Donald L Kohn: Economic outlook
Remarks by Mr Donald L Kohn, Vice Chairman of the Board of Governors of the US Federal Reserve
System, at the Money Marketeers of New York University, New York, New York, 4 October 2006.
* * *
I am pleased to be with you tonight to discuss my views on current economic conditions and the
economic outlook. These have been challenging times for economic forecasters and policymakers.
Since the summer of 2005, the economy has absorbed a wide variety of shocks - major hurricanes,
ongoing geopolitical tensions, and substantial increases in energy prices - and has adapted to a rise in
short-term interest rates to more normal levels. Yet real gross domestic product (GDP) increased a
respectable 3-1/2 percent from the second quarter of 2005 to the second quarter of 2006, and the
unemployment rate fell to 4-3/4 percent. At the same time, however, headline consumer price inflation
has been quite high, and an upward movement in core inflation has raised concerns about the
persistence in price pressures, a very worrisome development from the point of view of a monetary
policy maker.
The economic outlook for the next few years will be importantly shaped by ongoing responses to these
developments. Reflecting those responses, economic activity has slowed noticeably over the course of
the year, and inflation, though down from its level earlier this year, remains uncomfortably elevated.
However, I expect that the continuing adjustment will be relatively benign overall: The economy will
grow at a moderate pace for a while, somewhat below the rate of increase of its potential, and then
growth will begin to strengthen. In addition, as the cost pressures from the run-up in energy and
materials prices begin to play out, or perhaps even partly reverse, and as pressures on resources
ease slightly, I think we will likely see much lower headline inflation and a gradual diminution of core
consumer price inflation.
I know that to some this story of a soft landing seems too good to be true - the triumph of hope over
experience. One question is whether it is even feasible. Can inflation pressures decrease with only a
modest shortfall of economic growth from potential? And is it possible that a modest decline in
resource utilization will not cumulate into something more serious, as it has tended to do in the past -
at least without a major adjustment of policy? My view is that this economy is capable of generating
the type of favorable outcome that I have just sketched, but, as in any period of transition,
policymakers must be aware of heightened risks on all sides of the forecast. I must emphasize that
these views are my own and not necessarily those of my colleagues on the Federal Open Market
Committee (FOMC).1
Economic activity
Based on the data we now have, the growth of real GDP in the third quarter appears to have remained
as subdued as it was in the second quarter and may well have slowed further. As we enter the fourth
quarter, little in the way of hard economic data or anecdotal information suggests any sharp shift in the
pace of economic activity. If that is so, the economy could be in the process of registering several
consecutive quarters of growth below its potential rate, the first time it has done so since early 2003.
After three years of growth above potential, some slowing was inevitable and desirable. Trees do not
grow to the sky, and neither do the stocks of houses and durable goods held by households and
businesses. In addition, the run-up in energy prices sapped consumers' purchasing power and cut into
firms' profit margins. These hits to real incomes have restrained the growth of household and business
spending. The effects of the high relative price of energy that we have experienced for much of the
past year do appear to be reducing the demand for energy-intensive products. In particular, the major
domestic automakers are cutting production to eliminate unwanted stocks of gas-guzzlers, and these
cuts are exerting a further drag on the growth of real GDP in the second half of this year.
Spending is also being restrained by the removal of monetary policy accommodation over the past two
years. Without these policy actions, the developing pressures of demand on potential supply would
have added to inflationary pressures. As anticipated, higher interest rates have been felt most clearly
in the market for residential real estate. The adjustment in these markets has proven to have been
more rapid and deeper than many economists had predicted, and we have yet to see signs that
indicate just how the process will work itself out. Given the importance of housing markets in the
evolution of the economy, I will spend a bit more time discussing the performance of this sector over
the past five years and the factors that are likely to shape the adjustment process that is now under
way.
From a trough of fewer than 1.5 million units at an annual rate during the recession of 2000, starts of
new single-family and multifamily homes rose to a post-World War II high of 2.2 million units last year.
Sales of new and existing homes followed the same broad pattern, and the boom in residential real
estate markets was a powerful force driving the post-2000 economic expansion. Monetary policy
played an important role in these developments: Responding to the weakness in other sectors of the
economy, the FOMC held short-term interest rates at unusually low levels over much of this period.
With inflation expectations well contained, with investment weak relative to saving in other countries,
and with investors requiring much less extra compensation for holding longer-term obligations,
longterm mortgage rates also dropped to historically low levels. Housing affordability increased
substantially, and the homeownership rate hit new highs. In addition, a speculative element may have
emerged in this market as investors projected rapid price increases into the future.
And those price increases were considerable. Between the beginning of 2001 and the end of 2005,
the constant-quality price index for new homes rose 30 percent and the purchase-only price index of
existing homes published by the Office of Federal Housing Enterprise Oversight (OFHEO) increased
50 percent. These increases boosted the net worth of the household sector, which further fueled the
growth of consumer spending directly through the traditional "wealth effect" and possibly through the
increased availability of relatively inexpensive credit secured by the capital gains on homes. By the
end of last year, however, the high price of houses and rising interest rates had begun to take a
meaningful toll on demand for homes.
Determining the exact timing of the recent peak in the housing market is difficult given the effects of
last year's hurricanes, the volatility in the data, and timing differences in the evolutions of home sales
and housing starts. That said, the fourth quarter of last year seems to provide a reasonable reference
point: Since that time, housing starts have fallen about 20 percent, and home sales are down 10
percent. Home-price appreciation has also slowed dramatically since late last year, and some local
markets have experienced outright price declines. Homebuilders report that cancellations have
increased sharply, especially for second homes. Realtors note that existing houses are staying on the
market longer, and sellers must increasingly make concessions to buyers.
How much longer will the correction in housing last, and how much deeper will it go? I do not have a
definitive answer but would venture four observations. First, the reported declines in new home prices
in a number of areas should help to facilitate the rebalancing of supply and demand in those markets -
though it may accentuate the adverse spillover of the housing market correction to other sectors.
Deeper price cuts would allow builders to clear out their inventories of unsold homes sooner, helping
to stabilize the pace of residential construction activity faster, but the near-term hit to household wealth
presumably would also be greater. Second, calculations about the sustainable level of housing starts
based on demographic factors, such as population growth and household formations, suggest that
starts may be closer to their trough than to their peak. Although such calculations are, in general, not
particularly useful for near-term forecasting, they do suggest that any overbuilding in 2004 and 2005
was small enough to be worked off over coming quarters at close to the current level of housing starts.
Third, the Federal Reserve has returned short-term interest rates only to more-normal levels and
longterm rates are unusually low relative to those short-term rates. This situation stands in sharp contrast
to some past downturns in the housing market that followed actions by the Federal Reserve to tighten
credit conditions significantly. And fourth, continuing growth in real incomes should underpin the
demand for housing and, as home prices stop rising, help to erode affordability constraints.
To date there is little evidence that this correction in the housing market has had any significant
adverse spillover effects on other parts of the economy. The production of construction supplies has
decelerated, but in general, resources freed up in the residential market appear to have been largely
absorbed in nonresidential building or elsewhere. Indeed, after languishing for many years, the market
for nonresidential structures seemed to revive around the time that the residential market was starting
to show signs of slowing. This shifting of resources can likely continue for a while longer given the
declines seen in office and commercial vacancy rates and the higher rates of capacity utilization in
manufacturing.
Still, adverse spillovers will occur, and, as I indicated, their extent depends in part on the changing mix
of prices and quantities as the housing market adjusts. In the past, outright declines in the nominal
prices of houses have been relatively rare and localized. If something like this pattern prevails again,
the decline in real housing wealth relative to incomes will be modest, and household saving rates
should trend gradually higher. Such a rise in personal saving would not be an adverse outcome for an
economy that generates relatively little saving domestically.
One reason I expect the economic expansion to continue despite the retrenchment in housing markets
is the recent declines in energy prices. Oil prices have fallen around $15 a barrel from their recent
highs this summer, and because of abundant supplies and cooperative weather, the spot price of
natural gas is down significantly as well. If sustained, these lower prices are likely to boost consumers'
purchasing power and help to offset to some extent the adverse spillover effects from weakness in the
housing market.
In addition, financial conditions remain quite supportive of borrowing and spending. Market interest
rates are not high in nominal or real terms; credit spreads are narrow and equity prices continue to
rise, conditions that keep the cost of business finance down and suggest investor confidence in the
future course of the economy.
As the inventory overhangs in residential housing and automobiles are worked off, economic growth
should pick up again to a rate closer to the growth rate of its potential. One potential pitfall in this
argument is that, in the past, a noticeable and sustained shortfall of growth from its potential and an
accompanying decrease in resource utilization have often cumulated into a full-fledged recession.
Several features of the current financial situation, however, support my contention that "this time will
be different." These recessions have often been triggered by a highly restrictive stance of policy and a
generalized tightening of credit conditions through high long-term rates, wide risk spreads, and a
pullback of bank lending. Obviously, these conditions are not present today. Although one cannot rule out
the possibility that a withdrawal from risk-taking could impinge on credit supplies and intensify
downward pressure on activity, the preconditions for such a response do not seem to be in place.
Business balance sheets are in very good shape and financial institutions are quite well capitalized.
To be sure, the risks to these expectations of a limited shortfall of growth from potential seem to me to
be weighted toward a weaker outcome. The housing market is not yet clearing, prices are still elevated
relative to rents, the overhang could be larger than I perceive, and the attendant readjustment could
be more abrupt and destabilizing - and could possibly even overshoot on the downside. And spillovers
from the housing market could extend well beyond wealth effects if households had been relying on
easy access to rising housing equity to finance a substantial portion of their consumption spending.
Consumer confidence could erode as job growth and income gains slow, thereby sparking a steeper
rise in saving. But, given current information, including on consumer confidence and spending, I judge
my more benign scenario the more likely outcome.
Inflation
Would such an outcome for economic activity be consistent with an abatement of inflation pressures?
As you know from our announcements, minutes, and public utterances, the members of the FOMC are
very concerned about the rise in core consumer price inflation over the past year. From a pace of 2
percent in the twelve months ending in August 2005, the rate of core personal consumption
expenditures (PCE) inflation has risen to 2-1/2 percent.
One of the key issues in the analysis of core inflation is the role of the pass-through of energy cost
increases into the prices of other goods and services. The pass-through turns out to be harder to find
either econometrically or in the price data themselves than any savvy consumer might think. Turning
first to the data, a detailed breakdown of the consumer price index shows that the prices of the most
energy-intensive services, such as air travel or refuse collection, have picked up considerably, a result
likely attributable, at least in part, to the run-up in fuel prices over the past few years. But these items
represent a relatively small part of the core index; the small acceleration in many other nonshelter
portions of the index, while consistent with a small pass-through of energy costs, could also be
attributable to non-energy factors.
When we try to model energy pass-through econometrically, the results indicate that a break occurred
in pricing patterns in the early 1980s: Pass-through is clearly evident before 1980 but it is difficult to
find thereafter. I suspect this pattern has something to do with the monetary policy reaction to those
shocks and its effect on inflation expectations. In the 1970s, monetary policy not only accommodated
the initial shocks but also allowed second-round effects to become embedded in more persistent
increases in inflation. Since the early 1980s, the pass-through to core prices has been limited or
nonexistent, at least in part because households and firms have expected the Federal Reserve to counter
any lasting inflationary impulse that they might produce. This result reinforces the need today to keep
inflation expectations well anchored. In addition, movements in relative oil prices were more persistent
before 1980 and less persistent after - until recently. After 1980, households and firms probably
expected deviations of energy prices from long-run averages to be largely reversed and saw less
reason to try to adjust wages and prices in response to what they viewed as transitory changes in
energy costs.
In the final analysis, I think we probably saw some pass-through of higher energy costs into core
inflation once price and wage setters came to believe that the rise in energy prices would not soon be
reversed. But the magnitude of the effect has been small - perhaps on the order of a cumulative 1/2
percentage point or less since the end of 2003. If crude oil prices hold at close to current levels over
the next few years, the resulting absence or even partial reversal of these energy cost shocks should,
all else equal, put some modest downward pressure on core inflation.
Consumer energy prices have already flattened out according to the August data, and we will probably
see a big decline in September's report. This decrease will not erase the increases of the past few
years, but I believe that it will contribute to a lessening of consumers' fears that continued energy-price
increases will lead to a ratcheting up of inflation in the long run. Indeed, the most recent readings on
inflation expectations from the University of Michigan Survey Research Center showed a noticeable
decline in September, especially in the inflation rate expected twelve months ahead. In financial
markets, the spread of nominal over indexed yields has also retreated substantially at the near end of
the yield curve. To a monetary policy maker focused on the evolution of inflation expectations, these
developments are indeed steps (albeit small) in the right direction.
Another major force driving up core consumer price inflation over the past year has been shelter costs,
especially tenants' rent and owners' equivalent rent. Together, these two components account for a
substantial part of the core price indexes - 38 percent for the consumer price index (CPI) and 17
percent of PCE prices - and as a result, small shifts in price trends in these areas can have a
noticeable effect on core inflation. For example, after running at about a 2-1/2 percent pace for several
years, increases in owners' equivalent rent stepped up to an annual rate of 5 percent in the six months
ending in August. As you know, these prices are imputed from the rental housing market, and quite
possibly this acceleration resulted from a shift in demand toward rental housing as higher interest
rates and home prices, along with reduced expectations of capital gains, made the owner-occupied
market increasingly less attractive. In response to greater demand, the supply of rental housing should
increase over time, in part by drawing from the overhang of owner-occupied units; hence, I do not
expect rents to be a major influence on core inflation a year or two from now, the horizon that is the
focus of monetary policymaking. Clearly, however, the band of uncertainty about such a forecast is
rather wide.
Not only should the contribution of energy and shelter costs to underlying inflation be diminishing over
coming quarters, but the generalized pressure of demand on supply should also decrease if, as I am
anticipating, economic growth falls short of potential for a time. I would not expect modest changes in
the output gap to exert more than a marginal influence on inflation. But the anticipated slower pace of
growth will result in an environment in which firms will be less able to pass on increases in costs.
One potential source of higher costs comes from the labor market. I would not be surprised to see a
gradual rise in labor costs as workers capture a greater share of the productivity gains of recent years.
However, compensation per hour, a measure derived from unemployment insurance tax records,
indicates that labor costs accelerated sharply, to a pace of 7-3/4 percent from the second quarter of
2005 to the second quarter of 2006. In contrast, readings from the employer cost index (ECI), which is
derived from a probability sample of firms, shows labor costs decelerating. Some of the divergence
appears to be the result of an increased volume of stock option exercises in early 2006 - an
occurrence captured by the compensation per hour measure but not by the ECI - and these option
exercises should not represent costs that firms actually internalize when calculating their marginal cost
of production. Thus, in my own thinking, I have tended to discount, though not dismiss, the latest
readings on labor costs. However, I acknowledge that rising labor costs are an upside risk to my
inflation outlook, especially if they occur under product-market conditions in which firms can readily
pass costs through.
In sum, I think that the odds favor a gradual reduction in core inflation over the next year or so, but the
risks around this outlook do not seem symmetric to me: Important upside risks to the outlook for
inflation warrant continued vigilance on the part of the central bank. I say that not only because of the
questions about underlying labor costs and about the future direction of energy and shelter prices but
also because our understanding of the inflation process is limited, and I cannot rule out the possibility
that the upward movement earlier this year reflected a more persistent impulse that I cannot now
identify. Although I believe I have offered plausible explanations for the acceleration of inflation this
spring and summer and reasonable rationales for expecting inflation to moderate, I would feel much
more confident about where we are heading if I had a more accurate bearing on the direction from
whence we have come. In addition, in my view, if inflation failed to abate it could impose considerable
costs on economic performance over time, a concern that brings me to the topic of monetary policy.
Monetary policy
Even if my relatively favorable forecast comes true, the level of short-term interest rates that will
produce this forecast remains uncertain. Obviously, as my FOMC voting record indicates, I believe
that, for now, the current level of short-term rates has the best chance of fostering this outcome.
Looking ahead, policy adjustments will depend on the implications of incoming data for the projected
paths of economic activity and inflation. I must admit I am surprised at how little market participants
seem to share my sense that the uncertainties around these paths and their implications for the stance
of policy are fairly sizable at this point, judging by the very low level of implied volatilities in the interest
rate markets.
As I have outlined tonight, I think that the risks to my outlook for economic activity may be skewed a bit
to the downside, while those to my forecast of gradually declining inflation are tilted to the upside. In
my view, in the current circumstances, the upside risks to inflation are of greater concern. Although to
date inflation expectations have remained contained, failure to check and then reverse the greater
inflation pressures of earlier this year would risk embedding those higher inflation rates in the
decisions of households and businesses, an outcome that would be costly to reverse and would
impinge on the economy's long-term performance.