There appears to be widespread confidence that the Federal Reserve will keep inflation low and stable, consistent with our announced inflation goal of 2 percent. Indeed, most forecasters view the current readings on inflation to be a temporary phenomenon and expect inflation to run at or a little below 2 percent over the next few years. Household surveys and financial market measures also indicate that inflation is expected to remain near its longer-term average. My own view is that the transitory factors depressing inflation are likely to ebb, and we’ll see inflation edge back toward the Federal Open Market Committee’s target of 2 percent by next year.

... Looking ahead, the key question regarding the economic outlook is whether growth will remain relatively low. Many forecasters expect growth to pick up to over 3 percent next year. I have become increasingly persuaded, however, that low growth rates are likely to persist for several years.

...the slow growth in real GDP in this expansion is related to both lower productivity growth and lower employment growth. While economists understand the principles underlying productivity growth, it’s quite difficult to parse the causes of medium-term swings in productivity growth, particularly as they are happening. At this juncture, low productivity growth has persisted long enough that I think the best guess is that it will remain low for an extended period.

What can policy, broadly speaking, do to foster growth, innovation, and job creation? At a high level, three things. First, policymakers can remove obstacles to growth—for example, uncertainty regarding the fiscal path of government, policies that discourage new business formation, and disincentives to invest. Second, and the mirror image of obstacles, is positive, pro-growth policies. Examples include investment in human capital and critical infrastructure.

And finally, there is a role for monetary policy. In my view, monetary policy can deliver appropriately favorable interest rate conditions, always in a context of low and stable inflation. Monetary policy plays a critical role in creating the most favorable conditions for other policy actions to do their work.

Given that the current inflation rate is quite low and is expected to stay low for several years, we have the flexibility to push for more improvement in labor markets than if inflation were not so subdued. My own personal assessment is that as long as inflation and inflation expectations are expected to remain well-behaved in the medium term, we should continue to forcefully pursue asset purchases at least until the national unemployment rate falls below 7.25 percent and then assess the situation.

I think of this number as a threshold, not as a trigger – and the distinction is important. I think of a trigger as a set of conditions that necessarily imply a change in policy. A threshold, unlike a trigger, does not necessarily precipitate a change in policy. Instead, I think of my proposed threshold as follows. Once the unemployment rate declines to this level, we would undertake a full assessment of labor market conditions and inflationary pressures to determine whether further asset purchases are consistent with the desired trajectory for reaching our inflation and unemployment mandates in the medium term. Thus, a threshold precipitates a discussion and a more thorough assessment of appropriate policy, versus a trigger which starts a change in policy.  As an example, suppose we reach one’s threshold unemployment rate but at that time the economy is slowing, and no further improvement in the unemployment rate is expected in the short to medium term. This hypothetical situation would not necessarily imply a change in policy stance, especially if inflation was projected to remain below target.

Let me say also that an unemployment rate of 7.25 sounds high, but achieving an unemployment rate of 7.25 percent would require real GDP growth of roughly 3 percent for a year. That would be growth that is a full percentage point faster than the economy’s so-called “potential” rate of growth, making this a challenge to achieve.

...

Despite the challenge to communicating in simple terms the likely exit strategy, I will say that my own preference would be to continue asset purchases until we had at least reached an unemployment rate of 7.25 percent, given the low rates of inflation we have been experiencing and are likely to be experiencing over the medium term – however, I will say again that this is a threshold, not a trigger. Assuming that inflation and inflation expectations remain well-behaved, at that point the discussion should center on whether overall labor market conditions are consistent with “substantial improvement” – for example, whether the lower unemployment rate reflects job creation rather than reductions in the labor force as discouraged workers stop seeking jobs; whether we are seeing sustained, robust payroll employment growth; and whether we envision continued substantial improvement in labor markets for some quarters to come. Under those conditions, I would stop asset purchases.

We are barely cruising above what we at the Dallas Fed call “stall speed.” Annual real gross domestic product (GDP) growth below 2 percent has predicated every recession since 1970. If we continue to barely clear the 2 percent hurdle, the pace of economic recovery will be insufficient to create the number of jobs the United States needs to bring down unemployment significantly in the foreseeable future. If we cannot generate enough new jobs to sufficiently absorb the labor force over the intermediate future, we cannot expect to grow the final demand needed to achieve more rapid economic growth.

I expect real GDP growth from fourth quarter to fourth quarter to be between 3 and 3½ percent this year and in 2011. These rates of growth are slightly above what I believe is the underlying trend growth rate of the economy of about 2¾ percent.

We can never directly observe the level of economic potential--it is largely inferred from the behavior of related variables, like output, productivity, costs and prices. In that regard, a widely discussed upside inflation risk is the possibility that as a result of the financial turmoil and deep recession, the extent of economic slack in the economy is not as great as is commonly estimated. One possibility is that the steep drop in investment has caused a decline in capital services that could damp the rise in productivity. Another possibility is that the needed reallocation of resources away from a number of sectors--including finance, construction, and motor vehicles--will have a restraining influence on potential output for a time. In addition, prolonged periods of unemployment could have adverse effects on the skills of workers and their attachment to the labor force.

The financial crisis may also have affected potential output by reducing the ability of financial markets to effectively lubricate the flow of credit throughout the economy--and to allocate capital resources to their most productive uses. The deterioration in the health of the financial system conceivably may have disrupted the credit allocation system enough to seriously impair the efficiency of business operations, and this impaired efficiency could show up at some point in more meager gains in productivity. And, some have argued, as governments seek to build more stable financial and economic systems, they may impede innovation and efficiency.

Each of these arguments contains a grain of truth, and they are worthy of further research. But in my view, the cumulative reduction in aggregate demand has been much greater than any possible cutback in potential supply. The unemployment rate has risen by 5 percentage points in a very short period, and capacity utilization in industry hovers just above its lowest level in the history of the series, dating back to 1948. The downward pressures on both prices and labor compensation reinforce my impression that our economy is operating well below its productive potential. And, if anything, productivity has been surprisingly strong, not weak, in recent quarters.

During 2009 the housing sector should finally bottom and the actions taken by the Federal Reserve and the Treasury will gradually help financial markets return to some semblance of normalcy. So I expect the economy will start to pick up in the second half of next year with a gradual return to growth close to its trend of 2.7 percent in 2010 and 2011.

[A]t the Chicago Fed, our current analysis of them suggests that sustainable growth currently is somewhere in the range of 2-1/2 percent per year. Most other analysts' estimates fall in the 2-1/4 to 3 percent range.

The ongoing housing correction and the volatility and uncertainty in the credit markets are significant near-term drags on the economy and I expect growth in the first half of the year to be quite weak, around 1 percent. As conditions in the housing and financial markets begin to stabilize, I expect growth to improve in the second half of the year and to move back to trend, which I estimate is around 2.7 percent, in 2009. Overall, I am now anticipating economic growth in 2008 of near 2 percent.  

Given the slowdown in economic growth this year, payroll employment will rise more slowly than last year and will remain below trend for much of the year before picking up in 2009. Slower job growth will also lead to an unemployment rate near 5-1/4 percent in 2008, after fluctuating between 4‑1/2 and 5 percent in 2007.  

To sum up the story on the outlook for real GDP growth, my own view is that, under appropriate monetary policy, the economy is still likely to achieve a relatively smooth adjustment path, with real GDP growth gradually returning to its roughly 2½ percent trend over the next year or so, and the unemployment rate rising only very gradually to just above its 4¾ percent sustainable level.    

In particular, we expect that later in 2008 economic growth will move close to its current potential, which we at the Chicago Fed see as being slightly above 2-1/2 percent per year.

I expect that overall real GDP will grow faster in the second half of 2008 as it returns to its longer-run trend of about 2-3/4 percent.

[O]ur baseline forecast sees soft economic activity this fall; notably, it is likely that a further sharp decline in residential investment will weigh on the top-line growth numbers. But we see growth recovering next year and moving up to average close to potential later in 2008, which we at the Chicago Fed currently see as being somewhat above 2-1/2 percent. This lower potential number in part reflects an assumed trend in productivity growth that is slower than the trend we experienced over the 1995-2003 period. Nonetheless, the new productivity trend is still a healthy one by longer-term historical standards and, accordingly, should support income creation, job growth, and household and business spending. Solid demand for our exports should also be a plus for growth. Although we expect a small increase in the unemployment rate, labor markets in general should remain healthy. Indeed, on balance, I would characterize the data we have received on the real economy since the last FOMC meeting as supporting our baseline forecast.

He also said he views trend growth in the economy as “close to 3%, maybe a little below.” He said he last lowered that view last summer when government revisions showed the government grew more slowly in prior years than previously thought.

As reported by the Wall Street Journal

I should say, however, that while 100,000 [net entrants to the labor force] per month appears to be the right benchmark for the next year or two, there is a lot of uncertainty about this benchmark, particularly in the longer run. Some of this uncertainty revolves around the participation of the baby boomers. People are living longer, healthier lives, which may allow baby boomers to work until they are older. Moreover, wages for all workers may change in response to these trends, convincing some to work more, and others to work less, than they would otherwise.

....Putting together our best estimates of the trends of labor force growth and productivity growth, we at the Chicago Fed think potential GDP growth is lower than it was five years ago, and currently is somewhat below 3 percent.