Select Contributions to GDP growth 1995 2008 2014 2015:Q3 2015:Q4 2016:Q1 2007 2013 GDP Growth 3.2 0.8 2.4 2.0 1.4 0.5 Final Sales (Domestic) 3.5 0.4 2.5 2.9 1.7 1.2 Contribution of: Consumption 2.4 0.6 1.8 2.0 1.7 1.3 Goods 1.1 0.3 0.8 1.1 0.4 0.0 Services 1.3 0.4 1.1 1.0 1.3 1.2 Res. Investment 0.1 0.2 0.1 0.3 0.3 0.5 NonRes Investment 0.7 0.1 0.8 0.3 0.3 0.8 Net Exports 0.4 0.4-0.2 0.3 0.1 0.3 Chg. Inventories 0.0 0.0 0.1 0.7 0.2 0.3 Notes: Final sales data exclude inventories and exports. Numbers may not add due to rounding.

The first quarter continues a recent pattern of sluggish starts to the year. Little signal is being taken from the weak start, however, and growth is expected to increase over the remainder of the year. 4 Real GDP and PCE Growth Percent, Annual Rate 3 2 1 0 1 2014q1 2014q2 q4 Avg. 2015q1 2015q2 q4 Avg. 2016q1 2016q2 q4 Avg. Real PCE growth rate Blue Chip Consensus Forecast (PCE) Source: BEA/Aspen Publishers/Haver Analytics Real GDP growth rate Blue Chip Consensus Forecast (GDP)

The stock market has rebounded significantly from its lows in February, house prices continue to rise, and consumer sentiment remains at a favorable level. House and Stock Prices Consumer Sentiment 200 120 2000 110 1941 43 = 10 1500 1000 150 100 January 2000 = 100 1966Q1 = 100 100 90 80 70 500 1995m1 1998m1 2001m1 2004m1 2007m1 2010m1 2013m1 2016m1 S&P 500 Index National House Price Index Source: Standard & Poor s/corelogic/haver Analytics 50 60 50 1995m1 1998m1 2001m1 2004m1 2007m1 2010m1 2013m1 2016m1 Source: University of Michigan/Haver Analytics

Residential investment has also been improving in recent quarters 20 Real Private Residential Fixed Investment % Change Year to Year SAAR, Bil.Chn.2009$ 10 Percent (%) 0 10 20 30 2005q1 2007q1 2009q1 2011q1 2013q1 2015q1 Source: Bureau of Economic Analysis/Haver Analytics

Slow spending growth has contributed to the slow output growth. Consumption growth was closer to its pre-recession mean, on average, in 2014 and 2015, but fell back noticeably in the first quarter. 10 Real PCE Growth 7.5 Percent, Annual Rate 5 2.5 0 2016q1 2.5 5 1995q1 1997q1 1999q1 2001q1 2003q1 2005q1 2007q1 2009q1 2011q1 2013q1 2015q1 Source: BEA/Haver Analytics Average Growth 1995 2007 (3.5 percent) Average Growth 2014 2015 (3.0 percent) Real PCE Growth

Private forecasters continue to anticipate that consumption growth will pick up as the fundamentals for household spending remain favorable. Income and Wealth Consumption Outlook 5 Percent, Annual Rate 4 3 2 2016 2017 2.3 2.6 2.1 2.5 2.9 3 1 0 2014 2015 2016q1 0.5 1 1.5 2 2.5 3 Percent, Annual Rate Source: BEA/Flow of Funds/Haver Analytics Real Disposable Income Growth Real Net Worth Growth Bottom 10% Average Consensus Top 10% Average Source: Aspen Publishers/Haver Analytics

But, saving remains elevated (and spending low) relative to fundamentals. Given historical relationship between consumption (saving), income, and wealth we would expect more spending now than we are seeing. Net Worth to Income Ratio and the Saving Rate 7 6.4 6.4 6 5.7 Ratio, Percent 5 4 3 2 4.8 2.9 4.9 1 0 1998 2004 2005 2007 2013 2015 Source: BEA/Flow of Funds/Haver Analytics Net Worth/Income (Ratio) Saving Rate (%)

Saving could be higher (and spending lower) to the extent that gains in income and wealth have accrued to the wealthy since the recession. These households propensity to consume out of income and wealth changes is likely lower. 1.4 Change in Financial Wealth by Income Quintiles 1.2 2005 = 1 1.8.6.4 2005 2007 2009 2011 2013 2015 Bottom Quintile Middle Quintile Top Quintile Note: All values are real. Income quintiles are based on average household (before tax) income from 2005 2013. Source: PSID and author s calculations

Recent Indicators and the Outlook 2. The Labor Market and Inflation

The labor market has improved substantially since the Great Recession. Unemployment is near the CBO s estimate of the natural rate and initial claims are near 42 year lows. Unemployment Rate and NAIRU Unemployment Insurance Claims 10 700 Rate 9 8 7 6 5 4 Week Moving Average (Thousands) 600 500 400 4 1995q1 1998q1 2001q1 2004q1 2007q1 2010q1 2013q1 2016q1 300 Source: Bureau of Labor Statistics/CBO/Haver Analytics Unemployment Rate NAIRU 01jan1995 01jan2000 01jan2005 01jan2010 01jan2015 Source: Department of Labor/Haver Analytics

The labor force participation rate has rebounded recently. About 2.5 million people have entered the labor market since September. 67 Labor Force Participation Rate 66 65 Percent 64 63 2016m4 62 2007m1 2009m1 2011m1 2013m1 2015m1 Source: Bureau of Labor Statistics/Haver Analytics Note: Seasonally Adjusted, 16 years old and older

Core inflation remains relatively subdued, but is expected to rise toward the FOMC s 2 percent target. 2.5 Core PCE Inflation Path 2 Percent 1.5 1 Projection.5 0 2005q1 2007q1 2009q1 2011q1 2013q1 2015q1 2017q1 2018q1 Core PCE Inflation SEP March Projections FOMC Target as of 2012 Source: Bureau of Economic Analysis/Federal Reserve Board/Haver Analytics

Latest Employment Report (Friday May 6, 2016) The U.S. created 160,000 new jobs in April expected increase of 203,000 nonfarm jobs; trend employment growth is 80,000 jobs per month. The unemployment rate was unchanged at 5% (people dropped out of the labor force). The labor-force participation fell for the first time since last fall to 62.8%. Good news, average wages climbed 0.3% to $25.53 an hour. Hourly pay rose 2.5% in the past 12 months, up from 2.3%.

Table 1: Economic Forecast 2015 2016 2017 2018 Change in Real GDP FOMC (March Projections) 1.9 to 2.5 1.7 to 2.3 1.8 to 2.3 Consensus Forecast 2.8 2.7 2.6 Actual 2.4 Unemployment Rate FOMC (March Projections) 4.5 to 4.9 4.3 to 4.9 4.3 to 5.0 Consesus Forecast 4.9 4.9 5.0 Actual (Annual/December) 5.3/5.0 PCE Inflation FOMC (March Projections) 1.0 to 1.6 1.6 to 2.0 1.8 to 2.0 Consesus Forecast 2.2 2.3 2.4 Actual (December) 0.7 Federal Funds Rate FOMC (March Projections) 0.6 to 1.4 1.6 to 2.8 2.1 to 3.9 Actual (December) 0.25-0.50

The Road Ahead

The current policy debate centers on whether the Fed will raise rates in June or whether the weak first quarter will lead to a further pause. The financial markets have a different view than private forecasters. Implied Federal Funds Rates vs. Blue Chip Forecast 1.8 1.6 1.4 1.2 Percent 1.8.6.4.2 0 Aug 16 Nov 16 Feb 17 May 17 Aug 17 Nov 17 Fed Funds Rate Futures (April 22, 2016) Fed Funds Rate Futures (April 27, 2016) Blue Chip Consensus Note: Blue Chip forecast is for the quartelry average of the 3 month Treasury Bill. Source: Aspen Publishers/Bloomberg/Haver Analytics

Either way, the pace of rate tightening is expected to be very gradual. 4 Percentage Point Increase from First Tightening 2004 2006 3 1994 1996 2 March 2016 SEP 1 2015 2017 Implied by Fed Funds Futures Market 0 0 6 12 18 24 Months after First Tightening Note: The interest rate paths have been smoothed so that the lines more clearly reflect the slope of the tightening in the rate tightening cycles (1994 1995 and 2004 2006) following the last two recessions and the slope implied by the federal funds futures market over the 2015 2017 period and the SEP projections for 2016 and 2017. Source: Federal Reserve Board/Bloomberg/Haver Analytics

If you want to learn more Keywords: fractional reserve banking system, federal funds rate, open market operations, dual mandate, Federal Reserve independence, zero lower bound. Some Links: http://www.federalreserve.gov/ http://www.bostonfed.org http://www.bostonfed.org/economic/research.htm