Ben S Bernanke: The economic outlook
Testimony of Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal Reserve
System, before the Joint Economic Committee, US Congress, Washington DC, 28 March 2007.
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Chairman Schumer, Vice Chairman Maloney, Representative Saxton, and other members of the
Committee, thank you for inviting me here this morning to present an update on the outlook for the
U.S. economy. I will begin with a discussion of real economic activity and then turn to inflation.
Economic growth in the United States has slowed in recent quarters, reflecting in part the economy's
transition from the rapid rate of expansion experienced over the preceding years to a more sustainable
pace of growth. Real gross domestic product (GDP) rose at an annual rate of roughly 2 percent in the
second half of 2006 and appears to be expanding at a similar rate early this year.
The principal source of the slowdown in economic growth that began last spring has been the
substantial correction in the housing market. Following an extended boom in housing, the demand for
homes began to weaken in mid-2005. By the middle of 2006, sales of both new and existing homes
had fallen about 15 percent below their peak levels. Homebuilders responded to the fall in demand by
sharply curtailing construction. Even so, the inventory of unsold homes has risen to levels well above
recent historical norms. Because of the decline in housing demand, the pace of house-price
appreciation has slowed markedly, with some markets experiencing outright price declines.
The near-term prospects for the housing market remain uncertain. Sales of new and existing homes
were about flat, on balance, during the second half of last year. So far this year, sales of existing
homes have held up, as have other indicators of demand such as mortgage applications for home
purchase, and mortgage rates remain relatively low. However, sales of new homes have fallen, and
continuing declines in starts have not yet led to meaningful reductions in the inventory of homes for
sale. Even if the demand for housing falls no further, weakness in residential construction is likely to
remain a drag on economic growth for a time as homebuilders try to reduce their inventories of unsold
homes to more normal levels.
Developments in subprime mortgage markets raise some additional questions about the housing
sector. Delinquency rates on variable-interest-rate loans to subprime borrowers, which account for a
bit less than 10 percent of all mortgages outstanding, have climbed sharply in recent months. The
flattening in home prices has contributed to the increase in delinquencies by making refinancing more
difficult for borrowers with little home equity. In addition, a large increase in early defaults on recently
originated subprime variable-rate mortgages casts serious doubt on the adequacy of the underwriting
standards for these products, especially those originated over the past year or so. As a result of this
deterioration in loan performance, investors have increased their scrutiny of the credit quality of
securitized mortgages, and lenders in turn are evidently tightening the terms and standards applied in
the subprime mortgage market.
Although the turmoil in the subprime mortgage market has created severe financial problems for many
individuals and families, the implications of these developments for the housing market as a whole are
less clear. The ongoing tightening of lending standards, although an appropriate market response, will
reduce somewhat the effective demand for housing, and foreclosed properties will add to the
inventories of unsold homes. At this juncture, however, the impact on the broader economy and
financial markets of the problems in the subprime market seems likely to be contained. In particular,
mortgages to prime borrowers and fixed-rate mortgages to all classes of borrowers continue to
perform well, with low rates of delinquency. We will continue to monitor this situation closely.
Business spending has also slowed recently. Expenditures on capital equipment declined in the fourth
quarter of 2006 and early this year. Much of the weakness in recent months has been in types of
capital goods used heavily by the construction and motor vehicle industries, but we have seen some
softening in the demand for other types of capital goods as well. Although some of this pullback can
be explained by the recent moderation in the growth of output, the magnitude of the slowdown has
been somewhat greater than would be expected given the normal evolution of the business cycle. In
addition, inventory levels in some industries - again, most notably in industries linked to construction
and motor vehicle production - rose over the course of last year, leading some firms to cut production
to better align inventories with sales. Recent indicators suggest that the inventory adjustment process
may have largely run its course in the motor vehicle sector, but remaining imbalances in some other
industries may continue to impose some restraint on industrial production for a time.
Despite the recent weak readings, we expect business investment in equipment and software to grow
at a moderate pace this year, supported by high rates of profitability, strong business balance sheets,
relatively low interest rates and credit spreads, and continued expansion of output and sales.
Investment in nonresidential structures (such as office buildings, factories, and retail space) should
also continue to expand, although not at the unusually rapid pace of 2006.
Thus far, the weakness in housing and in some parts of manufacturing does not appear to have spilled
over to any significant extent to other sectors of the economy. Employment has continued to expand
as job losses in manufacturing and residential construction have been more than offset by gains in
other sectors, notably health care, leisure and hospitality, and professional and technical services, and
unemployment remains low by historical standards. The continuing increases in employment, together
with some pickup in real wages, have helped sustain consumer spending, which increased at a brisk
pace during the second half of last year and has continued to be well maintained so far this year.
Growth in consumer spending should continue to support the economic expansion in coming quarters.
In addition, fiscal policy at both the federal and the state and local levels should impart a small
stimulus to economic activity this year.
Outside the United States, economic activity in our major trading partners has continued to grow
briskly. The strength of demand abroad has helped to spur strong growth in U.S. real exports, which
rose about 9 percent last year, and a robust world economy should continue to provide opportunities
for U.S. exporters this year. Growth in U.S. real imports slowed to about 3 percent in 2006, in part
reflecting a drop in real terms in imports of crude oil and petroleum products. Despite the
improvements in trade performance, the U.S. current account deficit remains large, averaging 6-1/2
percent of nominal GDP during 2006.
Overall, the economy appears likely to continue to expand at a moderate pace over coming quarters.
As the inventory of unsold new homes is worked off, the drag from residential investment should
wane. Consumer spending appears solid, and business investment seems likely to post moderate
gains.
This forecast is subject to a number of risks. To the downside, the correction in the housing market
could turn out to be more severe than we currently expect, perhaps exacerbated by problems in the
subprime sector. Moreover, we could yet see greater spillover from the weakness in housing to
employment and consumer spending than has occurred thus far. The possibility that the recent
weakness in business investment will persist is an additional downside risk. To the upside, consumer
spending - which has proved quite resilient despite the housing downturn and increases in energy
prices - might continue to grow at a brisk pace, stimulating a more-rapid economic expansion than we
currently anticipate.
Let me now turn to the inflation situation. Overall consumer price inflation has come down since last
year, primarily as a result of the deceleration of consumers' energy costs. The consumer price index
(CPI) increased 2.4 percent over the twelve months ending in February, down from 3.6 percent a year
earlier. Core inflation slowed modestly in the second half of last year, but recent readings have been
somewhat elevated and the level of core inflation remains uncomfortably high. For example, core CPI
inflation over the twelve months ending in February was 2.7 percent, up from 2.1 percent a year
earlier. Another measure of core inflation that we monitor closely, based on the price index for
personal consumption expenditures excluding food and energy, shows a similar pattern.
Core inflation, which is a better measure of the underlying inflation trend than overall inflation, seems
likely to moderate gradually over time. Despite recent increases in the price of crude oil, energy prices
are below last year's peak. If energy prices remain near current levels, greater stability in the costs of
producing non-energy goods and services will reduce pressure on core inflation over time. Of course,
the prices of oil and other commodities are very difficult to predict, and they remain a source of
considerable uncertainty in the inflation outlook.
Increases in rents - both market rent and owner's equivalent rent - account for a substantial part of
the increase in core inflation over the past year. The acceleration in rents may have resulted in part
from a shift in demand toward rental housing as families found homeownership less financially
attractive. Rents should begin to decelerate as the demand for owner-occupied housing stabilizes and
the supply of rental units increases. However, the extent and timing of that expected slowing is not yet
clear.
Another significant factor influencing medium-term trends in inflation is the public's expectations of
inflation. These expectations have an important bearing on whether transitory influences on prices,
such as changes in energy costs, become embedded in wage and price decisions and so leave a
lasting imprint on the rate of inflation. It is encouraging that inflation expectations appear to be
contained.
Although core inflation seems likely to moderate gradually over time, the risks to this forecast are to
the upside. In particular, upward pressure on inflation could materialize if final demand were to exceed
the underlying productive capacity of the economy for a sustained period. The rate of resource
utilization is high, as can be seen most clearly in the tightness of the labor market. Indeed, anecdotal
reports suggest that businesses are having difficulty recruiting well-qualified workers in a range of
occupations. Measures of labor compensation, though still growing at a moderate pace, have shown
some signs of acceleration over the past year, likely in part the result of tight labor market conditions.
To be sure, faster growth in nominal labor compensation does not necessarily portend higher inflation.
Increases in compensation may be offset by higher labor productivity or absorbed - at least for a time
- by a narrowing of firms' profit margins rather than passed on to consumers in the form of higher
prices. In these circumstances, gains in nominal compensation would translate into gains in real
compensation as well. Underlying productivity trends appear generally favorable, despite the recent
slowing in some measures, and the markup of prices over unit labor costs is high by historical
standards, so such an outcome is certainly possible. Moreover, if the economy grows at a moderate
pace for a time, as seems most likely, pressures on resource utilization should ease.
However, a less benign possibility is that tight product markets might allow firms to pass some or all of
their higher labor costs through to prices. In this case, increases in nominal compensation would not
translate into increased purchasing power for workers but would add to inflation pressures. Thus, the
high level of resource utilization remains an important upside risk to continued progress in reducing
inflation.
In regard to monetary policy, the Federal Open Market Committee has left its target for the federal
funds rate unchanged, at 5-1/4 percent, since last June. To date, the incoming data have supported
the view that the current stance of policy is likely to foster sustainable economic growth and a gradual
ebbing in core inflation. Because core inflation is above the levels most conducive to the achievement
of sustainable growth and price stability, the Committee indicated in the statement following its recent
meeting that its predominant policy concern remains the risk that inflation will fail to moderate as
expected. However, the uncertainties around the outlook have increased somewhat in recent weeks.
Consequently, the Committee also indicated that future policy decisions will depend on the evolution
of the outlook for both inflation and economic growth, as implied by incoming information.
Thank you. I would be happy to take your questions.