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For release on delivery
6:00 p.m. EST
March 1, 2017

Transitions in the Outlook and Monetary Policy

Remarks by
Lael Brainard
Board of Governors of the Federal Reserve System
at the
John F. Kennedy School of Government
Harvard University
Cambridge, Massachusetts

March 1, 2017

The economy appears to be at a transition. We are closing in on full employment,
inflation is moving gradually toward our target, foreign growth is on more solid footing,
and risks to the outlook are as close to balanced as they have been in some time.
Assuming continued progress, it will likely be appropriate soon to remove additional
accommodation, continuing on a gradual path. 1
As normalization of the federal funds rate gets further under way, monetary
policy too is approaching a transition, prompting increased focus on the balance sheet.
How the federal funds rate and the balance sheet should be adjusted individually and in
combination depends on the degree to which they are substitutes, their relative precision,
and the degree to which their effects on the economy are well understood.
Let me start with the outlook and then turn to policy.
Progress at Home and Abroad
Over the past several quarters, we have seen improvement in inflation and activity
both at home and abroad following a period when the drag on domestic activity from
abroad was considerable. Between the middle of 2014 and 2016, a combination of
notable fragilities and risks in large foreign economies, elevated sensitivity of the dollar
to policy divergence, a sharp decline in oil prices, and financial markets’ heightened
sensitivity to these downside risks slowed progress in the U.S. economy and the
adjustment of monetary policy to an extent few had anticipated. After being an important
constraint in the past few years, the external environment currently appears more benign
than it has been for some time, even though risks remain.

I am grateful to Jim Clouse and Andrew Figura for their assistance in preparing this text.

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

-2Near-term risks to the United States from abroad appear to have diminished.
Recoveries are gaining traction in China, Europe, and Japan in part reflecting greater
confidence in their respective policy environments. The improvement in the global risk
outlook was also helped by the continued economic progress and the gradual pace of
monetary policy adjustment in the United States last year.
In recent quarters, market participants appear more confident that China has the
will and capacity to maintain its exchange rate regime, while achieving its growth targets,
although there is a tension with high credit growth that will eventually need to be
addressed. Early last year, China’s gross domestic product (GDP) growth, which had
averaged nearly 8 percent over the previous five years, was only a little above an annual
rate of 5 percent in the first quarter, according to official data, and many observers
believe that actual growth was weaker. Relatively large discrete declines in the renminbi
against the dollar and a surge in private-sector investment outflows led to considerable
volatility in foreign exchange markets and financial markets more broadly.
In response, Chinese authorities boosted the supply of credit, ramped up fiscal
stimulus, initiated new communications regarding the exchange rate, and clamped down
on capital outflows. These actions appear to have stabilized growth and calmed fears of
financial instability stemming from a sudden large devaluation in the renminbi. GDP
growth rebounded to an average annual pace of over 7 percent in the final three quarters
of the year. The exchange value of the renminbi has remained relatively constant against
the central bank’s designated basket of currencies, and it has depreciated against the
dollar at a more gradual pace. Capital outflows, while still significant, have moderated.

-3In Europe, the recovery has proven to be increasingly resilient. Monetary policy
has continued to provide crucial support. As a result, several challenges--including
referendums in the United Kingdom and Italy and liquidity and capital stresses faced by
German and Italian banks--have so far been navigated without significant damage to
growth, financial stability, or inflation expectations. Fiscal policy has ceased being a
drag on demand growth and, in some cases, has turned moderately expansionary. Overall
euro-area GDP increased at an annual rate of 1-3/4 percent last year, sufficiently in
excess of potential output growth to bring the unemployment rate down nearly 1
percentage point. Despite some instances of heightened volatility, financial markets have
functioned reasonably well, and risk spreads have stayed contained, although uncertainty
about upcoming elections has likely led to some increase in French and Italian sovereign
spreads in recent months. Fears of disinflation also appear to have abated: Measures of
inflation compensation based on 5-to-10-year-ahead inflation swaps, which fell to 1-1/4
percent in the middle of last year, have recently moved up to 1-3/4 percent.
Activity in Japan has also picked up recently, with GDP increasing 1-1/2 percent
last year--noticeably above the estimated rate of potential growth--and the unemployment
rate declining 1/4 percentage point to 3 percent, as monetary policy has remained
Of course, concerns regarding the medium to longer run remain. In China, the
price of near-term stability has been an increase in leverage, particularly in the corporate
sector. China’s overall debt-GDP ratio is elevated for an emerging market economy,
especially considering that Chinese growth is likely to slow noticeably in coming years.
In Japan, core consumer price inflation is close to zero--well below the central bank’s 2

-4percent target--and scope for additional monetary policy accommodation is limited,
leaving the economy vulnerable to adverse demand shocks. In the euro area, growth and
inflation may remain low for some time, which could pose challenges for banks with low
capital or high amounts of nonperforming loans and for highly-indebted sovereigns.
Political events in Europe also raise some uncertainty. Going forward, it will be
important to continue to monitor these and other foreign developments carefully.
Here at home, the economy is at a transition. The past few months have seen
continued progress in the labor market. Monthly gains in payroll employment have
maintained a pace sufficient to continue eroding labor market slack, and wage growth
appears to be moving higher on balance. Compensation per hour in the business sector,
the most comprehensive measure of wages, increased at a 3 percent pace the past two
years, noticeably above the pace earlier in the recovery.
We appear to be closing in on full employment. The unemployment rate--after
remaining relatively flat from the third quarter of 2015 to the third quarter of 2016--fell
1/4 percentage point last quarter to 4-3/4 percent. In addition, the labor force
participation rate has been about flat, on net, over the past 2-1/2 years, which indicates
considerable ongoing cyclical improvement, given the declining demographic trend.
Even so, there may be some room for further improvement. The prime-age employmentto-population ratio remains depressed relative to pre-crisis levels; the share of employees
working part time who would prefer full-time work remains elevated; and some measures
of wage growth, such as the employment cost index, have increased relatively little in
recent years.

-5Most recently, we are also seeing welcome signs of progress on the second leg of
our dual mandate after a protracted period of shortfalls from the FOMC target of 2
percent inflation. Recent months have seen a step-up in longer-run inflation
compensation, which had dropped to worrisomely low levels last year raising concerns
about a softening of inflation expectations to the downside. Both market- and some
survey-based measures of inflation expectations remain somewhat low, but there has
been some movement in the right direction in the past few months. Inflation has moved
up lately as the effect of past increases in the dollar and declines in energy prices have
faded. The 12-month change in headline personal consumption expenditures (PCE)
prices was 1.9 percent in January, although this partly reflects a temporary boost from
energy prices. Core PCE inflation--which strips out volatile food and energy prices and
is a good gauge of future inflation--has also increased. At 1.7 percent in January, the 12month change is 0.1 percentage point higher than a year ago. Still, core inflation has
been below our 2 percent target for almost all of the past eight years, and further progress
is necessary to reach and sustain our symmetric inflation goal.
Recent indicators of aggregate spending suggest we will continue to edge closer
to our goals in the months ahead. Consumption growth has been encouraging, supported
by continued job gains, rising wealth, and greater confidence. Business investment
changed little the past two years, but there are currently signs of renewed growth. The
contrast with the situation a year ago is sharp. Then, risk spreads on corporate bonds had
risen noticeably--often a precursor to downturns--measures of business sentiment were
relatively depressed, and corporate profits had declined over 10 percent. In recent
quarters, the environment has become more favorable. Risk spreads have moved back

-6down to more normal levels, business sentiment has rebounded, economic profits look to
have turned up, and new orders for capital goods are moving higher. The partial rebound
in oil prices has also given a boost to drilling activity. However, some crosscurrents
could weigh on aggregate demand this year. The recent increases in longer-term interest
rates could restrain housing activity as well as other interest-sensitive areas of demand,
and some further pickup in the dollar could weigh on net exports and business
Recent months have seen an increase in the upside risks to domestic demand.
Sentiment has increased along with equity prices, which are up around 10 percent since
October. Increased optimism could lead to faster growth in consumption and business
investment, although the spending data, thus far, do not suggest a noticeable acceleration.
Some of the increase in sentiment and changes in asset prices could be tied to
expectations of more expansive fiscal policy, another upside risk. In addition, the
progress that we have made over the past year, with the economy closer to meeting full
employment and inflation objectives, has contributed to the favorable shift in the balance
of risks. The increase in upside risks to domestic demand and the diminution of foreign
risks together suggest that risks to the outlook are more balanced today than they had
been for the preceding two years.
Nonetheless, the neutral real rate of interest--or the level of the real federal funds
rate that is consistent with output growing close to its potential rate with full employment
and stable inflation--is expected to remain low both in the near term and in the longer
run, and inflation is only slowly recovering from a protracted period of low levels. The
nominal neutral interest rate--which adjusts the real neutral rate for the level of inflation--

-7is likely to remain below its historical average even once it reaches its new longer-run
normal level. The lower rate environment means there will be less room to cut the
federal funds rate, so that if the economy experiences adverse shocks similar in severity
and frequency to those in the past the likelihood of returning to and operating near the
effective lower bound will remain elevated relative to historical experience. Prudent risk
management suggests that policy should take into account the asymmetry in risks posed
by the greater likelihood of the economy being at the effective lower bound, where
conventional policy is constrained.
What about the Balance Sheet?
Given the progress we have seen and the positive momentum in the incoming
data, continued gradual removal of accommodation is likely to be appropriate. But
unlike in previous tightening cycles, the Federal Open Market Committee currently has
two tools to remove accommodation: the balance sheet as well as the federal funds rate.
In December 2015, the Committee indicated that it would continue to reinvest
principal payments until normalization of the level of the federal funds rate is “well under
way.” 2 The decision to rely solely on the federal funds rate to remove accommodation
initially until normalization is well under way serves an important purpose, in my view. 3
With asymmetry in the scope for conventional monetary policy to respond to shocks,
there is a benefit to enabling the federal funds rate to rise more quickly than would be


See, for example, Board of Governors of the Federal Reserve System (2017), “Federal Reserve Issues
FOMC Statement,” press release, February 1, This approach is consistent
with the Committee’s Policy Normalization Principles and Plans, available on the Board’s website at
This is the rationale in Lael Brainard (2015), “Normalizing Monetary Policy When the Neutral Interest
Rate is Low,” speech delivered at the Stanford Institute for Economic Policy Research, Stanford, Calif.,
December 1,

-8possible with a shrinking balance sheet and sooner reach a level that allows for
significant reductions if economic conditions deteriorate. 4
Even so, recognizing that the median of the Committee projections places the
long-run value of the federal funds rate around 3 percent--a very low level by historical
standards--some could judge normalization to be well under way before too long. Thus,
monetary policy too may be approaching a transition.
Once the short-term rate is comfortably distant from its effective lower bound,
there are broadly two types of policy strategies that could be contemplated. Many central
banks around the world may contemplate similar choices in the coming years, while the
Bank of Japan has already grappled with these issues in the past. 5 One type of
“complementarity” strategy might actively deploy the balance sheet as an independent
second tool, complementary to the short-term rate. Under this strategy, both tools would
be actively used to help achieve the Committee’s goals. This strategy would seek to take
advantage of the ways in which the balance sheet might affect certain aspects of the
economy or financial markets differently than the short-term rate. Any differences in
effects might derive from the fact that the balance sheet more directly, though not
necessarily more precisely, affects term premiums on longer-term securities, while the
short-term rate more directly affects money-market rates.


The Bank of England has stated that it is unlikely that it will reduce the size of its balance sheet until the
Bank Rate has reached a level of around 2 percent; see Bank of England (2015), Inflation Report (London:
BOE, November), p. 34,
In 2006, the Bank of Japan reduced the size of its balance sheet by allowing short-term security holdings
to run off and without relying on asset sales; see Kazuo Ueda (2010), “The Bank of Japan’s Experience
with Non-Traditional Monetary Policy,” paper presented at “Revisiting Monetary Policy in a Low Inflation
Environment,” a conference held at the Federal Reserve Bank of Boston, October 16,

-9Although it may be tempting, in theory, to operate with the balance sheet as a
complementary, additional tool to the federal funds rate, we have virtually no experience
with how such an approach would work in practice away from the effective lower bound.
For that reason, one might instead prefer a “subordination” strategy that would prioritize
the federal funds rate as the sole active tool away from the effective lower bound,
effectively subordinating the balance sheet. Once federal funds normalization meets the
test of being well under way, triggering an end to the current reinvestment policy, the
balance sheet would be set on autopilot, shrinking in a gradual, predictable way until a
“new normal” has been reached, and then increasing in line with trend increases in the
demand for currency thereafter. 6 Under this strategy, the balance sheet might be used as
an active tool only if adverse shocks push the economy back to the effective lower bound.
The case for the subordination strategy is straightforward and compelling. This
strategy recognizes that the two policy tools are broadly similar in the ways they affect
the economy by indirectly changing the level of interest rates used to finance purchases
by households and businesses. These interest rate changes also have effects on asset
prices, and thereby on household wealth, as well as on the exchange value of the dollar
and, thereby, on net exports and core import prices. 7 However, relative to balance sheet
policies, the influence of the short-term rate is far better understood and extensively
tested: There have been several decades and many business cycles over which to
measure and analyze how the federal funds rate affects financial markets and real


The Committee has indicated that it intends to reduce the Federal Reserve’s securities holdings in a
gradual and predictable manner primarily by ceasing to reinvest repayments of principal on securities held
in the System Open Market Account; see Federal Open Market Committee, Policy Normalization
Principles and Plans, in note 2.
There may be differences in the specific ways changes in short-term rates and the balance sheet transmit
to different asset prices and the exchange rate, although estimates are limited and lack precision.

- 10 activity. In contrast, experience using the balance sheet as an active tool has been very
limited and largely confined to a highly unusual period around the Global Financial
Crisis, when short-term interest rates were constrained by the zero lower bound.
Predictability, parsimony, precision, and clarity of communications all would seem to
argue in favor of focusing policy on a single active tool that is most familiar. In short, it
makes sense to focus policy on the tool whose effects are better understood by both
policymakers and the public in circumstances where the tools are largely substitutes for
one another.
Even with this subordination strategy, however, there may be limited
circumstances in which the balance sheet might be employed in a manner that is
supportive of the short-term rate. Most obviously, during the period when the balance
sheet is running down, if the economy encounters adverse shocks, it may be appropriate
to commence the reinvestment of principal payments again in order to preserve
conventional policy space if the federal funds rate were to drop below some threshold
level, perhaps similar to the “well under way” threshold.
More broadly, although the two tools can achieve roughly similar effects, they are
different, and we cannot rule out that there may be special circumstances in which these
differences may be particularly valuable. In particular, these differences may be an
important consideration in circumstances when the transmission of changes in the shortterm rate to long-term rates and other financial market variables and the real economy is
impeded. In addition to directly affecting longer-term interest rates, changes to the
balance sheet could serve to reinforce policy communication associated with the shortterm rate. Some observers believe that such signaling was an important contributor to the

- 11 effect of the balance sheet on the economy during and after the Global Financial Crisis. 8
Thus, the subordination strategy will likely be appropriate in most circumstances, but we
cannot completely rule out special circumstances in which the complementary use of both
tools may prove compelling.
Assuming that a subordination strategy is adopted, and the balance sheet is set to
shrink passively and predictably once reinvestment ceases or is phased out, there is some
uncertainty around the size of the balance sheet when it returns to normal, which the
Committee has described as “no larger than necessary for the efficient and effective
implementation of monetary policy.”
There are good reasons to expect a normalized balance sheet to be considerably
smaller than its current size but larger than its pre-crisis level. Most obviously, trend
growth in the demand for currency gradually pushes up the size of the balance sheet over
time, but there are also other reasons to expect the post-crisis new normal to be larger
than pre-crisis levels. The structural demand for reserves may be considerably larger
now than prior to the financial crisis because of a number of changes, including new
regulations that favor safe liquid assets and changes in financial institutions’ attitudes
toward risk. 9 If the demand curve for reserve balances has shifted out, then a greater
supply of reserves will be needed to attain a given interest rate target. Moreover, the
supply of reserves will need to be set far enough above the structural level of demand to
accommodate unexpected shocks to the demand and supply of reserves. To accomplish


See, for example, Michael Woodford (2012), “Methods of Policy Accommodation at the Interest-Rate
Lower Bound,” paper presented at “The Changing Policy Landscape,” a symposium sponsored by the
Federal Reserve Bank of Kansas City, held in Jackson Hole, Wyo., August 30-September 1,
In addition, the Federal Reserve now remunerates reserve balances held by depository institutions.

- 12 this, the Committee could choose to implement policy by adjusting the supply of reserves
to offset such shocks. Or, the Committee could decide to maintain the current floor
system, in which a buffer of reserves, sufficient to accommodate any sizable shocks to
reserves demand and supply, is maintained, thereby obviating the need for highfrequency adjustments to the supply of reserves. The Committee’s normalization
principles suggest that any buffer would be the minimum amount needed to efficiently
and effectively implement policy. 10
Because of changes in structural and short-term factors since the crisis, it is
difficult to know with any precision how low reserves can be allowed to drop while still
maintaining effective interest rate control. Thus, as the balance sheet gradually declines,
it will be important to carefully monitor money markets for indications that any further
reduction in the supply of reserves will begin to put upward pressure on money market
rates. At that point, the amount of reserves will likely be close to the minimum amount
necessary to satisfy demand at the target rate. 11


For a discussion of floor systems and other frameworks for implementing monetary policy, see the
November FOMC minutes, available at Board of Governors of the Federal Reserve System (2016),
“Minutes of the Federal Open Market Committee, November 1-2, 2016,” press release, November 23,
Some experts have made financial stability arguments in favor of maintaining a level of reserves that is
somewhat larger than needed for monetary control alone. In the past, the demand for safe short-term assets
has sometimes been met by an increased supply of private-sector short-term debt, which has been
associated with increased leverage and maturity and liquidity transformation. Some argue that a greater
supply of safe short-term public debt could help prevent these potentially destabilizing developments from
occurring. See Robin Greenwood, Samuel G. Hanson, and Jeremy C. Stein (2016), “The Federal Reserve’s
Balance Sheet as a Financial-Stability Tool,” paper presented at “Designing Resilient Monetary Policy
Frameworks for the Future,” a symposium sponsored by the Federal Reserve Bank of Kansas City, held in
Jackson Hole, Wyo., August 25-27,; and Ben S. Bernanke (2017), “Shrinking the Fed’s Balance Sheet,” Ben Bernanke’s
Blog, January 26,

- 13 Conclusion
To conclude, recent developments suggest that the macro economy may be at a
transition. With full employment within reach, signs of progress on our inflation
mandate, and a favorable shift in the balance of risks at home and abroad, it will likely be
appropriate for the Committee to continue gradually removing monetary accommodation.
As the federal funds rate continues to move higher toward its expected longer-run level, a
transition in balance sheet policy will also be warranted. These transitions in the
economy and monetary policy are positive reflections of the fact that the economy is
gradually drawing closer to our policy goals. How the Committee should adjust the size
and composition of the balance sheet to accomplish its goals and what level the balance
sheet should be in normal times are important subjects that I look forward to discussing
with my colleagues.