Presentation to the Bay Area Council
2006 Outlook Conference
San Jose, California
By Janet L. Yellen, President and CEO of the Federal Reserve
of San Francisco
For delivery on Tuesday, April 18, 2006, 8:45 AM Pacific
11:45 AM Eastern
Prospects for the Economy
Thank you very much for inviting me to join you today.
It's a real pleasure to be part of this outstanding event
exploring the future of the Bay Area and of California.
Now that Lenny has given you a look at the economic profile
of the Bay Area, I'm going to take on a bigger canvas and
paint a picture of the forecast for the nation as a whole.
The national picture certainly contains some features that
are key factors in the fortunes of the Bay Area economy—particularly
housing markets. Of course, the overall performance of the
national economy will impact Bay Area firms and the state
and local economies.
My plan is to paint the outlook in three parts—economic
growth, labor markets and resource utilization, and inflation.
I'll start each one with fairly broad brushstrokes, and then
I'll fill in the highlights and shadows—that is, the
factors that add uncertainty to my views on the future. I'll
conclude with some thoughts on how I view this picture from
my perspective as a monetary policymaker. Then, of course,
I would welcome your questions and comments. But before I
begin, let me note that my remarks represent my own views
and are not necessarily those of my colleagues in the Federal
I'll start with the broad brushstrokes on the outlook for
economic activity. Prospects for growth in the year ahead
are solid at the national level, and of course, this can
only be good news for the Bay Area and California as well.
The U.S. economy has shown remarkable resilience in the face
of some severe shocks—in particular, the surge in energy
prices that began a couple of years ago and the devastation
wrought by the twin hurricanes last summer. Although economic
growth came in pretty weak in the fourth quarter of last
year, it appears to have roared back in the first quarter
of this year.
If growth were to continue to roar—that is, to keep
running at an unsustainable pace for too long, raising the
risk of building inflationary pressures—monetary policymakers
like me would start getting those frowny lines in their foreheads.
But, at the moment, my brow is fairly smooth. My best guess
is that economic activity will remain healthy, supported
by strong productivity growth and continued strength in consumer
spending and business investment, especially investment by
the vital high-tech sector. But I don't think we will get
a repeat of the very rapid first quarter growth. Rather,
I expect economic activity to settle back to a more trend-like
and sustainable rate as the year progresses.
One reason why is that part of the strength in the first
quarter is likely just the flip-side of some temporary factors
that made the economy weak in the fourth quarter—things
like the immediate disruptive effects of the hurricanes and
harsh winter weather that held back consumer spending. Another
reason is that the Fed's gradual removal of monetary policy
accommodation should tend to damp the pace of activity. This
effect is likely to be reinforced by a related development—a
significant moderation in the rate of appreciation of house
prices. This could well restrict not only the pace of residential
construction but also the pace of consumer spending. For
example, some observers believe that consumer spending has
been bolstered by the withdrawal of equity from housing,
and, of course, this source of funds would be smaller if
the pace of appreciation abated. Furthermore, there is the
so-called wealth effect on spending, because houses are such
an important part of many people's portfolio of assets. With
this asset appreciating more slowly, consumers are likely
to pull back on spending.
Now let me fill in the highlights and shadows—some
of the factors that could make economic activity either stronger
or weaker going forward. First, house prices could surprise
us in either direction. In other words, instead of the significant
moderation I've built into my forecast, house price appreciation
could either slow much more than I expect, or it could continue
at its current pace. If it slows much faster—or, worse
yet, reverses course—the impact could be very restrictive
for both residential construction and consumer spending.
Alternatively, house prices might go on climbing as fast
as ever. If so, the continued stimulus to spending could
keep economic activity growing at an unsustainable pace,
creating inflationary risks.
So far, the early signs of cooling in U.S. housing markets
are broadly consistent with the degree of moderation I've
envisioned. Home sales, especially new home sales, are off
their peaks, and mortgage refinancing is way down. Moreover,
the available evidence suggests that the rate of increase
of selling prices for new homes has slowed over the last
several months. 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.
Of course, housing markets are a big issue in the Bay Area,
and we have seen the same kind of cooling as in
the nation. The question of whether the housing stock here
is overvalued and therefore particularly vulnerable to downside
risk, however, is one I can't answer with any certainty.
I would note that there are some special things about the
Bay Area on both sides of the question. For example, consider
some tentative evidence on the side of greater vulnerability.
First, average house prices in the Bay Area are now about
six times what they were in 1982, versus only 3-1/2 times
in the U.S. as a whole. Moreover, the ratio of house prices
to rental rates—a measure of the price of houses relative
to the flow of housing services they provide—has more
than doubled since 1982, far out-stripping the national average.
But, even considering these features, there are well-known
and unique features of this area that lend some justification
to its high housing values. First, there is not much land
available for new home building, so the supply of new homes
is fairly limited. In addition, this area enjoys very favorable
lifestyle amenities and it has a job base that attracts high-income
Related to the house price story is another risk factor
for the growth forecast, namely, the so-called "bond rate
conundrum." Essentially, long-term interest rates have been
surprisingly—and inexplicably—low relative to
the path of short-term rates expected by the markets. If
the relationship were to return swiftly to something closer
to the historical norm—that is, if long-term rates
were to rise suddenly—economic growth might slow more
than my forecast suggests.
In fact, so far this year, bond rates have climbed
some, although even now they are only modestly higher than
when the Fed began raising the federal funds rate, back in
June 2004. Does this rise in long-term rates pose a downside
risk to growth? Frankly, I think it's too soon to tell, but
I'll give you a flavor of the views pro and con. On the "pro" side,
the rebound in longer-term rates may partly reflect an unwinding
of the conundrum due to an increase in the "term premium" toward
more normal levels. It might also reflect a strengthening
of economies abroad: specifically, greater spending on goods
and services in Europe and especially Japan may be absorbing
more of the supply of worldwide savings and driving up bond
rates in the U.S. and everywhere else. On the "con" side,
the rise in U.S. bond rates might itself reflect expectations
of even stronger growth in the U.S. While we don't have an
answer yet, I hope this discussion at least conveys a sense
of why developments relating to the yield curve will definitely
be on my radar screen.
The final factor that could alter the forecast for economic
growth—one that I will return to when I discuss inflation—is
energy prices. So far, at least, the near doubling of energy
prices has not been reflected in slower consumer spending—possibly
because of a stimulatory offset from rising house prices.
My assumption, based on the forecasts embodied in futures
markets, is that energy prices will stabilize around their
current levels. If so, the negative effect on spending should
dissipate over 2006, and, as it does, this would actually
contribute to higher overall economic growth. Of
course, predicting energy prices is an exercise fraught with
uncertainty, and any sustained rise or fall in these prices
could either depress or spur economic activity beyond my
Now to the next part of the picture—labor markets
and resource utilization. My broadbrush view is that the
economy is now operating in the vicinity of "full employment." Looking
ahead, if the growth rate of economic activity returns to
its trend, as seems likely, then labor markets are likely
to remain at this level.
This brings me to the inflation part of the picture itself.
Over the past twelve months through February, inflation,
as measured by the core personal consumption expenditures
PCE price index—is up 1.8 percent. This measure,
which FOMC participants forecast semiannually for Congress,
is an index of consumer prices that excludes the volatile
food and energy component. This rate is in my "comfort zone"—a
range between one and two percent. I consider core PCE inflation
in this range an appropriate long-run inflation objective
for the Fed.
What are the prospects for inflation over the next year
or two? When I look at all of the elements that influence
inflation, it seems that the most likely outcome over the
next year or so is that inflation will remain contained,
although there are risks, and I think they are tilted slightly
to the upside. First, there is the possibility that inflation
could intensify if labor and product markets continue to
tighten. Next, there are risks relating to energy and commodity
prices. Apparently, we haven't had much in the way of pass-through
from past increases in energy and commodity prices to core
inflation yet, but I wouldn't be surprised if some modest
amount were evident in the next couple of quarters. Assuming,
however, that energy and commodity prices level out, and,
importantly, that longer-term inflation expectations remain
stable, I would expect any pass-through of earlier increases
to boost core inflation only temporarily. We learned from
history that inflation expectations that are well-anchored
to price stability are critical to maintaining low inflation.
And, indeed, research suggests that they are well-anchored,
because people are confident that the Fed will act to limit
any sustained rise in inflation. In the current setting,
this result shows up in the stability of our measures of
core inflation as well as various survey and market measures
of inflation expectations.
In concluding my remarks, I want to step back from the
easel, where I've been painting this picture of the economy,
so that I can take it in as a whole, the way a monetary policymaker
should. What I see is essentially pretty positive. The economy
appears to be approaching a highly desirable trajectory.
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. If it does, the degree
of slack should remain within range of full employment and
have little effect on inflation going forward. Although inflation
is in the upper portion of my comfort zone, it appears to
be well contained at present, and my best guess for the future
is that it will remain well contained.
Moreover, this desirable trajectory appears to be within
reach at a time when the Fed's key policy interest rate—the
federal funds rate—is close to a neutral stance, one
that neither stimulates the economy nor restrains it. Before
I seem to make this picture too rosy-looking, I want to remind
you that there are a lot of uncertainties on both the upside
and the downside—those highlights and shadows I've
discussed. And any of them could certainly be disruptive,
especially if the Fed does not react quickly and appropriately.
So, the key question for policy is: What interest rate
path will help the economy achieve the desirable trajectory?
As you know, the Fed has raised the federal funds rate by
25 basis points at each of the last 15 FOMC meetings for
a total increase of 375 basis points and indicated that further
policy firming may be needed. Until recently, the funds rate
was low enough that it seemed rather clear that this path
of gradually removing accommodation had some way to go.
However, enough has been done by now that I view decisions
about the path of policy going forward as quite data-dependent.
This phrase—"policy will be data-dependent"—is
all the rage right now in policy circles, but I think it's
worth a moment to clarify what I mean when I use it. To me,
it means that we should interpret the implications of incoming
data for our forecast and evaluate whether resulting
changes in the forecast call for a change in the policy path.
For example, as I mentioned, there is little evidence thus
far of pass-through into core inflation of previous hikes
in energy and commodity prices. But I would not be surprised
to see some modest transitory pass-through over the next
few quarters. I would, however, be surprised to see evidence
suggesting that labor markets had tightened enough to boost
inflationary pressure. I also expect longer-term inflation
expectations to remain well contained.
Similarly, I expect first quarter real GDP growth to be
quite strong, and I've already factored that into my views.
The accumulation of more and more monthly data supporting
that expectation does not necessarily alter my views on policy.
I will, of course, be quite alert to any signs that the hot
pace of growth may not slow after the first quarter.
That would constitute a surprise.
But, by the same token, I am increasingly concerned about
the well-known long and variable lags in monetary policy—specifically,
that the delayed effects of our past policy actions might
impact spending with greater force than expected. This could
show up especially in the housing market and via housing
prices and balance sheet effects on consumer spending. While
I expect the housing sector to slow somewhat, I will be highly
alert to the possibility of the policy tightening going too
far. So, I'm watching the data for confirmation of my forecast
and for surprises that would make me alter my forecast. It's
not really data-dependence, but more accurately, data-surprise
In summary, I would not want to prejudge future decisions to
raise rates—or to hold them steady—but rather I
will be highly sensitive to the implications of incoming data
for the forecast for economic growth, employment, and inflation.
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