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President's Speech
Presentation to a Salt Lake City Community Leaders
Luncheon
Salt Lake City, Utah
By Janet L. Yellen, President and CEO of the Federal Reserve Bank
of San Francisco
For delivery October
18,
2005 12:40 PM Mountain Time, 2:40 PM Eastern, 11:40 AM Pacific
Update on the U.S Economy
Good afternoon. It's a pleasure to be here in Salt Lake City
with you today. I'm delighted to have the opportunity to outline
my thoughts on the U.S. economy and on monetary policy. I hope you'll
have some comments and questions for me afterward. As President of
the Federal Reserve Bank serving Utah and eight other Western states,
it is my job to bring the economic insights and perspectives of business
leaders in our region into deliberations at the policy table. So I
am eager to know what issues and developments are particularly on your
minds. Let me note, by the way, that my comments in these remarks and
in the Q&A reflect my own opinions, not necessarily those of my
colleagues in the Federal Reserve.
I'll start by addressing some major developments in the U.S.
economy relating to employment and output growth. I'll review
the recent past and indicate my sense of the economy's likely
path going forward, focusing particularly on risks I see relating to
energy and the housing sector. Next
I'll turn to the inflation picture. Finally, I'll conclude with
some thoughts on the course of monetary policy in the U.S.
Six weeks have
now passed since Katrina and Rita delivered powerful blows to the U.S.
Gulf Coast. Their consequences are by no means behind us and
are shaping
the near-term outlook in important ways. It goes without saying that the
human tragedy has been enormous. According to a recent report, Louisiana
alone attributes
nearly a thousand deaths just to Katrina. The economic consequences for
the region also are enormous. Millions of people were displaced, thousands
of
businesses and jobs were disrupted or destroyed, and the infrastructure
took a severe
beating. Hurricane Rita, of course, compounded the economic damage.
Staring
into the face of such disasters, it is natural at first to want to
use every tool at hand to try to help—which is precisely what
the people of Utah did. I understand that Utahns mobilized immediately,
sending volunteers
to the stricken area and welcoming over five hundred evacuees to the
state. The shelter that was put together so quickly at Camp Williams
has been
called a "mini-city," with crucial services, like medical
support and schooling, as well as those amenities—like hair
salons and entertainment—that
help give people a glimpse of "ordinary" life in such an
extraordinary situation. I understand that now that Camp Williams is
closed, apartments
or hotels have been found for those who are staying in the area, and
many of the
children are registered in local schools. This open-handedness, this
open-heartedness of the people here has, indeed, been a bright ray of
light amid the dark
despair that followed those storms.
As a policymaker, I, too, have been
concerned about how best to help. As you know, at the September 20th
meeting of the Federal Open Market
Committee,
the
members voted to continue on the path of gradual tightening that began
more than a year ago and increased the target federal funds rate by
25 basis points
to 3.75 percent. This was a very conscious decision. It reflected a
conviction, which I share, that monetary policy's greatest contribution
in a situation like this 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, and this process
is, indeed, underway.
When Hurricane Katrina hit at the end of August,
the economy was doing quite well. Over the preceding two and a half
years, real GDP had grown
steadily
at, or above, its potential or long-run sustainable pace, which,
due to continued robust structural productivity, is estimated at three
to three
and a quarter
percent. In the second quarter, the latest for which we have data,
real GDP performance was similar—that is, it 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 increased by more than enough to absorb a growing workforce.
Unemployment
has declined, and capacity utilization has risen. Indeed, the latest
reading on unemployment before the storm was for August, and it came
in at 4.9 percent,
a number that's near conventional estimates consistent with
so-called "full
employment."
My medium-term outlook, before Katrina, was for
growth averaging a pace sufficient to keep the economy operating
in the vicinity of
full
employment,
albeit
with notable risks, particularly relating to energy prices and
housing, two factors
I will discuss in greater detail in just a moment. Evidence amassed
since the storms suggests that the economy has been remarkably
resilient and
apt to remain
on a solid track even though the storms will probably alter the
near-term trajectory somewhat. The disruptions they caused will likely
put
a noticeable dent in
overall growth of output and employment in the second half of this
year, compared to earlier forecasts; indeed, in September, the
unemployment rate rose by a
couple of tenths of a percentage point to 5.1 percent, and most
of this
increase was probably due to the temporary effects of Katrina.
For 2006, it seems
likely that growth will pick up in the first half, as energy production
comes fully
back on line and rebuilding kicks in, and then will settle into
a trend-like pattern in the second half.
Now to the two risks to output
growth and employment that I mentioned—energy
prices and housing. As I said, these were present even before
Katrina struck. Over the two previous years, 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 amount that households are forced to spend
for the same amount of gasoline, natural gas, heating oil, and so
on, diminishes
their ability
to spend on other goods and services. Likewise, firms feel the
bite in narrower profit margins which may crimp the amount they decide
to spend on investment
in plant and equipment.
The outlook for trend-like growth in output
that I discussed earlier incorporates noticeable effects of the
energy shock on
household
and business spending.
However, there are inevitable uncertainties about the intensity
of these effects. For example, the intensity 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 they
are seen as largely transitory,
then consumers and firms typically try 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 perceptions concerning 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. For example, during
the run-up of spot oil prices over the past year and a half,
far-dated
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 of a
concern, 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 20 percent, respectively,
of total U.S.
production levels.
Importantly, Gulf Coast refineries account for a whopping
47 percent of total U.S. refining
capacity. The latest reports indicate that some of the
energy infrastructure of the Gulf has been restored, but progress
has been slower than
originally expected. Roughly 65 percent of offshore oil
and 56 percent of offshore
gas production in the Gulf still remains shut in, and about
ten percent of U.S.
refinery capacity is off line. Energy prices have been
quite volatile. At this point, retail gasoline and natural gas
prices remain well
above pre-Katrina
levels, while oil prices and wholesale gasoline prices
have actually fallen below those prevailing before the hurricanes.
Early
signs suggest that spending is holding up reasonably well in the
wake of higher energy prices, although consumer
confidence
dropped
substantially
after the storms. It will obviously be important to monitor
consumer spending carefully in the months ahead, as higher
energy prices
show up in winter
heating and electricity bills.
In addition to the uncertainties
raised by higher energy prices, there are downside risks to economic
growth relating
to the
housing market.
This sector
has been a key source of strength in the current expansion,
and the concern is that, if house prices fell, the
negative impact
on household
wealth
could lead to a pullback in consumer spending. Certainly,
analyses do indicate that house prices are abnormally
high—that there is a "bubble" element,
even accounting for factors that would support high
house prices, such as low mortgage interest rates.
So a reversal
is certainly a possibility. Moreover,
even the portion of house prices that is explained
by low mortgage rates is at risk. There is a controversy
about just why the rates have stayed so low.
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. So, we can't
rule out the possibility that they would rise to a
more normal relationship with short-term rates. This
obviously might take some of the "oomph" out
of the housing market. My bottom line is that while
I'm
certainly not predicting anything about future house
price movements, I think it's obvious that a
substantial cooling off of the housing sector represents
a downside
risk to the outlook for growth.
My focus thus far has
been on developments that relate to the Fed's
objective of keeping the economy growing and operating
in the vicinity of full employment.
However, like central banks worldwide, the Federal
Reserve is also keenly focused on maintaining price
stability. In my judgment, inflation has been relatively
well-contained and essentially compatible with the
Fed's price stability
objective, although rapid increases in energy prices
over the past year have boosted headline CPI inflation
to a whopping 4.7% over the last twelve months,
a level not seen since 1991. Abstracting from volatile
food and energy prices, however, core consumer price
inflation, as measured by the CPI, registered
a moderate 2.1 percent over the 12 months ending in
September. A second key index of core consumer prices,
the core PCE, or personal consumption expenditures
index, also rose 2 percent over the 12 months ending
in August. There is an anomaly here because the PCE
price index typically rises about 0.5 percent
less rapidly than the core CPI measure, and the aberrant
difference between the two measures places inflation
over the past 12 months, based on the core
PCE, near the top of my comfort range. In contrast,
over the past six months, core inflation has been more
modest. The core PCE was up 1.6% at an annual
rate in the six months ending in August—which
is right near the middle of my preferred range. Core
CPI inflation has been well behaved as well.
The question
for policy, of course, concerns the future, not the
past. Increases in energy prices, exacerbated
by events
in the
Gulf Coast,
are likely to
continue boosting headline inflation. And a key question
is whether higher energy prices
also will elevate core inflation. In part, this depends
on whether businesses are able to pass through higher
energy and material
prices or instead
are forced to absorb them into the bottom line. Many
of our
contacts report
that keen
competition, coupled with healthy profit margins, is
limiting their ability to pass these costs along. To
the extent
that there is
some pass-through,
however, core inflation could be higher, for a time.
Even so, any boost in core inflation
should prove transitory if energy prices stabilize
unless—and it's
a big unless—these developments impact wage and
salary developments in a broad-based way. Those of
you who lived through the 1970s will remember that
higher oil prices touched off a wage-price spiral that
pushed inflation into double-digit territory. At this
stage, wage and salary growth seems quite well-contained,
and I see no evidence of feedbacks from energy prices
to wage bargaining. The
risk, though, is that, without appropriate policy,
we could see a repetition of the 70's type dynamic.
Naturally,
much research has gone into analyzing what happened
during the 1970s, and I'm glad to report
that there are major differences between now and then.
One of the key findings concerns the role that inflation
expectations
play in generating the wage-price spiral. To sum up
a great deal of research very briefly, the idea is
that inflation expectations are like self-fulfilling
prophecies. If people expect higher inflation, they
will behave in the marketplace
in ways that will actually generate higher inflation;
for example, they will rush to make purchases thinking
that tomorrow's price will be higher
than today's. And, higher expected inflation
will tend to be built into wage bargaining, which raises
costs to businesses that, in turn, may get built
into the prices of their products. Unwinding the inflationary
spiral is no easy task. In the early 1980s, the Fed
did it by slamming hard on the brakes.
The costs of this action were high—the economy
went through a double-dip recession, and the unemployment
rate hit 10 percent in 1982. Since then, the
Fed has continued to work to lower the inflation rate
with considerable success. As a result, it appears
that the public expects inflation to remain in a low
range—as economists express it, inflation expectations
have become "well
anchored" to price stability.
What's the
evidence on people's inflation expectations?
One source of information comes from responses to surveys
about inflation expectations.
A recent survey taken by the University of Michigan
recorded a large jump in inflation expectations over
the next twelve months, and a smaller increase
in longer-term expectations. But I would not read too
much into this, since the short-term survey results
reflect recent energy price developments, and
they also account for at least part of the uptick in
longer-term expectations.
An alternative source of
information on inflation expectations comes from analyses
using a financial instrument that
is called TIPS for
short. This
stands for
Treasury Inflation-Protected Security, a class of government
debt obligation that was first issued in 1997. The
key feature of TIPS
is that the
payments to investors adjust automatically to compensate
for the actual change
in the CPI. Conventional Treasury securities, in contrast,
do not provide such protection,
so investors in those securities protect themselves
by demanding nominal interest rates that compensate
them
for expected
inflation as well
as for
bearing the
risk that actual inflation could turn out to differ
from their expectations. In principle, having information
from both types
of Treasury securities
allows researchers to separate out the inflation compensation
component embedded
in nominal interest rates, and this provides a rough
proxy for inflation expectations.1
Using this kind of
analysis, we can obtain an estimate of inflation compensation over
various time horizons.
Not surprisingly,
compensation for average
inflation over the next five years has risen as energy
prices have surged. However,
it is notable that longer-term inflation expectations—those
covering the period from five years ahead to ten
years ahead—appear to have declined
by half a percentage point since the Fed began tightening
policy. This development supports the view that the
public has confidence in the FOMC's commitment
to price stability, even in the face of a large energy
price shock. 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.
This
brings me to a discussion of recent Fed actions.
Over the past sixteen months, with the U.S. economy
growing slightly above
trend
and unemployment
gradually declining toward normal levels, the Federal
Open
Market Committee has been lifting its foot off the
monetary accelerator
at a measured
pace—bit by bit. We've been 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 even a risk of deflation.
The objective of these policy actions has been to
position the economy on a trajectory characterized
by "full employment" and price stability—the
two main policy goals articulated in the Federal
Reserve Act. As slack in labor markets is
absorbed, real output growth must converge toward
a sustainable long-run pace for inflation to remain
under control. This, in turn, requires that monetary
policy revert to a so-called "neutral" stance.
After
eleven 25-basis point upward moves since June 2004,
the federal funds rate now stands at 3.75 percent,
so
the question
of exactly
what constitutes
a neutral stance has become more compelling. Conceptually,
policy can be deemed "neutral" when
the federal funds rate reaches a level that is consistent
with full employment of labor and capital resources
over the intermediate run. The value of this
rate depends on the strength of spending—that
is, the aggregate demand for U.S. produced goods
and services. Aggregate demand, in turn, depends
on
a number of factors. These include fiscal policy;
the pace of growth in our main trading partners;
movements in asset prices, such as stocks and housing,
that influence the propensity of households to save
and spend; the slope of
the yield curve, which determines the levels of long-term
interest rates associated with any given value of
the federal funds rate; and the pace of technological
change, which influences investment spending. The
neutral value of the federal
funds rate also depends on, and rises roughly in
tandem with, inflation itself, because it is mainly
inflation-adjusted, or real, not nominal interest
rates,
that influence spending.
The neutral rate is easy
to define conceptually, but it's difficult
to know in practice when we're there, because
estimates of the neutral rate are highly uncertain
and the factors influencing that rate can change
over
time.2 That said, a number of different techniques
can be used to estimate the neutral rate and, based
on such estimates, I consider it reasonable to put
the current neutral rate in the range of 3-1/2 to
5-1/2 percent. At 3-3/4 percent,
the current federal funds rate is toward the lower
end of this band. This suggests a presumption that
the rate will need to be raised further. Indeed,
financial
markets now appear to expect the funds rate to peak
at about 4½ percent—in
the middle of this neutral range. Again though, I
want to emphasize that there is no way to know precisely
what the neutral stance is.
To my mind this means
that, as the federal funds rate target nears a reasonable
estimate of the neutral
rate,
monetary
policy must
become more and more
dependent on incoming data relating to the strength
of aggregate spending. It is equally
important, of course, to monitor developments relating
to inflation, because the very notion that a neutral
policy stance is appropriate
is
premised
on the assumption that inflation is and will remain
well-contained in a zone
corresponding to price stability.
The ideal trajectory for the economy and the funds
rate that I have described remains a plausible,
even probable,
scenario.
At
its September
meeting,
the risks engendered by Hurricane Katrina were
very much on the minds of Committee
members. Sharp jumps in energy prices always put
U.S. monetary policy on the horns of a dilemma.
On one side,
the negative
impact on spending
tends
to damp
economic activity, which calls for a more accommodative
policy, although in this case, the rebuilding effort
will provide
an important offset.
On the other
side, higher energy prices add to inflationary
pressures, potentially calling for a tighter policy. Although
the effects of Katrina
and Rita will remain
uncertain for some time and the storms may alter
the pattern of growth over the next year or so,
it seems
likely that
economy will
prove
resilient in
the medium term. With long-term inflation expectations
still well-contained, the
prospects for core inflation over the medium term
also, to my mind, look favorable. It thus made
sense to me
to continue
the
gradual
removal of
policy accommodation.
Going forward, it will be
necessary to continue to monitor developments closely
and weigh options
carefully.
As
I noted, the data dependence
of policy becomes
more critical the closer we get to a neutral stance.
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,
and this consistency of purpose remains essential.
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