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For release on delivery
12:30 p.m. EDT
June 3, 2016

The Economic Outlook and Implications for Monetary Policy

Remarks by
Lael Brainard
Member
Board of Governors of the Federal Reserve System
at
Council on Foreign Relations
Washington, D.C.

June 3, 2016

In recent months, financial conditions have eased, and there are encouraging signs
that consumption has regained momentum. On the other hand, there are tentative signs of
slowing in the labor market and risks remain.1 We cannot take the resilience of our
recovery for granted.
Recent Developments
As we consider the appropriate posture of policy going forward, the most
immediate question is whether the data provide confidence that domestic economic
activity has strengthened notably following two disappointing quarters. This is critical
for making progress on the Committee’s dual mandate objectives of full employment and
2 percent inflation. The data in today’s labor market report on balance suggest that the
labor market has slowed. Nonfarm payroll employment increased at an average monthly
pace of 116,000 over the last three months--well below the 220,000 per month average
pace over the preceding twelve months. The unemployment rate moved lower, reaching
4.7 percent, a new low in the current recovery, but involuntary part-time employment
increased and the labor force participation rate declined.
Even so, there are reasons to expect that the labor supply still has room to respond
if labor demand increases. Importantly, the employment to population ratio for primeage workers still remains 1-3/4 percentage points below pre-crisis levels. The recent data
on wage inflation suggest a similar conclusion. Although there have been some signs of
increasing wage growth recently, the step-up has been modest, and growth in the broad
measures of wages remains quite low. For example, the average change over the past

1

These remarks represent my own views, which do not necessarily represent those of the Federal Reserve
Board or the Federal Open Market Committee.

-2year across the three most commonly cited wage measures was about 2-1/2 percent,
compared with an average change from the end of 2009 to the end of 2014 of 2 percent.2
The recent news on inflation--the second leg of our dual mandate--has also been
mixed. The price of oil has rebounded significantly from the lows reached earlier in the
year on expectations that supply and demand are likely to come into better alignment.
Over the same period, the dollar has receded a bit, on net, from its peak in January,
though it is still about 15 percent above the level in mid-2014 in inflation-adjusted tradeweighted terms. As a result, non-oil import prices look likely to stabilize this quarter
after a year and a half of declines. Still, it should be noted that these developments
coincided with the easing in financial conditions since mid-February and are likely due,
at least in part, to expectations of more gradual U.S. monetary policy tightening. If those
expectations were to shift materially, the conditions supporting higher inflation could
diminish.
While there are thus signs that inflation will move higher over the medium term,
measures of core inflation have yet to convincingly exceed the low levels that have
prevailed over much of the recovery. The 12-month change in core personal
consumption expenditure (PCE) prices, a reasonable proxy for the underlying trend in
inflation, was only 1.6 percent in April. This is still noticeably below our target and is
roughly equal to the average change in core and total PCE inflation from the end of 2009
to the end of 2014.
We cannot rule out that stubbornly low inflation may be having an effect on
inflation expectations. Market-based measures of inflation compensation--which reflect

2

The three commonly cited measures of wages are the private-industry employment cost index,
compensation per hour in the business sector, and average hourly earnings.

-3inflation risk and liquidity premiums, as well as inflation expectations--remain extremely
low. For example, inflation compensation at the five-year, five-year-ahead horizon is
currently around 1.5 percent, 1-1/4 percentage points below levels prevailing prior to
mid-2014. Some survey-based measures of inflation expectations are also somewhat
below historical norms. Median 5- to 10-year inflation expectations in the University of
Michigan Surveys of Consumers, for example, over the past year have been on average
about 1/4 percentage point below the average over the 10 years from 2005 to 2014.
Thus, although some signs point to a firming of inflation going forward, I view
the persistently low level of inflation during the recovery together with some signs of a
deterioration in inflation expectations as suggesting that the risks to the return of inflation
to our 2 percent target over the medium term are weighted to the downside.
Progress toward our goals of full employment and 2 percent inflation will depend
importantly on solid growth in aggregate demand. Following disappointing gross
domestic product (GDP) growth in the fourth quarter of last year and the first quarter of
this year that averaged only 1.1 percent, I have been very attentive to incoming data,
especially on consumption, which point to a pick-up in growth this quarter.3 In
particular, consumer expenditures rose a strong 0.6 percent in April, and auto sales edged
higher in May. These are encouraging signs, but the data relevant for second-quarter
growth are still relatively sparse.
In general, demand growth in recent quarters has benefited from a relatively
strong household sector--buoyed by a recovering labor market, reduced oil prices, and

3

Growth in gross domestic income (GDI) has not slowed as much as GDP growth recently. However, the
average of GDP and GDI growth has still slowed recently from an average annual rate of 2-1/2 percent
from the third quarter of 2013 to the third quarter of 2015 to an average of 1-1/2 percent in the past two
quarters.

-4low interest rates--and has been pulled down by weak business investment and net
exports. Indeed, consumption and housing investment can more than account for the 2
percent increase in GDP over the past four quarters. By contrast, business investment
and net exports together subtracted 1/4 percentage point. The rise in the dollar and
decline in foreign growth reduced demand for American exports, as well as profits and
investment at U.S. firms, which were also adversely affected by declines in the price of
oil. Over the twelve months ending in April, manufacturing output increased only 0.4
percent, while total industrial production, which also includes the drilling for, and
extraction of, oil and gas, fell 1.1 percent. Although the most recent indicators suggest
that weakness in investment and net exports has persisted into the current quarter, if the
easing in financial conditions since mid-February and the recent firmness in oil prices
were to continue, along with stabilization of the dollar, business investment and exporters
would benefit.
Risks to the Outlook
Of course, there are risks to the projection that future GDP growth will be strong
enough to deliver progress on inflation and employment. Most immediately, there is
important uncertainty surrounding the United Kingdom’s June 23 “Brexit” referendum on
whether to leave the European Union (EU). The International Monetary Fund has noted
that a vote in favor of Brexit could unsettle financial markets and create a period of
uncertainty while the relationship between the United Kingdom and the EU is
renegotiated. Although the economic effects of this uncertainty and the costs of adjusting
to altered trade and financial ties are difficult to quantify, we cannot rule out a significant
adverse reaction to such an outcome in the near term, such as a substantial jump in

-5financial risk premiums. Because international financial markets are tightly linked, an
adverse reaction in European financial markets could affect U.S. financial markets, and,
through them, real activity in the United States.
In addition, we should not dismiss the possible reemergence of risks surrounding
China and emerging market economies (EMEs) more broadly. In recent months, capital
outflows in China have moderated as pressures on the exchange rate have eased. Should
exchange rate pressures reemerge, we cannot rule out a recurrence of financial stress,
which would affect not only China but also other emerging markets that are linked to
China via supply chains or commodity exports and, ultimately, conditions here. China is
making a challenging transition from export- to domestic demand-led growth, and the
cost of reallocating resources from excess capacity sectors to more dynamic sectors could
further impair growth in the near term. While China has taken policy steps to limit the
extent of the slowdown, there is an evident tension in policy between reform and
stimulus, and the effect of the stimulus may already be waning. Vulnerabilities--such as
excess capacity, elevated corporate debt, and risks in the shadow banking sector--appear
to be building, and could pose continued risks over the medium term.
The fragility of the global economic environment is unlikely to resolve any time
soon. Growth in the advanced economies remains dependent on extraordinary
unconventional monetary policy accommodation, while conventional policy continues to
be constrained by the zero lower bound. Conventional policy, whose efficacy is more
tested and better understood than unconventional policies, can respond readily to upside
surprises to demand, but presently would be constrained in adjusting to downside

-6surprises. This asymmetry in the capability of policy effectively skews risks to the
outlook to the downside.
It also may amplify the sensitivity of exchange rates. Indeed, the evidence
suggests that over the past year, dollar exchange rate movements have become
considerably greater in response to U.S. monetary policy surprises than previously.4 The
evidence that the sensitivity of exchange rate movements has been elevated lately is
consistent with recent research suggesting that cross border financial transmission is
likely to be amplified at near-zero interest rates where the ability to provide additional
support through domestic channels in response to negative shocks may be viewed as
limited.5
In this environment, markets have become quite sensitive to the possibility of a
prolonged period of low growth, low inflation, and economic underperformance. One
possible example of this sensitivity is the current negative term premium for 10-year
Treasury notes, or the difference between the yield on the 10-year Treasury and expected
risk-free short rates over the next 10 years. Prior to the Great Recession, the term
premium was positive, as bond investors seem to have been most concerned about the
risk that inflation would be higher than expected. But since the Great Recession, the term
premium has been persistently negative, suggesting that investors have instead been
focused on the risk of prolonged lower-than-expected inflation in the context of low
growth and underperformance.6

4

Recent research by Federal Reserve staff suggests that over the past year, a surprise of 25 basis points in
the Federal Funds rate following FOMC announcements has triggered dollar appreciation of over 5 percent,
although the confidence interval is extremely large, and the coefficient has varied substantially over time,
including intervals when the relationship has been negative.
5
See Caballero, Farhi, and Gourinchas (2015).
6
See Chen, Engstrom, Grishchenko (2016). Another factor affecting the term premium is Federal Reserve
asset purchases. In addition, some have suggested the low term premium could reflect an “insurance”

-7Thus, while the easing in financial conditions since mid-February is very
welcome, it is important to recognize that some of the conditions underlying recent bouts
of turmoil largely remain in place, and an important reason for the fading of this
turbulence was the expectation of more gradual U.S. monetary policy tightening.7
Should an event trigger renewed fears about global growth or a reassessment of the
policy reaction function in the United States, turbulence could well return.
Policy Implications
On balance, recent developments have signaled continued progress toward our
goals. While signs of weakness in business investment and global demand remain,
consumption and residential investment have held firm, and the labor market has moved
closer to full employment. At the same time, the relative stabilization in the dollar and
oil prices in recent months has boosted somewhat the likelihood of a return to 2 percent
inflation over the medium term. However, the data on progress toward our inflation
objective are equivocal. Measures of underlying inflation have yet to convincingly signal
a move back to 2 percent, and inflation expectations appear low, as I noted earlier.
I want to emphasize that monetary policy is data dependent and is not on a preset
course. In this regard, I look forward to hearing the deliberations of the Committee.
Recognizing the data we have on hand for the second quarter is quite mixed and still
limited, and there is important near-term uncertainty, there would appear to be an
advantage to waiting until developments provide greater confidence. Prudent riskmanagement would suggest the risks from waiting until the totality of the data provides

value that investors attach to Treasury securities because the price of Treasuries would be expected to rise
if there are adverse shocks to the global economy.
7
For an estimate of the role of U.S. monetary policy in offsetting the recent tightening in financial
conditions, see Del Negro, Giannoni, and Smith (2016).

-8greater confidence in a rebound in domestic activity, and there is greater certainty
regarding the “Brexit” vote, seem lower than the risks associated with moving ahead of
these developments. This is especially true since the feedback loop through exchange
rate and financial market channels appears to be elevated. In light of this amplified
feedback loop, when conditions are appropriate for a policy move, it will be important
that it be understood that any subsequent moves would be conditioned on further
evidence confirming continued progress toward our objectives and not as inevitable steps
on a preset course.
Indeed, several factors suggest that the appropriate path to return monetary policy
to a neutral stance could turn out to be quite shallow and gradual in the medium term. In
particular, it appears likely that the medium-term neutral rate, or the real federal funds
rate consistent with the economy remaining at full employment and 2 percent inflation,
may be quite low. With productivity running very low, substantial overcapacity and
disinflationary pressures abroad, and less favorable demographics, the neutral rate may
be lower and today’s federal funds rate closer to neutral than previously anticipated.
Although we cannot observe the neutral rate directly, a variety of models suggests that it
is currently very low relative to historical norms. Earlier in the recovery it seemed likely
that the low level of the neutral rate was largely due to temporary factors, such as tight
credit, weak consumer confidence, and the loss in household wealth following the crisis.
However, with the recovery well into its seventh full year, credit in many markets is
widely available, while consumer confidence and household net worth are at high levels.

-9As a result, it appears more likely that much of the decline in the neutral rate is likely to
prove persistent, consistent with a variety of estimates.8
One likely explanation for this persistence is the sharp drop-off in potential output
growth since the Great Recession. From 1953 to 2003, potential output growth varied
between 3 and 4-1/2 percent, with one brief exception, according to the Congressional
Budget Office. Over the recovery, it has averaged only 1-1/4 percent. One contributor to
this decline has been a reduction in the labor force participation rate due to population
aging. Another has been a marked slowing in productivity growth. Over the six years
from the end of 2009 to the end of 2015, productivity grew only a little over 1/2 percent
per year, compared with average growth of 2-1/4 percent over the 50 years prior to the
Great Recession.9
The reasons for such a dramatic slowing in productivity growth are not clear.
Possible explanations include the fading of a one-time boost to productivity from
information technology in the late 1990s and early 2000s; the reduced movement of
resources from the least productive to the most productive firms, including new
businesses, perhaps due to greater financial constraints for new and small businesses; and
a delay between the introduction of new technologies, such as robotics, genetic
sequencing, and artificial intelligence, and their effect on new production processes and
products.10

8

See, for example, Laubach and Williams (2015); the estimates from the dynamic stochastic general
equilibrium models cited in Yellen (2015); the median estimated neutral rate from the Federal Reserve
Bank of New York’s most recent Survey of Market Participants (Federal Reserve Bank of New York,
2016); and Johannsen and Mertens (2016).
9
Since the end of 2007, the average annual gain in productivity has been 1.1 percent.
10
For more on the recent slowing in productivity growth and its possible causes, see Fernald (2014),
Decker and others (2014, 2016), and Zarutskie and Yang (forthcoming). For an investigation into whether
mismeasurement may be responsible for some of the slowing in productivity growth, see Byrne, Fernald,

- 10 To conclude, recent economic developments have been mixed, and important
downside risks remain. In this environment, prudent risk management implies there is a
benefit to waiting for additional data to provide confidence that domestic activity has
rebounded strongly and reassurance that near-term international events will not derail
progress toward our goals. In addition, because the depressed level of the neutral rate of
interest reflects forces that are likely to persist, the appropriate path of policy is likely to
remain shallow for several years.

and Reinsdorf (2016) and Syverson (2016). For an optimistic outlook on future productivity growth, see
Baily, Manyika, and Gupta (2013).

- 11 References
Baily, Martin Neil, James Manyika, and Shalabh Gupta (2013). “U.S. Productivity
Growth: An Optimistic Perspective,” International Productivity Monitor, no. 25,
pp. 3-12.
Byrne, David M., John G. Fernald, and Marshall B. Reinsdorf (2016). “Does the United
States Have a Productivity Slowdown or a Measurement Problem?” Brookings
Papers on Economic Activity, BPEA Conference Draft, March 10-11,
www.brookings.edu/~/media/projects/bpea/spring2016/byrneetal_productivitymeasurement_conferencedraft.pdf.
Caballero, Ricardo J., Emmanuel Farhi, and Pierre-Olivier Gourinchas (2015). “Global
Imbalances and Currency Wars at the ZLB,” NBER Working Paper Series 21670.
Cambridge, Mass.: National Bureau of Economic Research, October.
Chen, Andrew, Eric Engstrom, and Olesya Grishchenko (2016). “Has the Inflation Risk
Premium Fallen? Is It Now Negative?” FEDS Notes. Washington: Board of
Governors of the Federal Reserve System, April 4,
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Decker, Ryan A., John Haltiwanger, Ron Jarmin, and Javier Miranda (2016). “The
Decline of High-Growth Entrepreneurship,” VoxEU.org. London: Centre for
Economic Policy Research, March 19, www.voxeu.org/article/decline-highgrowth-entrepreneurship.
-------- (2014). “The Role of Entrepreneurship in U.S. Job Creation and Economic
Dynamism,” Journal of Economic Perspectives, vol. 28 (Summer), pp. 3-24.
Del Negro, Marco, Marc Giannoni, and Micah Smith (2016). “The Macro Effects of the
Recent Swing in Financial Conditions,” Federal Reserve Bank of New York,
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Fernald, John (2014). “Productivity and Potential Output before, during, and after the
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Johannsen, Benjamin K., and Elmar Mertens (2016). “The Expected Real Interest Rate
in the Long Run: Time Series Evidence with the Effective Lower Bound,” FEDS

- 12 Notes. Washington: Board of Governors of the Federal Reserve System,
February 9, www.federalreserve.gov/econresdata/notes/feds-notes/2016/theexpected-real-interest-rate-in-the-long-run-time-series-evidence-with-theeffective-lower-bound-20160209.html.
Laubach, Thomas, and John C. Williams (2015). “Measuring the Natural Rate of Interest
Redux,” Working Paper Series 2015-16. San Francisco: Federal Reserve Bank of
San Francisco, October, www.frbsf.org/economic-research/files/wp2015-16.pdf.
Syverson, Chad (2016). “Challenges to Mismeasurement Explanations for the U.S.
Productivity Slowdown,” NBER Working Paper Series 21974. Cambridge,
Mass.: National Bureau of Economic Research, February.
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