Donald L Kohn: The economic outlook
Remarks by Mr Donald L Kohn, Member of the Board of Governors of the US Federal Reserve
System, at the 2006 Global Economic and Investment Outlook Conference, Carnegie-Mellon
University, Pittsburgh, 19 October 2005.
* * *
I appreciate this opportunity to discuss recent developments in the U.S economy and its prospects for
the future. Overall, the outlook remains favorable for continued solid growth in real activity and low
underlying inflation. To be sure, considerable uncertainties accompany that generally positive outlook.
The most obvious include the economic effects of Hurricanes Katrina and Rita, but those risks are by
no means the only ones currently confronting us. For perspective, I thought it might be useful to start
with a review of economic conditions in midsummer. I will then go on to discuss various influences on
the outlook, including my assessment of the likely effects of the storms, and the implications of these
developments for monetary policy. Finally, I will lay out some of the major risks in the economic
outlook. I stress that these views are my own and are not necessarily shared by my colleagues on the
Federal Open Market Committee (FOMC).1
Although economic growth slowed some this year from the pace in 2004, activity appeared to have
been on a solid upward trajectory before the landfall of Hurricane Katrina. The rise in crude oil prices
over 2004 and the first half of 2005--from about $30 per barrel to about $60 per barrel--undoubtedly
was damping demand to some extent this summer. As a result of these increases, households were
experiencing a hit to their real incomes as were those firms using energy; moreover, uncertainty about
the effects of energy price increases on demand may have led businesses to become somewhat more
cautious about capital spending.
Nonetheless, growth in aggregate demand continued to be supported by accommodative financial
conditions. Real interest rates--both short- and long-term--were still relatively low despite the gradual
upward adjustment of the federal funds rate. Credit was readily available to households and
businesses and on reasonably favorable terms. Lenders apparently were encouraged that an
economic environment of steady growth and low core inflation would persist and would sustain gains
in incomes and profits. In addition, households' wealth continued to be boosted by substantial
increases in the prices of houses, bolstering spending on goods and services as well as on residential
housing, including additions and improvements. Production did slow some over the spring and early
summer, but largely because inventories outside the auto sector were accumulated less rapidly. Firms
had built inventories at a rapid clip in 2004 and the first part of this year, and by late winter many
businesses seemed to have been more satisfied with their inventory positions. Consequently, they
scaled back rebuilding efforts and trimmed the growth of production accordingly. Still, activity rose
rapidly enough to further erode margins of economic slack. The unemployment rate fell from
5.4 percent at the end of last year to 4.9 percent in August, and the rate of capacity utilization
continued to rise toward its long-run average, though that increase was slowed with the production
adjustment in the spring.
Measures of labor compensation have given somewhat mixed signals about how tight labor markets
have become. The rate of increase in the measure of compensation per hour derived from the national
income and product accounts moved up appreciably over the four quarters ended in mid-2005
compared with the preceding year. This rise was apparently due in part to bonuses and stock options
that may be only loosely related to labor market slack, however. Moreover, according to the
employment cost index, which is based on a survey of firms, and to the growth in average hourly
earnings in the payroll employment report, compensation pressures remained quite subdued. On
balance, I do not believe conditions in labor markets have become excessively taut, but experience
suggests remaining humble in making any such assessment.
Measures of core consumer inflation eased some over the late spring and early summer, even as
headline inflation was pushed higher by rising energy prices. In addition to the favorable news on core
inflation, observations from the financial markets showed that forward measures of inflation
compensation beyond the next few years--the difference between distant forward rates on nominal
and indexed debt--moved down over the spring, despite the rising energy prices. Even so, core
inflation had moved higher in 2004, interest rates were still low, and the economy seemed to be
expanding at a pace that over time could threaten to impart added upward pressure on inflation. As a
consequence, the FOMC indicated in its August announcement that its intention, in the absence of
unexpected developments, was to continue to remove monetary policy accommodation at a measured
pace.
Hurricanes are obviously the very embodiments of unexpected developments. Among other effects of
Hurricanes Katrina and Rita, they have materially increased uncertainty about the economic outlook.
The questions raised include the following: What will be the extent and duration of the disruption to
economic activity in the Gulf Coast region? How fast will rebuilding occur, how much support will be
available for rebuilding from various levels of government and how will it be funded? And how quickly
will the energy infrastructure be brought back on stream? The answers to these questions will also
influence two important additional questions for the national economy: What will be the time path of
energy prices? And what will be the effects of the rise in retail energy prices on economywide
spending and inflation? Unfortunately, this added uncertainty is not likely to be resolved anytime soon;
Gulf Coast residents--both households and businesses--are assessing the damage; rebuilding plans
and supporting government programs are just beginning to be put in place; large portions of the
energy infrastructure remains shut down; and we are only starting to see the range of possible
reactions to higher energy prices. Economic activity and prices will be affected for some time and
discerning underlying trends will be difficult. It is not obvious that this form of uncertainty has
implications for monetary policy, however. Pausing or slowing down a rise in policy interest rates
would not itself help to reduce uncertainty because the way in which policy might affect spending or
inflation is not in question. Rather this is a situation in which a central bank generally is well advised to
make its best forecast, to evaluate the risks around that forecast as well as it can, and to act on that
forecast and associated evaluation of risks.
With regard to economic activity, my best guess is that the economy retains a good deal of forward
momentum and that the evolution over time of the balance between aggregate demand and potential
supply may not be greatly affected by the hurricanes and further rise in retail energy prices. In
particular, the factors that were supporting the growth of activity through the first two-thirds of the year
are still in place: Market interest rates remain relatively low and credit spreads narrow; underlying
growth of productivity--the ultimate source of long-run gains in incomes and living standards--appears
to be appreciable; and the rapid rise in house prices, which persisted through at least the first half of
the year, has given households a reservoir of housing wealth that they can draw on to support
spending.
Of course, several hurricane-related forces will be restraining consumer demand in the near term,
including the loss of jobs and income by displaced workers; the effect of the rise in energy prices on
disposable incomes, especially through the winter heating season; and perhaps the increase in
uncertainty itself, which could make both households and businesses more cautious about spending.
Households do appear to be responding to higher energy prices--driving less and favoring more
fuel-efficient vehicles, for example--and overall the growth of consumer spending has slowed from the
pace late last year and earlier this year. However, futures prices for crude oil and wholesale gasoline
suggest that some portion of the post-hurricane increase in retail energy prices is likely to reverse over
coming quarters. Moreover, rebuilding efforts in the Gulf Coast will gain momentum over time--aided
by considerable government support--and the pick up in activity will boost spending and employment
next year from their currently depressed levels.
Looking through the effects of the hurricanes, I would expect some slowing in the rates of increase of
consumer spending over time in response to higher interest rates and a less ebullient housing market.
We have some indications that housing markets are cooling off, although the signs are scattered and
mostly anecdotal. A substantial slowing in the pace of house-price appreciation seems inevitable as
prices reach high levels relative to interest rates, rents, and incomes. And such a slowdown would
tend to cause households to restrain their spending somewhat because they would need to save more
out of current income in order to build wealth. In my view, these developments--housing markets
coming off the boil and an accompanying gradual rise in household saving out of current income--
would be favorable for fostering sustainable economic growth and better balance between spending
and production here in the United States.
The effects on economic activity of a deceleration in consumption spending are likely to be offset to
some extent by a pickup in demand from other sectors. In addition to the boost to construction
spending from rebuilding efforts, the growth of business capital spending more broadly should
strengthen. Increases in business investment moderated substantially during the late spring and early
summer after exceptionally sharp gains late last year. Some of the slowing may have reflected the
normal unevenness of spending. But uncertainties about final demands from domestic households
and from foreign export customers as the dollar strengthened and foreign growth lagged earlier this
year also may have weighed on firms' capital spending plans. Moreover, there may have been some
spillover from the inventory adjustment in manufacturing. Looking ahead, some of the restraining
influences on investment spending appear likely to wane. Production and the demand for capital likely
will strengthen with the turn in inventory investment; several foreign economies, such as Japan, seem
to be experiencing more robust demand; and any tendency toward more-settled conditions in energy
markets would help to alleviate uncertainty about both foreign and domestic demand.
Taking account both of the hurricane-related disruptions and subsequent boost to activity from
rebuilding, and of the underlying fundamentals affecting aggregate demand, the economy would still
seem poised to expand more quickly than the rate of growth of its sustainable potential unless
monetary policy accommodation is removed further. However, a measured firming of policy should
forestall added cost and price pressures and keep inflation contained. True, the increase in business
costs that has resulted from the rise in the prices of petroleum products and natural gas is likely to
feed through to some extent into measures of core inflation for a time. But the effect of energy prices
on core inflation has been much attenuated over the past two decades as the energy intensity of
production has declined, increases in petroleum prices have generally been quickly reversed, and
inflation expectations have become better anchored. This time around, however, it seems likely that
only a small portion of the run-up of oil prices over the past year will be reversed, at least judging from
the path of futures prices. In that environment, keeping inflation expectations anchored will be
especially important for preventing the recent increases in energy prices from getting built into future
inflation. So far, market-based measures of required inflation compensation beyond the next few years
have changed little on balance since late August. Respondents in surveys of households appear to
have become a bit more concerned, though households have likely been influenced more than
financial market participants by what they are seeing at the gasoline pump each day.
The consumer price index (CPI) data released Friday provided some evidence that the very
substantial increases in the prices of many petroleum-based products have not found their way into
core consumer prices--at least not yet. And at 2 percent, the twelve-month change in core CPI in
September not only remained fairly low, but also was the same as it was a year ago. No one price
measure is ever a sufficient indicator of overall inflation developments, and the case for concentrating
on core inflation is not as strong when energy prices are not expected to reverse. But core inflation
measures still likely reflect underlying demand-supply balances better than do total inflation measures
and are therefore better gauges for judging future inflation developments.
As I noted earlier, the range of possible outcomes around these central tendencies seems wider now
than it has for some time--or at least there is a little more weight on lower-probability outcomes. And I
see several sources of uncertainty in addition to those associated with the intensity of the hurricane
disruptions and the timing and extent of rebuilding.
One source of uncertainty involves the reactions of households and businesses to higher prices of
petroleum products and natural gas. By their nature, such price increases point to downside risks to
demand and output--especially when they are associated with supply disruptions--and upside risks to
inflation. Although households seem to have cut back spending moderately in response to increases
in energy prices this year, surveys suggest that they are now feeling the pinch of higher energy prices.
Prices of gasoline should continue to retrace their post-Katrina upsurge, but natural gas prices are
likely to remain high for some time, and consumers could cut spending by more than is currently
anticipated over coming months, which could then feed back on business capital spending. At the
same time, however, persistently high energy prices also raise the possibility that inflation
expectations could ratchet higher, even if core inflation remains fairly low in the short run. If
expectations did become less well anchored, core inflation could subsequently rise and the higher
level could persist.
Another source of uncertainty is the housing market. It is possible that the rapid increases in house
prices could simply be a reflection of fundamental forces such as an increase in land use restrictions
and other legal restraints on building, innovations in mortgage finance, changes in tax laws and low
interest rates. But it could also be the case that much of the very rapid increase in prices very recently
has been based on the expectation that the pace of past increases will extend into the future. Or
perhaps the increases also have been fueled by eased lending standards that could well be tightened
in response to slower price appreciation. If expectations have been realistic and lending practices only
marginally important, a slowdown in house-price appreciation could be gradual and the consequences
for consumption growth could be modest; indeed, as signs of a slowdown are still quite tentative,
continued strength in house prices are an upside risk to any easing of demand going forward. But if
disappointed expectations or considerably tighter credit foster more severe or more abrupt price
adjustments in enough local housing markets, psychology could amplify the effects of diminished
wealth to restrain consumer spending. Economists, including those at central banks, simply are not
very good at understanding, much less predicting, the dynamics of asset price adjustments; and I
would guess that our ignorance is especially profound when those dynamics may be in the process of
shifting.
A third area of uncertainty concerns the broader macroeconomic risks to the inflation outlook. One risk
is a possible substantial tilt up in the growth of compensation per hour as workers try to offset some of
hit to their real incomes from higher energy prices at a time of relatively full resource utilization. A
second risk is a possible slowing in underlying productivity growth from the substantial gains of the
past decade toward the more subdued pace of the preceding quarter century. If both possibilities were
to be realized over the next year, unit labor costs could surge, putting severe upward pressure on
prices. Profit margins are elevated and competitive pressures could force firms to absorb a good
portion of those cost increases. But they would not do so willingly or completely. To the extent that
firms were able to exercise pricing power and maintain margins, rising costs would feed through to
greater inflation. This is not, however, what I expect to happen. As I noted already, productivity has
been well maintained and despite mixed signals, the growth of labor compensation does not appear to
be accelerating noticeably. But I will be paying close attention to developments in costs as well as in
prices as I update my inflation forecasts in the future.
In sum, I see risks on both sides of my expectations that the growth of economic activity will slow
modestly on balance over the next year or so, leaving the economy producing at about its sustainable
potential. But unless activity slows unexpectedly, and after the rise in retail energy prices, the risks
may be skewed a little toward the upside on inflation. Because the economy is producing at a
reasonably high level and activity is most likely on a solid upward track, my focus at this time is
naturally on keeping inflation contained. Our economy works best when households and businesses
do not need to take account of persistent increases or decreases in the general price level in making
their decisions about spending and production. Low inflation also makes policymaking easier because
a high degree of confidence by households and firms that inflation will remain low gives the Federal
Reserve added latitude to move aggressively against any economic weakness that may develop. And
a lesson of the 1980s is that it is costly to wring inflation out of the system once it becomes
entrenched.I do not know what path of rates will, in fact, be required to accomplish our objectives.
Obviously, we are considerably closer to where policy needs to be than we were sixteen months ago,
but we are not yet at a point where we can stop and watch the economy evolve for a while. But you
should appreciate that we did not enter into this episode of policy firming with a fixed notion of our
ultimate destination. How far we go will depend on the evolution of economic activity and prices. In this
regard, I think the policy tactics followed by the FOMC over recent years will be helpful. We have
moved rates higher gradually and announced our intentions in a manner that underscores that these
intentions depend on the economic outlook. The announcement should enable market participants to
get a more accurate view of our intentions sooner and build them into financial market conditions,
which then feed back on spending. This transparency, together with the gradual trajectory of policy
actions, should help us to get a better and more timely fix on the effects of our actions than in the past.
No doubt, the heightened level of uncertainty, along with the distortions to incoming data from
hurricane effects, will complicate the conduct of policy. Although it will be more difficult, we still should
be able to discern underlying developments in the important sectors I discussed--housing markets,
consumer purchases, business investment, costs and prices. It is these readings and their implications
for the future, together with developments in financial markets that could affect activity and inflation,
that I will be looking at to judge what policy setting is likely to foster stable prices and sustained
growth.