In thinking about the economic outlook, I try to stay focused on underlying fundamentals because they determine the outlook for the economy over the medium run, the time horizon over which monetary policy can affect the economy. In my view, the underlying fundamentals supporting the U.S. economic expansion remain sound. These include accommodative monetary policy, household balance sheets that have improved greatly since the recession, continued progress in the labor market, a more resilient banking system, and low oil prices. There are risks around all forecasts, but my modal forecast has been that over the next two years the U.S. economy will continue to expand at a pace slightly above its longer-run trend, which I estimate to be about 2 percent; that the unemployment rate will remain slightly under its longer-run level, which I estimate to be about 5 percent; and that inflation will continue to gradually return to the Federal Reserve's 2 percent target.

The second approach [to Fed policy], which I’ve been a little bit more inclined towards, is to say, "Gee, you know, it’s not clear what full employment is, we’re in a global environment which is not inflationary, and we can perhaps get some more employment and some higher wages"... Are we at a point where there’s an affirmative reason to move?

My own view is that overcapacity in non-U.S. economies must be considered along with domestic labor slack in assessing the implications of a given U.S. unemployment rate. In an increasingly globalized world, U.S. companies assess their employment decisions in a global context. As a result, I believe that the headline rate which constitutes “full employment” will likely be lower than the level to which we have historically been accustomed.

This brings me to the question of how to gauge what a healthy, full-employment labor market looks like. The most common metric is the “natural rate” of unemployment—the optimal rate we can expect in a fully functioning economy. Before the recession, it was generally thought to be around 5 percent... My assessment is that there has not been any lasting, significant shift in either direction. My estimate of the natural rate of unemployment today is 5 percent, consistent with pre-recession estimates. With the current rate at 5.1 percent, we are very close.

There has been a significant decline in the long-run neutral real interest rate in the United States over the past few years. This decline in the long-run neutral real interest rate increases the future likelihood that the FOMC will be unable to achieve its objectives because of financial instability or because of a binding lower bound on the nominal interest rate. Plausible economic models imply that the fiscal authority can mitigate this problem by issuing more public debt, although such issuance is not without cost. It is, of course, the province of the fiscal authority to determine whether those costs are worth the benefits that I’ve emphasized today.

An interesting implication of this demographic shift is that the unemployment rate should perhaps be lower at so-called “full employment.” Younger workers tend to have higher unemployment rates, since they are only beginning to acquire the skills needed by employers. Older workers tend to have very low unemployment rates if they remain in the workforce. As a result, the estimates of the unemployment rate at full employment need to consider whether changes in the demographic composition of the workforce have an impact. This is one reason why I personally have lowered my estimate of the natural rate of unemployment to 5 percent, and I believe it may need to be adjusted even lower if inflation continues to undershoot our forecasts.

BARTIROMO: Before we go in and looking back at what Janet Yellen said this week, let's look forward. We have a jobs number out next Friday. And, of course, we know that the unemployment story has been improving a bit. Where are the jobs in this country? Where is the growth in jobs from your standpoint?

WILLIAMS: Well, first of all, last year was remarkable. We added something like over 3 million jobs. So, we're in a really good place in terms of the improvement in the labor market that we've seen in the last year.

I expect this year -- we'd also see very good improvement in the labor market, continuing good momentum there. So, I think, you know, we still have a ways to go. Unemployment is 5.7 percent. We need to get closer to 5 percent to be at full employment. We made a lot of progress. And I think this is the year, we're going to reach full employment by the end of the year. That's my own forecast.

If one assumes that the unemployment rate will continue to fall at the same pace in 2016 as it is expected to fall in 2015, both forecasts would reach the Boston Fed’s 5.25 percent estimate of full employment around the middle of 2016. As I’ve said on many occasions, I personally do not expect that it will be appropriate to raise short-term rates until the U.S. economy is within one year of both achieving full employment and returning to within a narrow band around 2 percent inflation. Again, that is my personal view. And, if one were to also assume that tightening would begin roughly one year before reaching full employment and the 2 percent inflation target, then one could say that the primary dealers’ estimates of a rate rise bunched around mid-2015 seem roughly consistent with the forecasts for unemployment in Figure 2.

Yet the labor market’s journey is not yet complete – more progress needs to be made. My outlook is that as the expansion continues, firms will continue to add to their payrolls and the unemployment rate will continue to decline. I expect that by the end of next year, the unemployment rate will fall to around 5½ percent, which is what I view as the “natural rate,” or longer-run rate, of unemployment.

...

Putting all of this together, I expect growth over the next six quarters to be somewhat above my estimate of trend growth, which I put at around 2.5 percent. Of course, there is always a good deal of uncertainty around estimates of trend growth, perhaps even more so today in the aftermath of such a deep recession. I am a bit more optimistic than some about longer-run growth because while productivity growth has been running low, I think it is good to remember the experience of the 1990s. Back then, over a period of several years, many forecasters revised down trend growth estimates only to subsequently revise them up significantly in response to strong productivity growth.

...

One might ask whether that’s a reasonable inflation forecast given that we haven’t seen much acceleration in wages yet. I believe it is. Cleveland Fed analysis, based on several measures of wages and broader compensation, indicates that it is difficult to find a lead-lag relationship between wages and prices – the strongest correlations are contemporaneous ones, especially since the mid-1980s. We should expect wages to rise with prices, not necessarily lead prices. In my view, it would not be prudent for policymakers to simply wait for wages to accelerate before assessing the implications of the stance of monetary policy for future price inflation. Indeed, policymakers must always be forward looking.

As I said, employment has been growing at a good clip. In fact, the number of private-sector jobs is back above its pre-recession peak. Overall employment, which includes the public sector, will probably reach its previous peak in another month or so. But thats the number of jobs. In the interim, the population has been growing, bringing more potential workers into the fold. At the same time, the first round of baby boomers is headed into retirement, which means people being taken out of the labor pool.

Its hard to know precisely what the natural rate is, but I put it around 5 to 5 percent. To put things in perspective, the current unemployment rate of 6.3 percent is still well above the natural rate. My forecast is for the unemployment rate to gradually decline over the next two years, reaching the natural rate sometime in 2016.

One indication that unemployment is still higher than its natural rate is that growth in workers pay has been pretty modest. In fact, wage growth has averaged only about 2 percent over the past few years, and there are few signs of any acceleration in wages. That said, I expect that once the unemployment rate gets even closer to its natural rate, wage growth should pick up.

Personally, I expect that, over the long run, the unemployment rate will converge to just over 5 percent. Basically, an unemployment rate of 6.3 percent means that the U.S. labor market is not healthy

Recently, some economists have argued that the amount of slack in the labor market may be smaller than suggested by the official unemployment rate of 6.3 percent. They focus on the level of short-term unemployment—those workers unemployed for less than 27 weeks—which has returned close to its average long-term level—and argue that it is the short-term unemployed that are critical in driving compensation trends.
My own reading of this research suggests that one should not jump to such a conclusion. Instead, I conclude:
The relative impact of each type of unemployment on wages depends on whether long-term unemployment reflects primarily structural or cyclical force. I suspect that a much greater proportion of those who are currently long-term unemployed have simply been very unlucky compared to historical averages. This blunts somewhat the distinction between being short- versus long-term unemployed.
If the long-term unemployed are simply unlucky as opposed to not having the appropriate skills, then their impact on wages presumably depends on whether or not there is an excess supply of short-term unemployed. If there are plentiful short-term unemployed, they may get the best job opportunities first… But, once the short-term unemployed pool is depleted, then the long-term unemployed will become more relevant to the labor market supply, so their impact on wages and the labor market will likely increase as the labor market tightens.

With respect to the issue of short-term unemployment, I -- and its more relevant for inflation and a better measure of the labor market, I've seen research along those lines, I think it would be tremendously premature to adopt any notion that says that, that is an accurate read on either how inflation is determined or what constitutes slack in the labor market.

So I think this is something our committee will be looking at, especially as unemployment goes down and other labor market indicators hopefully simultaneously improve.

We'll be looking at a broad range of indicators. We're looking to see progress on many different mentions where we see slack in the economy, but I won't endorse -- I certainly don't think our committee would endorse the judgment of the research that you cited.

Consistent with these findings, my estimate of the current natural rate of unemployment is about 6 percent, roughly 2 percentage points below the current unemployment rate. This 6 percent figure is consistent with many other estimates, including the most recent median estimate of the Survey of Professional Forecasters.

Fortunately, many of the influences that have elevated the natural rate of unemployment since the crisis and recession should fade over time. In fact, this process is already under way. The extended unemployment insurance programs have been scaled back and are affecting fewer and fewer people. Eventually these programs will be phased out. In addition, measures of mismatch between workers and available jobs are receding. And, at least so far, we are not seeing permanent scarring effects of long-term unemployment. I expect that, in coming years, the natural rate will return to a more historically typical level of about 5½ percent.

Although we can’t know exactly what the natural rate of unemployment is at any point in time, a reasonable estimate is that it is currently a little over 6 percent. In other words, right now, an unemployment rate of about 6 percent would be consistent with the Fed’s goal of maximum employment.