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.

EISEN: Is the uncertainty what's holding back U.S. growth? How do we get out of this sub 2% or 2.5% level?

FISCHER: Well, technically we have to get something moving on productivity growth and that's not something we're good at doing. We don't know precisely how to do it. And we're all trying to find out whether what's going on is a long term change or a result of the cyclical situation. We'll get that right at some point. And when that changes, we'll go back to higher rates of growth. But it really turns on productivity. We've done everything we can and we've got achievements on employment. But productivity isn't going up and that's the remaining big factor in growth.

EISEN: if this is a long-term sort of secular story, stuck in low growth, as Yellen seemed to hint more so in her last news conference, what does the fed do about that?
FISCHER: Well, we can run as good a monetary policy as we like, but we will not have a direct influence on productivity growth. I mean, being more predictable, et cetera, will encourage more investment. But it isn't going to make an enormous change. People have to get more – we're looking for more investment to help get productivity going.

The slowdown in essentially all of these processes is seen in declining rates of creation and destruction of both firms and jobs.

Start-ups: Start-ups are a key driver of productivity growth. Although it may feel that we are living in an age of disruption, the birthrate of startups has actually been in decline since the 1970s. New firms can be loosely grouped into two categories: those started by "lifestyle entrepreneurs" who want to be their own boss, but who have little prospect or desire for high growth; and those founded by transformational entrepreneurs who start businesses that aspire to grow dramatically and change their industry. Before 2000, the decline in new firm entry was mainly in the first sort; since 2000, it is also found among the so-called transformational firms. While the drop in the formation of lifestyle-type firms could be neutral or even a positive for productivity, as in the case of the U.S. retail sector, the reduction in the creation of high-performance new firms suggests that lower dynamism could be associated with slower productivity growth.

Labor Market Dynamism: While changing jobs can be painful, job changes in the aggregate are associated with higher compensation, implying higher productivity. But the rewards to job change may have declined. Fewer start-ups has meant lower "job flows," as measured by job creation and destruction, and fewer opportunities for workers to find better jobs. And labor market dynamism across many dimensions has declined by more than can be explained by the reduction in startups. Workers have become less likely to leave their jobs, change jobs, or move geographically to take new jobs.

Dynamism is a relatively new field of inquiry, and there is no consensus yet on the reasons for, or implications of, these developments...

It may be that some government policies, while well intended, have contributed to these trends. One example that may explain a small portion of the reduction in dynamism is the substantial increase in occupational licensing. By some estimates, the fraction of workers who are required to hold a government issued license or certification to perform their jobs has risen from 5 percent in the 1950s to close to 40 percent. Like many policies, licensing has benefits and costs. Among the costs are that it tends to reduce job switching and employment opportunities for excluded workers, and may restrict competition and thus increase prices faced by consumers. Among the benefits may be higher quality products and services and improved health and safety standards. Some researchers have advanced the view that licensing requirements have become overly burdensome and may have contributed to the secular decline in job and worker reallocation.

Dynamism is a fast-developing field of research, and it will be important that public policy react appropriately as this work continues. It goes without saying that economic policymakers should use all available information and tools to create a supportive environment for growth. We need policies that support labor force participation and the development of skills, business hiring and investment, and productivity growth. For the most part, these policies are outside the remit of the Federal Reserve, but monetary policy can contribute by supporting a strong and durable expansion, in a context of price stability.

Re: Secular Stagnation

[A]lthough I am optimistic about the longer-run prospects for the U.S. economy, we cannot rule out the possibility expressed by some prominent economists that the slow productivity growth seen in recent years will continue into the future.  

One of the numbers in the Taylor Rule reflects Professor Taylor's estimate of what we sometimes refer to as the neutral level of the fed funds rate. 

It's a level of the fed funds rate that is consistent with the economy operating at full employment. And that's something that, by our estimate, has been very depressed in the aftermath of the financial crisis. Discussions about secular stagnation are very much about what is the level of interest rates that is consistent with the economy operating at full employment.

I'm hopeful that rate will rise over time, although I'm uncertain. But at the moment, most of the divergence between our settings and what would be the higher levels that would be called for merely reflect the headwinds facing the economy since the financial crisis.

[G]ross domestic product (GDP) growth over the two quarters ending in March 2016 is estimated to have averaged only 1 percent on an annualized basis. This estimate may continue to move around as more data come in. And there are good reasons to think that underlying growth is stronger than these recent readings suggest. Labor market data generally provide a better real-time signal of the underlying pace of economic activity. In addition, retail sales surged in April, as did consumer confidence in May, suggesting that the pause in consumption may have been transitory.
...
The tension between labor market and spending data is not a recent phenomenon. Throughout the recovery period, forecasters have consistently overestimated both actual and potential GDP growth while underestimating the rate of job creation and the pace of decline of the unemployment rate (table 1). For example, in 2007, the average expectation for long-run GDP growth from the Blue Chip survey of 50 forecasters was 2.9 percent (table 2). After successive reductions, the estimate now stands at 2.1 percent. Blue Chip forecasters also underestimated the decline in the unemployment rate. Other well-known forecasts followed this same pattern, including those of the Congressional Budget Office, the Survey of Professional Forecasters, and, yes, FOMC participants. The pattern suggests that forecasters have only gradually taken on board the decline in potential in the wake of the financial crisis.

I expect real GDP growth of about 2 percent in 2016, slightly below the average pace of growth in this expansion, but a bit above my estimate of the potential growth of the U.S. economy. If this materializes, then we should see some further reduction in the unemployment rate to around 4¾ percent—my estimate of the rate that I view as consistent with stable inflation over the long term.

Good monetary policy — meaning monetary policy that delivers on our price stability mandate — by virtue of it being good, will not affect long-term economic growth. Of course, it goes without saying that bad monetary policy can derail the economy and reduce economic growth.

Here's another way to put it: There is a growth potential out there, and the best that monetary policy can do is to help achieve that potential, but it cannot affect the potential itself. So, there are limits to the effectiveness of monetary policy that we must be careful to respect. In real time, it is always a challenge to determine if the economy is at its growth potential or if it is operating above or below it. This uncertainty is at the heart of the genuine disagreements that members of the FOMC can have regarding the stance of policy.

I continue to expect that the economy will expand at a pace slightly above its long-term trend in 2016...
Putting these positives and negatives together, the most likely outlook seems to be more of what we have experienced in this expansion—an economy that grows at slightly above a 2 percent annual rate this year.

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.

At the end of the day, it remains difficult to disentangle the cyclical from the structural slowdowns in labor force, investment, and productivity. Adding to this uncertainty, as research done at the Fed and elsewhere highlights, the distinction between cyclical and structural is not always clear cut and there are real risks that cyclical slumps can become structural; it may also be possible to reverse or prevent declines from becoming permanent through expansive macroeconomic policies. But three things are for sure: first, the rate of growth of productivity is critical to the growth of output per capita; second, the rate of growth of productivity at the frontiers of knowledge is especially difficult to predict; and third, it is unwise to underestimate human ingenuity.

The constant revision of estimates of potential output and thus of the output gap also underscore one of the difficulties policymakers have in trying to use gaps as a guide to policymaking in real time. Indeed, Athanasios Orphanides and Simon van Norden have argued that a major problem that gave rise to the great inflation of the 1970s was the mismeasurement of the perceived output gap. They explained how the Fed consistently relied on estimated output gaps that were subsequently revised and ended up being much smaller than initially thought. They argue that policymakers' reliance on estimated gaps led to overly expansionary monetary policy and the resulting high rates of inflation.

A different conceptual approach to defining a gap is implied by a class of economic models in wide use today the new Keynesian dynamic stochastic general equilibrium, or DSGE, models. DSGE models explicitly posit that firms have some pricing power; that is, there is imperfect competition so that a firm can choose to sell more of its output by lowering its price or to sell less of its output by raising its price, and the firm will set its price at a markup over marginal cost to maximize its profits. DSGE models also assume that firms are able to only adjust prices infrequently. This form of sticky prices, together with imperfect competition, allow monetary policy to have real effects in the short run, while remaining neutral for the real side of the economy in the long run. The sticky prices generate distortions that mean allocations and output can be inefficient in the face of shocks. In these models, the efficient level of output is the level of output that would prevail in the absence of the sticky prices and other market imperfections that allow deviations from perfect competition. In this framework, the relevant output gap to be addressed is the difference between the efficient level and that level generated by the distortion introduced by the sticky prices and market imperfections. The behavior of the efficient level of output is unlikely to be a smooth or a slowly evolving series like the CBO concept. In fact, it could be quite volatile and may bear little or no resemblance to the traditional concept of potential used by the CBO and others. Efficient output would be altered by changes in technology that affect productivity or changes in agents' preferences. The role of monetary policy in these models is to react to economic conditions in a way that minimizes the potential for distortions arising from the price stickiness or other market imperfections. The general policy prescription is to minimize the gap between output and the efficient level of output. In the absence of unexpected events that lead firms to change their desired markups over marginal cost, or other real rigidities like real wage rigidities, this would be equivalent to stabilizing inflation.

Although the Federal Reserve, like other forecasters, has tended to be overoptimistic in its forecasts of real GDP during this recovery, we have also, at times, been too pessimistic in our forecasts of the unemployment rate. For example, over the past year unemployment has declined notably more quickly than we or other forecasters expected, even as GDP growth was moderately lower than expected a year ago. This discrepancy reflects a number of factors, including declines in participation, but an important reason is the slow growth of productivity during this recovery; intuitively, when productivity gains are limited, firms need more workers even if demand is growing slowly. Disappointing productivity growth accordingly must be added to the list of reasons that economic growth has been slower than hoped.17 (Incidentally, the slow pace of productivity gains early in the recovery was not evident until well after the fact because of large data revisions--an illustration of the frustrations of real-time policymaking.) The reasons for weak productivity growth are not entirely clear: It may be a result of the severity of the financial crisis, for example, if tight credit conditions have inhibited innovation, productivity-improving investments, and the formation of new firms; or it may simply reflect slow growth in sales, which have led firms to use capital and labor less intensively, or even mismeasurement. Notably, productivity growth has also flagged in a number of foreign economies that were hard-hit by the financial crisis. Yet another possibility is weak productivity growth reflects longer-term trends largely unrelated to the recession. Obviously, the resolution of the productivity puzzle will be important in shaping our expectations for longer-term growth.

In the short run, it is possible that employment growth will be above 0.8 percent as we continue to recover from the recession. But we should also recognize some impediments to rapid employment growth. When the Affordable Care Act is fully implemented, it is likely to add to the cost of hiring an additional worker for many businesses, and firms are still trying to figure out just how costly that will be. Also, I've been struck by the large number of accounts I've heard recently about firms having difficulty finding workers with the appropriate skills, in many cases constraining production.


To summarize then, I think that in the short run, we are likely to see real GDP growth of 2 percent, or perhaps a bit higher. Over the longer run, we are likely to see growth average a bit below 2 percent.