Roger W Ferguson, Jr: Economic outlook for the United States
Remarks by Mr Roger W Ferguson, Jr, Vice Chairman of the Board of Governors of the US Federal
Reserve System, at the Howard University Economics Forum, Washington DC, 3 March 2006.
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I appreciate the opportunity to speak to you today about the macroeconomic outlook for the U.S.
economy. I will discuss both the baseline outlook and some of the risks to that outlook. As always, the
views that I will be expressing are my own and do not necessarily represent those of my colleagues at
the Federal Reserve.
Last year was, in some respects, a difficult one for the American people and the economy. As you
recall all too well, the hurricanes in the fall inflicted a terrible human toll, in terms of both the number of
lives taken and the dislocation of so many people. On the economic side, the storms destroyed
residential and business capital along with critical infrastructure and also disrupted economic activity,
particularly in the energy and petrochemicals industries and at ports on the Gulf Coast. These effects
also contributed to the sharp increase in energy prices that occurred last year. Both the aftermath of
the storms and the influence of the higher energy prices are reflected in the slower growth of real (that
is, inflation adjusted) gross domestic product in the fourth quarter of last year.
Even so, over the course of the year as a whole, real GDP rose a bit more than 3 percent, payroll
employment increased significantly, labor productivity posted another solid advance, and the
unemployment rate moved down further. Increases in overall consumer prices were boosted by the
rise in energy prices, but increases in prices apart from those for food and energy--that is core
inflation--remained moderate. In light of the challenges confronting the economy, this was quite a
favorable outcome.
Moreover, much of the slowdown in growth last quarter reflected factors that are unlikely to persist.
First, as I mentioned, the hurricanes significantly damped economic activity in the Gulf Coast region
and led to a sharp increase in energy-related imports. Although the recovery of economic activity in
the worst-affected areas will take a long time, many of the affected industries, including those in the
energy sector, have made considerable progress toward returning their production to normal levels.
Second, much of the weakness in consumer spending came from a sharp drop in motor vehicle sales
after the end of last summer's employee pricing programs. Third, defense spending, which can be
volatile from quarter to quarter, dropped sharply in the fourth quarter. The unwinding of these factors
should provide some support to growth of real activity in the near term.
Indeed, the most recent data suggest that economic activity in 2006 is off to a solid start. Payroll
employment expanded briskly in January--the latest month for which figures are available--on top of
sizable gains over the preceding two months. Although these increases contain some bounceback
from the effects of the hurricanes, they also likely reflect underlying strength in labor demand--an
impression that is corroborated by the recent low readings on initial claims for unemployment
insurance. In addition, the underlying pace of activity in the industrial sector has been quite robust
recently. Real household spending continued to climb in January; although unseasonably warm
weather that month left an imprint on the data, the result suggests some underlying strength in this
sector. Housing activity has, on balance, been a bit softer recently but still remains at a high level.
Overall, the fundamentals appear sufficient to support continued economic expansion. Underlying
productivity growth remains strong, the financial positions of households and businesses remain
conducive to spending, and, if we have no further run-up in oil prices, the drag on activity from higher
energy prices should diminish over time. And the outlook for activity abroad is quite favorable. In
Japan, the expansion appears to be broadening, and signs suggest that the Japanese financial sector
may finally be stabilizing. Prospects in Europe are gradually improving, particularly in Germany, after
several years of sluggish growth. Many emerging market economies also are doing well, with exports
providing a significant boost to activity in these countries. These developments should provide some
ongoing support to the U.S. economy.
The inflation outlook
The continued surge in energy prices was the dominant factor affecting inflation last year. Rising
energy prices contribute to consumer inflation in several ways--by boosting prices for gasoline and
other energy goods; by raising the price of non-energy goods and services as firms pass on increased
energy costs; and by putting upward pressure on expectations of future inflation. Despite those
pressures, core inflation has, as I mentioned, remained contained, a result likely attributable to a range
of causes.
The decline in the economy's energy intensity is one of the factors that has restrained the
passthrough of energy prices into core inflation in recent decades. As energy prices started to rise in the
1970s, households responded by purchasing products that were more energy efficient and adjusting
their consumption habits in other ways. Businesses responded by designing and purchasing capital
goods that were more energy efficient and by redesigning production processes in ways that used less
energy. One measure of these changes in energy intensity is the ratio of energy use to real GDP,
which has fallen more than half since the mid-1970s.
Econometric evidence suggests, however, that the pass-through of energy prices to core inflation has
dropped by more than would be implied by the decline in energy intensity. In particular, we often look
at forecasting equations for core inflation that include a term for the price of energy, weighted by a
measure of energy intensity. Using data for years preceding 1981, the pass-through of energy prices
to core prices is large and statistically significant. In the period since 1981, the evidence of
passthrough of energy prices to core inflation is more limited. Because the energy-price term in these
models already controls for the decline in energy intensity, this result suggests that other factors also
are restraining the pass-through of energy prices to core inflation.
Although many factors could have led to these results, a likely explanation is that inflation expectations
have become better anchored. In the 1970s, monetary policy unfortunately allowed large increases in
energy prices to have a persistent effect on inflation, a policy that undercut the Fed's credibility and
caused long-run inflation expectations to be more volatile. Since that time, however, the Federal
Reserve has been more aggressive in fighting all sources of inflationary pressures, including energy
price changes. This effort appears to have paid off not only in low and stable inflation but also in a
reduction in the sensitivity of long-run inflation expectations to energy prices. The reduced sensitivity is
evidenced by how little movement has appeared in survey measures in response to the rise in energy
prices over the past two years.
This same tendency can be seen in longer-horizon measures of inflation compensation derived from a
comparison of yields on nominal Treasury securities and those on Treasury inflation-protected
securities (TIPS), which are indexed to a measure of price change. Specifically, for the period five to
ten years ahead, the TIPS-based measure of inflation compensation has remained well anchored in
recent quarters. Moreover, econometric evidence suggests that since early 2004, energy prices have
had only a modest effect on TIPS-based inflation compensation at relatively longer horizons. Because
inflation-indexed securities were not issued in the 1970s and early 1980s, we cannot know for sure
how these recent effects differ from those that might have operated earlier, but I believe that the
difference would be stark.
All told, increases in energy prices over the past couple of years probably added about 1/2 percentage
point to core inflation in 2005, and the lagged pass-through of past increases in energy prices appears
likely to add roughly the same amount this year, provided that energy prices do not rise significantly
further.
The term structure of interest rates
Another development that has received considerable attention recently is the term structure of interest
rates--the yield curve. Typically, longer-term interest rates are higher than short-term rates, so a curve
plotting yields would rise as maturity lengthens. However, since late last fall, yields on longer
maturities have been equal to or less than those at some shorter maturities, creating a flat to inverted
yield curve. Going back to the 1950s, a simple picture suggests that the yield curve tends to invert
before recessions. In addition, some academic research, along with recent market commentary,
suggests that the shape of the yield curve is a strong predictor of future economic growth.
However, the Treasury yield curve is now only slightly inverted between one and five years and is
roughly flat beyond that. Moreover, yield curves can be flat or inverted either because short-term
interest yields are relatively high or because long-term rates are relatively low. Historically, flat or
inverted yield curves owing to unusually high short-term rates have tended to be followed by
slowdowns, but that has not been the case for those episodes of inverted yield curves owing to
relatively low long-term rates. And, in the current situation, the flatness of the term structure results
largely from relatively low long-term yields.
In addition, the relationship between the yield curve and future economic growth may have weakened
in recent decades because the decline in inflation, the dropoff in the variance of economic growth
since the mid-1980s, and financial innovation may have altered the sensitivity of households and
businesses to changes in rates. Indeed, in simple regression models estimated with recent data, a
change in the slope of the term structure has a smaller effect on economic growth than when the
models are estimated with data taken from a longer sample period. And models using the more recent
data anticipate more rapid real GDP growth in coming quarters than do models using the longer
sample period.
The relationship between the yield curve and future growth also appears to depend on the factors that
are keeping long-term rates low. Long-term interest rates embody both expectations of future interest
rates as well as the amount of compensation demanded by investors for the risk of unanticipated
movements in real interest rates and inflation--that is, the term premium. By historical standards, the
term premium appears to have come down significantly in recent years and to be quite low. A flat yield
curve resulting from low term premiums should have quite different implications for future growth than
would a flat yield curve resulting from tight monetary policy. Indeed, an exogenous decline in term
premiums would make financial conditions more accommodative and would, other things being equal,
be followed by higher growth. To account for these developments, an estimate of the term premium
can be added to a simple regression model of the relationship between real GDP growth and the slope
of the yield curve. Forecasts of future real GDP growth from this extended model are higher than those
from models that include only the slope of the yield curve. And the forecasts from this extended model
currently are very close to the private-sector consensus forecast.
Thus, we have reasons to believe that the current configuration of the term structure is not signaling
an economic downturn. At the same time, the amount of economic stimulus arising from low long-term
rates is probably not especially large. Indeed, low long-term rates may be signaling relatively low
demand for capital around the world relative to saving, which in turn may reflect a lack of sufficiently
attractive investment opportunities. For example, in the United States, the nominal share of business
fixed investment in GDP has risen recently only to about its long-run average--a level arguably
somewhat lower than might be expected given the low level of long-term interest rates. Because
interest rates equilibrate the supply and demand of capital, an excess of desired saving relative to
desired investment would tend, all else equal, to hold down long-term rates. In turn, low rates have
stimulated activity in areas outside of business investment: Housing has been boosted significantly,
and consumer spending may also have received some additional impetus.
Some risks to the outlook
All told, the U.S. economic expansion appears to be solidly on track. Nevertheless, the outlook for real
activity faces a number of significant risks, including the possibility that house prices and construction
could retrench sharply and that energy prices could rise significantly further.
Housing construction has been a significant source of strength in this expansion, and consequently,
some analysts have suggested that a correction in this sector could take a big bite out of growth. By
my reading, the incoming data suggest that the housing market has begun to cool somewhat, but they
do not point to a sharper falloff. Sales of both new and existing homes have declined in recent months,
although they remain at a high level; and after cutting though volatility likely related to swings in
weather, housing starts appear to have softened recently. Moreover, other indicators of activity, along
with anecdotal reports, also seem consistent with an easing, but not with a sharp downward
correction.
Of course, house prices may become an area of vulnerability. House prices have increased at a
remarkable rate during the past several years, and for some fundamentally sound reasons, including
low mortgage rates. However, the possibility remains that the recent run-up in prices may be greater
than can be justified by the fundamentals and that increases in house prices may moderate or
undergo a sharper adjustment. The latest data on house prices--including the figures released this
week--provide a hint that a moderation in house prices, and nothing more serious, may now be under
way.
The primary channel through which a deceleration or downturn in housing prices would be likely to
affect the economy is the so-called wealth effect. That is, the path of house prices directly affects the
value of housing wealth, and changes in wealth influence households' consumption and saving.
Estimates from the Federal Reserve Board staff's large econometric model and from various
consumption equations suggest that wealth effects are somewhere in the neighborhood of 3-1/2 cents
on consumption for every dollar of change in wealth, with roughly half the effect realized within a year.
However, these estimates are uncertain, and plausible estimates of the wealth effect range from about
2 cents to 6 cents for every dollar of change in wealth. Moreover, these estimates are obtained from
equations that look at changes in total wealth, whereas historically, much of the variation in wealth has
reflected movements in equity prices. Although efforts have been made to isolate the effects of
changes in different types of wealth, it is difficult to get precise estimates of wealth effects specifically
for real estate. And, it is always possible that the effects of housing wealth on consumption might have
changed in ways that would be hard to identify using standard econometric modeling techniques. For
example, the effects could, perhaps, have increased in the last decade as a wave of financial
innovation made it easier and less costly for households to tap accumulated housing equity.
A decline in consumer confidence is another channel through which a correction in house prices could
affect the economy. In the current situation, a sizable deceleration in house prices could have an
outsized effect on consumer confidence and thereby reduce household spending by more than is
implied by conventional estimates of the wealth effect.
Another possible avenue for gauging the effects of housing prices on the economy is to look at
experiences in other countries. House prices have risen markedly in recent years in many industrial
countries amid low long-term interest rates, ample liquidity, and steady economic growth. Although
movements in real house prices flattened out or turned down in several countries in the first half of
2005, they have since recovered for the most part. Of the countries that have seen recent booms in
house prices, Australia has experienced a decline in real house prices over the past year; real prices
are down about 3 percent since their peak at the end of 2003. During this period, residential
investment contracted, and the growth of real consumption slowed a bit; but the economy continued to
grow, in part because investment in other sectors picked up in response to strong global demand.
More countries have experienced a slowdown in rates of increase in home prices than experienced an
outright decline. For example, in the Netherlands--where residential property prices rose particularly
rapidly in the late 1990s--the rate of increase slowed significantly beginning in 2000. In 2002 and
2003, the economy experienced a mild recession, with domestic demand contracting as a result of
declines in investment (including residential investment) and contracting consumption. But, even so,
the economy started to recover in 2004 and 2005, and house prices there have continued to rise in
recent years.
In the United Kingdom, house prices also flattened out last year, and this deceleration was
accompanied by a slowdown in real consumption growth. More recently, house prices have started
rising again, and consumption growth has also picked up.
The experiences in Australia and the United Kingdom could be taken as suggesting that adjustments
in house prices can be associated, on balance, with continued modest economic growth, while the
Dutch experience paints a slightly more pessimistic picture. Having said that, one difficulty in
interpreting the foreign evidence is that gauging the direction of causality is difficult--that is, are
adjustments in house prices causing a slowdown in real economic growth or is a slowdown in activity
causing the adjustment in house prices. On this point, a recent Federal Reserve study of international
experience documented the pro-cyclicality of real house prices: House prices have tended to reach a
maximum near business cycle peaks, with real GDP growth slowing during the first year or so after
house prices peak.1
Given the limits of what we know about the future path of housing prices and about the implications of
any particular house-price scenario for real activity, the Federal Reserve will have to continue
monitoring this area closely.
Further increases in energy prices are another risk to the economic outlook. The spot price of West
Texas intermediate crude oil rose from around $30 per barrel in December 2002 to around $65 per
barrel in mid-August 2005, shortly before Hurricanes Katrina and Rita made landfall. Since the storms
hit, prices have fluctuated widely in response to developments in both domestic and foreign oil
markets and recently stood a bit below pre-Katrina levels. Over the same time period, prices of
fardated futures contracts have also risen a substantial amount. As oil prices have pushed higher since
late 2003, prices of natural gas also have trended up sharply. And storm-related disruptions to natural
gas production as well as weather patterns this winter have caused considerable volatility in natural
gas prices.
Economic theory suggests that energy price hikes of this magnitude should have an important
contractionary effect on the economy by reducing the purchasing power of households and holding
down business profits outside the energy sector. Persistently higher oil prices also likely reduce labor
productivity and potential output over time as firms adjust their production processes to use less
energy. As for the reduction in aggregate demand, higher energy prices increase the bill for imported
oil and natural gas, which can be viewed as a "tax" on U.S. residents by foreign energy producers,
thereby holding down aggregate demand. Given the rise in energy prices since 2003, the import "tax"
has risen more than $150 billion annually. Although they are imprecise, simulations from the Federal
Reserve Board staff's large-scale econometric model, which account for these effects, suggest that
increases in spot and futures prices of energy from late 2003 to the present subtracted a 1/2
percentage point from real GDP growth in 2004 and more than 1 percentage point in 2005. The model
suggests the subtraction this year will be about a 1/2 percentage point.
In addition to their effect on economic activity, further increases in energy prices also pose a risk to the
inflation outlook. Looking ahead, the path of far-dated futures prices for oil indicates that markets are
not expecting prices to rise significantly further. However, given strong global demand for energy
resources and the ever-present risk of supply disruptions, additional increases in energy prices cannot
be ruled out. Such increases would boost the overall inflation rate and might put additional upward
pressure on production costs and inflation expectations, which in turn, could create forces that would
tend to push core inflation up. If that were to occur, the Fed would need to be particularly vigilant to
ensure that inflation remained under control.
Where do we go from here?
As you know, the Federal Reserve seeks to foster price stability and to promote sustainable growth in
output, and the members of the Federal Open Market Committee (FOMC) are committed to achieving
these objectives. Translating these general economic objectives into operational decisions about
monetary policy poses many challenges, and no simple toolkit of economic and financial indicators or
economic models can provide reliable guidance at all times. Rather, the FOMC must assess the
implications of a wide range of developments and data as well as rely on the best modeling that the
economics profession can provide.
In the current situation, the economic expansion appears to be on track and core inflation has
remained moderate. As I indicated, significant risks, if realized, could alter this generally sanguine
outlook, and the Federal Reserve will continue to monitor developments closely. Given the
considerable uncertainties facing the economy and the outlook for policy, policy decisions in coming
months will depend heavily on the implications of incoming economic data for future growth and
inflation.