Four big issues affecting world recovery

US monetary normalisation will be gradual and patient

While the US and the world have made good progress in recovering from the economic crisis, we still face a number of significant challenges. Many of these issues arise from four longer-term secular forces taking shape over the past few years. They are likely to exert even greater influence in the future.

First, through globalisation, the world has become much more interconnected. Major companies have become more global and have spread their operations throughout the world to serve customers and improve their competiveness.

Companies increasingly think about their labour, products and services with a global mindset. Economic conditions in one nation have a greater potential to impact economic conditions elsewhere, through trade in goods and services as well as through the labour market.  Financial markets have become much more interconnected. Market strains or other challenges in one market have the potential rapidly to affect currency, debt and equity markets globally.

A second major challenge is demographics. The US and other major economies, including Europe, Japan and China, are all facing aging populations. In the US as the baby-boomer generation moves into retirement age, the fraction of the labour force age 55 or older is projected to increase from around 23% in 2014 to almost 25% in 2024 and is expected to rise steadily through 2060.

In the euro area, the working age population, as a percentage of the total, has been declining since 1990. The absolute size of the working age population will decline in coming decades.  In the UK, the working age population is projected to grow, but at a slower pace than that of the total population. These demographic trends bear directly on the rates of workforce participation and, in turn, impact rates of potential economic growth in advanced economies.

A third important factor is rising debt to GDP levels in advanced economies. US household balance sheets have improved since the crisis but business debt to GDP is somewhat higher and government debt to GDP has increased too. While publicly held US government debt is around 75% of GDP, underfunded entitlements are estimated at more than $40tn.  These underfunded obligations will increasingly work their way into the annual budget deficit over the next five to 10 years. The rising entitlements burden, coupled with a higher political polarisation, has impaired capacity for recovery-enhancing fiscal policy action. This, in turn, has put substantial focus on the role of monetary policy to address important economic challenges for which it was neither designed nor intended to act in isolation.

Fourth, the rate of disruption in industry is increasing. Consumers increasingly are able to use technology to rapidly compare prices for goods and services. New business models are emerging which offer products and services in a superior manner to older models. These trends are encouraging companies to look for new ways to use technology to lower costs, improve productivity and enhance customer service. These changes are reducing the pricing power of companies, putting downward pressure on the prices of many types of goods and services. This, in turn, is affecting the way companies think about traditional capital spending and overall resource allocation, with significant implications for monetary as well as fiscal policy.

We must consider these four factors in looking at international economic conditions. One important issue is the oil market. Dallas Fed economists estimate that global daily oil production exceeds daily consumption by more than 1m barrels per day. However, global oil supply and demand will get into some degree of daily balance by early 2017. Production outside the Organisation of the Petroleum Exporting Countries is expected to decline significantly during the latter half of this year. This estimate is underpinned by our forecast that global demand will grow by around 1.2m bpd in 2016.

Against this background, estimates of US first quarter GDP growth have been disappointing. But based on strong consumer demand economists at the Dallas Fed expect growth will improve over the remainder of this year with growth of around 2% in 2016. This is sluggish by historical standards but should be sufficient to continue to drive down unemployment below the current 5%.

Labour market slack needs to be viewed in a global context. The US may be able to achieve lower unemployment than in the past, without creating near-term inflation pressures. The Dallas Fed’s trimmed mean PCE (personal consumption expenditures) measure of core inflation shows that, while headline inflation has been running well below the 2% objective, the 12-month change in the trimmed mean ranged consistently between 1.6 and 1.7% from early 2014 until the end of 2015. This measure has ticked up to between 1.8 and 1.9% in 2016. These readings give us confidence that headline inflation will ultimately increase toward our 2% objective over the medium term as we move toward full employment.

Excess capacity outside the US may dampen US inflation pressures at a given level of unemployment. We may still have capacity for healthy job growth without overheating the economy or unduly stressing the capacity of the US workforce.

From a risk management point of view, our monetary policies have an asymmetrical impact at or near the zero lower bound. Yet the effort to ‘normalise’ monetary policy is important; excessive accommodation has a cost in terms of creating distortions in investing, hiring and other decisions which can create unhealthy imbalances. These imbalances are often easier to recognise in hindsight and can be very painful to address. As the Fed continues to make progress in achieving its dual mandate combining both unemployment and inflation, I will advocate that we take actions to remove some amount of monetary accommodation, but in a gradual and patient manner.

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