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President's Speech
Speech to a Community Leaders
Luncheon
Anchorage, Alaska
By Janet L. Yellen, President and CEO, Federal Reserve
Bank of
San Francisco
For delivery July 12, 2007, 12:40 PM Alaska DT, 4:40 PM
Eastern
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and Print PDF Version (55KB)
The U.S. Economy and Monetary Policy
Good afternoon, everyone. I’m delighted to have the
opportunity to speak to you today. This is my first trip
to Alaska as the President of the San Francisco Fed, and,
in preparation, I reviewed some of the economic statistics
about this region. The numbers say that local employment
has been growing at a healthy clip this year, especially
in the travel and tourism sector. As a policymaker, it is
very nice for me to be able to have those statistics come
to life, seeing firsthand the vigor of the economy in Anchorage.
As a tourist, I’m glad to be doing my part to boost
the economy here, and so far it has been a pleasure. For
example, yesterday, a group of us visited your outstanding
Museum of History and Art, and the exhibits were truly impressive,
as are the plans for its expansion. The museum is a fitting
jewel box for the many treasures it holds of the past and
present of the people and cultures of this state.
Alaska, of course, is not only famous for its immense natural
beauty and its fascinating cultures. It also is the home
of many of the key natural resources the U.S. economy depends
on, and tomorrow I will get a chance to see a bit of that
side of the state. Helvi will escort several of us to the
DeLong Mountains where we will tour the Red Dog mine, which
operates on land owned by the NANA Regional Corporation.
From there, we will go to Kiana, a fishing village 30 miles
inside the Arctic Circle in the Kobuk Valley.
Although I obviously get a lot of personal pleasure out
of traveling around the District to fascinating places like
Alaska, 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!
This afternoon I plan to talk about the outlook for the
U.S. economy and the prospects for monetary policy, concentrating
on several important factors shaping
that outlook. 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
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 financial conditions that could adversely affect
economic activity: I’m thinking
in particular about a possible shift in risk perceptions. There are now numerous
indications that the premiums in financial returns that compensate investors
for risk are notably low. 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. Similar indications
can be found in a variety
of places, including narrow spreads for credit risk on an 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. For example,
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.
In fact, 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, rates on certain default derivatives 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 seem to 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 particularly 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 for a couple
of reasons. First, increases in housing wealth have slowed dramatically. Second,
energy prices have moved back up this year. For example, after falling through
the latter half of last year, the price of West Texas Intermediate rose sharply
during the first half of this year. It averaged $67.50 in June, up from $54.20
in January; and with gasoline margins moving up over this period, the retail
price of gasoline has moved up even more. Such increases act like a tax on
consumers, often leading to reduced spending. Of course,
here in Alaska, their impact has
been largely beneficial. As you know, high oil prices bring substantial income
into the state, and, no doubt, this has helped to keep employment and personal
income growing at a healthy clip.
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 reflects a necessary correction
in house prices after years of phenomenal run-ups that ultimately have 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.
Housing markets in Alaska have not been immune to the slowdown
observed nationwide, but, in part because of high oil prices,
economic conditions here have been healthy
and this has limited the intensity of the downturn in housing. In 2006 as a
whole, sales of existing homes rose in Alaska while they
were falling nationwide. However,
the pace of sales here actually fell in the second half of last year and early
this year, and the pace of home price appreciation has slowed substantially
since 2005. Nevertheless, in a departure from the longer-term
trend, the rate of appreciation
here has been above the U.S. pace for the past couple of years.
The relatively consistent performance in Alaska’s housing market thus far
has helped the state to avoid significant problems with respect to mortgage financing
and payments. As in the nation as a whole, default and delinquency rates overall
have remained low at least though early 2007. Delinquencies on adjustable-rate
mortgages in the prime as well as the sub-prime market have increased somewhat
in Alaska over the past year or two, but these increases have not been sufficiently
large or widespread to significantly undermine mortgage credit conditions on
net.
The bottom line for housing from a national perspective
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 two years 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, 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.
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/el2007-27.html.
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