FRBSF Economic Letter
2007-19-20; July 13, 2007
The U.S. Economy and Monetary Policy
Pacific Basin Notes. This series
appears on an occasional basis. It is prepared under the auspices
of the Center for Pacific
Basin Studies within the FRBSF's Economic Research Department.
This Economic Letter is adapted from a speech
by Janet L. Yellen, president and chief executive officer
of the
Federal Reserve Bank of San Francisco, delivered via videoconference
to the First Annual Conference of the U.C. Berkeley-National
University of Singapore Risk Management Institute, on July
5, 2007.
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.
The current stance of monetary policy
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%.
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 12 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.
Pricing of risk in international financial markets
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 (see Swanson, forthcoming).
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 the
London Inter-Bank Offered Rate, 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. 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 (see
Rudebusch,
Sack, and Swanson 2007).
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.
The recent jump in long-term
interest rates
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.
Crosscurrents in
the forecast for U.S. output growth
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% 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 crosscurrents 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% 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% 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% in real terms. And during that period, this
sector—which represents only a little more than 5% 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%—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.
An ongoing puzzle: Strong labor market and moderating
economic activity
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%;
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 (Oliner,
Sichel, and Stiroh 2007, Jorgenson, Ho, and Stiroh 2007,
Fernald, Thipphavong, and Trehan 2007), 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 information technology
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% 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 12 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%. Just a few months ago, the 12-month
change was quite a bit higher, at nearly 2½%.
The outlook for inflation
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.
(See Trehan
and Tjosvold 2006; for a discussion of related issues,
see Williams 2006.)
Implications for monetary policy
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." Janet L. Yellen
President and Chief Executive Officer
References
[URLs accessed July 2007.]
Fernald, John, David Thipphavong, and Bharat Trehan. 2007. "Will
Fast Productivity Growth Persist?" FRBSF Economic Letter
2007-09 (April 6).
Jorgenson, Dale W., Mun S. Ho, and Kevin J. Stiroh. 2007. "A
Retrospective Look at the U.S. Productivity Growth Resurgence." Unpublished
paper.
Oliner, Stephen D., Daniel E. Sichel, and Kevin J.
Stiroh. 2007. "Explaining a Productive Decade." Brookings
Papers on Economic Activity (March 29-30).
Rudebusch,
Glenn, Brian Sack, and Eric Swanson. 2007. "Macroeconomic
Implications of Changes in the Term Premium." Federal
Reserve Bank of St. Louis Review 89(4) (July/August)
pp. 241-269.
Swanson, Eric. 2007. "What We Do and Don't Know about
the Term Premium." FRBSF Economic Letter, forthcoming.
Trehan, Bharat, and Jason Tjosvold. 2006. "Inflation
Targets and Inflation Expectations: Some Evidence from
the Recent Oil Shocks." FRBSF Economic
Letter 2006-22 (September 1).
Williams, John. 2006. "Inflation Persistence in an Era of Well-Anchored
Inflation Expectations." FRBSF Economic Letter 2006-27 (October
13).
Footnote
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.
Opinions expressed in this newsletter
do not necessarily reflect the views of the management
of the Federal Reserve Bank of San Francisco or of the
Board of Governors of the Federal Reserve System. Comments?
Questions? Contact
us via e-mail or write us at:
Research Department
Federal Reserve Bank of San Francisco
P.O. Box 7702
San Francisco, CA 94120
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