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President's Speech
Speech to the Emeryville Chamber of
Commerce
San Francisco, California
By Janet L. Yellen, President and CEO of the Federal Reserve
Bank of San Francisco
For delivery Tuesday, September 12, 2006, 12:35 PM Pacific,
3:35 PM Eastern
President Janet L. Yellen presented similar remarks at a
Community Leaders Luncheon in Boise, Idaho, on September
7, 2006.
Prospects for the U.S. Economy
Thanks, Tom, for the very kind introduction. Good afternoon,
everyone. It's a real pleasure to be here in "my
own backyard," so to speak. I was delighted that the
Chamber invited me to be part of your annual Outlook Conference,
and I thank you all for coming.
As you may know, next week
the Federal Open Market Committee meets in Washington, D.C.
The Committee is charged with setting the nation's
monetary policy to achieve its dual mandate of maximum sustainable
employment and price stability.
Naturally, I'm now in the midst of preparations for that meeting, so
my focus today will be mainly on the national economy.
Of course, I'm
also keenly interested in what is going on at the local level around the District.
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!
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.
At the last
meeting of the Committee, in August, something unusual happened. After raising
short-term interest rates at every one of its 17 meetings beginning
in June 2004, the Committee decided not to tighten the stance of monetary
policy. 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 economic outlook.
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. Here in the Bay Area, we're also
seeing some tightness in labor markets, as the unemployment rate is just below
the nation's at about 4-1/2 percent.
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 the Bay Area
economy. To the extent that business investments in computer equipment continue
to grow, this will help sustain the local economic expansion, which has picked
up over the past few years as conditions in the high-tech sector have improved.
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. This slowdown has
been amply in evidence here in the Bay Area, where sales of existing homes
have dropped by about 20-30 percent from a year ago.
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. Here in the
Bay Area, the pace of appreciation has fallen into the single digits, after
reaching about 20 percent in 2005. And there are signs that slower price growth
nationwide 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. Blurry though the picture may be, it
remains true that markups are very high. So I do draw some comfort from that,
because it means that, even with more wage and 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.
# # #
1. John C. Williams, "The
Phillips Curve in an Era of Well-Anchored Inflation Expectations," unpublished
paper
http://www.frbsf.org/economics/economists/staff.php?jwilliams.
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