Speech before an Australian Business Economists
Sydney, Australia via satellite link from San Francisco
By Janet L. Yellen, President and CEO of the Federal Reserve Bank of
For delivery on Wednesday, March 15, 2006, 6:00 PM Pacific Time,
PM Eastern (1:00 PM Sydney time, March 16)
The U.S Economy in 2006
Greetings, and many thanks for inviting me to join you today—or,
perhaps I should say “tomorrow,” since it’s only
Wednesday, March 15, for me. In my remarks, I will focus on the U.S.
economy, and I’ll organize my comments around three broad topics.
The first is employment and output growth. The second is inflation.
My third and last topic is the conduct of monetary policy.
In preparing for this talk, I took a quick look at the online edition
of the Sydney Morning Herald—just to see if anything might jump off the page as
particularly relevant to this discussion. In fact, something did jump off the
page. It was a story on March 4 about Mardi Gras in New Orleans, where the city
is still recovering from the devastation following Hurricanes Katrina and Rita.1 I found it especially interesting that the story was the fifth “most viewed” article
that day, indicating the ongoing concern Australians feel for the people in that
beleaguered area—let me add that I also found that gratifying.
This story is relevant to my remarks today, of course, because of
the effects that the hurricanes had on the U.S. economy last year,
and because of their
reverberations this year. As the newspaper story indicated, the loss and
disruption of life,
livelihoods, and property in New Orleans, and, indeed, in other parts of
the Gulf Coast region, have been tragic. More threatening for the health
national economy, of course, was the severe beating that the infrastructure
notably the infrastructure for energy. The timing was particularly unfortunate,
because, for the preceding year and a half, energy prices had surged worldwide.
So there were concerns that the damage to the Gulf’s energy infrastructure
might lead to a sustained hike in energy prices over and above those already
high prices. Indeed, energy prices did spike after the storms, but then they
retreated fairly quickly. So, at this point, the prices of oil, gasoline,
and natural gas are actually lower than they were before the storms, though
are still a good deal higher than they were before the worldwide surge.
Overall, the economy has shown considerable resilience in the face
of the direct effects of the hurricanes and the energy price shock.
When the storms
the end of August, economic activity had been quite robust for several
years, supported by monetary accommodation and strong productivity
GDP had grown steadily at, or above, its potential or long-run sustainable
which is estimated at around three and a quarter percent. This pattern
continued even during the third quarter—immediately following the hurricanes—when
real GDP grew by just over four percent.
In the fourth quarter, growth did drop sharply to about 1 ½ percent.
However, a good deal of this slowdown appears to have been due to several
none of which were related to the hurricanes. These included unusually
harsh winter weather which held back retail activity, delays in some
purchases which were moved from the end of last year into the first quarter
of this year, and a dip in auto production.
As for the current quarter, the monthly data so far show significant
strength in activity following the earlier weak quarter. The key issue
is the extent
to which this strength represents the pay-back from the temporary factors
growth in the fourth quarter or whether it is driven by more fundamental
factors that would be longer-lasting. At present, we don’t have
enough information to know for sure, and we will be watching the data
with the utmost interest to
see how this turns out.
My best guess is that a good part of this strength is the flip-side
of the factors that made the economy weak in the fourth quarter,
extrapolated to subsequent quarters. Therefore, it seems likely that
growth will settle back to a trend-like pattern as the year progresses.
factor is the winding down of the rebuilding effort later in the
year. Another is the lagged effect of monetary policy tightening; in
financial conditions will have a dampening impact on interest-sensitive
sectors, such as
consumer durables, housing, and business investment.
What could punch a hole in this forecast? Let me focus on a few things
in particular. One would be a serious retrenchment in house prices,
soared in the
U.S. during the past decade. I know that you have had some experience
with housing booms as well. Starting in the mid-1990s, average
rose rapidly in
Australia, but since 2003 they have been about flat and have had
some effect in slowing consumer spending and borrowing. A risk
to the U.S.
would come from a significant reversal of the boom in house prices,
which could have a very restrictive impact, especially through negative wealth
so far, I’d say that we’ve only seen early signs of a cooling off
in U.S. housing markets. While residential construction has held up pretty well
so far, the data for new homes—a good indicator of current market conditions—show
that sales have dropped off and that the median selling price is down modestly
since last fall, although both still remain at relatively high levels. Looking
ahead, the ratio of new houses for sale to those sold—a kind of inventory-to-sales
ratio for homes—has risen rather sharply since the summer,
suggesting that other signs of cooling in the housing market may
become more evident.
Second is another issue related to the housing market—the so-called “bond
rate conundrum,” wherein long-term interest rates are unusually
low relative to short-term rates. There are various theories
about why the risk premium on
bonds is so low, but, frankly, it remains a conundrum. If risk
premiums rose to more historically normal levels, this would
obviously have negative implications
not only for housing markets, but also for long-term business
The third thing that might upset the forecast is
a further sustained
surge in energy prices. If these prices stay at their current
levels, any negative
they might have should dissipate over 2006, and as that happens,
it would actually contribute to higher overall economic growth.
markets are highly
susceptible to shocks from political and other developments—I
need only mention Nigeria and Iran to illustrate the point
in the current environment.
So this factor remains, as always, a wild card in the outlook.
Indeed, not only is there uncertainty about where energy prices
will go in the future, but there also is a good deal of uncertainty
a further change in energy prices would have. This uncertainty
has been heightened by the strength of consumer and business
spending in the face
of the surge
in energy prices that started over two years ago. Of course,
that higher energy prices have had a negative impact on spending,
which has been offset by other stimuli, such as rising home
prices. This remains an open issue.
Turning to labor markets, as the economy has strengthened
in recent years, slack in these markets has gradually, but
diminished—for example, jobs
have increased by more than enough to absorb a growing workforce, and the unemployment
rate has declined. Indeed, for February, unemployment came in at 4.8 percent,
a number that’s slightly below conventional estimates consistent with so-called “full
And that brings me to the inflation situation. Specifically,
this relatively low unemployment number raises the question
has already gone a bit beyond full employment. If it has,
then, with real
expected to exceed its potential rate in the first half of
this year, the strain on
resources could build further, intensifying inflationary
pressures. Additional inflationary
pressures at this point would be particularly unwelcome,
because inflation is now toward the upper end of my “comfort zone.” Let me get quite specific
on this point. When I say “inflation,” I’m referring to the
core personal consumption expenditures price index; that is, the index that excludes
the volatile food and energy component. This measure is up by 1.8 percent over
the twelve months ending in January. When I say “my comfort zone,” I’m
referring to the range between one and two percent that I
have previously enunciated as an appropriate goal of monetary
I’ve tried to present the inflation issue in rather stark terms because
it is, after all, of the utmost importance for monetary policy. So let me give
you my own take on the matter. First, I think it’s important to look beyond
the unemployment rate to other measures of slack to get a full picture. Doing
so does give a somewhat more mixed picture. For example, there is some indication
of slack from the employment-to-population ratio—at nearly 63 percent,
it is still below its long-run average; of course, using the long-run average
as a benchmark may somewhat overstate the case, since ongoing declines in labor
force participation as the baby boom generation ages will tend to lower the ratio.
Another indicator is the Conference Board’s diffusion
index for job market perceptions. This index appears to be
a rather direct measure of perceptions
of labor market tightness, and it remains shaded toward the
side of some excess capacity in labor markets. Measures of
slack in product markets also are mixed.
Capacity utilization in manufacturing is above its long-run
average, but some measures of the output gap still show some
So these measures suggest a range of estimates from a modest
amount of slack to a modest amount of excess demand in the
would argue that what matters is not just U.S. productive
capacity, but also worldwide productive capacity. As I’m sure you know the argument
is that if the U.S. reaches full employment, we can simply
tap the vast workforces in China, India,
and elsewhere around the world and import those goods to
our economy. Since labor costs tend to be low in many developing
economies, the ability to switch from
domestic to imported goods could moderate the wage and price
increases which would otherwise occur as slack in the U.S.
labor market shrinks.
In my view, globalization has had a profound impact on the
U.S. economy, affecting product, financial and labor markets.
of foreign countries
to supply goods and services to the U.S. market has impacted
the structure of wages and the bargaining power of workers.
are good reasons
that such factors are sufficient to sever the usual link
between labor market slack and wage and price pressures.
goods and most
heart transplants to haircuts and new houses—must be
produced in the U.S., so foreign capacity is not an issue
there. Indeed only 10% of American workers
are in manufacturing, which is arguably the sector most exposed
to foreign competition.
Second, there is the issue of foreign
exchange rates. The
dollar prices of goods that we import into the United States
on the prices
their respective foreign currencies, and also the exchange
rates of these currencies vis à vis the dollar. However, the exchange rates of many currencies are
not fixed vis à vis the dollar and exchange rate movements—difficult
as they are to predict--can offset a good deal of the effects of import prices
on inflation. In order to utilize the productive capacity in foreign countries,
we need to run a trade deficit. In principle, such deficits put downward pressure
on our exchange rates, at least over time, and this tends to raise prices paid
for these goods in the U.S. Looking at the U.S. data on non-oil import prices,
in recent years they have risen at a 2-1/2 to 3 percent rate—which
is actually slightly faster than the U.S. core consumer inflation
rate. Finally, growth is
strong in many parts of the world, at present, and it is
not just foreign supply but also foreign demand that is expanding.
Indeed, strong global growth has played
a role in boosting energy prices.
So, overall, while I’m glad to see some lively debate on this issue, I’m
not convinced that foreign capacity is a major reason to shrug off concerns about
the possibility of overshooting capacity in U.S. labor and product markets. And,
as I’ve said, it appears that the economy is near full usage of resources,
but it’s not clear whether we are slightly above capacity
A second factor to consider in the inflation picture
expectations. As you know, under certain circumstances, inflation
be like self-fulfilling prophecies. If people expect higher
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
into wage bargaining, raising costs to businesses, which,
in turn, may get built into the prices of their products.
to price stability can make a crucial contribution to low
and stable inflation going forward.
On Monday, I gave a speech in Washington D.C. to the National
Association of Business Economics that argued that inflation
in the U.S. are
not as well anchored as they could be, and also not as well
anchored as they are
in many other developed countries, because those countries
have explicit, numerical inflation goals and the U.S. does
argued that U.S. inflation
has become much better anchored as a result of the efforts
of the Fed to enhance communication and transparency. A good
the recent surge
in energy prices has generally not been passed through to
core inflation to a significant extent.3 This
result shows up in
the stability of
our measures of
There also is indirect evidence from the financial markets.
For example, using analyses that compare the real yields
or TIPS for short, with those on standard Treasury securities
that are not indexed to compensate for inflation developments,
estimate what the
inflation will do over the life of the securities.4 Compensation
inflation over the next five years has been volatile at times
since energy prices began
rising in late 2003, and not surprisingly, has risen on balance
by almost a full percentage point over that period. However,
it is notable,
longer-term inflation expectations—those covering the period from five
years ahead to ten years ahead—are essentially unchanged
on balance over that same period.
Both slack and inflation expectations often work through
changes in labor compensation to influence price increases.
compensation can provide
a check on one’s views on the other factors. Looking at this channel, it’s
hard to find evidence suggesting upward inflationary pressures. For example,
growth in total compensation in private industry, as measured by the Employment
Cost Index, actually declined last year to only 3 percent from 3 ¾ in
2004. Going behind these numbers, we find that they include both a deceleration
in wages and salaries and unusually large increases in benefit costs. Looking
ahead, recent surveys suggest that growth in health insurance costs is likely
to moderate significantly this year. To some extent, such moderation could hold
down overall compensation growth, since it’s doubtful
that offsetting increases in wages and salaries would completely
fill the gap that quickly.
The final factor in the inflation picture that I’d like to discuss is productivity.
For about ten years now, U.S. productivity growth has been very strong. It grew
at around two and a half percent in the latter half of the 1990s and has increased
even more rapidly—at 3 ¼ percent—so far in this decade. Of
course, it’s not reasonable to expect the rather extraordinary 3 ¼ percent
pace to be maintained in the long run. A number of leading
experts estimate the trend rate at around two and a half
percent, still a very high number that would
dramatically enhance living standards in this country over
The issue for inflation going forward is whether
growth will match the trend rate of around two and a half
the side of
slowing productivity growth is the recent moderation in the
pace of price declines for high-tech goods. This could imply
to some extent.
While this is a source of concern, it’s too soon to tell how long it will
last. Moreover, there are a couple of reasons to think that firms may learn to
use the technology they already have in place to become more productive, and
that could keep productivity growing rapidly over the next several years. First,
some evidence suggests that the extraordinarily high rates of investment in high-tech
equipment during the second half of the 1990s actually led to a reduction in
productivity growth—nearly half a percentage point
during that period.5 The reason is that firms had to devote
a lot of human capital and time to learn
how to get the most out of it. If firms continue to increase
their proficiency in using the technology they already have,
this could help keep productivity
growing at a robust pace. Second, one fundamental way that
technology enhances productivity is by allowing firms to
reorganize and streamline the way people
work. This is a process that takes some time, of course.
And all signs suggest that it is ongoing and likely to continue
playing out for a good while.
Let me summarize this discussion of the inflation outlook.
When I look at all of the elements that influence inflation—slack, inflation expectations,
oil prices, and productivity—it seems that the most
likely outcome over the next year or so is that inflation
will remain contained. And, while I would
be happier if recent core inflation had been a bit lower,
it is encouraging that core inflation has been essentially
compatible with price stability, even in
the face of a rather large oil shock that started well before
This brings me to my last point, the conduct of
policy. I’d like to start
by summarizing my views on the economic situation: while we face a great deal
of uncertainty, the economy appears to be approaching a highly desirable glide
path. First, real GDP growth currently appears to be quite strong, but there
is good reason to expect it to slow to around its potential rate as the year
progresses. Second, it appears that we are operating in the vicinity of “full
employment” with a variety of indicators giving only
moderately different signals. Finally, inflation is near
the high end of my comfort zone, but it appears
well contained at present, and my best guess for the future
is that it will remain well contained.
Of course, the key question for policy is what interest rate
path will help the economy achieve the glide path? As you
Fed has raised
rate by 25 basis points at each of the last 14 FOMC meetings
for a total increase of 350 basis points. Until recently,
rate was low
enough that it
seemed rather clear that this path of gradually removing
accommodation had some way
to go. That is why, up until last November, our post-FOMC-meeting
release stated that “…the Committee believes that policy accommodation can
be removed at a pace that is likely to be measured.”
However, once the rate got to 4 percent in November, the
issue of exactly how much accommodation actually remained
of a judgment
call. As a result, our most recent press release, from late
January, states that, “the
Committee judges that some further policy firming may be needed to keep the risks
to the attainment of both sustainable economic growth and price stability roughly
in balance.” Indeed, I view decisions about the stance of policy going
forward as quite data-dependent. On the one hand, I will be alert to any incoming
data suggesting that economic growth is less likely to slow to a sustainable
pace or that inflation is less likely to remain contained; however, I will also
be looking for signs of the delayed effects on output and inflation of our past
policy actions and will be sensitive to the possibility that policy could overshoot.
While the Committee must always have the flexibility to respond to changing circumstances,
the need for the flexibility to respond appropriately to incoming data is especially
important right now.
Thanks very much for your attention, and I look forward to taking
1 “A river runs through it, into a gulf of
misfortune,” by Michael Gawenda, Sydney Morning Herald, March
2 See “Enhancing
Fed Credibility,” delivered
March 13, 2006, to the National Association of Business Economics
Annual Washington Policy Conference in Washington, D.C.
3 Bharat Trehan, “Oil
Price Shocks and Inflation,” FRBSF
Economic Letter, Number 2005-28, October 28, 2005.
4 Simon Kwan, “Inflation
Expectations: How the Market Speaks,” FRBSF Economic Letter, Number 2005-25, October
5 See “Productivity Growth in the 1990s: Technology,
Utilization, or Adjustment?” by S. Basu, J.G. Fernald, and M.D.
Shapiro, Carnegie-Rochester Conference Series on Public Policy 55,
December 2001, pp. 117-165.
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