By Richard H. Clarida
Current economic situation and outlook
In the second quarter of last year, the COVID-19 (coronavirus disease 2019) pandemic and the mitigation efforts put in place to contain it delivered the most severe blow to the US economy since the Great Depression, but economic activity rebounded sharply in the third quarter, supported by a robust and unprecedented fiscal and monetary policy response. More recently, the pace of recovery has moderated in part because of a winter resurgence in COVID-19 cases and hospitalizations.
A number of macroeconomic data releases have been weaker than expected in recent months. Spending on services has continued to remain well below pre-pandemic levels, particularly in contact-intensive sectors, including travel, leisure, and hospitality. The pace of improvement in the labor market has slowed notably in recent months. Although more than half of the 22 million jobs that were lost last spring have been regained, the unemployment rate remained elevated at 6.3 percent in January, and once one factors in the decline in the labor force since the onset of the pandemic and misclassification, the true unemployment rate is closer to 10 percent.
Core PCE (personal consumption expenditures) inflation is running at just 1.5 percent, and, for those sectors that have been most adversely affected by the pandemic, price increases remain subdued.
Of course, we have also received some encouraging data. Retail sales stepped up considerably in January, retracing the decline late last year. The housing sector has more than fully recovered from the downturn, supported in part by low mortgage interest rates. Business investment and manufacturing production have also rebounded robustly. And while the economy might not continue to grow at the once-in-a-century 33 percent annualized rate of growth reported in the third quarter of 2020, it is clear that the economy has turned out to be more resilient in adapting to the virus, and more responsive to monetary and fiscal policy support, than many predicted.
Indeed, it is worth highlighting that in the baseline projections of the Federal Open Market Committee (FOMC) presented in the latest Summary of Economic Projections, released last December, most of my colleagues and I revised up our outlooks for the economy over the medium term, projecting a relatively rapid return to levels of employment and inflation consistent with the Federal Reserve’s statutory mandate as compared with the recovery from the Global Financial Crisis (GFC).
In particular, the median FOMC participant projected in December that by the end of 2023—a little less than three years from now—the unemployment rate will have fallen below 4 percent, and PCE inflation will have returned to 2 percent. Following the GFC, it took more than eight years for employment and inflation to return to similar mandate-consistent levels.
While the winter surge in new COVID cases and the spread of new variants of the virus are cause for concern as well as a source of downside risk to the very near-term outlook, the welcome news on the development of several effective vaccines and the passage by the Congress in late December of a package of fiscal relief measures indicate to me that the prospects for the economy in 2021 and beyond have brightened and the downside risk to the outlook has diminished.
Recent FOMC decisions and the new monetary policy framework
At our most recent FOMC meetings, the Committee made important changes to our policy statement that upgraded our forward guidance about the future path of the federal funds rate and asset purchases, and that also provided unprecedented information about our policy reaction function. As announced in the September statement and reiterated in the following statements, with inflation running persistently below 2 percent, our policy will aim to achieve inflation outcomes that keep inflation expectations well anchored at our 2 percent longer-run goal.
We expect to maintain an accommodative stance of monetary policy until these outcomes—as well as our maximum-employment mandate are achieved. We also expect it will be appropriate to maintain the current target range for the federal funds rate at 0 to 1/4 percent until labor market conditions have reached levels consistent with the Committee’s assessments of maximum employment, until inflation has risen to 2 percent, and until inflation is on track to moderately exceed 2 percent for some time.
In addition, in the December statement, we combined our forward guidance for the federal funds rate with enhanced, outcome-based guidance about our asset purchases. We indicated that we will continue to increase our holdings of Treasury securities by at least $80 billion per month and our holdings of agency mortgage-backed securities by at least $40 billion per month until substantial further progress has been made toward our maximum-employment and price-stability goals.
The changes to the policy statement that we made over the past few FOMC meetings bring our policy guidance in line with the new framework outlined in the revised statement on longer-run goals and monetary policy strategy that the Committee approved last August. In our new framework, we acknowledge that policy decisions going forward will be based on the FOMC’s estimates of “shortfalls [emphasis added] of employment from its maximum level”—not “deviations.” This language means that going forward, a low unemployment rate, in and of itself, will not be sufficient to trigger a tightening of monetary policy absent any evidence from other indicators that inflation is at risk of moving above mandate-consistent levels.
With regard to our price-stability mandate, while the new statement maintains our definition that the longer-run goal for inflation is 2 percent, it elevates the importance—and the challenge—of keeping inflation expectations well anchored at 2 percent in a world in which an effective-lower-bound constraint is, in downturns, binding on the federal funds rate.
To this end, the new statement conveys the Committee’s judgment that, in order to anchor expectations at the 2 percent level consistent with price stability, it “seeks to achieve inflation that averages 2 percent over time,” and—in the same sentence—that therefore “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”
As chair Powell indicated in his Jackson Hole remarks, we think of our new framework as an evolution from “flexible inflation targeting” to “flexible average inflation targeting.” While this new framework represents a robust evolution in our monetary policy strategy, this strategy is in service to the dual-mandate goals of monetary policy assigned to the Federal Reserve by the Congress—maximum employment and price stability—which remain unchanged.
While our interest rate and balance sheet tools are providing powerful support to the economy and will continue to do so as the recovery progresses, it will take some time for economic activity and employment to return to levels that prevailed at the business cycle peak reached last February. We are committed to using our full range of tools to support the economy and to help ensure that the recovery from this difficult period will be as robust and rapid as possible.