|
President's Speech
Speech to the First Annual
Conference of the Risk Management Institute
Singapore via video-conference
By Janet L. Yellen, President and CEO, Federal Reserve
Bank
of San Francisco
For delivery July 5, 2007, 9:00PM PDT, (July 6, 12:00 PM
local time, Singapore)
Download and Print
PDF Version (53KB)
The U.S. Economy and Monetary Policy
Good afternoon, everyone. It's a pleasure to have the opportunity
to speak to the inaugural research conference of the Risk
Management Institute, a joint effort of U.C. Berkeley and
the National University of Singapore. I'm especially gratified
that the San Francisco Fed is cosponsoring this event with
the Monetary Authority of Singapore. My invitation to speak
to you today was tendered by Andy Rose, who was my colleague
and coauthor when I was at U.C. Berkeley, so, naturally,
I was delighted to accept. I last was in Singapore in 1995,
to attend the Monetary Authority's 25th birthday celebration.
My memories of that trip and of the interesting and gracious
people I met remain vivid. At that time, I visited as a member
of the Federal Reserve Board of Governors. Today, as the
President of the San Francisco Fed, I have an even keener
interest in economic issues in Asia, because they are a special
focus of research at the Bank's Center for Pacific Basin
Studies. Though I cannot be with you, I'm glad that Reuven
Glick, our Group Vice President of International Research,
is representing the Bank and presenting his work.
This afternoon I plan to talk about the outlook for the
U.S. economy and the prospects for monetary policy. I will
concentrate on several important factors shaping that outlook,
including the pricing of risk in international financial
markets, which is the focus of this conference. Before I
begin my formal remarks, I would like to note that my comments
represent my own views and not necessarily those of my colleagues
in the Federal Reserve System.
As many of you probably know, the Federal Open Market Committee
last met on June 27 and 28 and voted to hold the federal
funds rate, our main policy tool, unchanged at 5¼ percent.
To most observers of the Fed, the decision probably had a
familiar ring to it, because the funds rate has been kept
at that level for the last twelve months. Indeed, my views
concerning the logic of this decision will also have a familiar
ring to anyone who has heard me discuss monetary policy during
the past year. To my mind, the reason for adopting and maintaining
the current stance of policy is that it promises to keep
the overall economy on an adjustment path where growth is
moderate and sustainable. The virtues of this path are that
it avoids exposing the economy to unnecessary risk of a downturn,
while, at the same time, it is likely to produce enough slack
in goods and labor markets to relieve inflationary pressures.
I believed a year ago, and still believe now, that such a
path is likely and will enable us to achieve our dual mandate—low
and stable inflation and maximum sustainable employment.
Although the federal funds rate has remained unchanged for
the past year, a number of developments over that time in
both the U.S. and world economies have warranted our close
attention as well as our deliberate consideration about the
appropriate policy response. I plan to focus on several of
these developments today, and, in particular, the risks they
may still pose in diverting us from the desired path.
One issue concerns the possibility and potential consequences
of a shift in risk perceptions in international financial
markets. There are now numerous indications that risk premiums
are notably low—in the U.S. and also globally. One
indication is the low level of long-term bond rates compared
with expected future rates on short-term debt—in other
words, an unusually low term premium.1 Other indications
can be found in the very low options-based implied volatilities
on most types of financial instruments, including equities,
debt, and exchange rates, in the narrow interest rate spreads
between foreign securities and LIBOR, and in narrow spreads
for credit risk on a wide array of assets including, with
some notable exceptions, corporate debt, commercial real
estate, and residential mortgages.
One reason that risk premiums may be low is precisely because the environment is less risky: the volatility of output and
inflation has declined substantially in most industrial countries
since the mid-1980s, and a number of financial developments
associated with technological change and deregulation have
reduced transactions costs, diversified and expanded the
variety of credit providers, and fostered the creation of
new instruments for efficiently allocating and pricing risk.
In addition, the health of corporate balance sheets has improved
dramatically, and household delinquency rates, including
those on residential mortgages, have generally been quite
modest.
At the same time, however, the concern has been expressed
that some investors may be underestimating risks in both
domestic and foreign markets.2 For
example, in foreign markets, low borrowing costs have attracted
money into such investment
strategies as "carry trades," where investors borrow at lower
rates in one currency and invest, unhedged, in higher-yielding
bonds in another currency. This strategy obviously exposes
investors to substantial exchange rate risk, which they may
be underestimating. In the U.S., the rapid rise of lending
at variable rates in the subprime mortgage market may have
reflected an unduly sanguine view of the underlying risks;
as we have seen, some households, large mortgage lenders,
and hedge funds have felt the pinch of the problems in this
market.
The low long-term rates and low risk premiums that have
prevailed in financial markets over the last several years
mean that overall financial conditions have been notably
more accommodative than suggested by the current level of
the real federal funds rate. Given that, a shift in risk
perceptions would tend to push longer-term rates and credit
spreads up, restraining demand worldwide.3
In fact, in U.S. financial markets, we have seen developments
that might suggest to some that such a change may be starting.
For example, in response to the problems in the subprime
variable rate mortgage market, spreads on certain debt and
credit default swaps linked to those instruments have recently
moved up substantially. In addition, there has recently been
some tightening of lending standards and higher pricing of
debt being issued in connection with private-equity financed
leveraged buyouts. These recent reassessments of risk premiums
suggest to me that they are focused on certain targeted instruments
and therefore essentially represent the market's appropriate
response to the discovery of a higher probability of specific
adverse events. Nonetheless, I also believe such developments
are worth watching with some care, since there is always
the possibility that they do presage a more general and pronounced
shift in risk perceptions.
A recent noteworthy development is the recent jump in intermediate
and long-term interest rates. By mid-June, the nominal yields
on five- and ten-year Treasuries had shot up by nearly 50
basis points above their May averages, and the conventional
mortgage rate rose by nearly 35 basis points. Based on evidence
from Treasury Inflation Protected Securities, the bulk of
these increases was accounted for by real yields, while a
smaller share was due to compensation for inflation.
But I would not say that these increases in long-term rates
necessarily reflect a significant shift in risk perception.
Rather, I would point to the fact that they coincided with
a sharp upward shift in the expected funds rate path, as
suggested by the futures market. This upward shift followed
many months during which markets anticipated that the economy
would weaken and that the Fed would respond by cutting interest
rates fairly substantially. This view prevailed for some
time, even though the FOMC's policy statements have continually
emphasized that its predominant concern was the possibility
that inflation would not moderate as expected. So I suspect
that the markets and the Committee have become more closely
aligned, sharing the view that growth in the U.S. is, and
is likely to remain, healthy. In further support of this
view, stock market values have risen and implied volatilities
have been flat or trended down, as we continue to get stronger
news on overall economic growth. Moreover, these developments—robust
economic data, rising long-term rates, higher expected policy
paths and climbing stock market indexes—are global
phenomena, occurring in many industrialized countries.
Insofar as the rise in longer-term rates seems to be a response
to favorable economic conditions—developments that
have been part of my own forecast for some time—it
has not had a big effect on my overall assessment of the
economic outlook. For the very same reason, this rise in
longer-term rates does not quell my concerns about a reversal
in risk perceptions, a possibility which itself could pose
a downside threat to the global economy.
With that perspective on recent financial developments in
mind, let me now turn to an explicit discussion of the U.S.
economy and the outlook for growth and inflation. Beginning
in the second quarter of 2006, real GDP growth moderated
noticeably, registering 2 to 2½ percent rates in the
final three quarters of 2006, somewhat below most estimates
of the economy's potential growth rate. Growth in the first
quarter of 2007 was notably weaker, but a good part of that
was due to the temporary effects of business inventories
and net exports. Based on partial monthly data, it seems
likely that there was a bounce-back in the second quarter,
with growth averaging a modest rate for the first half of
the year as a whole. My expectation is for moderate growth
during the remainder of this year and in 2008.
I'd like to highlight developments in three sectors that
will have an important influence on whether this forecast
proves accurate. Two of them—personal consumption expenditures
and exports—have been quite robust but are expected
to slow moderately. The third is residential investment,
which has been quite weak, but it is expected to have a much
less negative impact on overall activity going forward. Thus,
overall real GDP in the coming period will depend importantly
on how the cross-currents among these three sectors play
out.
Personal consumption expenditures have been the main engine
of growth in recent years; indeed, with employment growth
strong and equity and housing wealth rising, American consumers
outspent their earnings, and that resulted in a personal
saving rate that has been in negative territory since early
2005. Going forward, at least some of the growth in consumption
can be expected to diminish, as increases in housing wealth
have slowed dramatically and energy prices have moved back
up this year.
Another source of strength in recent years has been the
very strong world economy. Foreign real GDP—weighted
by U.S. export shares—advanced at robust rates of 3¾ to
4 percent in 2004 through 2006, and this growth has been
widespread, affecting nearly every continent. With the trade-weighted
dollar falling over this same period, U.S. exports have been
strong—real exports increased by an average of nearly
8 percent during those three years. Partly for this reason,
U.S. net exports, which consistently weighed growth down
from 2000 to 2005, actually gave it a lift during 2006. Assuming
a modest deceleration in world economic activity, net exports
seem likely to "turn neutral"—neither retarding nor
stimulating growth in the year or so ahead.
Of course, a big drag on growth over the past year has come
from residential construction. Housing is likely to remain
an important source of weakness, so let me take a few moments
to discuss it in detail. The cooling in the housing sector
has, of course, been in part a response to a rise in financing
costs. Interest rates on variable-rate mortgages have risen
in recent years along with other short-term rates. However,
until a few weeks ago, traditional fixed mortgage rates were
actually down somewhat from their level at the beginning
of the Fed rate tightening in mid-2004. With the recent increases,
these rates now also are up. I should note that higher borrowing
costs are not the only explanation for the recent cooling;
it's likely that it also is a drop in demand that will be
reflected in a necessary correction in house prices after
years of phenomenal run-ups that ultimately proved to be
unsustainable.
Since the end of 2005, activity in this sector has contracted
substantially. Indeed, over the past four quarters, the level
of residential investment spending declined more than 16
percent in real terms. And during that period, this sector—which
represents only a little more than 5 percent of U.S. GDP—has
taken a large toll on overall activity, subtracting a full
percentage point from real GDP growth.
The more forward-looking indicators of conditions in housing
markets have been mixed recently. Housing permits and sales
have been weak. House prices at the national level either
have continued to appreciate, though at a much more moderate
rate than before, or have fallen moderately, depending on
the price index one considers. Looking ahead, futures markets
are expecting small price declines in a number of metropolitan
areas this year. Finally, and importantly, inventories of
unsold new homes remain at very high levels, and these most
likely will need to be worked off before we see a rebound
in housing construction.
The prospects for the housing market may also be affected
by developments in the subprime mortgage market. I should
note that the Fed pays close attention to these developments,
not only because of their potential impact on the economy,
but also because of our roles in bank supervision and regulation
and in consumer protection.
From the standpoint of monetary policy, I do not consider
it very likely that developments relating to subprime mortgages
will have a big effect on overall U.S. economic performance,
although they do add to downside risk. The types of subprime
loans of greatest concern are variable-rate mortgages. Delinquency
rates on these loans have risen sharply since the middle
of last year—they are now nearly 12 percent—and
there are indications that lenders are tightening credit
standards for these borrowers. Looking more broadly across
all types of mortgages, however, delinquency rates have remained
low; this includes prime borrowers with fixed-rate and variable
rate mortgages and even subprime borrowers with fixed-rate
loans. Tighter credit to the subprime sector and foreclosures
on existing properties have the potential to deepen the housing
downturn. I am nonetheless optimistic that spillovers from
this sector will be limited, because these mortgages represent
only a small part of the overall outstanding mortgage stock.
The bottom line for housing is that it has had a significant
depressing effect on real GDP growth over the past year.
While I wouldn't want to bet on a sizable upswing, I also
wouldn't be surprised to see it begin to stabilize late this
year or next. Furthermore, if and when it does stabilize,
it could contribute to a pickup in overall growth in the
future, as the negative force of its contraction turns neutral.
To sum up the story on output, real GDP appears to have
advanced at a modest rate in the first half of this year.
My best guess is that the pace will pick up a bit in 2007
to a rate just below potential, as housing's negative effect
eases up enough to offset the expected modest slowdowns in
consumption and exports. As I've indicated, these crosscurrents
may play out in unexpected ways, entailing both upside and
downside risks, and they will bear careful watching.
Indeed, careful watching will be required even if the scenario
for economic activity that I see as the best guess and the
best hope comes through. The reason is that a key part of
the desired adjustment path would involve the emergence of
enough slack in labor markets to counteract inflationary
pressures. The latest labor market data show payroll employment
growing steadily and at a robust pace. Moreover, the unemployment
rate has, somewhat surprisingly, declined by half a percentage
point over the past year and a half and now stands at 4½ percent;
that rate may represent a degree of tightness in the labor
market. If labor markets are indeed on the tight side, and
if they remain there, then there may be reason for concern
about the risk of building inflationary pressures.
This situation highlights a puzzle I have discussed before:
Why has the labor market continued to be so strong, even
while economic activity has moderated? Let me briefly outline
some possible explanations, beginning with the more worrisome
ones. One such explanation is that goods markets could be
stronger than we think. This is a possibility because an
alternative measure of real activity—real income—is
considerably stronger than our standard measure of real GDP—which
we normally measure on the output side. So, it's possible,
but by no means certain, that real GDP could be revised up
in future benchmark revisions, meaning that both labor and
product markets actually might contain inflationary pressures
at present.
Second, a number of experts are now arguing that trend productivity
growth may have slowed a bit recently,4 which might mean that
the growth of potential output is lower than commonly assumed.
Indeed, productivity has been surprisingly weak over the
past year. Of course, discerning the extent to which this
development reflects a short-lived, cyclical phenomenon,
a downshift in the trend rate or both, is neither obvious
nor straightforward. Those who believe that trend productivity
growth has slowed a bit point to the slowdown in the first
half of this decade in both the pace of productivity growth
in the IT sector and the pace of investment in equipment
and software, two factors that drove the productivity boom
that began in the mid-1990s.
Although this argument may well be correct, it seems likely
to me that the recent decline in the productivity data mainly
reflects cyclical factors; in other words, it is likely due
to labor hoarding and lags in the adjustment of employment
to output—common phenomena in periods when economic
activity decelerates. Interestingly, most of the recent slowdown
in labor productivity growth can be accounted for by such
lags in just one sector—residential construction. Although
this sector has experienced huge drops in spending, employment
has been remarkably well sustained. Going forward, as the
adjustment lags work themselves out, residential construction
employment may post significant declines and productivity
in that sector and the economy as a whole may rebound. The
possibility of long lags in the adjustment of employment
to economic activity is a benign explanation for the puzzle.
Another benign possibility is that labor markets may not
actually be particularly tight. There are a variety of ways
to estimate conditions in the labor market, and some of these
don't suggest much in the way of inflationary pressures.
For example, the Conference Board index of job market perceptions,
which is based on a survey of households, suggests that labor
markets are only very slightly on the tight side. Moreover,
if labor markets were tight, this could be expected to show
up in robust growth of labor compensation. Instead, some
of the data present a different picture: for example, the
employment cost index shows remarkably restrained increases
of only a little more than 3 percent over the past year.
At this point, I am not inclined to discount heavily these
benign explanations. Looking at the price inflation data
over the past year or so, signs of improvement are evident.
Over the past twelve months, our main measure of consumer
inflation—the price index for personal consumption
expenditures excluding food and energy, or the core PCE price
index—has increased by just under 2 percent. Just a
few months ago, the twelve-month change was quite a bit higher,
at nearly 2½ percent.
Moreover, I expect to see some further improvement in core
inflation over the next year or two. First, this should occur
as the economy develops some slack in response to real growth
that is modestly below the potential rate. Second, inflation
may have been elevated partly because of some transitory
factors that may unwind over the next year or so. One of
those transitory factors is oil prices. Although core inflation,
by definition, excludes energy prices, they still may affect
it to the extent that they are passed through to the prices
of other goods and services. While oil prices have risen
recently, they are still below their peaks of mid-2006. Over
the two and a half years before that, energy prices more
than doubled, and this probably put some upward pressure
on core inflation. However, the effects of energy price changes
on inflation are inherently temporary, and these upward pressures
are likely to dissipate in 2007, even if energy prices remain
at their current levels.
Another transitory factor is upward pressures on rents,
including imputed rents on owner-occupied housing that enter
importantly into the calculation of the price of housing
services and, therefore, consumer inflation. Over the last
year, rents have been rising at an unusually rapid rate.
But if rents adjust to more normal levels relative to house
prices, these increases will taper off, also damping inflation.
That said, the risks to inflation are also significant.
One I have already mentioned is the possibility that structural
productivity growth has slowed, which could add to cost pressures.
While cyclical swings in productivity are not generally passed
on to product prices, a decline in structural productivity
growth might escalate inflation pressures. Another risk is
possible slippage in the market's perception of our inflation
objective. Although inflation compensation over the next
five years, as measured in Treasury markets, has been essentially
unchanged recently, longer-run inflation compensation rose
modestly, along with the rise in long-term rates that I discussed
earlier. My guess is that this increase largely reflects
an elevation in inflation risk premiums or the influence
of some idiosyncratic factors affecting the demand for Treasury
debt, rather than an increase in long-run inflation expectations.
I base this conclusion on the fact that longer-run inflation
compensation also ticked up in the United Kingdom, a country
where inflation expectations have been remarkably well anchored
over the past decade and where inflation has been trending
downward. The fact that longer-run inflation compensation
rose in both countries, despite their different monetary
policy regimes, suggests that a common explanation is needed,
rather than one specific to the U.S. This result suggests
that inflation expectations in the U.S. continue to be well
anchored as they have been for at least 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.5
Turning to monetary policy, I hope I've made it clear that—based
on what we know now—I think the current stance of policy
is likely to foster sustainable growth with a gradual ebbing
of inflationary pressures. It has been heartening to see
core consumer inflation edging down in recent months. However,
as the most recent statement noted, "a sustained moderation
in inflation pressures has yet to be convincingly demonstrated." Moreover,
upside risks to inflation continue to be present, given the
possibility that labor markets are somewhat tight. I believe
it is important to be particularly attentive to these risks
not only because price stability is desirable in its own
right, but also because a credible commitment to keeping
inflation low and stable is necessary to ensure that inflation
expectations remain well-anchored. At the same time, we must
be careful not to pose unnecessary risks to continued expansion.
An "asymmetric policy tilt" seems appropriate given the
upside risks to inflation. However, it is also essential
that policy retain considerable flexibility in responding
to emerging data. Last week's FOMC statement thus continued
to emphasize that "Future policy adjustments will depend
on the evolution of the outlook for both inflation and economic
growth, as implied by incoming information."
1. See also Eric Swanson, "What
We Do and Don't Know about the Term Premium," FRBSF Economic
Letter, forthcoming.
2. There is some research into why risk
might be underpriced, but so far, the answers remain tentative.
Some have pointed to the greater role of investment managers
in this more deregulated, competitive environment. These
managers may have incentives to herd with other investment
managers in order not to underperform their peers, and they
may also have incentives to take more "tail" risks, in cases
where compensation is weighted more towards achieving positive
returns, without sufficient regard for low probability negative
returns.
3. See Glenn Rudebusch, Brian Sack, and
Eric Swanson. 2007. "Macroeconomic
Implications of Changes in the Term Premium," Federal Reserve Bank of St. Louis,
Review, July/August, 89(4), pp. 241-269. http://research.stlouisfed.org/publications/review/07/07/Rudebusch.pdf
4. Stephen D. Oliner, Daniel E. Sichel,
and Kevin J. Stiroh, "Explaining
a Productive Decade," Brookings
Papers on Economic Activity (March 29-30, 2007) http://www3.brookings.edu/es/commentary/journals/bpea_macro/forum/200703oliner.pdf;
Dale W. Jorgenson, Mun S. Ho, and Kevin J. Stiroh, "A Retrospective
Look at the U.S. Productivity Growth Resurgence," unpublished
paper, 2007; John Fernald, David Thipphavong, and Bharat
Trehan, "Will
Fast Productivity Growth Persist?" FRBSF
Economic Letter, 2007-09, http://www.frbsf.org/publications/economics/letter/2007/el2007-09.html.
5. 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, http://www.frbsf.org/publications/economics/letter/2006/el2006-22.html.
For a discussion of related issues, see John Williams, "Inflation
Persistence in an Era of Well-Anchored Inflation Expectations," FRBSF
Economic Letter, 2006-27, October 13, 2006, http://www.frbsf.org/publications/economics/letter/2006/el2006-27.html.
# # #
|
