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For release on delivery
4:30 p.m. EDT
October 12, 2015

Economic Outlook and Monetary Policy

Remarks by
Lael Brainard
Member
Board of Governors of the Federal Reserve System
at
“North America’s Place in a Changing World Economy”
57th National Association for Business Economics Annual Meeting
Washington, D.C.

October 12, 2015

The will-they-or-won’t-they drumbeat has grown louder of late. To remove the
suspense, I do not intend to make any calendar-based statements here today. Rather, I
would like to give you a sense of the considerations that weigh on both sides of that
debate and lay out the case for watching and waiting.1
The Outlook
Domestic real activity has proven reassuringly resilient. Most notably, the labor
market has continued to improve this year, pushing the economy closer to full
employment. While monthly nonfarm payroll employment growth looks to have slowed
over the past three months to a 167,000 monthly pace, so far this year it has averaged
about 200,000. With these gains more than sufficient to absorb trend growth in the labor
force, they have led to gradual increases in resource utilization. At 5.1 percent in
September, the unemployment rate has declined ½ percentage point since December.
Alternative broader gauges of unemployment--which include individuals who are
marginally attached to the labor force and employees working part-time for economic
reasons--have also shown steady improvement this year.
Even so, a variety of evidence suggests there may be some distance to go to
achieve full employment. Although the unemployment rate is near longer-run norms,
other measures of labor utilization are not. The labor force participation rate remains
materially below the pre-recession trend, even after adjusting for demographics.2 And

1

These remarks represent my own views, which do not necessarily represent those of the Federal Reserve
Board or the Federal Open Market Committee.
2
Much of the decline in recent years is due to the aging of the baby boom cohort. But even holding
demographics constant, the participation rate is considerably lower now than before the recession,
suggesting it is cyclically depressed. Aaronson and others (2014) find that demographics can explain only
about half of the decline in the participation rate since the end of 2007.
Thus, it may be a while further before the participation rate fully reacts to the full amount of
improvement in labor market conditions that we have seen thus far, since wage growth has remained low,

-2the share of employees working part time for economic reasons remains a full percentage
point above the pre-recession level of around 3 percent, despite considerable recent
improvement. Even if there has been some trend increase in part-time work, it seems
unlikely to account for all of the difference between current levels and pre-recession
levels.3
Perhaps the most striking evidence in support of continued labor market slack is
the absence of any acceleration in wages and prices. Our main gauges of wage inflation
suggest that labor compensation is increasing at a pace of about 2 to 2-1/4 percent, little
different from the rate of increase over the past several years. Indeed, the lack of wage
acceleration is likely one of the key reasons that many Federal Open Market Committee
(FOMC) participants have revised down their estimates of the longer-run level of the
unemployment rate. Most recently, a majority of participants moved their estimates
below 5 percent.4 By comparison, in September 2012, the central tendency of estimates
of the longer-run unemployment rate ranged from 5.2 to 6.0 percent.
More broadly, domestic real activity appears likely to continue to grow at a
moderate pace. Domestic final sales, which exclude net exports and the volatile category
of inventory investment, increased at an annual rate of 2-3/4 percent in the first half of

and the decision to participate in the labor force may respond with a lag to cyclical improvements. See
Aaronson and others (2014) and Erceg and Levin (2014).
3
Changes in the structure of labor demand, such as a shift toward occupations or industries characterized
by flexible and part-time hours, may have led to an increase in the equilibrium level of part-time work. For
more on this issue, see Cajner and others (2014) and Valletta and van der List (2015). If workers combine
two or more part-time jobs to arrive at a full-time workweek, part-time employment could be elevated with
average weekly hours at normal levels. But the logistical costs of multiple job holding make such an
outcome unlikely, and in recent years elevated part-time employment has not coincided with an increase in
official estimates of multiple job holding.
4
See “Figure 3.B, Distribution of Participants’ Projections for the Unemployment Rate, 2015-18 and over
the Longer Run,” in the Summary of Economic Projections, addendum to the minutes of the September
2015 FOMC meeting, released on October 8, 2015, and available at
www.federalreserve.gov/monetarypolicy/files/fomcminutes20150917.pdf.

-3the year, and recent indicators suggest a similar pace in the second half. Perhaps most
notable, personal consumption expenditures are estimated to have increased at an annual
rate of a little over 3 percent in the three months ending in August, and auto sales moved
up to a strong 18.1 million unit annualized pace in September. Thus, even though equity
prices are down this year, continued job growth, lower gas prices, rising house prices and
some loosening in consumer credit look likely to support consumer spending over the
second half of the year.
Moreover, domestic investment also looks to be increasing at a moderate pace
despite the drag from the energy sector. New orders and shipments of nondefense capital
goods have turned up recently, pointing to positive equipment investment going forward,
and investment in nonresidential buildings looks to have risen noticeably in the middle of
the year. While investment in energy-related structures will likely move lower over the
second half of the year in response to the most recent step-down in oil prices, the decline
should be smaller than the sharp decline in the first half.
Importantly, recent data suggest that the gradual recovery in housing continues.
Single-family building permits were close to an annual rate of 700,000 units in August,
up nearly 5 percent from the fourth quarter of last year. The improvement in singlefamily housing is welcome after having been somewhat slow to materialize. Even so,
current levels remain below what would be suggested by fundamentals, such as
population growth.
While private consumption and investment thus appear to be on reassuringly solid
trajectories, growth in government expenditures on goods and services is likely to remain
tepid. Combined purchases at the federal, state, and local levels rose at an annual rate of

-4only 1-1/4 percent in the first half of the year, and modest growth in revenue at the state
and local level suggest continued limited gains going forward. In addition, spending
restrictions in the Budget Control Act and the winding down of defense spending related
to Afghanistan and Iraq have led to restraint at the federal level, although there is some
uncertainty on the federal budget outlook.
In contrast to the considerable progress in the labor market, progress on the
second leg of our dual mandate has been elusive. To be clear, I do not view the
improvement in the labor market as a sufficient statistic for judging the outlook for
inflation. A variety of econometric estimates would suggest that the classic Phillips
curve influence of resource utilization on inflation is, at best, very weak at the moment.
The fact that wages have not accelerated is significant, but more so as an indicator that
labor market slack is still present and that workers’ bargaining power likely remains
weak.
Overall inflation has been subdued, running persistently below our 2 percent
target. The personal consumption expenditures (PCE) price index increased only 0.3
percent over the 12 months ending in August. Much of the weakness in this index can be
explained by the drop in oil and energy prices over the past year. Assuming energy
prices stabilize going forward, as futures markets suggest, then energy should be a neutral
or perhaps even a small positive influence on inflation next year.
But inflation has been stubbornly low, even excluding energy prices. Over the 12
months ending in August, core PCE prices, which exclude the often volatile categories of
food and energy, increased 1.3 percent, and the 12-month change in core prices has been
around 1-1/4 to 1-1/2 percent since the beginning of 2013.

-5The persistence of the weakness in core price inflation deserves attention. For the
post-recession period as a whole, low levels of resource utilization surely accounted for a
substantial part of the weakness. But resource utilization has increased dramatically
since 2009, and core price inflation has remained quite low.
A sizable decline in import prices over the past year has also contributed. As a
result of the sharp increase in the dollar over the past year or so, prices for non-oil
imports fell at an annual rate of a little over 4 percent in the first half of the year and look
to decline a further 2 percent at an annual rate over the second half. Estimates suggest
the dollar’s rise will hold down core inflation between 1/4 and 1/2 percentage point this
year, restraint that would wane if the dollar stabilized going forward.
However, recent weakness is not completely explained by import prices. Services
prices excluding energy, which are generally relatively little affected by changes in the
dollar, have also shown no sign of acceleration in recent years. Instead, inflation in this
category has moved lower over the past year. In August, the 12-month change in nonenergy services prices was 2 percent, 1/4 percentage point lower than the pace of increase
from 2012 through the middle of 2014.
The outlook for inflation is critical for purposes of assessing progress toward our
2 percent goal, since monetary policy operates with a lag. In this regard, the gravitational
force of long-term inflation expectations is critically important. Although the story on
this front is mostly reassuring, it warrants monitoring. Projections from the Survey of
Professional Forecasters suggest that longer-run inflation expectations--which appear to
be most relevant for predicting future inflation--have remained at 2 percent since the end
of 2012. Household surveys, such as University of Michigan Surveys of Consumers,

-6suggest that households’ longer-run inflation expectations have remained in a narrow
range throughout the crisis and the recovery, although they have stayed in the lower end
of that range over the past year. In contrast, market-based measures of inflation
compensation, such as inflation swaps and the difference between nominal and inflationindexed Treasury bond yields, have declined noticeably over the past year and a half at
longer-term horizons. Of course, factors other than inflation expectations, such as
changes in liquidity premiums and inflation risk premiums, may be at play.
Although the balance of evidence thus suggests that long-term inflation
expectations are likely to have remained fairly steady, the risks to the near-term outlook
for inflation appear to be tilted to the downside, given the persistently low level of core
inflation and the recent decline in longer-run inflation compensation, as well as the
deflationary cross currents emanating from abroad--a subject to which I now turn.
Over the past 15 months, U.S. monetary policy deliberations have been taking
place against a backdrop of progressively gloomier projections of global demand. The
International Monetary Fund (IMF) has marked down 2015 emerging market and world
growth repeatedly since April 2014.
In the second half of 2014, persistently weak aggregate demand in Japan and the
Euro Area led to heightened deflationary pressures. The policy response to these
pressures and the anticipated divergence between the policy trajectory in these economies
and the United States contributed to a 10 percent appreciation in the dollar in inflationadjusted terms through the spring of this year, pushing down net exports and restraining
activity in the United States. Net exports subtracted nearly 1 percentage point from the

-7annual rate of U.S. gross domestic product (GDP) growth in the first part of the year, and
the most recent trade data suggest another substantial subtraction in the third quarter.
More recently, weakness in foreign demand has extended to emerging market
economies, which now account for about half of world output and have been an
important source of growth for more than the past decade. Growing recognition of this
weakness pushed the dollar up further to 15 percent above its level last summer, and has
contributed to a more general tightening of financial conditions in the past few months.
Much of the focus has been on China, whose large size and double-digit growth
rate put it at the center of a powerful global commodity super-cycle over the past decade.
Consequently, the challenges China faces today are raising questions about emerging
market growth prospects more broadly. Most immediately, China’s buildup of past
property, and more-recent stock market, bubbles together with a steep run-up in business
debt levels and questions about the policy stance and the outlook have raised concerns
about downside risks.
In weighing the implications for the U.S. outlook, it would be misleading to focus
narrowly on the direct effect of U.S.-Chinese bilateral trade alone. Many commodityexporting countries that have depended heavily on Chinese demand are adjusting with
difficulty to the recent sharp commodity price declines. After increasing at an average
rate of nearly 5-1/2 percent over the period from 2003 through 2011, GDP growth in
emerging market commodity exporters is projected to be only 3-1/2 percent this year.
Projected growth going forward has also been marked down materially. Moreover, more
developed economies, such as Mexico and Canada, our most important trading partners,

-8have also been affected, with Canadian GDP declining in the first two quarters of the
year.5
In addition, many non-commodity-producing East Asian economies are closely
tied to China through trade and investment. Because of these ties, and for other
idiosyncratic reasons, growth in East Asian economies has been weak so far this year.
Growth in emerging Asia economies outside of China that are important destinations of
U.S. exports slipped to 2-1/2 percent in the first half of the year, well below a trend rate
of close to 5 percent.
Downgrades to foreign growth affect the U.S. outlook through several channels.
First, weak growth abroad reduces demand for U.S. exports. Second, the expected
divergence in U.S. growth increases demand for U.S. assets, putting upward pressure on
the dollar, which, in turn, weighs on net exports. The estimated effect of dollar
appreciation on net exports has been shown to be substantial and to persist for several
years.6 Weak demand weighs on global commodity prices, which, together with the
effects on the dollar, restrains U.S. inflation. Finally, the anticipation of weaker global
growth can make market participants more attuned to downside risks, which can reduce
prices for risky assets, both abroad and in the United States--as we saw in late August-with attendant effects on consumption and investment.

For more detail on the recent experiences and likely prospects of commodity exporters, see “Where Are
Commodity Exporters Headed? Output Growth in the Aftermath of the Commodity Boom,” chapter 2 of
the International Monetary Fund’s (IMF, 2015) World Economic Outlook, available at
www.imf.org/external/pubs/ft/weo/2015/02/pdf/c2.pdf.
6
Looking across a broad set of countries, the IMF (2015) estimates that a 10 percent appreciation in the
real exchange rate will cause an eventual 1.5 percentage point reduction in the contribution of net exports
to real GDP, with effects lasting for several years (see chapter 3, “Exchange Rates and Trade Flows:
Disconnected?” available at www.imf.org/external/pubs/ft/weo/2015/02/pdf/c3.pdf).
5

-9Over the past year, a feedback loop has transmitted market expectations of policy
divergence between the United States and our major trade partners into financial
tightening in the U.S. through exchange rate and financial market channels. Thus, even
as liftoff is coming into clearer view ahead, by some estimates, the substantial financial
tightening that has already taken place has been comparable in its effect to the equivalent
of a couple of rate increases.
Looking ahead, one of the biggest sources of known uncertainty to the U.S.
outlook is whether this foreign weakness fades or intensifies. A plausible baseline
scenario might include a soft landing in China and growth in other emerging markets
moving gradually back up to underlying trends. Of course, it is possible that a recovery
in emerging market growth occurs sooner than in the baseline, such that the U.S economy
moves modestly more quickly toward our goals.
However, demand in emerging markets could also fall short of such a baseline.
China is only part-way through challenging economic adjustments and financial market
reforms, including reform of its exchange rate regime, debt deleveraging, and rebalancing
of its economy toward more consumer-driven growth. During this process, market
participants may have less accuracy in forecasting developments in China relative to
many other major economies due to less clarity regarding the macroeconomic data and
the policy framework. A more negative assessment of underlying Chinese growth
fundamentals or its exchange rate regime would likely affect other important economies
in the region, as well as commodity-producing economies, pushing global demand down
further. In turn, expectations of additional weakness in global demand could have

- 10 important effects on the exchange rate of the dollar, the valuation of risky assets in the
United States, and U.S. inflation, moving the economy further from our goals.

Policy Considerations
There is a risk that the intensification of international cross currents could weigh
more heavily on U.S. demand directly, or that the anticipation of a sharper divergence in
U.S. policy could impose restraint through additional tightening of financial conditions.
For these reasons, I view the risks to the economic outlook as tilted to the downside. The
downside risks make a strong case for continuing to carefully nurture the U.S. recovery-and argue against prematurely taking away the support that has been so critical to its
vitality.
These risks matter more than usual because the ability to provide additional
accommodation if downside risks materialize is, in practice, more constrained than the
ability to remove accommodation more rapidly if upside risks materialize. The
asymmetry in risk management stems from the combination of the likely low current
level of the neutral real interest rate and the effective lower bound. Let me take each in
turn.
First, casual empiricism would suggest that we are experiencing a period of
unusually low rates not only in the United States but also at the global level. Ten-year
sovereign bond yields in G-7 economies excluding Japan currently range from just above
1/2 percent to just above 2 percent--well below the average range of 4 1/2 to 5 percent in

- 11 the decade before the financial crisis.7 This observation receives substantial support from
a number of rigorous empirical papers over the past year that have estimated the longerrun equilibrium federal funds rate to be lower now than previously.8 The projection of a
relatively low neutral rate over the next few years also receives some weight in the
September 2015 Summary of Economic Projections. Most FOMC participants lowered
their estimate of the appropriate target level for the federal funds rate in the long run, and
a majority of participants now forecast a level no higher than 3.62 percent--down from
4.12 percent in September 2012.9 A lower equilibrium funds rate implies a higher
probability of policy being constrained by a lower bound for nominal interest rates.
Second, the ability of policymakers to react to unexpected shocks using
conventional tools remains highly asymmetric in the neighborhood of an effective lower
bound. From the perspective of risk management, in today’s circumstances, we have
considerably greater latitude to adjust the path of policy in response to inflation that
exceeds current forecasts than we have to provide additional accommodation in response
to additional adverse shocks.
Consider two possible scenarios. First, many observers have suggested that the
economy will soon begin to strain available resources without some monetary tightening.

7

In Japan, the level is currently around 0.3 percent, down from an average of 1.5 percent in the decade
before the crisis.
8
Building on the work of Laubach and Williams (2003), both Hamilton, Harris, Hatzius, and West (2015)
and Kiley (2015), for example, have recently constructed alternative estimates of the longer-run
equilibrium federal funds rate. While these papers differ in their estimates and acknowledge a considerable
amount of uncertainty, they all weigh in on the side of a relatively low equilibrium federal funds rate over
the next few years.
9
See “Figure 3.E, Distribution of Participants’ Judgments of the Midpoint of the Appropriate Target Range
for the Federal Funds Rate or the Appropriate Target Level for the Federal Funds Rate, 2015-18 and over
the Longer Run,” in the Summary of Economic Projections, addendum to the minutes of the September
2015 FOMC meeting, released October 8, 2015,
www.federalreserve.gov/monetarypolicy/files/fomcminutes20150917.pdf .

- 12 Because monetary policy acts with a lag, in this scenario, high rates of resource
utilization may lead to a large buildup of inflationary pressures, a rise in inflation
expectations and persistent inflation in excess of our 2 percent target. However, we have
well-tested tools to address such a situation and plenty of policy room in which to use
them. Moreover, the persistently deflationary international environment, the gradual
pace of increases in U.S. resource utilization, the estimated small effect of resource
utilization on inflation, the likely low level of neutral interest rates, and the persistence of
inflation below our 2 percent target suggests this risk remains modest. Financial markets
appear to agree, as five-year inflation compensation is well below 2 percent.
Now, take the alternative risk: that the underlying momentum of the domestic
economy is not strong enough to resist the deflationary pull of the international
environment. A further step-down in global demand growth and a further strengthening
in the dollar could increase the already sizable negative effect of the global environment
on U.S. demand, pushing U.S. growth back to, or below, potential. Progress toward full
employment and 2 percent inflation would stall or reverse. With limited ability to ease
policy, it would be more difficult to move the economy back on track.
Indeed, many central banks in advanced economies have tightened policy since
the financial crisis, prompted by improving domestic activity. In these cases, the
tightening was reversed as the outlook evolved. Given the current uncertainty, we should
put some weight on the risk of following this pattern. Indeed, market participants put the
probability of returning to the zero lower bound within two years of liftoff at 20 percent.10

See the July 2015 “Responses to Survey of Market Participants,” from the Federal Reserve Bank of New
York, available at http://www.newyorkfed.org/markets/survey/2015/mp-July-result.pdf.
10

- 13 To be fair, the past few years have demonstrated the capacity and will of central
banks in many jurisdictions to deploy unconventional monetary policy tools, including
quantitative and credit easing, forward guidance, and negative rates. That said, resorting
to such tools is not without costs and uncertainties.
We should not take the continued strength of domestic demand growth for
granted. Although the outlook for domestic demand is good, global forces are weighing
on net exports and inflation, and the risks from abroad appear tilted to the downside. Our
economy has made good progress toward full employment, but sluggish wage growth
suggests there is some room to go, and inflation has remained persistently below our
target. With equilibrium real interest rates likely to remain low for some time and policy
options that are more limited if conditions deteriorate than if they accelerate, riskmanagement considerations counsel a stance of waiting to see if the risks to the outlook
diminish.

- 14 References
Aaronson, Stephanie, Tomaz Cajner, Bruce Fallick, Felix Galbis-Reig, Christopher
Smith, and William Wascher (2014). “Labor Force Participation: Recent
Developments and Future Prospects,” Brookings Papers on Economic Activity
(Fall), pp. 197-275, www.brookings.edu/~/media/projects/bpea/fall2014/fall2014bpea_aaronson_et_al.pdf.
Cajner, Tomaz, Dennis Mawhirter, Christopher Nekarda, and David Ratner (2014).
“Why Is Involuntary Part-Time Work Elevated?” FEDS Notes. Washington:
Board of Governors of the Federal Reserve System, April 14,
www.federalreserve.gov/econresdata/notes/feds-notes/2014/why-is-involuntarypart-time-work-elevated-20140414.html.
Erceg, Christopher J., and Andrew T. Levin (2014). “Labor Force Participation and
Monetary Policy in the Wake of the Great Recession,” Journal of Money, Credit
and Banking, vol. 46 (October), pp. 3-49.
Hamilton, James D., Ethan S. Harris, Jan Hatzius, and Kenneth D. West (2015). “The
Equilibrium Real Funds Rate: Past, Present, and Future,” NBER Working Paper
Series 21476. Cambridge, Mass.: National Bureau of Economic Research,
August.
International Monetary Fund (2015). World Economic Outlook: Adjusting to Lower
Commodity Prices. Washington: IMF, October,
www.imf.org/external/pubs/ft/weo/2015/02/pdf/text.pdf.
Kiley, Michael T. (2015). “What Can the Data Tell Us about the Equilibrium Real
Interest Rate?” Finance and Economics Discussion Series 2015-077.
Washington: Board of Governors of the Federal Reserve System, August,
http://dx.doi.org/10.17016/FEDS.2015.077.
Laubach, Thomas, and John C. Williams (2003). “Measuring the Natural Rate of
Interest,” Review of Economics and Statistics, vol. 85 (4), pp. 1063-70.
Valletta, Rob, and Catherine van der List (2015). “Involuntary Part-Time Work: Here to
Stay?” FRBSF Economic Letter 2015-19. San Francisco: Federal Reserve Bank
of San Francisco, June, www.frbsf.org/economic-research/publications/economicletter/2015/june/involuntary-part-time-work-labor-market-slack-post-recessionunemployment.