With respect to inflation, as long as growth remains strong enough to lead to further improvement in labor market conditions – and this is an important caveat – I am becoming more confident that inflation will move up toward the FOMC’s 2 percent objective over the medium term. The firming of inflation that I anticipate reflects my expectation that resource utilization will increase and the fact that some of the factors that have pulled down inflation, such as lower oil and gas prices and a firmer dollar, have already stabilized or partially reversed. Putting this all together, I still think it is likely that conditions will be appropriate to begin monetary policy normalization later this year. But the likelihood and timing will depend on the economic outlook, and that will be largely shaped by the incoming economic data. When the FOMC begins to raise short-term interest rates, this will occur in a very different environment than in the past. Reserves in the banking system are very plentiful, reflecting the large increase in the Federal Reserve’s balance sheet over the past few years. But this circumstance should not adversely affect our ability to push the federal funds rate into a higher target range. We have the appropriate tools to push up short-term interest rates. However, lift-off may not go so smoothly in terms of the impact on financial asset prices. After all, lift-off will represent a regime shift after more than six years at the zero lower bound.
As always, what I have to say today reflects my own views and not necessarily those of the FOMC or the Federal Reserve System. 1 The economic outlook Turning first to the economic outlook, the real GDP growth rate appears to have slowed sharply during the first half of 2015. Based on the revision we received last week, firstquarter real GDP fell by 0.7 percent at an annualized rate. Although most projections anticipate a pickup in growth to around 2 percent or slightly higher in the current quarter, there is little question that economic growth has slowed significantly from last year’s secondhalf pace. What’s going on? Why has growth slowed and what does this portend for the remainder of the year? As I see it, the contraction in GDP growth in the first quarter represents a mix of factors. These include another unseasonably cold and snowy winter, a sharp contraction in oil and gas investment, a deterioration in the trade balance due – in large part – to the stronger dollar and sluggish foreign demand, and a slowdown in consumer spending growth after a very strong fourth quarter. After adjusting for weather effects, I think seasonal adjustment issues probably also played some role. For example, real defense spending has declined eight times in the past nine years in the first quarter, suggesting there is a seasonal adjustment issue. But I judge that this has had only a modest effect on measured real GDP growth.