Assuming that my reading of the data is correct and long-run inflation expectations are in fact anchored near their pre-recession levels, what implications does the preceding description of inflation dynamics have for the inflation outlook and for monetary policy?
This framework suggests, first, that much of the recent shortfall of inflation from our 2 percent objective is attributable to special factors whose effects are likely to prove transitory. As the solid black line in figure 8 indicates, PCE inflation has run noticeably below our 2 percent objective on average since 2008, with the shortfall approaching about 1 percentage point in both 2013 and 2014 and more than 1-1/2 percentage points this year. The stacked bars in the figure give the contributions of various factors to these deviations from 2 percent, computed using an estimated version of the simple inflation model I just discussed. As the solid blue portion of the bars shows, falling consumer energy prices explain about half of this year's shortfall and a sizable portion of the 2013 and 2014 shortfalls as well. Another important source of downward pressure this year has been a decline in import prices, the portion with orange checkerboard pattern, which is largely attributable to the 15 percent appreciation in the dollar's exchange value over the past year. In contrast, the restraint imposed by economic slack, the green dotted portion, has diminished steadily over time as the economy has recovered and is now estimated to be relatively modest.31 Finally, a similarly small portion of the current shortfall of inflation from 2 percent is explained by other factors (which include changes in food prices); importantly, the effects of these other factors are transitory and often switch sign from year to year.
Although an accounting exercise like this one is always imprecise and will depend on the specific model that is used, I think its basic message--that the current near-zero rate of inflation can mostly be attributed to the temporary effects of falling prices for energy and non-energy imports--is quite plausible. If so, the 12-month change in total PCE prices is likely to rebound to 1-1/2 percent or higher in 2016, barring a further substantial drop in crude oil prices and provided that the dollar does not appreciate noticeably further.
To be reasonably confident that inflation will return to 2 percent over the next few years, we need, in turn, to be reasonably confident that we will see continued solid economic growth and further gains in resource utilization, with longer-term inflation expectations remaining near their pre-recession level. Fortunately, prospects for the U.S. economy generally appear solid. Monthly payroll gains have averaged close to 210,000 since the start of the year and the overall economy has been expanding modestly faster than its productive potential. My colleagues and I, based on our most recent forecasts, anticipate that this pattern will continue and that labor market conditions will improve further as we head into 2016.
The labor market has achieved considerable progress over the past several years. Even so, further improvement in labor market conditions would be welcome because we are probably not yet all the way back to full employment. Although the unemployment rate may now be close to its longer-run normal level--which most FOMC participants now estimate is around 4.9 percent--this traditional metric of resource utilization almost certainly understates the actual amount of slack that currently exists: On a cyclically adjusted basis, the labor force participation rate remains low relative to its underlying trend, and an unusually large number of people are working part time but would prefer full-time employment. Consistent with this assessment is the slow pace at which hourly wages and compensation have been rising, which suggests that most firms still find it relatively easy to hire and retain employees.
Reducing slack along these other dimensions may involve a temporary decline in the unemployment rate somewhat below the level that is estimated to be consistent, in the longer run, with inflation stabilizing at 2 percent. For example, attracting discouraged workers back into the labor force may require a period of especially plentiful employment opportunities and strong hiring. Similarly, firms may be unwilling to restructure their operations to use more full-time workers until they encounter greater difficulty filling part-time positions. Beyond these considerations, a modest decline in the unemployment rate below its long-run level for a time would, by increasing resource utilization, also have the benefit of speeding the return to 2 percent inflation. Finally, albeit more speculatively, such an environment might help reverse some of the significant supply-side damage that appears to have occurred in recent years, thereby improving Americans' standard of living.
Consistent with the inflation framework I have outlined, the medians of the projections provided by FOMC participants at our recent meeting show inflation gradually moving back to 2 percent, accompanied by a temporary decline in unemployment slightly below the median estimate of the rate expected to prevail in the longer run. These projections embody two key judgments regarding the projected relationship between real activity and interest rates. First, the real federal funds rate is currently somewhat below the level that would be consistent with real GDP expanding in line with potential, which implies that the unemployment rate is likely to continue to fall in the absence of some tightening. Second, participants implicitly expect that the various headwinds to economic growth that I mentioned earlier will continue to fade, thereby boosting the economy's underlying strength. Combined, these two judgments imply that the real interest rate consistent with achieving and then maintaining full employment in the medium run should rise gradually over time. This expectation, coupled with inherent lags in the response of real activity and inflation to changes in monetary policy, are the key reasons that most of my colleagues and I anticipate that it will likely be appropriate to raise the target range for the federal funds rate sometime later this year and to continue boosting short-term rates at a gradual pace thereafter as the labor market improves further and inflation moves back to our 2 percent objective.
By itself, the precise timing of the first increase in our target for the federal funds rate should have only minor implications for financial conditions and the general economy. What matters for overall financial conditions is the entire trajectory of short-term interest rates that is anticipated by markets and the public. As I noted, most of my colleagues and I anticipate that economic conditions are likely to warrant raising short-term interest rates at a quite gradual pace over the next few years. It's important to emphasize, however, that both the timing of the first rate increase and any subsequent adjustments to our federal funds rate target will depend on how developments in the economy influence the Committee's outlook for progress toward maximum employment and 2 percent inflation.
The economic outlook, of course, is highly uncertain and it is conceivable, for example, that inflation could remain appreciably below our 2 percent target despite the apparent anchoring of inflation expectations. Here, Japan's recent history may be instructive: As shown in figure 9, survey measures of longer-term expected inflation in that country remained positive and stable even as that country experienced many years of persistent, mild deflation.34 The explanation for the persistent divergence between actual and expected inflation in Japan is not clear, but I believe that it illustrates a problem faced by all central banks: Economists' understanding of the dynamics of inflation is far from perfect. Reflecting that limited understanding, the predictions of our models often err, sometimes significantly so. Accordingly, inflation may rise more slowly or rapidly than the Committee currently anticipates; should such a development occur, we would need to adjust the stance of policy in response.
Considerable uncertainties also surround the outlook for economic activity. For example, we cannot be certain about the pace at which the headwinds still restraining the domestic economy will continue to fade. Moreover, net exports have served as a significant drag on growth over the past year and recent global economic and financial developments highlight the risk that a slowdown in foreign growth might restrain U.S. economic activity somewhat further. The Committee is monitoring developments abroad, but we do not currently anticipate that the effects of these recent developments on the U.S. economy will prove to be large enough to have a significant effect on the path for policy. That said, in response to surprises affecting the outlook for economic activity, as with those affecting inflation, the FOMC would need to adjust the stance of policy so that our actions remain consistent with inflation returning to our 2 percent objective over the medium term in the context of maximum employment.
Given the highly uncertain nature of the outlook, one might ask: Why not hold off raising the federal funds rate until the economy has reached full employment and inflation is actually back at 2 percent? The difficulty with this strategy is that monetary policy affects real activity and inflation with a substantial lag. If the FOMC were to delay the start of the policy normalization process for too long, we would likely end up having to tighten policy relatively abruptly to keep the economy from significantly overshooting both of our goals. Such an abrupt tightening would risk disrupting financial markets and perhaps even inadvertently push the economy into recession. In addition, continuing to hold short-term interest rates near zero well after real activity has returned to normal and headwinds have faded could encourage excessive leverage and other forms of inappropriate risk-taking that might undermine financial stability. For these reasons, the more prudent strategy is to begin tightening in a timely fashion and at a gradual pace, adjusting policy as needed in light of incoming data.
Conclusion
To conclude, let me emphasize that, following the dual mandate established by the Congress, the Federal Reserve is committed to the achievement of maximum employment and price stability. To this end, we have maintained a highly accommodative monetary policy since the financial crisis; that policy has fostered a marked improvement in labor market conditions and helped check undesirable disinflationary pressures. However, we have not yet fully attained our objectives under the dual mandate: Some slack remains in labor markets, and the effects of this slack and the influence of lower energy prices and past dollar appreciation have been significant factors keeping inflation below our goal. But I expect that inflation will return to 2 percent over the next few years as the temporary factors that are currently weighing on inflation wane, provided that economic growth continues to be strong enough to complete the return to maximum employment and long-run inflation expectations remain well anchored. Most FOMC participants, including myself, currently anticipate that achieving these conditions will likely entail an initial increase in the federal funds rate later this year, followed by a gradual pace of tightening thereafter. But if the economy surprises us, our judgments about appropriate monetary policy will change.
emphasis added
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