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President's Speech
Speech to a Community Outreach Luncheon
Boise, Idaho
By Janet L. Yellen, President and CEO of the Federal Reserve
Bank of San Francisco
For delivery September 7, 2006 – 12:40 PM Mountain
Time, 2:40 PM Eastern
Prospects for the U.S. Economy
Good afternoon. I'm delighted to be with you today. I'd
like to start by saying how much I appreciate the very warm
welcome we've received here, especially
from many of our past and present Directors. They have done a great job of
arranging for us to see some of the highlights of your beautiful city. High
on the list, of course, was the Basque Museum, which reflects the many cultural
and economic contributions Basque immigrants and their descendants have made
to this area and, indeed, to the nation. Unfortunately, that tour was scheduled
during our Board meeting, so I had to miss it. My envy was soothed a bit,
though, because I was able to attend a special presentation and demonstration
of the research being done at the Center for Ecohydraulic Research at the
Idaho Water Center, clearly a worldclass scientific research facility. So,
all in all, I have to agree with what Money Magazine had to say recently
about Boise: It definitely deserves its ranking among the top ten "Best
Places to Live" in the country.
Although I obviously get a lot of personal
pleasure out of traveling around the District to places like Boise, I'm
also here for important official reasons.
One of the great strengths of the Federal Reserve is its connection to the
citizenry of the country. In this respect, the twelve Reserve Banks play
a particularly important role. Through our directors, our
advisory councils,
and through meetings like this one, we can get some insight into the public's
viewpoint on issues that are vital to the conduct of monetary policy—issues
like labor market conditions, expectations about inflation, and industry-specific
developments, to name just a few. So I'm very much looking forward to the question
and answer session that will follow my remarks, because I'm sure that I'm going
to learn from you as much as you're going to learn from me!
My remarks today
will focus on conditions in the U.S. economy and their implications for monetary
policy. But before I begin, let me note that my comments represent
my own views and not necessarily those of my colleagues in the Federal Reserve
System.
The last time I spoke publicly was a little more than a
month ago. Since then, something unusual happened. After
raising short-term interest rates at
every
one of its 17 meetings beginning in June 2004, the Federal Open Market Committee
decided not to tighten the stance of monetary policy at its last meeting,
which was last month. As a matter of fact, the August meeting
was the first since
I became President of the Federal Reserve Bank of San Francisco that the
Committee didn't raise rates. The August pause may seem a
bit puzzling to some, since
we had some rather bad news on inflation for several months in a row. Today,
I'd like to focus my remarks on why I think the pause was a good idea, and,
of course, in following that theme, I'll need to get into the prospects for
the U.S. economy.
I'll start with a quick review of recent developments. The
U.S. economy has suffered some significant shocks in the past couple of years:
in particular,
a sustained surge in energy prices and the devastation from the twin hurricanes
just over a year ago. Despite these challenges, the economy grew at a solid
clip, averaging just over 3¼ percent for the past two years.
This pace
of growth is moderately above current estimates of the growth rate that is
sustainable in the long run, and it has lasted long enough to eliminate
much of the slack in labor and product markets that was apparent a year ago.
Over that time, both the rate of unused capacity in the industrial sector
and the civilian unemployment rate have fallen noticeably.
Indeed, the unemployment
rate dropped by about three-fourths of a percentage point, coming in at 4¾ percent
in August. This rate is actually a little bit lower than conventional estimates
of so-called "full employment," and therefore suggests that there
may be some tightness in labor markets.
Turning to inflation, the recent news,
as I said, hasn't been what I'd like to see. Headline inflation, as measured
by the personal consumption expenditures
price index, showed an increase of three and a half percent over the twelve
months ending in July. While this is an important and comprehensive index
of changes in the cost of living, the Committee also focuses
on a different measure—the
core number, which excludes the volatile food and energy components—because
it is a better indicator of underlying trends in inflation. This measure rose
at an uncomfortably high rate of nearly 2½ percent over the past year.
Although it is encouraging that the rate has edged down recently, it has remained
a bit above my "comfort zone"—a range between one and two percent
that I consider an appropriate long-run inflation objective for the Fed.
With labor and product markets close to full utilization
and inflation above the comfort zone, one of the key
questions for policy is whether economic growth
will proceed at a moderate enough rate, and stay there long enough, to avoid
a sustained buildup of inflationary pressures. And that is my next topic.
Prospects
for Economic Activity
Recent data suggest that the needed slowdown is indeed underway. After hitting
a rapid 5½ percent pace in the first quarter, real GDP growth slowed
in the second quarter to a rate of just under 3 percent. In looking ahead to
the rest of the year, I see factors working both to support economic activity
and to restrain it somewhat. Taken together, these lead me to expect that we'll
probably see growth that is healthy, but somewhat below the rate that is sustainable
in the long run.
The factors working to support growth include ongoing strength
in business demand, fueling relatively rapid growth in spending on nonresidential
structures
as well as in business investment in equipment and software. This sector,
of course, includes high-tech industries, which are important
to Boise. To the
extent that business investments in computer equipment continue to grow,
this will help sustain your area's rapid economic expansion,
which has been propelled
in part by the success of local high-tech companies in recent years.
As for
factors that could restrain the nation's growth, one immediately thinks of
energy prices, which have surged over the past couple of years. This increase
has been due to developments on both the demand and the supply sides of the
market. Demand for energy has been quite strong, not only from industrial
economies, but also from emerging markets, most notably,
China. On the supply side, there
are reports of limited capacity to expand production, not to mention extraordinary
events that threaten to restrict supply, like disruptions in the Middle East.
It
appears that the resulting higher energy prices have restrained consumer
spending, even while offsets from job gains, as well as growth
in wages and
wealth have kept it rising overall. Of course, further increases in energy
prices could imply some additional restraint. However, futures markets expect
energy prices to stabilize around current levels. If they do, then the restraint
we've felt this year should evaporate over 2007, and that could actually
contribute to a pickup in growth next year. But that's a
very big "if." The
fact is that futures markets haven't done such a hot job at predicting where
these prices are headed. Ever since energy prices started to rise in 2004,
futures markets have usually predicted a relatively flat path going forward.
When oil was $30 a barrel, they implied the price would flatten out. At $40
a barrel, they implied the price would flatten out. At $50 a barrel—well,
you get the picture. And here we are with oil fluctuating around $70 a barrel.
So energy prices are a bit of a wildcard.
Another factor restraining growth
is the rise in interest rates over the past couple of years as the Fed has
removed monetary policy accommodation. Since
this process began in mid-2004, short- and intermediate-term interest rates
are up substantially. Long-term rates present a more mixed picture, with
some—such
as mortgage rates—up slightly, and others down slightly. The overall
effect of these rate changes should be to reduce demand, particularly in interest-sensitive
sectors, such as autos, consumer durables, and housing.
Indeed, we already have
seen clear evidence of cooling in the housing sector. Nationally, housing
permits are down noticeably—by more than 20 percent—from
a year ago. In addition, inventories of unsold houses are up significantly,
sales of new and existing homes are off their peaks, and surveys of homebuyers
and builders are showing much more pessimistic attitudes. Even in a market
that has been as hot as Boise's, some recent evidence points to cooling in
the pace of home sales and residential construction activity.
The national
data on residential investment reflect all of these developments and enter
directly into the calculation of real GDP growth. After adjusting
for inflation, (real) residential investment dropped at nearly a 10 percent
annual rate in the second quarter following two small declines in the prior
two quarters.
The effects of the housing slowdown go beyond their direct
contribution to GDP. In particular, what happens to house
prices could have important effects
on consumer spending, which is a very big part of the economy—roughly
70 percent. As we all know, the pace of house-price appreciation has definitely
moderated, after rising at heart-stopping rates in recent years. And there
are signs that it may continue. For example, rents are finally moving up more
vigorously after a long period of stagnation. This may reflect, in part, expectations
that house-price appreciation will continue to slow, 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.
Slower increases
in house prices could weaken consumer spending in a couple of ways. Both
of them have to do with what I'm going to call the "piggy
bank" phenomenon. To be honest, I've stolen this term from some news stories
I've seen, but I think the crime is worth it because the description is apt.
Back when house prices were rising so fast, people saw that more and more equity
was being built up in their house values; in other words, they saw their houses
as piggy banks that got fuller and fuller, faster and faster, by just sitting
there. Insofar as the piggybank of house value makes up a good chunk of many
households' portfolios, they might well have felt that they could afford to
spend pretty freely. In economic terms, this is called the "wealth effect." A
second factor stimulating spending relates to the ease with which households
can now pull money out of the piggy bank. With home equity loans, refinancings,
and so on, the piggy bank is now pretty simple to access. So it's no surprise
that homeowners seized the opportunity and drew some of the money out to support
their spending. Now, with the pace of house-price appreciation slowing, of
course, the piggy bank is not getting so full so fast anymore, which may weaken
the growth in consumer spending.
While it's likely that the slowdown in the
housing sector will have only moderating effects on economic activity and
will continue to unfold in an orderly way,
I should note that we can't ignore the risk that a more unpleasant scenario
might develop. In particular, we have heard a lot in recent years about 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 steep fall. While I 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—it is a risk we have
to watch out for.
Another risk has to do with household saving behavior. In
the U.S., the personal saving rate has been declining for more than a decade.
During the 1980s, it
averaged 9 percent. This July, it was all the way down to minus 1 percent.
Frankly, it's hard to see how it could go much lower. So the risk is that
a sustained rise could occur, which would put a real crimp
in consumer spending
and therefore in overall economic activity. Though there's some uncertainty
about why the saving rate has fallen into negative territory, I strongly
suspect that part of it is related to the growth in consumer
wealth over the last several
years both through rising housing values and through rising stock values.
Therefore, the more recent softening in both of those sources
of wealth may provide a
bit more impetus for a reversal in the saving trend; in other words, it is
conceivable that people will shift gears and try to build up savings the
old-fashioned way, by spending less. Whatever its source,
the very low—in fact, negative—saving
rate represents a downside risk for the economy, with the chance of sizeable
drop-off in consumer spending likely to be bigger than a surge in spending.
Prospects for Inflation
This brings me to the outlook for inflation. As
I've indicated, core consumer inflation has been a bit above
my comfort zone recently. Therefore, in keeping
with the Committee's responsibilities for promoting price stability for the
nation, I believe it is critical that inflation trend in a downward direction
over the medium term. Indeed, my expectation is that this is the most likely
outcome.
That said, I must admit that I'm also less sanguine than
I was a month ago about one particular factor in the inflation
process—namely, labor
compensation. This factor is a major component of business costs and can therefore
affect
the prices that firms charge for their products. A month ago it appeared that
compensation was growing quite modestly. Moreover, for nonfarm businesses,
markups of product prices over costs have been near historic highs, which means
that businesses have had room to absorb higher costs rather than passing them
on to their customers. These two developments together gave me considerable
comfort in thinking about the inflation outlook. However, recently revised
information on compensation per hour suggests that wages and benefits are growing
rapidly. This blurs the picture considerably, since another measure, the Employment
Cost Index, shows only moderate growth. Of course, we also look for information
about labor markets from people around the District. Here in Idaho, our contacts
tell us that they have noticed shortages of skilled workers, and they also
are seeing increasing difficulties recruiting unskilled workers, all of which
has put strong upward pressure on wages in the state. While reports like these
do heighten my sense of concern, I still draw some comfort from the fact that
markups remain very high. So, even with more cost pressures, firms would have
the room to absorb the increases without fully passing them on into their prices
if competitive conditions in product markets induced them to do so.
Beyond this,
I would point to several factors that could make inflationary pressures recede.
The first factor I want to discuss is a somewhat technical
point. Try to bear with me on this, because it does matter. In statistical
analyses of inflation, the data historically have exhibited persistence.
This basically means that, when you're forecasting inflation,
it works pretty well
to assume that the rate in the future will be the same as it is today. The
implication of persistence is frankly worrisome: Since inflation is too high
today, persistence implies it could stay too high for an extended period.
However,
recent research at the Federal Reserve Bank of San Francisco has shed new
light on this issue. It finds less evidence of persistence
during the past
ten years. That is, rather than sticking at a certain rate, inflation has
tended to revert to its long-run average, which, over that
period, is within my comfort
zone. Admittedly, the past ten years constitute a relatively small sample
from which to draw definitive conclusions. Nonetheless, this
evidence is important
because, if it holds up, it implies that inflation may move down from its
elevated level faster than many forecasters expect.
Interestingly, this apparent decline
in the persistence of core inflation has occurred at roughly the same time
that long-run inflation expectations appear
to have become well anchored. The behavior of long-run inflation expectations
can serve as a kind of proxy for the Fed's credibility as an inflation-fighter.
For example, in the face of the large energy price increases we've seen in
recent years, this credibility shows up in the stability of survey and market
measures of inflation expectations covering the period five-to-ten years
ahead. This may not be a coincidence. Research suggests that
if a central bank's commitment
to price stability has gained credibility with the public, then the persistence
observed in the inflation data will tend to be dampened.
I would like to stress
that our Bank's recent research on persistence concerns simple correlations
in the inflation data that can be used for forecasting
only, and it does not necessarily inform us about how policy decisions affect
the economy or about the best course for policy. In other words, low persistence
is no reason for the Fed to rest on its laurels of credibility. Rather, credibility
is something that neither I—nor my colleagues—take for granted
for a moment. We know full well that maintaining credibility requires that
we act when necessary to keep inflation under control.
Another reason to expect
inflationary pressures to lessen has to do with energy prices and what is
called "passthrough." Even
though higher energy prices do not seem to have boosted long-term inflation
expectations, the energy
shock may have been passed through to recent results for core inflation itself.
This might seem surprising, since core inflation excludes energy prices. But
even so, it is possible that higher energy prices have passed through into
the prices of core goods that use energy as an input to production—airfares
are a good example. Now it's true that recent research suggests that the extent
of passthrough for any given rise in energy prices has been lower in the past
twenty-five years than it was back in the 1970s. However, it seems likely that
energy passthrough probably has played at least some role in recent core inflation
movements. In this case, if energy prices level out, as expected by futures
markets, this upward pressure on core inflation is likely to dissipate at some
point, and this would help on the inflation front.
Finally, as I've explained,
the economy appears to have entered a period of slightly below-trend growth.
If it continues, as I think is likely, it would
tend to moderate any underlying inflationary pressures over time. This factor,
together with the others I've discussed, provides reason to think that the
most likely outcome is that inflation will move gradually lower. However,
I am keenly aware that this pattern has yet to show up in
the data. The inflation
outlook remains highly uncertain, and until we actually see inflation begin
to slow down, I will be focused on the notable upside risks in the outlook.
Policy issues
This leads me to the concluding topic in my presentation today—monetary
policy. As you know, in August the FOMC decided not to raise the funds rate
for the first time in more than two years. I think this was the prudent course
of action that properly balances the dual mandate given to the Fed by Congress—to
foster price stability and maximum sustainable employment.
Given that inflation
is outside of my comfort zone, why do I think it makes sense to pause? 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 because there is a need to incorporate lags between policy actions
and effects on the economy. 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, which would unnecessarily
endanger the economic expansion. Instead we need to be forward-looking.
And,
by a variety of measures, it appears that the current stance of policy will
move inflation gradually back to the comfort zone while giving due consideration
to the risks to economic activity. By a variety measures, I'm referring to
my forecast that I have outlined today, as well as the recommendations from
commonly used monetary policy rules that are used to gauge the stance of
policy. Taken as a whole, these rules indicate that the funds
rate is currently within
the range that appears appropriate, given the current condition of the labor
market and the position of inflation relative to my comfort zone.
However, since
all such approaches are inherently imprecise, policy must be responsive to
the data as it emerges. The advantage of pausing is that it allows
us more time to observe the data. When I say that policy should be responsive
to the data, I mean that 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
inflation expectations.
The bottom line is this. With inflation too high, policy
must have a bias toward further firming. However, our past actions have already
put a lot of firming
in the pipeline. With the lags in policy we haven't yet seen the full effect
of our past actions. These will unfold gradually over time. By pausing, we
allowed ourselves more time to observe the data and more time to gauge how
much, if any, additional firming is needed to pursue our dual mandate.
Thank you for having me today, and I will be pleased to
address your questions.
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