FRBSF Economic Letter

2018-10 | April 9, 2018 | Research from the Federal Reserve Bank of San Francisco

Supporting Strong, Steady, and Sustainable Growth

John C. Williams

The U.S. economy is on course to be as strong as in many decades, and inflation is moving
closer to the Federal Reserve’s target. The challenge for monetary policy is to keep it that way.
While this is never an easy task, the Fed is well positioned to achieve its goals and respond to
unexpected developments. The following is adapted from a speech by the president and CEO
of the Federal Reserve Bank of San Francisco to the World Affairs Council of Sonoma in Santa
Rosa, CA, on April 6.

I’ve spent this year so far giving “good news” speeches; talking about the strong economy, the long
expansion, and robust job growth. And with good reason: We’re in the third – in fact, very soon to be the
second – longest economic expansion in American history. We added over two million jobs last year, the
unemployment rate is the lowest it’s been since 2000, and inflation is closing in on our 2 percent target.

The San Francisco Bay Area is a leading example of the growth we’re seeing across the country. Many of the
things that drive us crazy—bad traffic, sky-high housing costs, and sidewalks and streets blocked by
construction—are signs of a robust economy. It’s easy to blame the gridlock on 101 on all the techies flooding
the Bay Area. But it’s not just tech that’s powering the American economy—far from it. This healthy
expansion is taking place nationwide and across the full range of sectors. And it’s part of a global trend of
stronger-than-expected growth.

Today, I will continue to accentuate the positive and highlight the reasons I expect the economy will continue
to improve, reaching milestones that we haven’t seen in nearly 50 years. I’ll finish with my views on what this
means for monetary policy and how we can keep this economy, strong, resilient, and growing at a steady
pace.

What drives sustainable growth?

Last year real gross domestic product, or GDP, increased 2.6 percent. This is a solid performance.
Importantly, it’s above the trend growth rate, which I peg at about 1¾ percent.

I’m often asked what the trend growth rate is and how it differs from GDP growth. The trend growth rate is
the rate of growth that can be sustained by the economy over the long term. It has two main drivers: labor
force growth and productivity growth. With more people working, making things and using their income to
buy things, the more we can produce. Equally, if innovations in technology mean that companies can make
more state-of-the-art microprocessors in an hour than they could before, that will also contribute to higher
sustainable growth.

An important development of the past decade is that the trend growth rate today appears to be considerably
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slower than the growth trends we’ve previously seen in our lifetimes. This slower pace of growth is a
reflection of a sharp decline in labor force growth and relatively slow productivity growth (Fernald 2016).

What’s behind the decline in labor force growth? Two main things: First, the baby boomers are retiring in
droves, and second, the fertility rate in the United States has declined to a low level (Hamilton et al 2017).

And despite the rampant innovations we’re seeing around us, especially in the Bay Area—robots delivering
take-out, driverless cars, and Alexa in every living room—these aren’t yet translating into rapid gains in
productivity growth. To give some context, in the 1990s and early 2000s, annual productivity gains in the
United States averaged 2 to 3 percent. By contrast, productivity gains over the past decade have averaged
only about 1 percent per year.

Looking ahead, I expect growth to average around 2.5 percent over this year and next. Strong financial
conditions, better-than-expected global growth, and fiscal stimulus of lower taxes and higher spending have
all created tailwinds that account for growth running above trend.

Growth above trend doesn’t necessarily pose a particular risk at this time. But it’s one of the factors I’m
assessing when I’m thinking about how to best support economic growth over the medium term. In that
regard, a question I’m frequently hearing as the expansion closes in on nine years is: are we “due” for a
recession?

The short answer is no. Recessions don’t happen because a timer goes off. Research shows that the odds of
going into a recession are the same whether you’re in the seventh, eighth, or ninth year of the expansion
(Rudebusch 2016). Instead, recessions generally happen because of some big event: the housing crash of a
decade ago or the bursting of the dot-com bubble in the early 2000s. These kinds of events are notoriously
hard to predict, and the recessions that often follow don’t happen because the business cycle has a time limit
on it.

Given that the current pace of growth is above trend, my view is that we need to continue on the path of
raising interest rates. This will keep things on an even footing and reduce the risk of us getting to a point
where the economy could overheat, and create problems that could end badly.

Obviously, growth figures are the ones that many people are focused on. But as President of the San
Francisco Fed and a voting member on the Federal Open Market Committee (FOMC), I’m judged on what
happens to employment and inflation. The Federal Reserve has a dual mandate of maximum employment
and price stability, so my day job is about understanding what’s going on with those figures and then making
appropriate monetary policy recommendations.

Employment
When it comes to the maximum employment goal, we have made enormous strides and I see the labor
market continuing to improve. We added about 2.2 million jobs in 2017. That’s about twice the number
needed to keep pace with normal labor force growth (Bidder, Mahedy, and Valletta 2016). Based on the data
we’ve seen recently, we are set to add even more jobs to the economy this year.

With jobs growth being so robust, the unemployment rate has moved down to around 4 percent. Based on
my forecast for the economy, I expect the unemployment rate to continue to edge down to 3-1/2 percent by
next year. That would be the lowest rate of unemployment recorded in the United States since 1969. What’s

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happening in the nation as a whole is also happening here in California, where the unemployment rate is
already the lowest since 1969.

These low unemployment numbers have many people asking why we’re not seeing greater wage growth, but
that number actually has been slowly ratcheting up. And this is consistent with the reports I’ve been hearing
from business leaders for a while. As talent becomes increasingly scarce, they’re offering higher wages in a
bid to compete for employees. I expect this to intensify as the competition for workers gathers steam.

Inflation
Wage growth is the perfect segue to discuss inflation. Six years ago, the FOMC set itself the goal of 2 percent
inflation. Admittedly, since then, inflation has been running below that mark most of the time. This
underrun of our target reflects a number of influences. These include the weak economy following the
recession, a strong dollar that reduced the costs of imported goods and services, and some special factors
that had a temporary effect on prices in certain categories.

Inflation undershooting its target by a few tenths of a percentage point probably doesn’t sound that
concerning to most people. In fact, historically, high and rising inflation has acted as an alarm bell to warn
that the economy is on an unsustainable footing. But inflation that’s too low also poses a risk. Very low
inflation raises the possibility of deflation – that is, falling prices – which carries with it its own set of
problems for the economy. That’s why, as a policymaker, I’m keeping such a close eye on the behavior of
inflation, even when the economy is performing so well.

The good news is for most of the past year, inflation has been running closer to 2 percent. With the economy
strong, and strengthening further, I expect that we’ll see inflation reach and actually slightly exceed our
longer-run 2 percent goal for the next few years.

Monetary Policy
I began by describing a very positive economic outlook of strong growth, low and falling unemployment, and
inflation that is closing in on our 2 percent long-run goal. Against this background, the FOMC raised the
target range for the federal funds rate by ¼ percentage point at our most recent meeting (Board of
Governors 2018a).

We also indicated that we expect further gradual interest rate increases to be appropriate. In particular, our
recent projections indicate that the center of the distribution of FOMC projections foresees a total of three to
four rate increases this year and further gradual rate increases over the next two years, bringing the target
federal funds rate to around 3-1/2 percent by the end of 2020 (Board of Governors 2018b). In my view, this
is the right direction for monetary policy.

We are certainly not “due” for a recession, but it’s equally important we keep growth on a sustainable footing
to keep the strong economy going as long as possible. This gradual process of removing the monetary
stimulus put in during the recession is designed to keep the healthy expansion on track, maintain inflation
near our 2 percent goal, and to minimize the risk that the economy could overheat down the road.

Note that the rate increases we have put in place so far have not stalled the economy. In fact, the economy
continues to steam ahead. For that reason, I am confident that we can carry on the process of gradually
moving interest rates up over the next two years while seeing solid growth and historically low rates of
unemployment.

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That’s our plan. Of course, even the best-laid plans can go awry when the unexpected happens. Therefore, my
approach is to always follow the data very carefully and adjust my recommendations accordingly. If actual
growth is paltry, or if there are signs of an economy that’s overheating and inflationary pressures are
building too fast, then I’ll reevaluate my position and advocate for adjusting the path of rates accordingly.

To sum up: the outlook is very positive. The economy is on course to be as strong as we have seen in many
decades and inflation is moving closer to our target. The challenge for monetary policy is to keep it that way.
This is never an easy task, but we are well positioned to achieve our goals, and to respond to any unexpected
twists and turns that may lie in the economic road ahead.

John C. Williams is president and chief executive officer of the Federal Reserve Bank of San Francisco.

References
Bidder, Rhys, Tim Mahedy, and Rob Valletta. 2016. “Trend Job Growth: Where’s Normal?” FRBSF Economic Letter
2016-32 (October 24). https://www.frbsf.org/economic-research/publications/economic-letter/2016/october/trend-
job-growth-where-is-normal/
Board of Governors of the Federal Reserve System. 2018a. “Federal Reserve Issues FOMC Statement.” Press release,
March 21. https://www.federalreserve.gov/newsevents/pressreleases/monetary20180321a.htm

Board of Governors of the Federal Reserve System. 2018b. “FOMC Projections materials, accessible version.” March 21.
https://www.federalreserve.gov/monetarypolicy/fomcprojtabl20180321.htm

Fernald, John. 2016. “What Is the New Normal for U.S. Growth?” FRBSF Economic Letter 2016-30 (October 11).
http://www.frbsf.org/economic-research/publications/economic-letter/2016/october/new-normal-for-gdp-
growth/

Hamilton, Brady E., Joyce A. Martin, Michelle J.K. Osterman, Anne K. Driscoll, and Lauren M. Rossen. 2017. “Births:
Provisional Data for 2016.” Vital Statistics Rapid Release 2 (June), National Center for Health Statistics.
https://www.cdc.gov/nchs/data/vsrr/report002.pdf

Rudebusch, Glenn D. 2016. “Will the Economic Recovery Die of Old Age?” FRBSF Economic Letter 2016-03 (February
4). https://www.frbsf.org/economic-research/publications/economic-letter/2016/february/will-economic-
recovery-die-of-old-age/

Opinions expressed in FRBSF Economic Letter do not necessarily reflect the views of the management
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