Frederic S Mishkin: Outlook and risks for the US economy
Remarks by Mr Frederic S Mishkin, Member of the Board of Governors of the US Federal
Reserve System, to the Money Marketeers of New York University, New York,
10 September 2007.
The original speech, which contains various links to the documents mentioned, can be found on the US Federal
Reserve System's website.
* * *
Thank you for the invitation to be here this evening.1 It is always a pleasure to be back in my
hometown, and it is a particular pleasure to have a chance to talk again with the Money
Marketeers. At the outset, I would like to acknowledge that tomorrow marks the sixth
anniversary of the terrorist attacks on the World Trade Center, the Pentagon, and United
Flight 93, which crashed in Pennsylvania. The anniversary weighs on the minds of
Americans everywhere, and it weighs especially heavily on members of the New York
financial community. That terrible day and its aftermath remind us that resilience is a defining
characteristic not just of our economy and financial system but also of our country and our
city. For as long as anyone who experienced it is alive, the memory of that awful day will not
fade.
In my remarks this evening, I will review the current economic situation and outlook and
make some specific observations about recent developments in financial markets. I should
note that the views I will express here are my own and not necessarily those of my
colleagues on the Federal Open Market Committee (FOMC).
As everyone in this room knows, financial markets have been front and center in recent
discussions about the economy. The FOMC noted on August 17 that financial market
conditions deteriorated last month and that the associated tighter credit conditions and
increased uncertainty have the potential to restrain economic growth going forward. Indeed,
at this point, housing demand seems likely to be crimped further by a marked reduction in the
availability of mortgages, and consumer and business spending also could be damped as a
consequence of the recent financial turmoil. In light of these events, we will need to make the
best possible real-time judgments about the extent to which the recent developments in
financial markets are likely to affect economic activity in the period ahead.
That said, the economy ended the second quarter on a positive note. The Commerce
Department's Bureau of Economic Analysis recently reported that the economy expanded at
an annual rate of 4 percent in the second quarter, about 1/2 percentage point higher than the
first estimate. Of course, the jump in growth followed a sluggish first-quarter gain: That
choppiness in growth reflected large swings in several factors that are often volatile,
including inventory investment, federal defense outlays, and net exports. Smoothing through
this volatility, the underlying pattern of activity in the first half of the year essentially
represented a continuation of the moderate growth that had prevailed since the spring of last
year when growth in real gross domestic product stepped down from an above-trend pace.
Many of the spending indicators for the current quarter have remained consistent with that
earlier trend. However, for the most part, these data cover a period that predates the recent
onset of financial turbulence.
The step-down in the growth of real output that began in mid-2006 and proceeded through
the middle of this year primarily reflected weakness in the housing market. Declines in real
residential investment subtracted nearly 1-1/4 percentage points from the growth of real GDP
in the second half of last year and about 3/4 percentage point in the first half of this year.
Moreover, the demand for housing appears to be weakening further amid credit conditions
for home mortgage lending that are generally tighter, but especially so in the subprime
segment. Sales of existing single-family homes in July were more than 20 percent below
their peak in mid-2005, while sales of new homes in July were more than 37 percent below
their peak. Although housing starts have also moved down over the past year, the decline
thus far has lagged the downturn in sales, and the backlog of unsold new homes has climbed
to a very high level relative to sales. Given this sizable backlog and the likelihood that sales
will remain weak or weaken further in coming months, cutbacks in housing construction are
likely to continue to be a drag on economic activity in future quarters.
Turning to consumer spending, real outlays decelerated considerably in the second quarter.
To some extent, a moderation from the very rapid pace of growth around the turn of the year
probably was to be expected. In the second quarter, in particular, a jump in energy prices
eroded the purchasing power of gains in household income, placing downward pressure on
the growth of real spending at that point. Even so, early indications are that household
spending is holding up reasonably well thus far in the current quarter: Real outlays for goods
excluding motor vehicles posted a solid increase in July, and sales of light motor vehicles -
which had slumped in June and July - rebounded last month.
Having said that, several factors suggest that consumer spending will be subdued in the
period ahead. This summer's retrenchment in equity markets and the sharp deceleration in
house prices have damped gains in household wealth this year and are likely to restrain
consumer outlays. Moreover, at least some households are likely to find it more difficult or
expensive to borrow, and consumer sentiment - which turned down in August - could soften
further if households become more anxious about recent financial market developments.
Business investment in equipment and software weakened toward the end of last year and
remained sluggish in the first quarter. In part, the slowing reflected a downturn in outlays for
capital goods that are used heavily by the motor vehicle and construction industries, two
sectors in which activity had softened considerably. But spending on other types of
equipment also was soft in the first quarter. In the second quarter, however, demand for
these other types of equipment bounced back strongly, and the gains were extended in July
- as reported in the most recent data on orders and shipments of capital goods.
We have no direct readings on capital spending in August, but the limited indicators currently
in hand - such as the Institute for Supply Management's survey of purchasing managers -
have held up reasonably well and remain at levels consistent with modest growth in
manufacturing production and business investment. Of course, all this could change
noticeably if many firms were to face significantly tighter credit conditions or if business
sentiment were to soften appreciably.
Regarding international developments, the recent deterioration in financial market conditions
has had effects around the world, but the economies of our major trading partners appear set
to continue their expansion. That growth should continue to stimulate demand for U.S.
exports of goods and services.
Turning to the labor market, payroll employment has weakened. As reported on Friday,
nonfarm payrolls fell 4,000 last month, and private payrolls rose only 24,000. Smoothing
through the recent monthly numbers, private payrolls increased an average of about 70,000
per month over the past three months; this is down from gains near 120,000 per month in the
first five months of the year and about 165,000 per month in the second half of 2006.
As for the economy's longer-run growth rate, a key determinant is the trend in labor
productivity. As you know, from 1995 to 2000, productivity in the nonfarm business sector
increased at an average annual rate of 2-1/2 percent, well above the lackluster pace of the
preceding twenty-five years. Then, remarkably, productivity accelerated further, rising at an
average of about 3-1/2 percent per year for the first three years of this decade, despite the
challenges of a recession, the fall of the dot-com market, a broad stock market correction,
and the terrorist attacks.
Since the middle of 2004, however, the growth of labor productivity has slowed, registering
an average annual rate of about 1-1/4 percent. Previously, that figure had looked higher, but
this summer's annual revision of the national income and product accounts marked down
productivity growth over the 2004 to 2006 period by an average of 0.3 percentage point per
year. Part of the recent deceleration in productivity almost surely reflects a typical cyclical
response to a slowing economy. The difficult questions, of course, are whether some of the
recent slowing also reflects a downshift in the underlying trend, and, if so, to what extent?
The latest evidence suggests that structural productivity might be increasing somewhat more
slowly than it did during the second half of the 1990s, but the confidence band around any
such estimate of trend productivity growth surely is very wide.2 These issues remain an area
of active debate, the outcome of which will be essential for gauging the economy's potential
rate of growth going forward.
Let me turn now to inflation and inflation dynamics. Over the past year, the price index for
total personal consumption expenditures (PCE) rose 2.1 percent, down from nearly 3-1/2
percent during the comparable period twelve months earlier. Recently, topline inflation has
been boosted by sizable increases in food prices; energy-price increases slowed
considerably over the past twelve months after sizable advances in earlier years. Excluding
food and energy, core PCE prices decelerated over the past year; the July reading on the
twelve-month change stood at 1.9 percent, almost 1/2 percentage point less than it was a
year earlier.
In my view, inflation expectations have been a key element in the recent performance of core
inflation. By a range of measures, inflation expectations appear to have remained contained
even as headline inflation moved temporarily higher. According to the Reuters/University of
Michigan Survey of Consumers, the median expectation of inflation five to ten years ahead
has been essentially flat since the beginning of last year. In addition, measures of long-run
inflation compensation derived from spreads between yields on nominal and inflation-indexed
Treasury securities have not pushed above the range that has prevailed in the past couple of
years.
As I discussed in a speech earlier this year, I read the evidence as suggesting that
households' long-run inflation expectations are consistent with PCE price inflation in the
neighborhood of 2 percent.3 To be sure, this figure is sensitive to the assumptions used to
tease such estimates from the available data, so I do not want to overstate its precision. Still,
the professional forecasters surveyed by the Philadelphia Fed also project PCE inflation to
be close to 2 percent over the next five to ten years.
As I look at the incoming inflation data, I would judge them to be consistent with expectations
in this range; moreover, I believe that having expectations reasonably well anchored in this
range has been a helpful influence on the path of actual inflation. However, let me be clear: I
deus ex machina
do not subscribe to a view of the inflation process, in which inflation is
driven solely by inflation expectations and is little influenced by the balance of aggregate
demand and aggregate supply. Indeed, I take the view that expectations of future resource
utilization are also an important factor affecting inflation outcomes.
If households and businesses believe that the Federal Reserve will set monetary policy in a
way that keeps aggregate demand in reasonable alignment with aggregate supply over time,
then expectations of future resource utilization will be stable, and current resource utilization
will provide less information about future inflation movements. In that situation, which I
believe describes the current environment, inflation expectations will be a key driver of
inflation dynamics.
The stable inflation expectations we have seen lately derive from confidence that monetary
policy will keep inflation under control. If monetary policy allowed aggregate demand to get
out of sync with supply and if the Fed was not expected to bring demand back into balance
with supply, then inflation expectations would be much less likely to remain stable. This is
why I believe that the Federal Reserve must remain vigilant on inflation but give appropriate
attention to keeping demand from falling below supply as well.
What does this all mean for the inflation outlook? At present, labor and product markets
appear to be in reasonable balance. And I would expect the pressures on inflation that we
have experienced from food and energy prices to abate. Accordingly, with inflation
expectations remaining stable around their current level, I see inflation as remaining in
alignment with long-run expectations at around a 2 percent pace for the PCE deflator. In
addition, I believe that the risks to the inflation outlook have become more balanced, given
the greater downside risks to real growth.
Let me shift gears and discuss developments in financial markets. As you know, the recent
turmoil had its beginnings in the subprime mortgage market.4 The development of the
subprime market in the 1990s was an important financial innovation that enabled borrowers
with higher credit risk to obtain mortgages that previously were unavailable to them. This
expansion appears likely to have been a significant factor in raising the rate of
homeownership from 64 percent, the level in 1994, to about 68 percent currently. In addition,
subprime and other nonprime lending played an important role in the high volume of home
sales in the mid-2000s. Indeed, data collected under the Home Mortgage Disclosure Act
indicate that about 25 percent of the loans used to purchase single-family, owner-occupied
homes in 2005 were high-priced loans, including primarily subprime and some near-prime
mortgages.5
However, as has been the case in previous instances of rapid financial innovations,
adequate mechanisms to control excessive risk-taking may not have been in place during the
subprime market's greatest growth. One innovation, further development of securitized
products, gave mortgage lenders greater access to the capital markets and spread risks
more broadly. However, securitization also widened the separation of the originators from the
ultimate holders of the loans - that is, those who bought securities backed by loans. In this
setup, a classic principal-agent problem can arise if originators (the agents) do not have a
sufficient incentive to shield the owners of the securities (the principals) from suffering
higher-than-expected losses.
Against a backdrop of continued strong investor demand for high-yielding securities, some
lenders began loosening underwriting standards for subprime mortgages in late 2005. Loans
to subprime borrowers were approved with high loan-to-value ratios and incomplete income
documentation. Had house prices kept appreciating, loan-to-value ratios would have fallen
and some borrowers would have been able to refinance, perhaps into a prime loan with a
lower interest rate. But, instead, as the housing market softened and interest rates rose,
delinquencies in the adjustable-rate subprime market began to soar and reached nearly 15
percent in July.6 Among other types of nonprime mortgages, delinquencies on fixed-rate
subprime mortgages have been fairly steady at less than 6 percent; rates on mortgages in
alt-A pools have increased to nearly 3 percent, up notably from the 1 percent rate of only a
year ago.
The rise in delinquencies in the subprime market has led to the collapse of some large
subprime lenders and inflicted substantial losses on holders of subprime residential
mortgage-backed securities (RMBS) and of some collateralized debt obligations (CDOs). As
a result, underwriting standards have been tightened, and fewer households are qualifying
for subprime loans. In addition, some borrowers apart from the subprime segment are
reportedly finding it more difficult to qualify for loans or are having to pay more for them.
These developments have contributed materially to the drop in demand for housing this year.
Without a doubt, they also have caused significant hardship for many individuals and
families.
Recently, we have watched the deterioration in financial conditions extend beyond the
subprime market. Investors appear to have reassessed their outlook and their tolerance for
risk, especially for structured financial products and for securities of highly leveraged firms.
Bond spreads - especially those for speculative-grade debt - widened substantially in June
and July, and the volatility of equity prices increased as well. In mid-August, following several
events that led investors to believe that credit risks might be larger and more pervasive than
previously thought, the functioning of financial markets, including short-term and interbank
funding markets, became increasingly impaired. Notably, many asset-backed commercial
paper programs found rolling over their paper increasingly difficult. To help restore orderly
conditions, the Federal Reserve in recent weeks has increased the provision of reserves, cut
the discount rate, and changed its usual discount-window lending practices in order to
facilitate term borrowing, together with other measures.
Stepping back from the rush of unfolding events, we are seeing a pattern that occurs from
time to time. Financial markets and institutions perform the essential function of channeling
funds to those individuals or firms having the most productive investment opportunities.
However, an increase in uncertainty and concerns about the quality of information can lead
investors to pull back from financial markets and restrict productive lending - with potentially
adverse implications for real activity. That is essentially the story I laid out in a paper
delivered at the Kansas City Fed's Jackson Hole conference about ten years ago.7
In my view, such an increase in uncertainty is an important part of what we have observed
recently and stems from heightened concerns about the value of financial securities related
to certain types of loans, about who is holding these securities, and about how a revaluation
of these securities might affect the balance sheets of various financial intermediaries.
Consequently, investors have become less willing to put funds into various financial markets,
particularly into the more opaque segments of those markets.
As best we can tell thus far, the imprint of these developments on economic activity appears
likely to be most pronounced in the housing sector. However, economic activity could be
affected more severely in other sectors should heightened uncertainty lead to a broader
pullback in household and business spending. That scenario cannot, in my view, be ruled
out, and I believe it poses an important downside risk to economic activity.
I also believe that the process of adjustment that is under way in financial markets - of
investors reassessing the outlook for risk and their tolerance for that risk - will ultimately
create a more solid financial footing for the real economy. But in the meantime, the FOMC is
monitoring the situation and is prepared to act as needed to mitigate the adverse effects on
the economy arising from the disruptions in financial markets.
Thank you for your interest and attention. I look forward to your questions and observations
on recent developments.