Susan Schmidt Bies: The economic outlook
Remarks by Ms Susan Schmidt Bies, Member of the Board of Governors of the US Federal Reserve
System, at the Drake-FEI Lecture, Des Moines, Iowa, 2 November 2006.
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Thank you for inviting me to speak with you today. I am pleased to have the opportunity to address
both leading financial professionals - the members of Financial Executives International - as well as
future leaders - the students here at Drake University. In my remarks today, I will discuss the
nearterm outlook for the U.S. economy and some of the longer-run issues that economic policy makers
should consider. I want to emphasize that these views are my own and not necessarily those of my
colleagues on the Federal Open Market Committee (FOMC).
Economic activity slowed in the middle part of this year. Real gross domestic product increased at a
2.6 percent annual rate in the second quarter of this year, and last week the Commerce Department
announced that output rose at only a 1.6 percent rate in the third quarter. These figures are down
notably from the nearly 3-1/2 percent average pace of the preceding two years. Despite the recent
slowing in output, however, resource utilization remains relatively high by historical standards and thus
continues to be a potential source of upward pressure on inflation.
In the aftermath of the 2001 recession, the FOMC eased monetary policy substantially. However, the
degree of easing in place in 2003 and 2004 was clearly unsustainable and risked overheating the
economy. Since mid-2004, the FOMC has gradually moved monetary policy from an accommodative
stance to a more neutral position. As a consequence, the elements now appear to be in place for
some easing of resource utilization rates over the next year or so and a reduction in inflationary
pressures. However, substantial uncertainty surrounds the near-term outlook. In determining the future
path of interest rates, the FOMC will be guided by the incoming data on both output and prices, so let's
begin by reviewing recent developments.
Economic activity
The slowdown in the growth of real GDP since the spring largely reflects a cooling of the housing
market: The number of single-family and multifamily housing starts has fallen nearly 25 percent since
the beginning of the year; sales of both new and existing homes have dropped sharply since their
peak of last summer, and the inventory of unsold homes has soared. At the same time, homes are
appreciating more slowly and in some markets prices are even declining.
While much of the downshift in the housing market appears to have occurred already, some further
softening may yet lie ahead. Nonetheless a variety of factors should help limit any remaining
contraction in housing demand. For example, despite the 4-1/4 percentage point increase in
shortterm interest rates over the past two years, the interest rate on a thirty-year fixed-rate mortgage has
increased only about 1/2 percentage point, and borrowing costs continue to be relatively low. The
ongoing growth in real incomes and the recent increase in the stock market wealth of households
should also support the demand for housing.
It is encouraging also that the recent weakness in residential construction does not appear to have
spilled over to other sectors. For instance, employment has been growing smartly in nonresidential
construction, even as it has shrunk in the residential sector. In addition, consumer confidence currently
stands a bit above its long-run average and consumption is still being fueled by past house-price
gains, which raised household wealth. This contrasts with previous slowdowns in the housing market,
which have typically coincided with widespread economic weakness.
Although the slowdown in the housing market has so far done little to reduce consumer outlays, other
factors do appear to have had a damping effect. In particular, consumption likely was restrained earlier
this year by the rise in energy prices, which took a large bite out of household budgets. The rise in
energy prices over the past few years has also affected the auto sector - reducing the demand for
sport utility vehicles and other gas-guzzling automobiles. As a result, inventories of these vehicles
have risen, and domestic automakers have been cutting production in response.
In the business sector, spending on nonresidential construction has been particularly robust. In the
third quarter, nonresidential investment grew at an annual rate of 14 percent, down from the sizzling
20 percent pace in the previous quarter but still very substantial. Expenditures on drilling and mining
structures have increased particularly rapidly in response to high prices for natural gas and crude oil.
Investment in other types of structures, such as offices and commercial buildings, has also been
strong over the past year or so.
Spending on equipment and software, which grew quite rapidly from mid-2004 to early 2006, has
advanced at a more moderate pace lately. The recent slowdown in the growth of business sales would
be expected, all else equal, to have a damping influence on capital spending, and in fact business
confidence has moved down since the start of the year. However, order books for capital goods such
as industrial machinery and other types of heavy equipment appear to be full and should support
nearterm investment gains. Moreover, the demand for information technology equipment is also likely to be
well maintained, in part because of the recent introduction of a new generation of microprocessing
chips and more-efficient large servers.
Current financial conditions also are supportive of business spending. Corporate balance sheets are
strong and flush with cash, and broad stock price indexes are up more than 10 percent so far this
year. At the same time, yield spreads on corporate bonds across the ratings spectrum have been low,
supported by the strong balance sheets and robust profit growth.
Inflation
The picture painted here is one of an economy that has been growing solidly, albeit at a rate below its
potential. What are the implications of this picture for inflation prospects? Consumer prices excluding
food and energy have accelerated over the past year, and this clearly is a concern. The core inflation
rate rose 2.4 percent over the most recent four quarters, up from 2.0 percent for the same period a
year ago. In thinking about the macroeconomic consequences of inflation, it makes sense to abstract
from the prices of energy and food when the focus is on the short run. Temporary shocks to food and
energy prices typically don't translate into changes in inflationary pressure. However, if these shocks
persist, they may have an effect on core inflation and, more generally, on the economic behavior of
households and businesses. Core inflation can be affected when the price changes are propagated
along the production chain - say from oil prices to the prices of chemicals and ultimately to the prices
of goods made with those chemicals. In addition, the shocks to food and energy prices may affect
inflation expectations. Thus, we also pay attention to broader measures of inflation.
Nonetheless, the scene appears to be set for a deceleration in prices over time. One contributing
factor is likely to be the slowing in activity I already discussed, which should ease the overall pressure
on resources. Another important factor affecting the inflation outlook is household and business
expectations for inflation. As best we can judge, inflation expectations appear to be well contained:
Measures of longer-term inflation expectations, based on surveys and on a comparison of yields on
nominal and inflation-indexed government debt, have remained within the ranges in which they have
fluctuated in recent years. Finally, the recent decline in energy prices, if it is sustained, should reduce
cost pressures along the production chain.
One upside risk to the inflation outlook comes from the labor market. The unemployment rate declined
steadily between the second half of 2003 and the beginning of 2006 and has stood at a relatively low
4.7 percent for the past six months. With labor markets comparatively tight by historical standards, unit
labor costs have begun to accelerate, especially since the end of last year, and firms may pass on
some of these higher costs to consumers. However, the large markup of prices over costs - the margin
is currently well above its historical average - could act as a shock absorber if cost strains were to
intensify. Thus, in my judgment, inflation appears poised to decelerate in coming months as energy
prices stabilize and resource pressures ease. But the risks to that outlook seem tilted toward the
upside.
Aggregate supply
In considering the appropriate setting for monetary policy, the level of the economy's underlying
productive capacity - its potential output - is the benchmark against which we assess actual output.
Accordingly, whether the recent slowdown in economic activity eases resource constraints enough to
reduce inflationary pressure depends importantly on how fast potential output is growing. If the key
determinants of potential output - the workforce, economic efficiency, and the capital stock - grow
quickly, as they did in the second half of the 1990s, then GDP can also rise quickly without increasing
the pressure on the economy's resources. Conversely, a reduced rate of growth of potential output
would require slower growth of actual GDP to keep resource pressures from increasing.
I'd like to spend a little time examining in greater depth the outlook for some of the factors that
determine potential output, starting with the labor force. The size of the labor force depends on a
combination of two factors: the size of the working-age population and the likelihood that members of
this population join the labor force - a likelihood that economists refer to as the labor force participation
rate.
The labor force participation rate tends to vary over the business cycle as potential workers become
more or less encouraged about job prospects. However, the influence of labor force participation on
potential output does not depend on short-run conditions in the labor market but rather on long-run
changes due to demographic and social factors. For instance, in the 1950s and 1960s the labor force
participation rate stood at just under 60 percent. In subsequent years, women entered the labor force
in large numbers and thus dramatically pushed up the participation rate. Indeed, by some estimates,
the increase in the labor force participation of women aged sixteen years and older added a little more
than 1/2 percentage point per year to the growth rate of potential output between the late 1960s and
the early 1990s.
Now, the United States is facing another change in the trend of labor force participation. The baby
boomers, the large population born between 1946 and 1964, are getting older, and the oldest are
turning sixty this year. Older individuals tend to have relatively low participation rates, with many
people starting to retire in their fifties and more still when they reach sixty and then sixty-five. Thus,
with the aging of the boomers, a large share of the population is entering the low-participation years,
which will tend to pull down the aggregate labor force participation rate.
Recent work by economists at the Federal Reserve Board has explored how changes in the age
distribution of the population affect the participation rate. For instance, between 1995 and 2005 the
participation rate declined on net from 66.4 percent to 66.0 percent. The study suggests that changes
in the age distribution of the population - the movement of a large portion of the population from their
high-participation-rate years to their later, low-participation-rate years - can explain the bulk of the
decline.1 The changing age distribution - primarily the aging of the baby boomers - is expected to
lower the participation rate by about 0.2 percentage point next year and continue to lower it over the
next several years.
However, this decomposition assumes that the participation rate for each age group is constant at its
average between 1995 and 2005. But the propensity of individuals of a given age to participate in the
labor force changes over time. Already, individuals aged fifty-five and older are working more than
they did ten years ago, perhaps because of better health; higher levels of education; and a reduction,
over time, in the share of workers employed in physically strenuous occupations. Unfortunately, there
is still much we do not understand about the increase in the participation rates of older workers, so it is
difficult to predict how much their participation will rise in the future. However, given the magnitude of
the predicted age-related decline, it is unlikely that changes in behavior could completely offset it.
As I noted earlier, the reduction in the growth of the labor force and, thus, of potential output has
important implications for how we interpret incoming economic data. For example, to the extent that
the aging of the baby boomers reduces the growth in labor force participation and hence potential
output, the benchmark we use for assessing the macroeconomic implications of actual GDP growth
will need to be lower. Similarly, changes in the expected growth rate of the labor force affect our
interpretation of the monthly employment data. If the labor force participation rate remains at its
current level, then what might be thought of as the "equilibrium" growth rate of payroll employment -
that is, the increase consistent with a stable unemployment rate - would be about 140,000 per month.
However, if the labor force participation rate instead declines 0.2 percentage point over the next year,
as suggested by the Fed's staff research, then the comparable equilibrium payroll employment growth
would be closer to 110,000 per month.
While reductions in the labor force participation rate will apparently damp the growth rate of potential
output in coming years, productivity growth, another important factor in determining the capacity of the
economy, likely will remain supportive. Although productivity growth has stepped down from the
scorching pace seen early in the recovery, factors remain in place for continued solid growth over the
next few years. One element is capital deepening, that is, the rate at which the stock of equipment,
software, and so forth is expanding relative to the number of workers, or - to put it even more simply,
how fast workers are getting more of the tools they need. As I mentioned earlier, business investment
spending has been strong in recent years and seems likely to remain at a high level for some time.
Another element is improvements in the efficiency of how businesses do business. Here it appears
that the flexibility of business processes and product, financial, and labor markets in the United States
will continue to allow for the quick adoption of new technologies and the efficient reallocation of
resources.
On balance, despite the outlook for continued solid longer-run productivity growth, the slowing in trend
labor force growth will likely yield a modest deceleration the growth of potential output. However, the
considerable uncertainty that, as I noted earlier, surrounds the prospect for all of these elements
makes it extremely difficult in real time to discern changes in potential output. Ferreting out the
changing trends in these elements is an important part of making monetary policy. For example, the
early identification of the resurgence of productivity growth, and hence of potential output growth, that
began in the mid-1990s allowed the Federal Reserve to put in place a monetary policy that
accommodated both strong economic growth and low inflation during the second half of that decade.2
Similarly, it is important now to try to understand the new forces determining potential output growth so
that monetary policy can respond accordingly.