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President's Speech
Presentation to the California Chamber of Commerce
San Francisco, CA
By Janet L. Yellen, President and CEO of the Federal Reserve Bank of
San Francisco
For delivery
Friday, December 2, 2005 11:00 AM Pacific, 2:00 Eastern
The U.S Economy: 2005 in Review and Prospects
for 2006
Good morning, and thanks very much for inviting me today. I'm
delighted to be here with you. As 2005 draws to a close, it's
a good time to take a look back at the year that has passed and to
think about what may lie ahead for the U.S. economy in 2006. In taking
this retrospective and prospective approach, I'm going to organize
my remarks around three broad topics. The first is employment and output
growth. The second is inflation. Not surprisingly, energy prices factor
significantly into developments in both realms and are relevant in
shaping the risks going forward. My third and last topic is the conduct
of monetary policy, and here I plan to touch on one of the legacies
of Chairman Greenspan. As you no doubt know, at the end of January,
he is stepping down after 18 years of distinguished service to the
Federal Reserve and to the country, and Ben Bernanke will then, in
all likelihood, have been confirmed by the Senate and will therefore
be in a position to assume the Chairmanship. The Greenspan legacy I
want to focus on is this: the public's increased confidence in
the Fed's commitment to price stability, and the Fed's
increased transparency about monetary policy. In particular, I will
give you some of my thoughts about how greater central bank credibility
and transparency enhance the conduct of monetary policy and the stability
of the U.S. economy.
Looking back at 2005, clearly one of the most dramatic events was
the one-two punch of Hurricanes Katrina and Rita. It goes without saying
that the economic consequences for the Gulf Coast region have been
enormous. More than a million people have been displaced, thousands
of businesses and jobs have been disrupted or destroyed, and the infrastructure—notably
for energy—took a severe beating.
When the hurricanes hit at the end of August, the economy had been
doing quite well. Over the preceding two years, monetary accommodation
and robust productivity growth supported economic activity. Real GDP
grew steadily at, or above, its potential or long-run sustainable pace,
which is estimated at three to three and a quarter percent. This pattern
continued even during the third quarter, when real GDP is estimated
to have grown by four 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, and the unemployment
rate has declined. Indeed, for October and November, unemployment came
in at 5 percent, a number that's near conventional estimates
consistent with so-called "full employment." At the same
time, capacity utilization in American industry has risen—although,
at 79 percent, it is still somewhat lower than its long-run average.
Moreover, signs point to another robust performance in the fourth quarter,
so growth for the last half of 2005 could well come in noticeably above
the potential rate.
This positive performance suggests that the overall economy has been
quite resilient in absorbing the impact of the storms. For 2006, it
seems likely that this strength will continue in the first half, as
rebuilding kicks in. Then, in the second half, a couple of factors
are likely to cause economic growth to settle into a trend-like pattern.
One of the factors is the winding down of the rebuilding effort. The
other is the lagged effect of monetary policy tightening; in other
words, tighter financial conditions will have some dampening impact
on interest-sensitive sectors, such as consumer durables and housing.
An important factor shaping the outlook, of course, is energy prices.
Over the year and a half before the storms, energy prices had surged
worldwide, with the price of oil nearly doubling and the price of natural
gas rising by about two-thirds. Energy prices spiked following the
storm, but they retreated fairly quickly. At this point, oil and wholesale
and retail gasoline prices are actually below those prevailing
before the storms, though they are still a good deal higher than they
were a year and a half ago. Finally, natural gas prices have fallen
substantially, but now are above pre-hurricane levels.
Of course, we normally would expect the year-and-a-half-old energy
price surge to push down spending. This is because the additional amount
that households are forced to spend for the same quantities of gasoline,
natural gas, heating oil, and other energy-intensive products tends
to diminish 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.
Recent data suggest, however, that consumer spending has held up well
so far. For example, although personal consumption expenditures were
up only modestly in October, they were held down by a big drop in auto
sales that probably reflected reduced sales incentives; outside of
autos, personal consumption expenditures were robust, despite the surge
in energy prices and plummeting confidence. Indicators of business
spending and output also have held up well. It is possible that higher
energy prices have had a negative impact on consumer spending,
but the drag from this factor has been offset by other stimuli to spending
such as rising home prices and growth in disposable income. But for
now, at least, it appears that the national economy has come through
the twin shocks of the hurricanes and the year and a half long escalation
in energy prices quite well. Concerns about downside risks to the economy
seem much smaller than just a few months ago.
This is definitely good news, but uncertainties do remain—especially
during a period like this, when the stance of monetary policy is changing.
It's inherently difficult to judge the exact magnitude and timing
of the effects of removing policy accommodation. Therefore, it will
be very important to monitor this situation in the months ahead, particularly
if, as seems likely, there is cooling in the housing market and other
interest-sensitive sectors.
My focus so far has been on developments that relate to the Fed's
objective of keeping the economy operating in the vicinity of full
employment. However, like central banks worldwide, the Federal Reserve
is also keenly focused on maintaining price stability. One particularly
comprehensive measure of consumer prices that the Fed monitors closely
is the index for personal consumption expenditures—the so-called
PCE price index. Inflation in this measure has jumped to 3.3 percent
over the last twelve months, reflecting large increases in energy prices.
However, energy prices, like food prices, tend to be quite volatile.
So a better measure of underlying inflation—one that tells us
more about where inflation is likely to be in the longer run—is
so-called core inflation, which excludes the energy and food components.
Inflation by this measure is up by a much more moderate 1.8 percent
over the twelve months ending in October.
I have previously enunciated that, in my view, core PCE inflation
in a range of 1 to 2 percent constitutes an appropriate price stability
objective for the Fed. Since 1.8 percent is in the upper portion of
this comfort range, I'd be happier if this measure were somewhat
lower. And, indeed, it is lower if we look over a shorter horizon.
For the six months ending in October, core PCE inflation came
in at 1.6 percent at an annual rate—which is near the middle
of my preferred range. This suggests to me that core inflation has
been essentially compatible with the Fed's price stability objective,
even in the face of a rather large oil shock that started well before
Katrina.
Looking ahead, I'm generally fairly optimistic about the future
for inflation, though I do think there are upside risks—mainly
having to do with energy prices—that require vigilance by the
FOMC in the period ahead. Let me start with the optimistic factors.
First, productivity growth has remained quite strong, and growth in
labor costs has remained modest so far. Second, although there is probably
little if any slack in labor markets at this point in the cycle, the
economy does not appear to have overshot full employment. Furthermore,
there still appears to be a bit of unused capacity left in the industrial
sector.
With regard to energy, it's certainly a good sign that—so
far—higher energy prices have not been passed through
to higher non-energy or core prices to a significant extent. I want
to emphasize the "so far" part of that statement, because
a ny sign of a more significant pass-though would be a concern for
monetary policy. One need only think of the 1970s to know what I'm
referring to. At that time, higher oil prices were associated with
a wage-price spiral that pushed inflation into double-digit territory.
Naturally, much research has gone into analyzing what happened during
that period, and I'm glad to report that the research suggests
major differences between then and now. 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 literature very briefly, the idea
is that under some circumstances inflation expectations can be 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
they will tend to build higher expected inflation into wage bargaining;
this raises costs to businesses, which, in turn, may get built into
the prices of their products. Unwinding the inflationary spiral is,
to put it mildly, not fun. In the early 1980s, the Fed had to do
it by slamming hard on the brakes, and the costs were high—the
economy went through a large double-dip recession, and the unemployment
rate hit 10 percent in 1982.
What's different now? Since the early 1980s, the Fed has continued
to work to lower the inflation rate with considerable success, so that
over the last ten years core PCE inflation has averaged a moderate
1.7 percent. With this history of low inflation, it's natural
that the public would expect inflation to remain in a low
range. As economists express it, inflation expectations have become "well
anchored" to price stability—most likely because people
are confident that the Fed will act to limit any potential rise in
inflation. This may account for research results suggesting that, during
this period, energy price increases have generally not been passed
through to core inflation.1
We actually have some evidence on people's current inflation
expectations. One source of information comes from responses to surveys
about inflation expectations. A University of Michigan survey taken
shortly after the hurricanes hit recorded a large jump in inflation
expectations—for the overall CPI—over the next
twelve months, and a smaller increase in expectations for the next
ten years. But I would not read too much into this, since the near-term
survey results reflect the impact of energy price developments; of
course, the higher near-term result also affects the average increase
expected over the next ten years.
Another source of information on inflation expectations comes from
analyses using a financial instrument that is called Treasury Inflation-Protected
Security, or TIPS for short. The key feature of TIPS is that the payments
to investors adjust automatically to compensate for the actual change
in the CPI. By comparing yields on these securities with those on standard
Treasury securities that are not indexed to compensate for
inflation developments, we can estimate what the market thinks inflation
will do over the life of the securities.
In other words, using this kind of analysis, we can estimate inflation
expectations over various time horizons.2 Compensation
for average inflation over the next five years rose by about ¼ percentage
point in the month following Katrina, but has since dipped below pre-hurricane
levels. Furthermore, it is notable that longer-term inflation expectations—those
covering the period from five years ahead to ten years ahead—are
slightly below the level that prevailed when oil prices started to
rise in early 2004. 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.
This brings me to my last point, the conduct of policy. Clearly, for
monetary policymakers, the public's confidence in our commitment
to price stability is a very helpful thing. As I've just indicated,
well-anchored inflation expectations themselves are likely
helping to contain the inflationary pressures associated with higher
energy prices. Therefore, policy's response to those pressures
can be more tempered than "slamming on the brakes," and
that means running less of a risk of pushing the economy into a deep
recession. Public confidence is helpful in other circumstances, too.
If there's a sudden drop in demand, the Committee can ease to
offset it without worrying that the public will think policy is on
a path toward overstimulation that would generate inflation.
Stable inflation expectations allow monetary policy to respond to shocks
without having to pitch the economy too far in one direction or the
other; in other words, credibility facilitates the pursuit of our dual
mandate for price stability and "full" employment—the
two main policy goals articulated in the Federal Reserve Act.
How has the Committee established credibility? First, of course, as
I said, inflation has come down markedly over the past twenty-five
years and stayed low for quite some time. I don't want to give all the
credit for this to monetary policy, because, of course, rapid productivity
growth has played an important role as well. But the Committee has been
diligent about the actions it has taken—setting policy
to lower inflation gradually and to keep it low.
In keeping with this strategy, at the November meeting, the Committee
voted to continue its gradual removal of policy accommodation and raised
the federal funds rate target to four percent. The objective of this
policy action—as well as any future actions—is to position
the economy on a trajectory characterized by "full employment" and
price stability. Such a so-called glide path requires that as slack
in labor markets is absorbed, real output growth must converge toward
a sustainable long-run pace at the same time that inflation is at its
desired rate.
In addition to actions such as this, I believe the Committee has reinforced
its credibility with the public by becoming more transparent and focusing
on communication. By this I mean that the Committee has made a significant
effort to let the public know what it has done and why in recent years.
Let me recount quickly the steps toward greater transparency which
began in 1994. First, the Committee started issuing post-meeting press
releases that explicitly announced changes in the federal funds rate
target; then it added descriptions of the state of the economy and
the rationale for the policy action to the release; then it introduced
a statement describing the "balance of risks" to the outlook;
then it began releasing the votes of individual Committee members and
the preferred policy choices of any dissenters; then it added explicit
language concerning future policy to its post meeting press
release; and finally, it decided to release the minutes of its meetings
with a much shorter delay—only three weeks instead of five to
eight weeks—so that now the minutes appear before the
next meeting, instead of after it.
Transparency is helpful not only in building credibility, but it is
also helpful in another important way. By letting everyone in on its
current thinking, the Committee helps to align expectations, including
those in financial markets, with its best estimate of where policy
is likely to go. A good example of this was in 2003, when it appeared
that there was a threat of outright deflation. This was a potentially
serious situation and the Committee wanted to lean on the side of an
accommodative policy until the threat had passed. The statement said
that "In these circumstances, the Committee believes that policy
accommodation can be maintained for a considerable period." I
think this forward-looking language was helpful in keeping long-term
interest rates lower than they otherwise would have been, which helped
to reduce the risk of deflation.
Another example is what happened following the recent hurricanes.
Before the September FOMC meeting, there was a great deal of speculation
about the Committee's response to the potential for a simultaneous
slowdown in growth and rise in inflation. The September release stated
that "While these unfortunate developments have increased uncertainty
about near-term economic performance, it is the Committee's view that
they do not pose a more persistent threat." It went on to say
that, "the Committee believes that policy accommodation can be
removed at a pace that is likely to be measured." I believe that
these clarifications and signals about future actions helped avoid
confusion about the Committee's perspective and contributed importantly
to making policy more effective.
As I said, the sentences about where policy is likely to go reflect
the Committee's best estimates. And best estimates, of course,
are always subject to revision. So I want to emphasize that, in my
view, the Committee must always have the flexibility to respond to
changing circumstances. Indeed, the statement typically includes language
along those lines. For example, in November, the statement said "the
Committee will respond to changes in economic prospects as needed to
fulfill its obligation to maintain price stability."
If you look at the minutes from the November meeting, you will see
that the statement is currently a subject of discussion. Two phrases
in particular are at issue: "remove accommodation" and "at
a measured pace." While it seems unlikely that the end of the
current tightening phase is yet at hand, there obviously will come
a time when these two phrases are no longer appropriate, and other
changes to the statement may be needed as well. As the November minutes
suggest, going forward, the Committee will pay close attention to incoming
data and weigh options carefully in assessing the stance of policy
and the wording of the statement.
I started this discussion of the conduct of policy by saying that public
confidence in the Committee's commitment to price stability is
a helpful thing. As I've indicated, I believe that this public confidence
has strengthened under Chairman Greenspan's leadership of the Fed, with
years of consistently low inflation and a communication strategy that
has made the conduct of U.S. monetary policy more transparent to the
public.I'd like to close by saying that public
confidence is also a very valuable thing—and like all valuable
things, it is hard to win and easy to lose. For my part, this must mean
ensuring—in both deeds and words—that, as developments
unfold, our economy does not suffer from an unacceptable rise in inflation.
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