Speech at the Golden Gate University Speakers Series
San Francisco, California
By Janet L. Yellen, President and CEO of the Federal Reserve
Bank of San Francisco
For delivery July 31, 2006 – 8:45 AM Pacific Daylight
Time, 11:45 AM Eastern
Prospects for the U.S. Economy
Thank you very much for inviting
me to join you. It's a real pleasure to be part of this
outstanding speakers series. Today I will discuss my views
the prospects for the U.S. economy—for labor markets and economic activity
and also for inflation. This focus mirrors the two main objectives for monetary
policy enunciated in the Federal Reserve Act, namely maximum employment and
price stability. I plan to explore the implications of these developments for
monetary policy. Then, of course, I would welcome your questions and comments.
Before I begin, let me note that my remarks represent my own views and are
not necessarily those of my colleagues in the Federal Reserve System.
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 from the twin hurricanes last summer. Over
the past two years, economic growth has averaged just over 31/4 percent, moderately
above current estimates of the growth rate that is sustainable in the long
run. As a result, the economy now appears to have moved within range of the
full utilization of its resources—in other words, the slack in labor
and product markets that was apparent a year ago has most likely been eliminated.
For example, over that time, both the rate of unused capacity in the industrial
sector and the civilian unemployment rate have fallen noticeably.
unemployment rate dropped by one full percentage point, coming in at just
over 4½ percent in June. This rate is actually a bit lower
than conventional estimates of so-called "full employment," and therefore
suggests that there may be a bit of excess demand in labor markets.
the benchmark for these calculations—full employment or utilization—cannot
be measured with a lot of precision, and may change over time. As a check on
the degree of utilization, I like to look at the behavior of labor compensation,
including both wages and benefits. If, for example, labor markets were excessively
tight, it seems likely that we would see a pickup in the growth of labor compensation
as firms competed for scarce workers. Instead, based on the most recent data,
we find that broad measures of compensation increased at a moderate rate over
the past year. Nonetheless, tight labor markets could affect labor compensation
with a lag, so it's possible that there is pressure for acceleration in the
pipeline. Moreover, these broad measures may have been held down by a deceleration
in benefits costs—for example, there has been a sharp slowdown in the
growth of health insurance costs—which may have only a temporary effect
on overall compensation. So, while moderate growth in compensation provides
me with some degree of comfort that we have not overshot full utilization,
or, at least, not by very much, the jury is still out on this issue.
and product markets close to full utilization, the key concern going forward
is whether economic growth will slow enough and for long enough to
avoid a buildup of inflationary pressures. Recent data indicate that real
GDP growth did slow noticeably in the second quarter, coming
in at 2½ percent.
This is well below the rapid 5½ rate in the first quarter, and moderately
below most estimates of the rate that is sustainable in the long run.
guess is that growth will still be healthy but will remain somewhat below
the sustainable rate as the year progresses. This outlook
the net effect of a number of disparate forces. The impetus to keep the economy
ticking along includes factors such as ongoing strength in the fundamentals
for productivity and relatively rapid growth in business investment in equipment
and software—including the vital high-tech sector—as well as in
spending on nonresidential structures.
As for the factors that are likely to
restrain growth, there is the rise in both short- and long-term interest
rates over the past couple of years as the
Fed has removed monetary policy accommodation. Since mid-2004 when the Fed
began this process, most short-term interest rates have increased between
4 percentage points. Many long-term rates are up by ¼ to ½ of
a percentage point, with most of this increase occurring since early this year.
These higher rates should reduce demand, particularly in interest-sensitive
sectors, notably, autos, consumer durables, and housing.
Indeed, we have already
seen some cooling in the housing sector, and this brings me to another factor
that is likely to restrain growth—that is, the significant
moderation in the rate of house-price appreciation. Slower increases in house
prices could put a crimp in consumer spending in a couple of ways. First, some
observers believe that consumers have been keeping their spending up by withdrawing
equity from the increased value of their homes; of course, this source of funds
starts to shrink as the pace of appreciation slows. Furthermore, there may
be some pullback by consumers due what is called the wealth effect—that
is, slower house-price appreciation reduces growth in their wealth and therefore
their tendency to increase their spending.
While I expect the housing situation
to have only moderating effects on economic activity going forward, I should
note that we can't ignore the risks of more
unpleasant scenarios developing. One scenario that we have heard a lot about
in recent years is the possibility that there is a house-price "bubble," implying
that prices got out of line with the fundamental value of houses and that the
current softening could be just the beginning of a more precipitous fall. While
I seriously doubt that we'll see anything like a "popping of the bubble"—in
part because I'm not convinced there is a bubble, at least on a national level—I
certainly do acknowledge that there is more reason to worry that house prices
would fall sharply than that they would rise sharply.
A second scenario has
to do with the wealth effect I mentioned and its impact on household saving
behavior. In the U.S., the personal saving rate has been
declining for years, and in the second quarter it reached minus 1½ percent.
Part of this development probably relates to the growth in consumers' wealth
in housing. As it has become easier and easier to tap into that wealth, people
have felt less of a need to save from current income. But with the softening
in house prices acting to slow consumers' accumulation of wealth, the urge
to save rather than spend may resurge. In fact, consumer wealth is getting
another hit from the recent declines in the stock market, which also may induce
people to build up savings. So, the very low—in fact, negative—saving
rate makes the chance of a sizeable drop-off in consumer spending seem larger
than the chance of a big surge.
Since housing is so important for the outlook,
I'll spend a moment sketching in the overall picture for this sector. So
far, the signs of cooling, including
the deceleration in house-price appreciation, are broadly consistent with
the degree of moderation I've envisioned, and fortunately
these developments seem
to be unfolding in an orderly way. After adjusting for inflation, residential
investment has dropped by a total of 2 percent over the past three quarters.
Housing permits are down from highs established earlier this year. In addition,
inventories of unsold houses are up significantly, sales of new and existing
homes are off their peaks, and surveys of home buyers and builders are showing
more pessimistic attitudes. Finally, after long being stagnant, rents are
finally moving up more vigorously. This may reflect, in part,
expectations of lower
house-price appreciation, as landlords raise rents to try to maintain the
total rate of return on rental properties and as those in
the market for housing
grow more inclined to rent than to buy.
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 3½ 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. Even so, 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 residents.
In closing my description of the forecast for economic
activity, I have to mention the big "wild card"—energy prices. And I'll return
it to it when I discuss the inflation outlook. It is quite likely that rising
energy prices have restrained consumer spending moderately even though offsets
from job gains and wealth have kept it rising overall. If energy prices stabilize
around their current levels, as futures markets indicate is expected, then
the negative effect of energy on spending should dissipate over 2007. While
we all certainly hope the energy futures markets are right, to be honest, their
record hasn't been so great. During the whole period of rising energy prices
that began in 2004, futures markets have usually predicted that the path of
prices would be relatively flat, and they've had to revise the path up as energy
prices have continued to exceed expectations. Basically, over this period,
energy markets have been marked by strong demand, including demand from emerging
markets—notably China—and by reportedly limited capacity to expand
production. In addition, of course, there have been extraordinary events that
threaten to restrict supply and therefore jack up energy prices, like the current
situation in Lebanon and Israel. Needless to say, then, future energy prices
are a big question mark, and any sustained rise or fall in these prices could
either depress or spur economic activity beyond my current expectations.
This brings me to the inflation part of the picture. The
recent news has been disappointing. The measure of core consumer
inflation that the FOMC
for Congress—the personal consumption expenditures price index excluding
the volatile food and energy components—has risen rather sharply in recent
months. It rose by nearly 3 percent in the second quarter, which implies an
increase over the past year of 2¼ percent. This rate is somewhat above
my "comfort zone"—a range between one and two percent that
I consider an appropriate long-run inflation objective for the Fed.
it is critical that core inflation trend in a downward direction over the
medium term, and I think this is the most likely outcome.
said, I expect that the economy has entered a period of slightly below-trend
growth that should relieve any underlying inflationary pressures emanating
from tightness in labor and product markets. In addition, there are three
other underlying factors that tend to bode well for future
inflation. One I've already
mentioned—labor compensation has been rising at a moderate rate. While
there may be increases in the pipeline for the reasons I spelled out earlier,
we haven't seen convincing signs of them so far. Second, productivity growth
has remained strong, maintaining the pattern of strength established in the
latter half of the 1990s. Finally, markups by businesses of product prices
over costs are at historic highs. So, even if costs begin to rise, firms would
have the room to absorb the increases without raising their prices.
is the issue of the role of energy prices in the recent disappointing data
on core inflation. As I said, core inflation excludes energy prices. But
there may have been some passthrough of higher energy prices into the prices
of core goods that use energy as an input to production—airfares are
a good example. If this is the case, and if energy prices level out as expected
by futures markets, this pressure is likely to dissipate at some point. However,
the whole question of passthrough is actually the subject of some debate. For
example, recent evidence suggests that there has been much less passthrough
in the past twenty-five years than there was back in the 1970s, when inflation
got out of control in the face of soaring energy prices. If it's true that
there's only a very small passthrough of higher energy prices to inflation
currently, then that raises the concern that something more fundamental is
pushing up inflation. Unfortunately, at this point, it's too soon to untangle
these alternative interpretations.
Finally, inflation expectations must be considered
in any discussion of inflation. No matter what the cause of the recent increases
in core inflation, it is important
that they do not get built into longer-term inflation expectations and, in
turn, wages. Research suggests that expectations have been well-anchored
to price stability in recent years because people have confidence
that the Fed
will act to limit any sustained rise in inflation. This result shows up in
the stability of survey and market measures of inflation expectations in
the face of the large energy price increases we've seen.
But, I want to emphasize
that this is not something that I—or my colleagues—take for granted.
Maintaining credibility requires that we act when necessary to keep inflation
I've explained why I think there are reasons to expect inflation
to move gradually lower in the future. However, I am keenly aware that this
pattern has yet to
show up in the data. And, given the inherent uncertainties, I would say that
there are currently upside risks to this inflation forecast.
This leads me to the concluding topic in my presentation
implications of recent economic developments for monetary policy. With inflation
high and labor and product markets in the vicinity of full utilization—or
perhaps even a bit beyond it—a period of growth modestly below trend
would ease any cyclical pressures on core inflation and, given the other elements
in the inflation outlook that I just discussed, would be likely to set the
stage for a gradual decline back into my comfort zone.
In these circumstances,
it might be thought that policy should continue to tighten until the inflation
data move back to a rate consistent with price
stability. But I would argue that a gradual approach is likely to be better.
Let me illustrate this point with a medical analogy. Suppose you go to the
doctor for your annual physical and she finds you have high blood pressure—say,
150 over 100. The doctor prescribes medication to get it down toward 120 over
80. She tells you that the evidence indicates that it takes a while for the
medication to work, so you should take one pill a day for a week and then retest
your blood pressure. You take the pill the first day. On the second day, you're
worried and nervous—elevated blood pressure is no laughing matter—and
you can't resist taking another reading. When you do, you find that your pressure
is still up there. You are so worried about the ill effects of your condition
that you figure that it's okay to take two pills instead of the one the doctor
prescribed. You repeat this pattern on the third day, as well, upping the dosage
to three pills. This approach almost certainly will reduce your blood pressure.
But by not properly considering the lags between the time you take the medicine
and the time it takes effect, you could end up with blood pressure that's too
low, and that could well present its own health hazards.
The need to incorporate
lags between policy actions and effects on the economy is a key issue for
monetary policy as well. We don't know what the lags are
with precision, but we still need to do the best we can to take them into
account. We simply don't get the necessary feedback on the
effects of our policy actions
for a long time. So if we kept automatically raising rates until we saw inflation
start to respond, we most likely would have gone too far. Instead we need
to be forward-looking.
That is why I've focused today on the economic outlook,
and particularly on those aspects of the outlook that pertain to the dual
mandate the Congress
has given the Fed. We are charged with achieving both price stability and
maximum sustainable employment. So, for all of these reasons,
it makes sense for us
to target a forecast for inflation, output, and employment—in other words,
to set the funds rate at a level that is likely to foster a desirable path
for the economy.
However, forecasts are uncertain and depend heavily on the
particular view of the world—or model—that is being used. That's
why I also like to use other methods to obtain benchmarks for the thrust of
our policies in
the future. One alternative approach is to estimate the so-called neutral federal
funds rate, which is defined as the rate—or policy setting—that
would be consistent in the intermediate run with stable inflation and full
employment. If we could determine what the neutral rate is, we could set the
actual rate appropriately. For example, in the present circumstances, I would
consider it appropriate for the actual rate to be a bit above the neutral rate—in
other words, I'd like it to be modestly restrictive—to promote price
stability, especially given that the economy may be operating with labor and
product markets that are a bit on the tight side. Estimates of the neutral
rate can be based on a variety of large and small models and on statistical
techniques. Of course, we can't get precise estimates, only an indication that
can be helpful along with other benchmarks.
Another approach involves monetary
policy rules—such as the so-called
Taylor rule—that can be consulted for appropriate policy settings. These
rules incorporate estimates of the neutral federal funds rate as a benchmark.
They then prescribe how the actual funds rate should stand relative to the
neutral rate depending on how inflation and resource utilization stand relative
to our dual mandates—price stability and full utilization. So, for example,
if inflation is above a particular definition of price stability, the rules
will say that the funds rate should be above the neutral rate. These rules
have been shown to broadly characterize actual Fed monetary policies that have
been successful in the past.
Consulting all of these approaches, it appears
to me that the federal funds rate currently lies in a vicinity that is roughly
appropriate for the Fed to
attain its key objectives over the medium run. However, since all such approaches
are inherently imprecise, policy must be responsive to the data that actually
emerges. When I say that policy should be responsive to the data, I mean
that the extent and timing of any additional firming should
depend on how emerging
developments affect the economic outlook. And when I say data, I don't just
mean data on inflation, output, and employment. I also mean data on factors
that might affect those variables in the future—such as energy prices,
the dollar, the stock market, long-term interest rates, housing prices and
I believe that the wording of the policy statement the
FOMC issued at the end of June—following our last meeting—succinctly
captures the essence of the basic point I'm making: it states that "Although
the moderation in the growth of aggregate demand should help to limit inflation
over time, the Committee judges that some inflation risks remain. The extent
and timing of any additional firming that may be needed to address these risks
will depend on the evolution of the outlook for both inflation and economic
growth, as implied by incoming information."
Thank you for having me today, and I will be pleased to
address your questions.
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