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President's Speech
Portland Community Leaders’ Luncheon
By Janet L. Yellen, President and CEO of the Federal Reserve Bank
of
San Francisco
July 29, 2005, 12:30 PM Pacific Time, 3:30 PM Eastern Time
Views on the Economy and Implications for Monetary Policy
Thank you for that very kind introduction. It’s a pleasure to
be here with you in this beautiful “City of Roses.” As a
monetary policymaker, my main concern is the national economy, and that
will be the chief focus of my remarks today. But as President of the
San Francisco Fed, I also pay close attention to developments here in
the Twelfth District, which, in many respects, mirror those of the nation.
Looking
at the big picture elements—growth, employment, and inflation—I’d
say things are in reasonably good shape. Over the past two years, the nation’s
output growth has been pretty steady, averaging just over four percent; this
is solidly above trend, which, by most estimates, is around three and a quarter
to three and a half percent. This growth has been amply in evidence here
in the Pacific Northwest. While unemployment rates in Oregon and Washington
remain
above the nation’s rate, your region has largely recovered from the
severe hit you took during the 2001 recession and its aftermath. As a result
of sustained
growth at the national level, slack in labor and product markets has trended
down. At 5.0 percent, the national unemployment rate now stands near conventional
estimates of the natural rate consistent with “full employment.” When
it comes to inflation, I focus on core measures, which exclude the volatile
food and energy components, to assess underlying trends. Two different measures
of core inflation have given slightly different signals in recent months:
one—the core CPI—is well within my comfort zone; the other—the core PCE—is
at the
upper end. However, I expect to see some moderation in inflation going forward.
Similarly, most forecasters expect the pace of economic activity also to
moderate toward trend-like growth. Given all this, it seems to me that the
economy is
on track to achieve price stability and “maximum employment”—the
dual goals assigned to monetary policy by the Federal Reserve Act—and that
we’ll likely continue to move in a positive direction over the next
couple of years.
This sounds like a rosy scenario and I realize that it ignores
all of the things that could go wrong. You might well ask, “What
about oil prices?” “What
about the record trade deficit?” “What about the possibility
of a housing bubble?” “What about the ‘conundrum’ of
surprisingly low long-term interest rates?” Well, indeed—what
about them? You would be right to ask. These questions touch on important
economic developments
that create risks for the positive scenario I just described. They therefore
receive serious attention at the policy table. From my perspective, trying
to assess such risks is what makes the conduct of monetary policy both
interesting and challenging.
Inflation risks
Let me start by looking at some of the factors that create risks for
the inflation outlook and explain why I’m nevertheless fairly
optimistic that inflation will moderate over the next few years.
Of course, oil prices do pose an inflation
risk. The price of oil has just about doubled over the past two years,
from the low $30 range to around $60 per barrel recently. Higher
oil prices are
reflected in higher “headline” inflation. And they have been
passed through to some extent to core inflation as well, but, unless
they rise further,
the effect on core inflation should begin to dissipate next year. Another
risk relates to labor compensation, which is the single largest component
of business
costs. Recently, one measure of compensation per hour jumped abruptly.
Here, too, though, I am not terribly worried because a good part of the
jump is probably
accounted for by one-time events, such as bonus payments and the exercising
of stock options. This interpretation is supported by readings from an
alternative measure of labor compensation, the Employment Cost Index,
which excludes these
items and has recorded only modest increases.
I’m also quite encouraged
by several developments that portend a moderation in inflation going
forward. For example, even with the recent revaluation of
the Chinese renminbi, the dollar has increased by 7½ percent
against major currencies so far this year, which should take some of
the pressure
off of import prices. In addition, inflation expectations, which may
affect wage
and price setting, appear to be edging lower: We see this both in survey
results and in the financial markets—through noticeable declines
in “inflation
compensation”, measured by the difference between the yields
on Treasury bonds with and without inflation protection. A third factor
is productivity
growth. There have been concerns that a structural productivity slowdown
was in the offing, which could put upward pressure on inflation; the
good news
is that structural productivity growth apparently still remains above
the levels reached during the second half of the 1990s, although it
may
have edged down
just a bit over the last few years.
A final factor impacting the inflation
outlook is the degree of slack in the labor market. Right now, the
unemployment rate is relatively
low: at
5 percent
it’s near most estimates of the so-called natural rate. But
other measures—such
as the employment-population ratio, a survey of job market perceptions,
and industrial capacity utilization—suggest that some slack
still remains.
Risks to economic growth and employment
Now let me turn to the real side of the economy—growth
and employment—and
highlight some of the risks that affect my optimistic baseline
projection. Even though overall growth has been respectable, economic
activity has been
burdened by some major drags over the past year or so. Three major
ones result from the oil price shock, the deterioration of the trade
balance, and a still
relatively low level of business investment spending.
As I mentioned,
the price of oil has just about doubled over the past two years.
Typically, the markets view oil price jumps as
temporary. But this
time around,
far-dated oil futures prices also have increased sharply, suggesting
that the high prices may be here to stay. This is a highly unusual
development. Most
likely, it reflects the perception that there is little excess
supply of
oil available in the world and that global demand is likely to
remain strong. The
perception that the oil price shock is more permanent tends to
intensify its negative effect on spending. Estimates suggest
that the oil price
shock has
noticeably restrained real GDP growth—by about three quarters
of a percentage point in 2005. This impact is certainly nontrivial.
However, it is worth emphasizing
that the recent price change and spending impacts are far smaller
than those of the oil shocks in the 1970s.
The U.S. trade deficit,
as we all know very well, has been growing rapidly for years.
By the end of last year, it topped five and
three-quarters percent of GDP, a new record. Two of the major
factors contributing
to
the sizable
imbalance between our imports and our exports are the strength
of the U.S. economy relative to our major trading partners
and the relative
strength
of the dollar. In 2004, the increase in the trade deficit—by
itself—subtracted
almost one percentage point from real GDP growth, representing
a significant drag on overall activity.
Finally, while business
investment in equipment and software rose strongly last year,
by almost 14 percent, the level of
investment is still not
as high relative to GDP as we’d expect, given favorable
economic conditions and firms’ healthy balance sheets.
Economic growth has been solid for a few years now. And,
with the very low level of interest rates, borrowing costs
can’t be the problem. Moreover, profit margins have
been high for some time, so firms are certainly not strapped
for
cash. The shortfall might be
due to business caution, perhaps related to reverberations
from 9/11 and subsequent terrorist threats and actions or
perhaps to the corporate governance scandals
and the adjustments required by the legislation that followed
them. Alternatively, the investment shortfall might reflect
the perception by businesses that productivity
gains can be realized at this stage that do not require major
new investments in equipment and software.
Whatever the explanation,
the consequence of these drags is that the Fed had to keep
interest rates exceptionally
low for
a long
time just
to get
respectable,
but not stellar, economic growth. In fact, the federal funds
rate was lowered all the way to 1 percent and held there
until the middle
of
last year.
Since then, the FOMC has raised the funds rate nine times
to 3¼ percent, but
it still remains in a range normally considered stimulative.
Bond
rate conundrum
Increases in the federal funds rate typically lead to increases
in longer-term interest rates. But, as we all know, long-term
rates have actually fallen
as the FOMC has raised short-term rates. For example, the
benchmark ten-year Treasury
rate is down by more than ½ percentage point since
the funds rate started heading up in the middle of last year.
This is the basis for what Chairman
Greenspan has called the bond rate “conundrum” that
has commanded so much attention recently.
There is a debate
about how to interpret the decline in longer term yields
and it essentially boils down to whether the
surprising behavior
of long
rates is due to various “special factors” operating
independently of the current business cycle or instead augurs
bad economic news on the horizon.
If special factors are holding down long term yields, then
the total amount of stimulus to spending from interest rates
is currently greater than would
be surmised on the basis of the current federal funds rate.
In effect, unusually low long-term bond rates are now providing
extra stimulus to offset the drags
I described. A number of “special factors” might
be at work to flatten the yield curve. One possibility is
that low bond rates reflect a drop
in risk premiums because inflation has become better anchored
and the volatility of the real economy has fallen. But let
me also note that other factors would
seem to work in the opposite direction—for example,
our large and growing federal budget and trade imbalances
could be raising risk premiums.
Another possibility is that
low long-term rates reflect unusually strong demand for long-term
securities, for example, by pension
funds seeking
to improve
the match between the durations of their assets and liabilities,
by holders of mortgage-backed securities seeking to maintain
the durations
of their
portfolios, or by foreign central banks that have been acquiring
dollars. China may have
been playing an especially large role, as its central bank
has intervened in foreign exchange markets to peg the renminbi
at
a low level against
the dollar.
Of course, last week the People’s Bank of China announced
that it had revalued the renminbi against the dollar by 2.1
percent, with the stated intention
of managing the renminbi’s exchange value against an
unspecified currency basket. This is not a large revaluation,
but some observers think that it is
the beginning of a much bigger move over time. If this is
the case, we may gain a better understanding of the impact,
if any, that Chinese exchange rate
policy has had on U.S. bond rates.
An alternative to “special
factors” as an explanation for the low
level of long-term yields is the possibility that the flat
yield curve reflects the market’s assessment that bad
news is on the horizon. In other words, investors may expect
only modest increases in the funds rate in the future
because they think that the drags I’ve described will
keep demand on the weak side for some time to come.
We probably
won’t know the most important sources of this “conundrum” until
more time passes, but the causes of the conundrum do matter
to monetary policy. If the first class of explanations turns
out to be correct, the federal funds
rate probably needs to be somewhat higher than would otherwise
be appropriate to offset the additional stimulus due to the
flat yield curve. If the latter
explanation fits the bill, and the market is correct that
the drags going forward will be unusually strong, a somewhat
easier policy may be appropriate.
Housing
Whatever the source of the conundrum, clearly low long-term
rates have contributed to the continuing boom in the housing
market.
The share
of residential investment
in GDP is now at its highest level in decades. The question
on everyone’s
mind, of course, is whether this source of strength in
the economy could reverse course and become instead a source
of weakness. Put more bluntly: Is there
a housing “bubble” that might collapse, and
if so, what would that mean for the economy? To begin to
answer this question, we need to know what
we mean by the term “bubble.” A bubble does
not just mean that prices are rising rapidly—it’s
more complicated than that. Instead, a bubble means that
the price of an asset—in this case, housing—is
significantly higher than its fundamental value.
One common
way of thinking about housing’s fundamental
value is to consider the ratio of housing prices to rents.
The price-to-rent ratio is equivalent
to the price-to-dividend ratio for stocks. In the case
of housing, rents reflect the flow of benefits obtained from
housing assets—either the monetary
return from rental property, or the value of living in
owner-occupied housing. Historically, the ratio for the nation
as a whole has had many ups and downs,
but over time it has tended to return to its long-run average.
Thus, when the price-to-rent ratio is high, housing prices
tend to grow more slowly or fall
for a time, and when the ratio is low, prices tend to rise
more rapidly. I want to emphasize, though, that this is a
loose relationship that can be counted
on only for rough guidance rather than a precise reading.
Currently,
the ratio for the country is higher than at any time since
data became available in 1970—about 25 percent above
its long-run average. Of course, the results vary widely
from place to place. For Los Angeles and
San Francisco, the price-to-rent ratio is about 40 percent
higher than the normal level, while for Cleveland the ratio
is very near its historical average.
Closer to home, the
figure for Seattle is just over 35. For Portland, it turns
out that the price-to-rent ratio
is a
bit anomalous.
Unlike the ratio
for the
nation and many of the cities I’ve mentioned, Portland’s
ratio has been trending up, and this pattern has been going
on since the late 1980s.
This means that there’s not a stable long-run average
ratio to use as a comparison for today’s ratio, so
the analysis we did for the other cities wouldn’t
be that meaningful for Portland. What we do know is that
the pace of home price appreciation in Portland has been
close to the national pace over the past few years, lagging
behind somewhat in 2003 as the state
struggled to recover from the 2001 recession, but mostly
catching up in 2004 and early 2005 as economic growth picked
up noticeably in the state. As of
early this year, home prices in the Portland area were
up 12 percent over a year earlier, only a bit below the
national pace of 12½ percent. More
recently, I’ve heard reports that upscale homes in
the Portland area are increasingly being sold at above-asking
price—a phenomenon we’re
all too familiar with in the Bay Area! So it’s clear
that Portland’s
housing market has been hot, but I’m sure that’s
no surprise to you.
In any event, as I said before, the
fact that the ratios for the nation and many areas of the
country are higher
than normal
doesn’t necessarily
prove that there’s a bubble. House prices could be
high for some good reasons that affect their fundamental
value. The most obvious reason is the
low level of mortgage rates. This stems both from very
stimulative monetary policy and from the conundrum I discussed
earlier. Conventional mortgage rates
have dropped from around 6 percent in early 2004 to around
5 percent recently.
Other factors could also be raising
housing’s fundamental value. For
example, recent changes in tax laws may be having an effect.
In 1998, tax rates on capital gains were lowered and the
exemption from capital gains taxation
for housing was raised to $500,000. Both of these changes
would reduce the potential tax bite from selling one home
and buying another. Another development,
which may be making housing more like an investment vehicle,
is that it’s
now easier and cheaper to get at the equity—either
through refinancing, which has become a less costly process,
or through an equity line of credit.
Both of these innovations in mortgage markets make the
funds invested in houses more liquid.
So there are good
reasons to think that fundamental factors have played a
role in the unusually high price-to-rent
ratio. But
the bottom line
here is fuzzy.
It’s very hard to say how big a role these factors
have played, so we don’t know how much remains unexplained.
Frankly, even the best available estimates are imprecise,
and they don’t definitively answer the question:
Is there a bubble, and if there is, how large is it?
Given
this uncertainty, my focus as a monetary policymaker is
on trying to understand what kind of risks a drop in
house prices
would pose
for the economy.
One of the classic ways to do this is to ask “What
if…?”—in
other words, to pose a purely hypothetical question. In
this case, the “what
if” question might be, “What’s the likely
effect if national house prices did fall by 25 percent,
enough to bring the price-to-rent ratio
back to its historical average?” Before going any
further, I want to emphasize that I’m not making
any predictions about house price movements, but instead,
simply discussing how a prudent monetary policymaker could
assess
the risk.
First, there would be an effect on consumers’ wealth.
With housing wealth nearing $18 trillion today, such a
drop in house prices would extinguish about
$4½ trillion of household wealth—equal to
about 38 percent of GDP. Standard estimates suggest that
for each dollar of wealth lost, households
tend to cut back on spending by around 3½ cents.
This amounts to a decrease in consumer spending of about
1¼ percent of GDP. To get some perspective
on how big the effect would be, it’s worth comparing
it with the stock market decline that began in early 2000.
In that episode, the extinction of
wealth was much greater—stock market wealth fell
by $8½ trillion
from March 2000 to the end of 2002. This suggests that
if house prices were to drop by 25 percent, the impact
on the economy might be about half what it
was when the stock market turned down a few years ago.
Moreover,
the spending pullback wouldn’t happen all of a sudden.
Wealth effects—positive or negative—tend to
affect spending with fairly long lags. So, a drop in house
prices probably would lead to a gradual cutback
in spending, giving the Fed time to respond by lowering
short-term interest rates and keeping the economy steady.
Now
let’s complicate things. Suppose house prices started
falling because bond and mortgage interest rates started
rising as the conundrum was resolved,
say, because the risk premium in bonds rose due to concerns
about federal budget deficits or other factors. Then we’d
have the cutback in spending because of the wealth effect,
plus there’d likely be further spending cutbacks,
as borrowing costs for households rose. Furthermore, a
rise in long-term rates would have effects beyond just
households—it also would dampen business
investment in capital goods through a higher cost of capital.
How
manageable would this scenario be? Like the wealth effect,
these added interest-rate effects operate with
a lag, so,
again, there
probably would
be time for monetary policy to respond by lowering short-term
interest rates. This obviously would not be a “slam
dunk,” but in many circumstances
it would seem manageable.
A matter of more concern is whether
this scenario would lead to financial disruptions that
could cause spending
to slow
sharply and quickly.
One issue that receives
a lot of attention is the increasing use of potentially
riskier types of loans, like variable rate and interest-only
loans
that may make
borrowers and lenders
vulnerable to a fall in house prices or increase in interest
rates.
I believe
that the odds of widespread financial disruption on this
count are fairly slim, although, clearly, some borrowers
are vulnerable.
First,
the shift
to these
new instruments appears relatively modest overall. Second,
the equity cushions available to both borrowers and lenders
still
seem, on average,
to be pretty
substantial. This is evident in looking at loan-to-value
ratios, which have fallen, on average, as home valuations
have risen
faster than
mortgage debt.
In addition, most financial institutions enjoy comfortable
capital positions, so they’re better able to weather
any problems with their mortgage portfolios. Finally, some
of the risk associated with mortgages has been transferred
from
banks to investors, as banks have sold off securitized
bundles of mortgage debt. These investors may be in a better
position to handle the associated
risk. So, while there undoubtedly would be some fallout
from a substantial drop in house prices, the financial
system and consumers appear to be in reasonably
good shape to handle the situation.
Monetary policy
I’d like to close my remarks by taking a step back from the home
price story and putting it in the broader context of the economy’s
overall performance—which, after all, is the chief concern of
monetary policymakers. As I’ve emphasized, economic activity
has been burdened by some major drags over the past several years.
As a result, the Fed has had to keep interest
rates exceptionally low for a long time just to get respectable
economic growth. In fact, respectable growth is all we have gotten—even
with exceptionally low long-term yields and unexpectedly rapid gains
in house prices.
This growth has had to rest on the backs of just a
few
interest-sensitive sectors—business
investment, consumer durables, and housing. From this
perspective, it’s
not all that surprising that housing markets have been
hot. My point is that to offset the “drags” we’ve
needed to give the economy a strong dose of stimulus—which
inevitably boosted the housing sector.
As I’ve
discussed, if a sizable reversal in house prices were
to occur, it probably would affect the economy mainly
through the lagged effects of declines
in wealth and increases in interest rates, rather than
through widespread financial disruptions. This would
give monetary policy time to react to any resulting
economic weakness by lowering interest rates. In addition,
the magnitude of
the potential house price overvaluation may be only
around half that of the earlier stock market overvaluation.
In
conclusion, policy still appears to be somewhat accommodative, and
given the recent inflation performance
and the dwindling
of slack, it makes sense
to continue the process of removing that accommodation.
I
hope I’ve provided you with some insight on the issues that I
think are important to focus on as the Fed goes through this process.
I look forward
to taking your questions.
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