Global economic growth has slowed as European activity has stagnated and this is capping the demand for U.S. exports. On the brighter side, some of these headwinds appear to be subsiding. Employment growth has picked up somewhat (Figure 3), which should eventually lead to faster household formation and more demand for housing. U.S. banks are healthier so that credit conditions, while still tight, are gradually easing. And, households appear quite far along in the deleveraging process by a number of important measures. For example, the ratio of household debt service relative to income is back to levels last seen in early 1990s (Figure 4). For these reasons, I expect that growth will gradually strengthen over the next few years. Nevertheless, significant downside risks remain, especially those related to the challenges in Europe and how the potential “fiscal cliff” in the United States will be resolved after the fall elections. Even if these risks do not materialize, I anticipate only slow progress toward full employment. On the inflation side, in recent years our forecasts have been noticeably more accurate than on the growth side, and we have succeeded in delivering inflation very close to our 2 percent price stability objective. Through March, as measured by the personal consumption expenditures deflator, overall consumer prices have risen 2.1 percent over the past 12 months, and prices excluding food and energy have risen 2.0 percent (Figure 5). But price trends have been a bit stickier than one might have anticipated given the large amount of slack in the economy.
If private sector economic agents – workers, businesses, investors – thought we would implement a particular policy rule regardless of changes of these kinds, policy would not be effective at stabilizing private sector expectations in ways that promote the dual mandate objectives. This is particularly relevant in the unusual environment that we find ourselves in – the aftermath of a housing bust and a financial crisis. In the current context, there is an additional complication that is extremely important. Simple policy rules implicitly assume that monetary policy is unconstrained and that the Fed can always achieve the federal funds rate policy setting the rule proposes – even if it is negative. By extension, they also assume that it is as easy to ease policy as it is to tighten policy if certain risks materialize. In practice this is not the case. Because our traditional tool, the federal funds rate, is already at its effective zero lower bound, we may want to react differently to a given economic outlook and set of risks than we would if policy were unconstrained. We are certainly not completely constrained: we have additional tools such as the balance sheet and forward policy guidance that we can use to provide additional monetary policy stimulus. But these tools have costs as well as benefits. Moreover, we can only imperfectly translate the impact of these policy instruments into interest rate equivalents for the purposes of evaluation using simple rules.