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President's Speech
Speech at Sacramento State
University’s
College of Business Administration Executive Speaker Series,
Co-hosted with the Chartered Financial Analysts Society
of Sacramento
Sacramento, California
By Janet L. Yellen, President and CEO, Federal Reserve
Bank of San Francisco
For delivery February 23, 2007, 12:35 PM Pacific, 3:35
PM Eastern
Download and Print
PDF Version (42KB)
The U.S. Economy in 2007
Good afternoon, everyone. It’s a pleasure to have
the opportunity to speak to you today. My remarks will center
on recent developments affecting the U.S. economy and what
they may portend for the future and especially for the conduct
of monetary policy. I will spend some time focusing on housing
markets, since they may play a key role in determining which
direction economic activity and inflation will head over
the rest of this year. 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.
As you no doubt remember, the Federal Open Market Committee
began to remove monetary stimulus in mid-2004, after a long
stretch of keeping the federal funds rate—our
main policy tool—at a very low level. Altogether, there were 17 consecutive
quarter-point increases in the funds rate over about two years. During much of
that time, the economy averaged solid growth, absorbing a good deal of the slack
in labor and product markets. The object of the policy tightening was to slow
the economy’s growth to a more sustainable pace and to foster a gradual
decline in inflation, promoting price stability. In August of last year, the
Committee voted to “pause,” that is, not to raise the funds rate
another quarter point, but to leave it at 5¼ percent. By then, some of
the effects of the earlier increases were being felt, as the economy showed signs
of slowing, and this gave some sense of reassurance that inflation was likely
to moderate from an elevated level. These moves held the promise of setting the
economy on a glide path for the proverbial “soft landing”—an
orderly slowing of growth that avoids the risk of a severe downturn while producing
enough slack in labor and goods markets to relieve inflationary pressures and,
indeed, to bring inflation down gradually to a more acceptable level than it
has registered over the prior year or so.
In large measure, the economy has moved within range of
this outcome. And at the last meeting of the Committee, the
members voted to keep the funds rate at
5¼ percent. But as always, there are risks to this forecast that need
to be watched closely. At this stage, the predominant risks center on whether
inflation will continue to move down gradually. This concern was expressed in
the statement following our last meeting, and I’d like to elaborate on
that point in the remainder of my remarks.
Let me begin with where inflation is right now. Based on
our main measure—the
price index for personal consumption expenditures excluding food and energy,
or the core PCE price index—consumer inflation was 2.2 percent over the
past year, which, as I indicated, is higher than I would like to see. However,
it is encouraging that we have seen some easing recently: in the last three months,
this index has registered a more acceptable 1.7 percent annual rate of increase.
The core CPI, which came out earlier this week, was on the high side of expectations
in January. However, this followed three straight months of low core CPI inflation;
after smoothing through the volatility, this measure of inflation also has eased
in recent months.
One explanation for this decline in inflation involves
the impact of stabilizing, and now falling, oil prices. As
I mentioned, core inflation, by definition, excludes
energy prices, but they still may affect core inflation to the extent that
they affect the prices of other goods and services. For example,
transport companies
might raise their prices to pass along the higher costs of filling their trucks'
gas tanks. This is known as "pass-through," and it is likely that it
has played at least some role in recent movements in core inflation. Now that
oil prices have fallen a fair bit from recent highs and are expected by futures
markets to remain at those lower levels, this upward pressure on core inflation
is likely to dissipate and may even be turning into modest downward pressure.
However, it’s important to remember that the effects of oil price changes
on inflation are by their very nature temporary. So at some point, the fall in
oil prices will no longer have a favorable effect. Abnormally rapid rent increases,
likely reflecting an increase in the demand for rental units by would-be owners
who have been priced out of the housing market, have also elevated core inflation
over the past year. As the housing market adjusts over time, however, this source
of inflationary pressure is also apt to dissipate.
Beyond these temporary effects, the stability of inflation
expectations is another reason to take a positive view and
project a gradual diminution of inflation.
Expected future inflation is one of the factors that businesses consider in
setting their prices and that workers consider when they
bargain for compensation. These
expectations appear to have been well anchored over the past ten years or so
as the Fed has established its credibility with the public about both its commitment
to and its competence in keeping inflation at low and stable rates. One piece
of evidence supporting this credibility is that, in the face of the recent
large oil price increases, we’ve seen stability in
survey and market measures of inflation expectations looking
ten years ahead.
By now you are probably asking yourselves, if the inflation
rate has been falling and if inflation expectations are well
anchored, why the concern about risks
to the forecast of gradually lower inflation? Part of the answer is to be found
in the strength of labor markets. The latest data show payroll employment growing
at a rather robust pace for all of last year. Moreover, the unemployment rate
has declined by half a percentage point over the past year and now stands at
just over 4½ percent; that rate suggests a degree of tightness in the
labor market, because it is somewhat below common estimates of the rate that
can be sustained in the long run without generating rising inflation.
I say “suggests” a degree of tightening in labor markets because
there is uncertainty about it. For example, if labor markets are tight, one would
expect that labor compensation—including both wages and benefits—would
be rising rapidly. However, the available information on this provides a mixed
picture. We have two broad measures of labor compensation. One, the employment
cost index, is showing remarkably restrained increases of only 3¼ percent
over the past year, up only slightly from the prior year, and this development
would seem to belie tight labor markets. The other measure, compensation per
hour, gives a higher reading of about 5 percent. However, this measure includes
compensation methods like stock options that are more akin to profits than wages.
So part of the strength in this measure may not actually indicate a tight labor
market.
Still, given the probability of some tightness, we would
need to see real GDP growth remain moderately below its long-run
trend for a time to have confidence
that the economy is heading for a soft landing with inflation continuing to
move lower. The impetus for the needed moderate growth is
likely already in train,
given the cumulative effects of the 17 stepwise increases in the funds rate
that began a couple of years ago. Since then, short- and
intermediate-term interest
rates have risen substantially. For example, Treasury bill rates are up by
more than 3½ percentage points from mid-2004. It’s true that corporate
long-term rates are actually down by around ½ percentage point over this
period, while conventional fixed mortgage rates are essentially unchanged. However,
variable mortgage rates have risen along with short-term rates. The overall effect
of such rate changes has been to reduce demand. Not surprisingly, the housing
sector has been at the leading edge of the overall economic slowdown, and I’d
like to turn my attention to that important sector now.
Nationally, growth in spending on residential structures—after adjusting
for inflation—was quite strong during 2002 through 2005. The decline started
toward the end of 2005 and residential investment has fallen—in absolute
terms—by a total of 13 percent, with especially steep drops over the last
two quarters. In fact, during both of those quarters, this sector alone—which
represents only a small fraction of U.S. real GDP—subtracted a hefty 1¼ percentage
points from real GDP growth. Housing starts have followed a similar pattern,
reaching a peak in January 2006 and then falling by roughly 40 percent through
January of this year. That, of course, includes the headline-grabbing plunge
for January announced last week.
Despite the continued weakness in housing construction,
which as I said enters directly into the calculation of real
GDP, there are some signs of stabilization
in other aspects of housing markets, suggesting that construction activity
may level out before too long. For example, home sales have
steadied somewhat after
falling sharply for a year or so. Considering this in combination with the
continued drop in housing starts that I mentioned earlier,
it is not surprising to find
that inventories of unsold homes have begun to shrink. This development suggests
that the process of resolving the imbalances between demand and supply in the
housing market may be underway, and, as a result, we could very well see the
drag on real GDP from housing construction wane later this year.
Of course, such a turn of events is by no means a given,
because the improvements we’ve seen may just be temporary.
For example, it is possible that they were related to a decline
in fixed mortgage rates since the middle of last year,
a development that probably supported home sales, at least to some extent.
However, the decline in mortgage rates came as a bit of a
surprise to me in a period when
the FOMC maintained the funds rate target at 5¼ percent, especially
in view of the widely discussed “conundrum” about why long-term
interest rates were already so low. Therefore, we can’t count on further
declines in mortgage rates to bring the housing market back.
In addition to concerns about weakness in housing construction,
there has been worry that difficulties related to housing
markets could spread to consumer spending
more generally. Since consumption expenditures represent two-thirds of real
GDP, even a relatively modest impact from housing markets
on this big sector could
put a noticeable dent in overall economic activity.
Up to this point, we haven’t seen signs of such spillovers. Consumption
spending has been well maintained, showing a robust growth rate for all of 2006.
However, going forward, there are at least a couple of ways that spillovers from
weakness in housing could depress consumer spending, and these channels bear
watching. First, housing makes up a significant fraction of many people’s
wealth, so a significant change in house values can affect consumer wealth and
therefore consumer spending. As you know, there have been fears about plummeting
house prices. But so far, at least, house prices at the national level either
have continued to appreciate, though at a much more moderate rate, or have fallen
moderately, depending on the price index you look at. Looking ahead, futures
markets are expecting small declines in a number of metropolitan areas this year.
While these modest movements are undoubtedly imparting less impetus to consumer
spending now than during the years of rapid run-ups, their effects are not likely
to be dramatic.
The slowdown in housing market activity has certainly been
noticeable here in the Sacramento area. Previously, the local
housing market had been very hot, with home prices growing
consistently at a double-digit pace from 2000 to 2005, reaching
a peak growth rate of about 25 percent in 2004. This was
fueled in part by substantial in-migration from other parts
of California, notably the Bay Area, and other states; during
the first half of this decade, Sacramento was ranked very
highly among the nation’s metropolitan areas in its
rate of domestic in-migration. This process slowed down as
home prices rose and the region’s affordability advantage
was eroded. Indeed, Sacramento was one of the first areas
in the state to show signs of the current housing slowdown.
Prices in this area started to flatten out in early 2006
while they were still rising in most of the rest of the state,
and building permits fell substantially even before that,
in 2005. The slowdown in the local housing market intensified
as 2006 progressed, and the latest available numbers indicate
that in the fourth quarter of last year, sales of existing
homes were down about 25 to 30 percent, and prices were down
by about 4 percent.
The price decline has been small so far, but it raises
fears about a more significant drop. Such fears are understandable,
based on the historical experience: between 1991 and 1996,
Sacramento area home prices fell about 15 percent. However,
a key difference between then and now is the overall health
of the local economy. While the pace of employment growth
slowed last year in the Sacramento area, as it did in the
rest of the state, the state government’s fiscal situation
has improved over the past few years, helping to create new
jobs locally and keeping the area economy on a stable expansion
path. Continued economic growth of this sort can only help
the adjustment in your area proceed in an orderly fashion.
Returning to the national economy, housing market developments
also could spread to consumer spending if enough homeowners
experienced financial distress. For example, rising variable
mortgage rates could strain some consumers’ cash flow.
What we find, however, is that, because of the rapid appreciation
of home prices in prior years, most homeowners are sitting
on a substantial amount of equity, a financial resource that
they can fall back on. In particular, adjustable-rate borrowers
with equity can avoid a rate reset by refinancing. Moreover,
only a small fraction of outstanding variable rate mortgages
are scheduled to be reset in each of the next few years.
Of course, financial distress could be a bigger problem
for some borrowers who used so-called exotic financing—like
interest-only loans, piggy-back loans, and loans with the
possibility of negative amortization. These instruments are
often designed to allow subprime borrowers into the market.
In fact, there are signs of trouble for some households.
Delinquencies on variable-rate mortgages to subprime borrowers
have risen sharply since the middle of last year and now
exceed 10 percent. But fortunately, delinquency rates for
other types of mortgages—including all prime borrowers
and even subprime borrowers with fixed-rate loans—have
edged up only very modestly. I know that it’s common
to see newspaper stories about homeowners who have run into
trouble, and those situations are, indeed, regrettable. From
a national perspective, however, the group with rising delinquencies
still represents only a small fraction of the total market,
with little impact on the behavior of overall consumption.
A forward-looking view of the credit risks associated with
subprime mortgages can be obtained from a new financial
instrument related to these mortgages. These
instruments suggest a big
increase in the risk associated with loans made to the
lowest-rated borrowers, but little change in risk for other
higher-rated
borrowers. Based on these results, it appears that investors
in these instruments expect the losses to be fairly well
contained. Of course, a shift in market sentiment about
the risk of some of these securities is always possible.
Such
a shift would have ramifications for mortgage financing
and housing, likely through tighter credit standards and
higher
mortgage rates for certain borrowers. In fact, we already
have seen some tightening among commercial banks in recent
months.
The bottom line for housing is that the concerns we used
to hear about the possibility of a devastating collapse—one
that might be big enough to cause a recession in the U.S.
economy—while not fully allayed have diminished. Moreover,
while the future for housing activity remains uncertain,
I think there is a reasonable chance that housing is in the
process of stabilizing, which would mean that it would put
a considerably smaller drag on the economy going forward.
In addition to housing, weakness in auto production has
slowed the economy during the past few quarters. The auto
industry
has felt the effects of high oil prices and people’s
growing demand for more fuel-efficient vehicles. That has
been good news for some of the foreign automakers, but not
such good news for U.S. automakers, for which SUVs and trucks
have been a key source of strength. As the demand for these
vehicles dropped, producers found themselves holding unsustainably
high inventories. It's little wonder that they slashed production.
These production cuts slowed overall real GDP growth in the
U.S. last year. However, once the adjustment to a lower level
of production is reached, probably in the not too distant
future, this factor will cease to hold down growth in the
U.S. economy.
Outside of housing and domestic autos, the rest of the
economy has been doing quite well; that’s why it might be called
a “bi-modal” economy. I’ve already mentioned
that consumer spending has been robust. Business demand also
has been solid, fueled by high profits and relatively favorable
financing conditions, leading to healthy growth in spending
on business investment in structures as well as equipment
and software. Growth in investment in high-tech goods has
been especially strong and the outlook is favorable, as telecommunications
companies expand their fiber-optics networks and businesses
continue to improve their productivity by upgrading their
IT equipment.
The net impact of both the weak and healthy sectors I’ve
described has produced moderate real GDP growth rates of
2½ and 2 percent in the second and third quarters
of last year. The advance estimate of fourth-quarter growth
showed a surge to a strong 3½ percent rate. However,
recent monthly data have been on the weaker side. After smoothing
out the volatility, my overall assessment is that economic
activity has proceeded at a moderate underlying pace for
close to a year now.
In other words, it looks as if the economy is pretty close
to the “glide path” I mentioned before—since
the first quarter of last year, growth has slowed to a bit
below most estimates of the economy’s long-run potential,
and more recently the risk of an outright downturn has receded
along with the early signs of stabilization of housing markets.
At the same time, while core inflation remains on the high
side of what I would like to see, it has begun to ebb modestly
in recent months.
A key question for inflation going forward —and therefore, for monetary
policy—is what happens if the drag from housing and autos disappears
later this year? As I’ve stressed, with labor markets apparently somewhat
tight, something else will need to slow to keep growth below potential.
One possibility is consumer spending. Growth in that sector
seems likely to slow because of a diminishing impetus from
household wealth, as house prices
increase less rapidly and as past increases in interest rates impose a greater
drag. In general, it wouldn’t be surprising to see a slowdown in consumer
spending given that the personal saving rate—the fraction of income not spent—has fallen to very low levels in recent years and even into negative
territory! There are good reasons for much of the drop in the saving rate over
the past decade, including the rapid growth in household wealth from housing
and the stock market. Given the extremely low recent level of saving, it wouldn’t
be shocking to see some rebound in the saving rate. That said, the saving rate
has been falling for more than a decade, so it’s obviously risky to put
too much reliance on an upswing this year.
In summary, I believe that a soft landing is the most likely
outcome over the next year or two. However, I hope my remarks
so far make it abundantly clear
that there are sizeable risks to this forecast and that I am especially concerned
about the upside risks to our inflation forecast.
These considerations play a key role in my views on monetary
policy. I have supported the decision to hold policy steady
at the current rate despite inflation
remaining higher than I would like it to be. Let me be clear that I do want
inflation to move down, but as I just indicated with my forecast, I believe
policy may now be well-positioned to foster exactly such an outcome. Moreover,
I continue to support the bias in policy toward tightening precisely because
it gives due consideration to the upside risks to inflation.
I’m casting my statements about the outlook in very conditional terms
because of the great uncertainty that surrounds any economic forecast. This
uncertainty argues for policy to be responsive to the data as it emerges. The
decision to keep policy on hold allows us more time to observe the data so
that appropriate adjustments can be made to achieve our goals of maximum stainable
employment and price stability.
1. See Bharat Trehan and Jason
Tjosvold, “Inflation
Targets and Inflation Expectations: Some Evidence from the
Recent Oil Shocks,” FRBSF
Economic Letter, 2006-22, September 1, 2006. For a discussion of related
issues, see John Williams, “Inflation
in an Era of Well-Anchored Inflation Expectations,” FRBSF Economic
Letter, 2006-27, October 13, 2006.
2. See Tao Wu, “The
Long-Term Interest Rate Conundrum: Not Unraveled Yet?” FRBSF Economic
Letter, 2005-08, April 29, 2005, and Glenn Rudebusch, Eric
Swanson, and Tao Wu (2006), “The Bond Yield ‘Conundrum’ from
a Macro-Finance Perspective,” Monetary and Economic
Studies 24 (S-1), 83-128.
3. Credit default swaps (CDS) on securities
related to subprime mortgages.
4. January 2007, Federal Reserve Board,
Senior
Loan Officer Opinion Survey.
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