On balance, I believe we have been making progress toward our goals, recognizing that a few issues still cloud the outlook. Most noteworthy is the fact that inflation continues to run well below our 2 percent objective. With respect to the economic growth outlook, the softness in third-quarter real GDP – which according to its initial estimate rose at only a 1.5 percent annualized pace – and the weakness of the manufacturing sector have raised concerns that the U.S. economy may be losing some forward momentum. Sharp reductions in oil and gas drilling activity and a loss of international competitiveness associated with the dollar’s appreciation over the past year have restrained factory output. Judging from historical experience, the impact of the dollar’s recent strength has the potential to be protracted, so that the trade sector probably will continue to be a drag on growth in 2016. Thus, the manufacturing sector is likely to continue to lag behind the rest of economy. But these negatives need to be set against the many positive aspects of the economic outlook. In particular, domestic demand continues to grow at a solid pace as increases in consumer spending, housing and business fixed investment all contributed to the third quarter’s 2.9 percent annualized gain in real domestic final sales. A large decline in the pace of inventory accumulation was the main reason why real GDP growth faltered in the third quarter.
First, the decline in these forward inflation compensation measures has been highly correlated with the fall in oil prices – a pattern that is hard to explain. Second, a careful analysis of the factors behind the decline in inflation compensation suggests that changes in liquidity risk premia and what investors are willing to pay for inflation protection account for most of the decline, rather than the decline reflecting a change in inflation expectations. Still, we need to continue to monitor inflation compensation closely, while recognizing that sorting out the allocation of the decline in inflation compensation across the three factors – liquidity risk premia, the price for inflation protection and inflation expectations – is admittedly difficult. And also, the conclusions reached in such models are sensitive to these models’ assumptions and structures. Regardless of how much signal one takes from these recent data, a decline in inflation expectations below levels consistent with our 2 percent inflation objective would be problematic because inflation expectations are an important influence on actual inflation. Businesses, for example, make decisions about the size of annual wage increases based, in part, on their expectations of future inflation. And, households base their spending decisions, in part, on how fast they expect their incomes to rise, and inflation expectations play a role in that process. Lower inflation expectations also raise the level of real interest rates, all else equal, which can undercut the power of monetary policy to support economic activity. This is particularly relevant at the zero lower bound for interest rates.