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President's Speech
Presentation to the members of Parliament at
the Conference on US Monetary Policy convened by the European Economics
and Financial Centre
London, England
By Janet L. Yellen, President and CEO of the Federal Reserve Bank
of San Francisco
For delivery September 27, 2005, 9:00 AM Pacific, 12:00 noon Eastern,
5:00 PM London BST
The U.S Economy and Monetary Policy
It's a pleasure and an honor
to speak to you today, and I thank you for the kind invitation. Indeed,
I'm always eager to accept invitations to
speak in London, because it was my home many years ago, when I was on the faculty
of the London School of Economics. I came to know and love the city then, and
I'm always happy to return.
My main topics today are the U.S. economy
and the Federal Open Market Committee's
conduct of monetary policy. I'd like to start with conditions in the
U.S. economy, including output growth and employment as well as inflation.
I'll review the recent past and indicate my sense of the likely path
going forward, along with some of the risks that I see—especially energy
and house prices, concerns that our two countries share in common. I'll
conclude with some thoughts on the course of monetary policy in the U.S.
Obviously,
at the forefront of everyone's mind are the two huge hurricanes
that recently struck the U.S. Gulf Coast. The human tragedy following Katrina
is enormous. I know the nation is grateful for the outpouring of sympathy and
tangible support from the rest of the world, not the least of which is your
own country's offer of food, expert personnel, and search-and-rescue
gear. We all mourn the loss of life, and we are working to alleviate the dire
conditions for many of the survivors. The economic consequences for the region,
of course, also are enormous. Katrina displaced millions of people, disrupted
or destroyed thousands of businesses and jobs, and wrought severe damage on
much of the infrastructure. Hurricane Rita, of course, has compounded the economic
damage, however, early reports indicate little lasting effect on energy production,
refining, and distribution.
Staring into the face of such disasters, it is natural
at first to want to use every tool at hand to try to help, including monetary
policy. However,
it seems clear that where monetary policy can make its greatest contribution
is in keeping the national economy on an even keel. Monetary policy, unfortunately,
has little scope to cushion the immediate economic fallout because monetary
actions can't be directed only at a particular area of the country and
because their effects take time to be felt. Instead, it's appropriate
to use the tools of fiscal policy—especially government spending and
transfers—to address the immediate crisis.
When Hurricane Katrina hit
at the end of August, the economy was actually doing reasonably well. Over
the preceding two and a half years, real GDP had grown
steadily at, or above, its long-run sustainable pace, which, based on continued
robust structural productivity, is estimated at three to three and a quarter
percent. And in the second quarter, the latest for which we have data, the
preliminary estimate looks similar—that is, real GDP grew by three and
a quarter percent. With this stretch of near or above-trend growth in economic
activity, slack in resource use has gradually, but steadily, diminished—that
is, jobs have grown and capacity utilization has risen. According to the latest
data, which are for August, and therefore before the storm, the U.S. unemployment
rate was at 4.9 percent, a number that's near conventional estimates
consistent with so-called "full employment."
As this scenario has
unfolded—above-trend growth and diminishing slack—the
FOMC has been able to lift its foot off the accelerator bit by bit, gradually
removing the policy accommodation that had been put in place during the 2001
recession and then held there during the slow recovery when there was a risk
of deflation. At each of its last 11 meetings—including the one last
week—the Committee raised the federal funds rate by a quarter of a percentage
point, bringing it to three and three-quarters percent today.
The goal of these
policy actions, of course, is to establish a solid trajectory for the economy
going forward. As slack in labor markets is absorbed, real
output growth must converge toward its potential rate for inflation to remain
under control, which, in turn, requires that monetary policy reach a so-called "neutral" stance.
Such a trajectory still remains a plausible, even probable, scenario. However,
looking ahead I'd say there are a number uncertainties and risks that
could complicate things considerably, and these were evident even before the
havoc unleashed by Hurricane Katrina.
Heading my list of risks to the economy
in both the near and medium-term is energy prices. In the two years before
Katrina struck, energy prices had surged
worldwide, with the price of oil more than doubling and even spiking at one
point to over $70 per barrel. The macroeconomic effect of higher energy prices
is to dampen aggregate demand, as the additional dollars people spend for
the same amount of gasoline, natural gas, heating oil, and so on, take
away from
their spending on other goods and services. Likewise, firms feel the bite
in terms of their profit margins or the dollars they would have spent
on investment
in plant and equipment.
The intensity of this dampening effect depends importantly
on whether the higher prices are viewed as transitory—a passing phenomenon—or
as a more permanent feature of the economic landscape. If transitory, then
consumers
and firms will tend to maintain something close to their usual level of spending
while the higher prices last—perhaps by dipping into their reserves.
If higher energy prices are expected to persist, however, a deeper and longer-lasting
cutback in spending is more likely.
To gauge the perception of the permanence
of higher energy prices, the natural place to look is at futures prices.
Even before Katrina, they suggested that
higher prices may be here to stay. During the run-up of spot prices over
the past year and a half, far-dated oil futures prices rose sharply.
Most likely,
these futures prices reflected the sense that global demand for oil would
remain strong in an environment where there is little excess supply
available and
where geopolitical uncertainty creates risks to existing supplies.
With first
Katrina and then Rita slamming into the Gulf Coast, the energy situation
naturally has become even more severe, since that area has such an
extensive
drilling, refining, and distribution infrastructure. For example, offshore
crude oil and natural gas production in the Gulf of Mexico accounts for approximately
29 percent and 19 percent, respectively, of total U.S. production levels.
Importantly, Gulf Coast refineries account for a whopping 47 percent
of total U.S. refining
capacity. While futures prices gyrated a lot around the time both hurricanes
struck, since then, they've settled back to roughly their pre-hurricane
levels.
Before Hurricane Katrina, the outlook was for very strong growth in
the second half of this year, with a return to trend-like growth in 2006.
Indeed, a concern
at the time was that the economy's momentum was sufficiently strong that
it might overshoot full employment, adding to inflationary pressures. The damage
and destruction from the hurricanes have significantly raised uncertainties
about the outlook through three main channels. One is the immediate and direct
effects on businesses and jobs in the Gulf Coast region; the second is the
longer-term effects of higher energy prices on consumer and business spending
throughout the nation; the third is the spending devoted to rebuilding the
affected area.
The direct effects will alter the near-term trajectory of the
national economy. These disruptions seem very likely to put a noticeable
dent in overall U.S.
growth in the second half, which will only be partly offset by increased
government spending for reconstruction. Most estimates of the size
of the dent run around
half a percent, and that seems about right to me. This suggests that growth
in the second half may be only modestly above the potential rate.
Turning to
2006, it seems likely that growth will rebound as energy production comes
fully back on line and rebuilding kicks in. However, the magnitude
of
the rebound is highly uncertain, with considerable risks on both the upside
and downside. Estimates of the extent of spending are escalating, and the
recovery and bounce-back—fueled by massive fiscal stimulus—could propel
the U.S. economy on an unsustainable upward trajectory. Alternatively, the
recovery could proceed less quickly and less vigorously than one might hope
over the next few months. Even before Rita, the pace of restarting closed oil
and natural gas platforms and rigs in the Gulf of Mexico damaged by Katrina
had leveled off, and the prognosis for restarting the remaining closed facilities,
as well as refineries and natural gas treatment plants, remained in question.
It is too soon to say which of these risks might materialize. Some reports
say the recovery in oil and natural gas production and in oil refining is moving
ahead faster than expected. At the same time, facilities in the region are
still operating well below capacity.
* * * *
Turning to inflation, the data on core price inflation covering the
months before Katrina were encouraging. Despite rapid increases in
energy prices, prices for core personal consumption expenditures rose
at only a 1-1/2 percent rate over the six months through July, right
in the middle of my preferred range. Core CPI inflation has been well
behaved as well. Of course, six months of data do not make a trend,
and forthcoming data bear continued close scrutiny, but what I've
seen so far gives me some reassurance that unacceptably high inflation
remains just a risk, not the most likely outcome.
Another encouraging
development is that labor compensation is still growing at a modest
pace. This suggests that at least some slack remains
in labor markets, a good sign for inflation going forward. Labor
compensation growth, as measured by the Employment Cost Index and measures
of wages
and salaries drawn from the employment surveys, remains remarkably
subdued. An alternative index of compensation growth that includes
bonuses and stock options, from the Productivity and Cost report,
indicates an elevated rate of growth in compensation per hour over
the past year,
but my sense is that this may be more an outlier than a strong signal
of tight labor markets and wage pressure.
Events in the Gulf Coast
obviously will tend to push up headline inflation through higher
energy prices. An important question concerns the extent
to which higher energy prices will work their way into core inflation—that
is, excluding energy and food prices. There is a chance that core inflation
may be raised for a time, as a part of the rise in energy prices gets
passed through to other goods and services. However, a more persistent
increase in inflation, such as was witnessed during the 1970s, seems
unlikely as long as inflation expectations remain well contained.
During
the 1970s, higher oil prices touched off a wage-price spiral which
was costly to unwind. In contrast, U.S. experience since the
early 1980s reveals no evidence of passthrough from real energy prices
to core inflation. The crucial difference seems to be that, during
the 1970s, the public's inflation expectations became unmoored
from price stability, whereas, since the early 1980s, they have been
well-anchored. Evidence comes from the relative stability of longer-term
inflation expectations as derived from the market for inflation-protected
Treasury securities this year, even as oil prices surged. This stability
supports the view that the public has confidence in the FOMC's
commitment to price stability. A recent consumer confidence survey
recorded a worrisome jump in inflation expectations, but I would not
read too much into this, since the survey was conducted so soon after
Katrina.
Given these considerations, I wouldn't be surprised
to see core PCE inflation actually fall a bit over the next two years
and to see
the longer-run trend settle in near the center of my 1 to 2 percent
comfort zone. However, the Federal Reserve cannot take it for granted
that inflation expectations will remain well-contained. Rather, it
is the job of a central bank to earn, through its actions, the public's
confidence in its commitment to price stability.
* * * *
In addition to energy prices, the huge and unsustainable current account
deficit and the budget deficit pose longer-term risks to the U.S. economic
outlook. Indeed, the latter is even more of an issue now, with the
massive rebuilding plans for the Gulf Coast. But I want to focus my
remarks today on another longer-term issue, namely, the housing market,
as this is a situation that has also been a concern in the U.K.
The
share of residential investment in GDP is now at its highest level
in decades, and this sector has been a key source of strength in
the current expansion. The question is: will this source of strength
reverse
course and become instead a source of weakness? Put more bluntly:
Is there a house-price "bubble" that might collapse, and if
so, what would that mean for the U.S. economy? To answer this question,
let me begin by clarifying what I 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 U.S. has had many ups and downs, but over time it has tended
to return to its long-run average. In other words, 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 U.S. 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 in the U.S. and in different countries.
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. For the U.K., the ratio is more than double its long-run
average, whereas in Japan it's only about three-quarters of its normal
level.
Higher than normal ratios do not necessarily prove that there's
a house-price bubble. House prices could be high for some good, fundamental
reasons. For
example, in the U.S. 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 in
the U.S., 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.
Probably the most obvious candidate for
a fundamental factor—in the U.S.and
in the U.K. —is low mortgage interest rates. But in the U.S, this phenomenon
raises some issues of its own because there is a controversy about just why
the rates have stayed so low. As I've said, over the past year, the Fed
has raised the federal funds rate significantly. Normally, long-term interest
rates also rise with increases in the expected path for the federal funds rate.
But, long-term rates—such as those on 30-year fixed rate mortgages—have
actually fallen over the period. This is what Chairman Greenspan has labelled
a conundrum because there seems to be no convincing explanation for it.
While
the fundamentals I've mentioned do play a role, the consensus seems
to be that much of the unusually high price-to-rent ratio for housing remains
unexplained. Moreover, with controversy over exactly why long-term interest
rates have remained so low, we can't rule out the possibility that they
would rise to a more normal relationship with short-term rates, and this obviously
might take some of the "oomph" out of the housing market. So, while
I'm certainly not predicting anything about future house price movements,
I think it's obvious that the housing sector represents a risk to the
U.S. outlook.
This brings me to the debate about how monetary policy should
react to unusually high prices of houses—or other assets, for that
matter. I know you're
all familiar with the issues, as they have been in the public spotlight here
in the United Kingdom for some time. But let me frame them briefly. As a
starting point, the issue is not whether policy should react at all; I believe
there
is quite general agreement that policy should be calibrated to the wealth
effects of house prices on output and inflation. The debate lies in determining
when,
if ever, policy should be focused on deflating the asset price bubble itself.
In
my view, the weight of a decision to deflate an asset price bubble rests
on positive answers to three questions. First, if the bubble were to
collapse
on its own, would the effect on the economy be exceedingly large? Second,
is it unlikely that the Fed could mitigate the consequences? Third,
is monetary
policy the best tool to use to deflate a house-price bubble?
My answers to
these questions in the shortest possible form are, "no," "no," and "no." In
the most thorough possible form, my answers might take a few hours, and would
give full play to the many gray areas that are involved. Since the short answer
is not satisfactory and the thorough one overwhelms our time limits, I will
compromise and give just a brief explanation for my trio of "nos."
In
answer to the first question on the size of the effect, it could be large
enough to feel like a good-sized bump in the road, but the economy
would likely
to be able to absorb the shock.. For example, a reversion to the long-run
price-rent ratio would appear to represent a shock that is only about
half the size of
U.S. stock market collapse in 2000 and 2001.
In answer to the second question
on timing, the spending slowdown that would ensue is likely to kick in gradually,
because it mainly affects household wealth.
That would give the Fed time to cushion the impact with an easier policy.
In
answer to the third question on whether monetary policy is the best tool
to deflate a house-price bubble, there are several points to consider.
For
one thing, no one can predict exactly how much tightening would be needed,
or by exactly how much the bubble should be reduced. Beyond that, a tighter
policy to deflate a housing bubble could impose substantial costs on other
sectors of the economy that would lead to equally unwelcome imbalances. Finally,
it's possible that other strategies, such as tighter supervision or changes
in financial regulation, would not only be more tailored to the problem, but
also less costly to the economy.
Taking all of these points into consideration, it seems that the
arguments against trying to deflate a bubble outweigh those in favor
of it. So, my bottom
line is that monetary policy should react to rising prices for houses or
other assets only insofar as they affect the central bank's goal variables—output,
employment, and inflation. But let me stress that the debate surrounding these
issues is still very much alive.
* * * *
I'd like to wrap up with a few thoughts on U.S. monetary policy, and
particularly on last week's policy meeting. Of course, the risks engendered
by Hurricane Katrina were very much on our minds and added to an already challenging
situation. Higher energy prices put U.S. monetary policy on the horns of a
dilemma. On one side, the negative impact of higher energy prices on spending
tends to damp economic activity, which calls for a more accommodative policy,
although in this case, the rebuilding effort will provide some offset. On the
other side, it adds to inflationary pressures, which calls for a tighter policy.
Although
the effects of Katrina and Rita will remain uncertain for some time, it appears
that the most likely outcome is a significant dip in growth in this
quarter and the next, stemming both from the direct loss of activity in the
Gulf Coast region and the rise in energy prices, followed by a rebound in
the first half of next year as the region rebuilds. Given this best
guess, it made
sense to me to continue the gradual removal of policy accommodation. So,
for the eleventh straight meeting, the Committee voted to increase
the federal
funds rate by 25 basis points.
Going forward, the Committee will certainly continue to monitor developments
closely and weigh the options carefully. One option that is clearly not on
the table is allowing an unacceptable rise in inflation. It has taken many
years of consistent performance for the Federal Reserve to earn the public's
confidence in its commitment to price stability. As William Pitt, the Elder,
once said, "Confidence is a plant of slow growth." I would add
that it is also a plant that needs constant nurturing; in other words, to maintain
its credibility, the Federal Reserve must deliver—again and again–on
its commitment to price stability.
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