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President's Speech
Presentation to the University of California at Berkeley Boalt School Alumni
(San Francisco, California)
By Janet L. Yellen, President and CEO of the Federal Reserve Bank
of
San Francisco
For delivery March 2, 2005, 6:05 PM Pacific Time, 9:05 PM Eastern
Prospects for the U.S. Economy
Good evening, and thanks for the warm welcome. I’m delighted
to be here. I plan to give you my thoughts on the prospects for the U.S.
economy and the implications for monetary policy. As always, my remarks
reflect my own views, and not necessarily those of others in the Federal
Reserve.
Let me start with a little background. When I set off to Washington
a decade
ago to become a Fed Governor, a friend gave me William Greider’s The
Secrets of the Temple to read. He thought it would be good preparation.
As the title of the book suggests, the Fed was not considered an open, transparent
or communicative
institution. Indeed, most central banks for centuries had cultivated the image
of being powerful and secretive.
The world has changed a lot since then. Several countries have now
followed the lead of New Zealand which, in 1990, became the first country
to adopt a
strategy
for conducting monetary policy known as inflation targeting. Inflation targeting
is a highly transparent regime in which a central bank publicly specifies
a numerical inflation objective—typically a range—and routinely issues
reports detailing its performance in meeting that objective. The central bank
must explain
the reasons for any deviations that occur. New Zealand went so far as to specify
that the Governor could be dismissed for failing to attain the target. The
Bank of England not only has a numerical inflation target but also gives explicit
probabilistic assessments of the odds of alternative outcomes via a series
of
so-called “fan charts.”
Perhaps one day the Fed will adopt an explicit
numerical inflation objective. It has not gone so far yet, but over the past
decade, the Federal Open Market
Committee has taken many steps to improve its communications with the public,
the markets, and the press, and thereby its transparency.
The rationale for
increased central bank transparency is highly practical—not
simply ideological. The more people understand about the goals of monetary
policy, and the Committee’s strategy to achieve them, the more
effective policy can be. One reason is because people’s expectations about future policy actions have a strong influence on today’s
longer-term interest rates and on financial conditions more generally—including
the value of assets like equities and the dollar. And it is these broader
financial conditions that influence
people’s and firms’ economic decisions and plans. If the Fed’s
only leverage were on the overnight federal funds rate governing lending
of deposits between financial institutions, it would have little effect
on the economy. Better
communication both strengthens and speeds the impact of the Fed’s
policy moves on the economy.
Improved understanding of the Fed’s
inflation objective can also serve to anchor inflationary expectations.
That gives the Fed more latitude to respond
to the adverse real economic impact of supply shocks, such as an increase
in the price of imported oil—without touching off an expectations-led,
destabilizing wage-price spiral. So, greater transparency can actually
lead to better economic
performance.
I’ll give you some examples of the steps the Fed has
taken toward greater transparency. During the Greenspan era it became
standard practice for the Committee
to release an explicit statement following the end of a meeting announcing
its policy actions. Before that, Fed watchers had to infer policy changes
from the
Fed’s behavior in the open market.
Over time, the amount of information
in that statement has also gradually increased. For example, the
Committee introduced language in 2000 describing
its assessment
of the balance of risks with respect to each of its objectives—price
stability and growth. Then, in 2003, the statements included explicit
discussions concerning
likely future policy actions. This was a controversial step. It was
taken because the Committee, probably for the first time since the
Great Depression, became
concerned about the risk of deflation and the fact that the federal
funds rate, at 1 percent, was about as low as it can go. Beginning
in August 2003, it sought
to condition market expectations about future policy with the explicit
statement that “policy accommodation can be maintained for
a considerable period.” This
strategy likely served to hold down long-term interest rates and
stimulate economic growth.
The most recent move toward increased transparency,
which began at
the end of last year, has been to speed up the release of the minutes
so
that they’re
available before the next meeting, rather than shortly after it.
This is significant because it gives the public more information
in assessing the Fed’s next
policy decision.
The minutes from the January meeting—released
a week ago Wednesday— reiterated the views in the Committee’s
statement after the meeting ended. It noted that, at present,
inflation and longer-term inflation expectations remain well-contained,
output appears to be growing at a moderate pace, and the risks
to price stability and sustainable growth for the next few quarters
are roughly equal. As a result,
policy accommodation most likely can be removed at a measured
pace.
But there are some big differences between the statement
and
the minutes. For example, the minutes provide a wealth of information
on the nuanced
views of
all 19 participants in the discussion—one sees the full
range of opinions in gory detail, rather than just the consensus.
In addition, the minutes for
the January meeting contain a discussion of a longer-term topic
the Committee considered—namely, the pros and cons of
formulating an explicit numerical definition
of the price stability objective of monetary policy. The pros
were basically the ones I already noted—a numerical objective
might anchor inflation expectations,
help with communication about likely future policy actions,
and also provide greater clarity for Committee deliberations.
The
cons were that it might appear
to be inconsistent with the Fed’s dual mandate of fostering
maximum sustainable employment as well as price stability and
that it might constrain policy at times.
It was a lively discussion that may be rejoined in the future.
Although I have some sympathy with the con arguments, on balance,
I generally favor increased
transparency and think the benefits of establishing a numerical
objective are likely to outweigh the costs.
Does this description entice you to want to read the minutes?
Well, before you run out to download your own copy, let me
be honest.
The text will
not rivet
you with an action-packed, blow-by-blow account of clashing
opinions. But it does lay out a range of issues—short-term,
medium-term,
and long-term—that the Committee is worried about. And that’s very fitting. After all, the
classic description of Fed officials, and of central bankers generally, is that
we’re people who are paid to worry about things.
U.S. economic prospects
With that bit of background, let me turn explicitly to my personal views
concerning the outlook for the U.S. economy—particularly the likely
evolution of output, employment, and inflation. Then I’ll spend
a little time going over some of the things that seem to me worth worrying
about. Before I begin, I’d like to emphasize that my assessment
of the outlook for the economy is quite consistent with the FOMC statement—that
the risks to moderate growth and price stability are both balanced.
First,
I’ll briefly review where we are in terms of the real economy
and inflation and how we got here. According to the National Bureau
of Economic Research, which is the semi-official arbiter of business
cycle
peaks and troughs, the U.S. economy has been expanding since November
2001. Last summer, however, there was widespread concern that the expansion
might falter. Consumer spending, which has been the mainstay of this
expansion, suddenly and substantially slowed. It seemed likely at the
time that energy prices were a culprit. Energy prices had increased
a lot, and that increase took a big bite out of consumers’ wallets.
It had the potential to noticeably depress spending on a wide range
of other goods and services. The hope was that the impact on spending
would
diminish over time and the growth rate of consumer spending would spring
back.
That is exactly what has happened. Consumer spending, and the
economy overall, have proven quite resilient. Investment spending
by businesses
has also picked up substantially. I now feel that we’ve seen
enough positive signs to be reasonably confident that the expansion
is self-sustaining.
Over the past year, output has grown at just under 4 percent, noticeably
above trend, which is estimated to be 3-1/4 to 3-1/2 percent. And recent
data show strength in business investment in equipment and software,
consumer spending, and housing.
In terms of the labor market, the expansion
began as a jobless recovery, but the data on job creation have been
consistently positive for most
of last year. Taking the average over all of 2004, the economy gained
181,000 jobs per month. In January it added another 146,000 jobs,
and the unemployment rate fell to 5.2 percent, reasonably close to common
estimates of “full employment.” Other indicators, however,
including the fraction of the population that is employed and measures
of job vacancies suggest that quite a bit more slack remains than
might be surmised from the unemployment rate. The record of job creation
during the past year is by no means spectacular, but it’s good
enough to suggest firming in the labor market and a gradual elimination
of remaining
slack. I would note that it takes a gain of about 125,000 to 140,000
jobs per month to match labor force growth, holding unemployment
constant.
Now, the outlook for inflation. The Committee tends to
focus more on core inflation—that
is inflation excluding volatile food and energy prices—and probably the
best measure of it is the personal consumption expenditures, or “PCE” price
index. This measure’s behavior over the last twelve months has
been generally quite reasonable—around the value I would endorse
as a numerical, long-run inflation objective if the Committee ever were
to adopt
one. It rose at 1-1/2
percent in 2004, up from just over 1 percent in 2003—a period in
which the Committee was worried that inflation might drop to a dangerously
low level.
The uptick this year probably reflects in part the pass-through of higher
prices for oil, commodities, and imports. Given that I think the economy
will continue
to grow modestly above trend and that inflation expectations will remain
stable, my expectation is that inflation in 2005 will be much as it was
in 2004. I’d
consider this an excellent outcome, and I see the risks to it as roughly
balanced.
Worries
But, as I said, my job is be a worrier, so now let me turn to
my list of worries—developments
or potential developments that could have an impact on economic activity
and inflation. My list won’t be exhaustive—I’ll keep
it to just five items, which are not in any particular order of concern.
They are: oil prices,
the trade gap, the saving rate, productivity, and fiscal policy.
Worry
#1—oil prices. As I said, consumer spending has been remarkably
resilient in the face of higher oil prices, but the evidence does
suggest that there was some negative impact on spending over the
past year
and oil prices
have again ratcheted up over $50 per barrel. In terms of inflation,
we have seen some modest upward pressure coming from higher oil prices
in the past
year. The key question is whether this upward pressure on inflation
will persist or intensify. The answer depends on at least two factors.
One, obviously, is
whether oil prices rise further. This is not what futures markets
are forecasting, but it is a notoriously tricky thing to predict.
The second
is whether the
effects on inflation today are changing people’s expectations about future inflation. As I indicated at the outset, if people begin
to expect higher inflation
because of the current impact of oil prices, we could face a kind
of scaled down version of the devastating wage-price spiral we lived
through
in the 1970s.
The good news is that evidence from financial market indicators,
surveys, and recent patterns of labor compensation all indicate that
long-term
inflation
expectations have been extremely stable. Presumably, this reflects
the market’s
view that the Fed will continue to demonstrate that it’s willing
to do what’s necessary to ensure U.S. price stability.
Worry
#2—the trade gap. This has risen from near balance
in the mid-1990s to a (nominal) deficit of almost $700 billion
now. By reducing the
need for domestic production of goods and services, the trade deficit
subtracted about
three quarters of a percentage point from real GDP growth in the
first half of this year. Whether the trade gap will narrow depends—in
part—on
the strength of economic growth among our trading partners, because
that affects demand for our exports. However, most of our major
trading partners have had
only moderate growth recently. So long as these conditions prevail,
they won’t
provide much impetus for growth in our own economy.
Of course,
prospects for the trade gap also depend on the prices of goods
produced in the U.S. versus those produced abroad. It’s
true that non-oil import prices have risen modestly over the past
year, while the prices of U.S. exports
have declined relative to foreign price levels. Such price shifts
do tend to curb imports and boost exports over time. But they’re
hardly enough to narrow the gap very quickly.
Worry #3—the
low saving rate. The personal saving rate has fallen over the
past decade from about 7 percent to under half a percent in the third
quarter
of this year. One reason that consumers are saving so little
out
of disposable income is that their wealth has been on the rise;
in the latter half of the
1990s, rising stock prices had a lot to do with the increase
in wealth, but more recently, the main impetus has been house price
appreciation. With interest
rates rising now and housing prices unlikely to continuing advancing
at their recent robust pace, consumers will need to curtail their
spending to keep wealth
growing in line with income. In other words, the saving rate
might rise to more normal levels. If this happens, the falloff in spending
growth by consumers
could have a significant effect on overall economic activity.
Worry
#4—productivity growth. The concern here is that some
recent developments hint at a slowdown in productivity growth.
Slower
productivity growth would
have negative consequences for economic activity and would
boost inflation because less rapid productivity growth translates into
more rapid increases
in firms’ production costs. One development hinting at
slower productivity growth is the recent moderation in the
pace of price declines for high-tech
goods. This could imply that technological progress is slowing
to some extent. Another is the productivity data themselves.
Until recently, the productivity
news was exceptionally good. Since the middle of the 1990s,
the U.S. has been enjoying strong productivity growth. In the
latter
half of that decade, the
pace of productivity growth was around 2-1/2%, a speedup of
about 1% relative to the 1973-1990 period. It is now recognized
that
that speedup was a key reason
why unemployment was able to drift so low without igniting
inflationary pressures—quite
the contrary, inflation fell. Beginning in 2001, productivity
grew even faster—at
an amazing 4% rate.
The very recent data have not been as good.
In the last half of 2004, productivity growth slowed sharply—averaging
less than 2 percent in the third and fourth quarters. Though
these numbers seem to confirm suspicions of a slowdown,
I’d have to say I’m not convinced on several
counts. One is simply that productivity data are very typically
quite
volatile, so you just can’t
make that much out of the performance over a few quarters.
Second, the concern is not whether productivity growth will
remain at that amazing 4% rate—in
fact, few economists would expect to see that. Rather, the
issue is whether productivity growth will remain at the current
estimate of its trend rate,
which, according to several leading experts, is around 2-1/2%.
If it does, that would be very good news indeed. It would
support robust output growth
and help keep inflation well-contained.
My view is fairly
optimistic. I think there is some evidence that the economy
is continuing to reap productivity gains
from much
of the investment
firms
and people already have made. These reasons are laid out
in a growing literature on technology and productivity, much
of
which
focuses
on the significant
lag that often exists between the time that firms invest
in technological capital
and the time they benefit from greater output and higher
productivity. What takes time is the human element. People
need time to learn
how to get the
most out of the technology they have. For example, one of
our contacts at the Fed—a
lawyer!—told us that his firm had recently discovered
they could use search engines, rather than lawyers and paralegals,
to look for incriminating
evidence in emails. Beyond developing proficiency, people
also need time to figure out how to reorganize their work
processes to maximize the benefits
of the technology they have. For example, Sam Walton argued
that he benefited in the 1980s and 1990s from knowledge he
had accumulated in the 1960s and 1970s,
when he flew around the country visiting competing discount
stores and attending IBM conferences. These anecdotes and
analyses suggest to me that this learning
and reorganization is still ongoing and is likely to play
out for a good while, providing a continuing boost to productivity
growth.
Worry #5—fiscal policy. Fiscal policy has been very
stimulative in recent years—we’ve had two large
tax cut packages and an increase in spending on defense,
Iraq, Afghanistan, and homeland security. In principle, it
is appropriate
for fiscal policy to stimulate demand during a recession,
when private sector spending is sluggish. However, the policy
went well beyond these desirable
countercyclical effects. The tax cuts have mushroomed the
deficit for the long term at a time when the baby-boomers
are becoming golden-agers and when the
costs of retirement programs are set to soar. In fact, Social
Security, Medicare and Medicaid are projected to rise dramatically
as fractions of GDP over the
next several decades. Currently projected budget deficits
are unsustainable and will ensure a low level of national
saving. Conventional economic analysis
suggest that this situation is likely to raise long-term
interest rates, crowd-out business capital investment, depress
productivity growth, and exacerbate the
current account deficit.
Monetary Policy
I’ll conclude with just a few thoughts on monetary policy. To
assess the stance of monetary policy, economists commonly compare the
inflation-adjusted
level of the federal funds rate to a benchmark rate called “neutral.” The
neutral real federal funds rate is defined as the rate
that would be consistent with full employment of the economy’s
labor and capital resources over the medium term. Efforts
to quantify this rate, via statistical techniques
or model-based simulations, take into account factors such
as productivity growth in the economy, the stance of the
fiscal policy, and the magnitude of
the trade deficit that conceptually affect this neutral
rate. Because these factors vary over time, the neutral
rate also tends to change over time. In
addition, I should emphasize that estimates of the neutral
rate are highly uncertain. That said, reasonable estimates
place the neutral real federal funds
rate in the range of 1.5 to 3.5%. With inflation now in
the vicinity of 1.5%, the associated value of the nominal
federal funds rate corresponding to “neutral” ranges
from 3 to 5 percent.
Judged from the perspective of a neutral
policy stance, monetary policy at present is accommodative.
At 2 ½ percent
in nominal terms (about 1% in real terms), the federal
funds rate remains below the lower bound of the
estimated neutral range. An accommodative monetary policy
stance is appropriate when there is excess slack in the
labor market—the current situation—or
when inflation is below desirable levels. In my judgment,
inflation is now at a level consistent with price stability.
With slack in the economy diminishing,
the degree of monetary accommodation also needs to diminish
over time, toward neutral, for inflation to remain well
contained. The Committee has stated for
some time that, with underlying inflation remaining low,
policy accommodation can be removed at a pace that is likely
to be measured. In fact, we have raised
the rate by 25 basis points at each of the last six meetings.
However, it should be obvious that the closer the actual
rate gets to the neutral range, the more
carefully the Committee will need to consider each successive
increase. In other words, the pace of removing policy accommodation
must, in reality, depend
on how economic activity and inflation actually develop.
Moreover, these developments themselves could affect the
Committee’s judgment concerning the momentum
in aggregate demand or supply and thus the real federal
funds rate corresponding to a neutral policy stance.
If
the pace of economic activity accelerates and labor
market slack erodes more quickly than expected—or if some
of the
upside risks
to inflation
materialize—it
would probably be appropriate to remove accommodation more
rapidly. If, alternatively, the expansion falters or we
experience some of the downside inflation risks,
there are likely to be more opportunities for the Committee
to pause. Policymakers could be confronted with more difficult
choices if output growth and inflation
move in opposite directions. Naturally, risks to both growth
and inflation abound. Nevertheless, I would reiterate that
at present, the economy appears
to be well positioned for healthy economic growth with
stable inflation going forward. The upside and downside
risks to both objectives appear to be roughly
balanced.
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Endnote
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