Mark W Olson: Update on the US economy
Remarks by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve
System, at the University of Arkansas at Little Rock, Little Rock, Arkansas, 13 April 2006.
* * *
Recent trends in the U.S. economy have been, on the whole, quite favorable. Real gross domestic
product (GDP) increased 3-1/4 percent during 2005, on the heels of two years during which it rose at
an annual rate of almost 4 percent. By the end of last year, businesses had added another 2 million
jobs to their payrolls, and the unemployment rate had dropped to its lowest level in five years.
Although top-line consumer price inflation was boosted by the run-up in energy prices, core consumer
price inflation remained relatively steady, at about 2 percent for the year.
One of the significant challenges for a policymaker is to be able to discern the underlying trends in real
activity and inflation in the midst of the inevitable noise and shocks that come along. The recent period
has presented a number of those types of unanticipated events: Most notably, the devastating
hurricanes that hit the Gulf Coast last fall destroyed residential and business capital and tragically
uprooted the lives of many people. The resulting disruptions to economic activity, particularly in the
energy and petrochemical sectors, held down the rise in real GDP in the fourth quarter. The restarting
and rebuilding that began late last year should be providing a boost to activity this year, but the size of
that effect and the extent to which it will be distributed in coming quarters remain uncertain. Another
special factor at work early this year was the atypically warm weather that very likely advanced
homebuilding and perhaps other spending that might otherwise have stretched into the spring. As a
result, most forecasters believe that the incoming information has been adding up to a sizable, but
quite likely temporary, acceleration in real GDP in the first quarter after the small increase in the final
quarter of 2005.
Another, more persistent economic challenge in recent years has been the climb in world oil prices. As
a result, last year marked a third consecutive year of rapidly rising--and sometimes volatile--domestic
energy costs. To be sure, higher energy prices cut into households' purchasing power and the profits
of non-energy firms. While recognizing the difficulty of identifying the reactions of consumers and
businesses to higher energy prices, Chairman Bernanke has recently noted that the surge in energy
prices since late 2003 probably reduced the growth of real GDP between 1/2 percent and 1 percent
per year. One important change in the economic landscape that has limited the current effect of an
energy shock compared with the effects in our earlier experience is that energy costs today are not
nearly as important as they were during the 1970s, when the energy intensity of U.S. production was
significantly higher.
After taking into consideration the unusual factors that have been influencing the pattern of economic
activity of late, most forecasters are projecting that, after a sizable increase in the first quarter,
production and spending will return to a moderate and sustainable pace over the remainder of the
year. Several fundamental factors support that view. First, although longer-term yields have begun to
move up recently, they remain low by historical standards, and financial conditions remain favorable.
Second, business balance sheets are strong, and corporate earnings have been robust. Third,
household credit quality has shown few signs of stress. Finally, households' real income has been
receiving a boost from the recent strong gains in employment, and the ongoing increases in house
prices and gains in the stock market have kept the ratio of wealth to income at a high level.
All told, prospects for ongoing gains in consumer spending and business investment appear good, and
the recent indicators are positive. This morning's report on retail sales, together with the information on
motor vehicle sales released last week, points to a solid rise in real consumer spending in March and
a very strong reading for the first quarter as a whole. The outlook for moderate increases in personal
consumption expenditures in the near term is consistent with the latest readings on consumer
sentiment. In addition, the continued low level of new claims for unemployment insurance bodes well
for further net gains in employment and, thus, income. A survey of businesses' capital spending plans
conducted by the National Association of Business Economists at the end of last year pointed to
another solid year of spending on plant and equipment. And, through February, backlogs of orders for
nondefense capital goods were still moving up.
Another important factor in the outlook for the United States is the likelihood of a continued solid
expansion in economic activity abroad. Notably, the Japanese economy has strengthened, and
economic activity in emerging Asian economies has continued to rise at a brisk pace, while the outlook
in Canada calls for sustained moderate growth.
Domestic economic activity should also continue to receive a boost in coming quarters from
reconstruction in the Gulf region. In part, the reconstruction represents some temporary federal fiscal
stimulus from the hurricane relief that the Congress has provided. However, despite the additional
support to construction from hurricane-related repair and rebuilding, residential construction overall
appears likely to cool a bit this year. The most recent indicators suggest that demand and home-price
inflation have begun to moderate.
With respect to inflation, although forecasting energy prices is risky, I should note that the futures
market suggests that crude oil prices will move up a bit further in coming months before flattening out
at $70 per barrel. If so, the drag on real income and spending from rising energy costs should diminish
over time, as should the risk of additional energy cost pressure on underlying, or "core," inflation.
The general contour of economic activity that most forecasters are expecting, in which they see little
change in resource utilization over the year, should be consistent with relatively stable core inflation.
As I noted earlier, the unemployment rate is now at a five-year low of 4-3/4 percent. More important, it
and other indicators of resource utilization--such as the industrial capacity utilization rate--are now at
levels at which, in the past, little or no economic slack remained. At this point, we have seen few signs
of upward pressure on labor compensation or core inflation. Although we have experienced run-ups in
prices of commodities, such as building supplies, that are more sensitive to changes in supply and
demand conditions and in prices of energy-intensive commodities and services, the pass-through to
core inflation appears to have been limited. Important in that regard is the fact that longer-run inflation
expectations have been well anchored, as is apparent in the stability of the five-to-ten-year inflation
expectations of households in the Michigan SRC survey and in the reading implicit in
Treasuryinflation-protected securities.
The observations I've just shared illustrate the evolving economic forces that the Federal Open Market
Committee (FOMC) will consider as it makes monetary policy decisions over the remainder of the
year. The FOMC has raised the target federal funds rate 25 basis points at each of the past fifteen
meetings over roughly two years. During much of that time, we described our actions as "removing
accommodation" at a "measured pace." At our March meeting, we indicated that some additional
tightening may be necessary to keep the risks to the attainment of both sustainable economic growth
and price stability roughly in balance. Thus, the future path for the target federal funds rate will depend
importantly on how incoming information on economic activity and inflation affect our assessment of
these risks.