Ben S Bernanke: The economic outlook
Remarks by Mr Ben S Bernanke, Chairman of the Board of Governors of the US Federal Reserve
System, before the National Italian American Foundation, New York, 28 November 2006.
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Thank you for inviting me to speak today. I will take this opportunity to present an update on the
economic outlook.
This month marks the fifth anniversary of the beginning of the current expansion. Frequently, the early
stages of an expansion include a period of above-trend growth, as underutilized resources are put
back to work. As slack in the economy is reduced, however, economic growth tends to moderate.
Indeed, at that stage, some slowing of growth to a pace consistent with the rate of increase in the
nation's underlying productive capacity is necessary if the expansion is to be sustained without a
buildup in inflationary pressures. In my testimony to the Congress in July, as part of the Federal
Reserve's semiannual monetary policy report, I noted that the U.S. economy had entered this
transition phase, and that some moderation of economic growth over the remainder of the year
seemed likely.
The deceleration in economic activity currently under way appears to be taking place roughly along the
lines envisioned in the Federal Reserve's July report. As anticipated, the slowdown primarily reflects a
cooling of the housing market. Most other sectors of the economy appear still to be expanding at a
solid rate, and the labor market has tightened further.
Inflation, which picked up earlier this year, has been somewhat better behaved of late. Overall inflation
was pushed up this spring by a surge in energy prices, but the recent declines in energy prices have
largely reversed those effects. Price inflation for consumer goods and services excluding energy and
food, the so-called core inflation rate, has also moderated a bit in the past few months. But the level of
the core inflation rate remains uncomfortably high.
Over the next year or so, the economy appears likely to expand at a moderate rate, close to or
modestly below the economy's long-run sustainable pace. Core inflation is expected to slow gradually
from its recent level, reflecting the reduced impetus from high prices of energy and other commodities,
contained inflation expectations, and perhaps further reductions in the rate of increase of shelter costs
and some easing in the pressures on capital and labor resources. However, substantial uncertainties
surround this baseline forecast. The Federal Open Market Committee (FOMC), the committee that
sets monetary policy, will continue to monitor the incoming data closely. In its latest statement, the
FOMC reiterated its view that the upside risks to inflation are the predominant risks to the forecast and
indicated that it is prepared to take action to address inflation if developments warrant.
Economic activity: recent developments and prospects
As I have just noted, the pace of economic activity has moderated over the course of the year.
According to the latest estimates by the U.S. Department of Commerce, real gross domestic product
(GDP) increased at an annual rate of 2.6 percent in the second quarter of 2006 and at a rate of only
1.6 percent in the third quarter. These figures are down noticeably from the 3-1/2 percent average
pace of growth of the preceding two years. We will receive an updated estimate of third-quarter GDP
growth tomorrow. At this juncture, information about economic activity in the fourth quarter is limited,
and the range of plausible outcomes remains wide. But the indicators in hand suggest that real GDP
growth this quarter is likely to be in the same general range that it was in the second and third
quarters.
Housing has played a significant role in the recent slowing of overall activity, and developments in this
sector are likely to have an important influence on economic growth going forward as well. As you
know, the correction in the housing market that is now in train follows a boom during the first half of
this decade. Between 2000 and late 2005, the pace of construction of single-family homes rose more
than 40 percent, and sales of both new and existing homes increased by a similar amount. Nationally,
home prices increased about 60 percent over that period - an average figure that masks considerable
variation in the rate of price appreciation across cities and regions, as home prices rose exceptionally
rapidly in some "hot" locations but only modestly in others.
No real or financial asset can be counted upon to pay a higher risk-adjusted return than other assets
year after year, and housing is no exception. Thus, a slowing in the pace of house-price appreciation
was inevitable. Moreover, the sustained rise in prices, together with some increase in mortgage
interest rates, sowed the seeds of the correction by making housing progressively less affordable.
Declining affordability ultimately served to limit the demand for housing, leading to a deceleration in
house prices and slowing home purchases.
The drop in home sales that began earlier this year has led homebuilders to curtail the rate of new
construction. Indeed, single-family housing starts are down about 35 percent since their peak earlier
this year. Obtaining a precise read on home prices is difficult: During a period of weak demand,
potential sellers often choose to leave their homes on the market longer or even to remove them from
the market, rather than accept price offers that are below their expectations. The timeliest data on
house prices do not fully account for changes in the composition of home sales by location, size, and
other characteristics. Moreover, the data do not capture hidden price cuts, as when builders try to
stimulate sales through the use of "sweeteners" such as paying the customer's mortgage points or
upgrading features of the house at no additional cost. Nevertheless, there can be little doubt that the
rate of home-price appreciation has slowed significantly for the nation as whole. Some areas have
continued to experience gains - albeit smaller ones than before - while other markets have seen
outright price declines.
Notwithstanding the sharp reduction in starts of new single-family houses, inventories of both new and
existing homes for sale have increased markedly this year. For example, according to the most recent
data, homebuilders currently have about 550,000 new homes for sale, roughly half again the number
that has been typical during the past decade. Moreover, the official statistics likely understate the full
extent of the inventory buildup, as many homebuilders have reported a sharp increase this year in the
number of buyers canceling signed contracts. A home for which the sales contract is cancelled
becomes available for sale once again but is not included in the official data on the inventory of unsold
new homes. To reduce this inventory overhang, builders are likely to continue to limit the number of
new homes under construction.
Although residential construction continues to sag, some indications suggest that the rate of home
purchase may be stabilizing, perhaps in response to modest declines in mortgage interest rates over
the past few months and lower prices in some markets. Sales of new homes ticked up in August and
increased a bit further in September. The University of Michigan's survey of consumers shows an
increase in the share of respondents who believe that now is a good time to buy a home, from 57
percent in September to 67 percent in November. Meanwhile, an index of applications for mortgages
for home purchases has been trending up since July. Although these developments are encouraging,
we should keep in mind that even if demand stabilizes in its current range, reducing the inventory of
unsold homes to more normal levels will likely involve further adjustments in production. The slowing
pace of residential construction is likely to be a drag on economic growth into next year.
Growth in some manufacturing industries has also slowed of late, and data prepared by the Federal
Reserve show that aggregate manufacturing production declined in September and October. The
motor vehicle sector in particular has experienced weaker demand and an accompanying buildup in
stocks of unsold cars and trucks over the past year. Energy prices have contributed to these
developments, as consumers have responded to high prices at the pump by reducing their demand for
less fuel-efficient vehicles. The decline in sales caused inventories of these vehicles to surge this past
spring. Since then, automakers have cut production to reduce the overhang of inventories; on a
seasonally adjusted basis, the pace of light vehicle assembly in October was about 10 percent below
the pace in the second quarter. The growth of production in some other manufacturing industries,
notably those closely tied to the housing and automobile sectors, has also been slowing. Elsewhere in
the industrial sector, though, production in high-tech industries has been growing rapidly, and high
prices for energy and other commodities have stimulated drilling and mining activity. The global
economy continues to be strong, with cyclical recoveries under way in Europe and Japan and ongoing
growth in the emerging-market economies; this growth abroad should support the continuing
expansion of U.S. exports of goods and services.
Outside of the housing and motor vehicle sectors, economic activity has, on balance, been expanding
at a solid pace. Perhaps the clearest evidence of this broader economic strength comes from the labor
market. Although the number of jobs in manufacturing and construction fell in October, most other
sectors of the economy experienced solid job gains. Private employers in industries outside of
manufacturing and construction added nearly 125,000 workers to their payrolls last month, following
an average increase of 140,000 jobs per month during the preceding three months. With labor
demand continuing to expand over the past several months, the national unemployment rate fell to 4.4
percent in October, its lowest level since May 2001.
The strength of the labor market and the associated increases in wage and salary income have
supported consumer spending. The data in hand indicate that, the slowdown in housing
notwithstanding, inflation-adjusted outlays for personal consumption increased in the third quarter at
about the average rate seen since the current economic expansion began in late 2001. The latest
retail sales figures suggest an increase in consumption at roughly that pace in the current quarter as
well. Other factors that are positive for consumer spending include the recent declines in energy
prices, which have boosted household purchasing power and consumer confidence; increases in stock
prices, which have added to household wealth; and relatively low long-term interest rates.
In the business sector, capital investment has continued to expand at a healthy pace. Spending on
nonresidential construction - a component of business investment - has been particularly robust,
reflecting higher outlays for new office and commercial buildings as well as a rapid increase in
expenditures on drilling and mining structures. Outlays for equipment and software, which grew briskly
from mid-2004 through the early part of this year, have moderated somewhat, though order backlogs
for capital goods such as industrial machinery and other types of heavy equipment remain substantial.
Moreover, financial conditions continue to be favorable for investment spending, as profitability is high,
the cost of capital is relatively low, and significant cash reserves remain on firms' books.
Overall, the economy is likely to expand at a moderate pace going forward. A reasonable projection is
that economic growth will be modestly below trend in the near term but that, over the course of the
coming year, it will return to a rate that is roughly in line with the growth rate of the economy's
underlying productive capacity. This scenario envisions that consumer spending - supported by rising
incomes and the recent decline in energy prices - will continue to grow near its trend rate, and that the
drag on the economy from the motor vehicle and housing sectors will gradually diminish. The motor
vehicle sector may already be showing signs of strengthening; after having cut production significantly
in recent months in response to the rise in the inventory of unsold vehicles, automakers appear to
have boosted the assembly rate a bit in November, and they have scheduled further increases for
December. The effects of the housing correction on real economic activity are likely to persist into next
year, as I have already noted. But the rate of decline in home construction should slow as the
inventory of unsold new homes is gradually worked down.
Like all economic forecasts, this one is provisional, and risks exist in both directions. On the downside,
the correction in the housing market could turn out to be more severe and widespread than seems
most likely at present. A deeper correction would directly affect economic activity through additional
cutbacks in housing starts and through its effects on employment in construction and housing-related
industries. More indirectly, it might also impose greater restraint on consumer spending by reducing
homeowners' equity and thus household wealth, and perhaps by affecting consumer confidence as
well. Because consumption makes up more than two-thirds of aggregate expenditure, any significant
effect on consumer spending arising from further weakness in housing would have important
implications for the economy.
On the other hand, economic growth could rebound more vigorously than now expected. The solid
rate of job growth, the decline in the unemployment rate, and the healthy pace of capital investment
could be signals that underlying economic fundamentals are stronger than generally recognized.
Moreover, to date there is little evidence that the weakness in housing markets is spilling over more
broadly to consumer spending or aggregate employment. If these trends continue, growth in real
activity might return to a pace that could intensify upward pressures on resource utilization.
Potential output
In my remarks today, I have alluded to the economy's underlying productive capacity - in the jargon of
economists, "potential output." The growth rate of potential output is the rate of growth that the
economy can sustain in the long run. I will briefly discuss the factors determining potential output and
the implications that the growth rate of potential output has for the economy and monetary policy.
Growth in potential output is determined to a large extent by two factors: the trend growth rates of the
labor force (that is, the number of individuals available to work) and of labor productivity (that is, the
amount of output that each worker can produce).
With regard to the labor force, research by the Board's staff highlights the role of demographic factors
in determining the number of people available to work in the years just ahead. Most notably, the
impending retirement of the baby boomers and the fact that women are no longer increasing their
participation in the labor force at the rate they were in the past will tend to restrain the future growth
rate of the U.S. labor force. All else being equal, these developments translate into a slower rate of
growth of potential output. Estimates of the magnitude of the likely slowdown in labor force growth,
particularly in the longer run, are subject to significant uncertainty. For example, to a degree that is
hard to predict, improved health and increased longevity may increase the interest of older workers in
remaining in the labor force, perhaps on a part-time basis, and an increasing scarcity of labor may
prompt changes in labor-market institutions and employer behavior that facilitate the participation of
older workers. But those adjustments are likely to take time, and some slowing in the growth of the
labor force thus seems likely over the next few years at least.
With regard to productivity, I remain optimistic that the recent favorable trends will continue. The price
of computing power continues to fall sharply, having declined by nearly half between 2000 and 2005.
Increased computing power has contributed, in turn, to the development and growth of other
commercially relevant technologies, such as biotechnology, and has led to improvements in efficiency,
through better supply-chain management, for example. Moreover, whatever the pace of future
technological progress, further diffusion of already-existing technologies and applications to more firms
and industries should continue to increase aggregate productivity for a time.
That said, longer-run trends in the growth of productivity are very difficult to predict. During the first half
of the decade, productivity in the nonfarm business sector increased at an unusually high average
annual rate of about 3 percent. However, according to current estimates, productivity growth slowed in
the second quarter of this year and came to a halt in the third quarter. Moreover, the strength of recent
hiring raises the possibility of subpar productivity growth in the fourth quarter as well. When all is said
and done, however, I expect that the latest numbers will turn out to have been a reflection of the
typical volatility in the data and some cyclical response to the slowing in economic activity, not a signal
of a sea change in the longer-run outlook for productivity growth.
Even if productivity growth is sustained at a reasonably good rate, the slower expansion of the labor
force will imply some moderation in the rate of growth of potential output over the next few years. In
the very near term, that slower growth in the labor force needs to be taken into consideration when
assessing the sustainability of given rates of expansion in economic activity. In the medium term,
because the factors that affect potential output and thus aggregate supply also tend to affect
aggregate demand, slower growth of potential output does not necessarily mean that inflation will be
higher or that monetary policy will have to be tighter. Rather, the implications for monetary policy of a
possible slowing in the growth of potential output depend on the extent to which such a slowing alters
the balance of supply and demand in the economy. For example, as we saw in the second half of the
1990s, changes in expected productivity growth and potential output can significantly affect aggregate
demand through their influences on income expectations and asset prices. The problem for
policymakers is to identify, in real time, any changes in the prospective growth rate of potential output
and to anticipate the accompanying effects on the balance of supply and demand.
Inflation and monetary policy
Overall (or "headline") inflation has slowed significantly since earlier this year; indeed, in October the
consumer price index fell by 1/2 percent for the second consecutive month. This improvement is
largely the result of the recent declines in energy prices. The price of crude oil has fallen about
onefourth since its recent peak, reflecting some easing of geopolitical concerns and other factors. In
particular, participants in crude oil markets - still mindful of the devastating effects on energy supplies
of the hurricane season in 2005 - appear in retrospect to have incorporated a substantial risk premium
into spot prices earlier this year. In the event, no damaging storms occurred this hurricane season. As
the good news about the weather unfolded, spot prices of crude oil fell from August through early
October.
Readings on the core inflation rate - that is, the inflation rate excluding the energy and food
components - have improved modestly since the spring, but core inflation nevertheless remains
uncomfortably high. Core CPI inflation over the most recent twelve months was 2.7 percent, up from
2.1 percent over the previous twelve months. Another measure of core inflation that we monitor, the
price index for personal consumption expenditures excluding food and energy, is available only
through September; that index was up 2.4 percent over the past year, compared with a 2.1 percent
rise in the preceding twelve months.
Several factors underlie the increase in core inflation over the past year, although the relative
contributions are impossible to estimate precisely. Increased pressure on resource utilization as the
economic expansion matured and slack was reduced has likely played some role. The sharp
increases in energy and materials costs figured in the rise in core inflation as well, as some suppliers
of non-energy goods and services may have been able to pass through their higher input costs into
final prices.
More-rapid increases in shelter costs also boosted core consumer inflation over the past year. In the
broad measures of consumer prices that we follow, substantial weight is given to an item called
owners' equivalent rent (OER). OER is a measure of the price of the dwelling services enjoyed by
people who own their homes; conceptually, if homeowners were to rent their homes from themselves,
OER would be the market rent that they would pay. Economic statisticians estimate OER by using
prices in the rental housing market. Over the past twelve months, the consumer price index for OER
has risen about 4 percent, compared with 2-1/4 percent during the preceding twelve months. The
acceleration in OER may reflect in part a shift in demand toward rental housing as families judged
homeownership to have become less financially attractive of late. The most recent monthly increases
in OER generally have been smaller than those earlier in the year, and further slowing may occur as
the supply of rental units increases and the demand for owner-occupied housing stabilizes. However,
the future evolution of this measure is difficult to know with any certainty.
Looking forward, core inflation seems likely to moderate gradually over the next year or so. Some of
the factors that pushed up core inflation in the recent past - in particular, energy prices and shelter
costs - appear likely to be more neutral in the coming year, and inflation expectations remain
contained. Moreover, if, as seems most probable, the economy grows at a rate modestly below its
potential for a time, pressures on resource utilization should ease a bit.
However, as with the outlook for economic activity, there are substantial uncertainties about the
inflation forecast. In the case of inflation, the risks to the forecast seem primarily to the upside. Given
the current level of inflation, a failure of inflation to moderate as expected would be especially
troublesome.
One factor that we are watching carefully is labor costs, which depend on both the compensation
received by workers and labor productivity. Although the available indicators give somewhat different
signals, it seems clear that labor costs - which account for roughly two-thirds of firm's total costs - have
been rising more quickly of late. Some part of this acceleration no doubt reflects the current tightness
in labor markets. For example, anecdotal reports suggest that businesses have been finding it difficult
to recruit well-qualified workers in certain occupations.
What implications does the pickup in labor costs have for price inflation? One possible outcome is that
increases in labor costs will largely be absorbed by a narrowing of firms' profit margins and not be
passed on to consumers in the form of higher prices. The fact that the average markup of prices over
unit labor costs is currently high by historical standards suggests some scope for this outcome to
occur. If higher labor costs are mostly absorbed by firms and not passed on, then workers will see the
gains in their nominal compensation per hour of work translated into greater real compensation per
hour; in the process, workers would capture a greater share of the fruits of the high rate of productivity
growth seen in recent years. The more worrisome possibility is that tight product markets might allow
firms to pass all or part of their higher labor costs through to prices, adding to inflation pressures. The
data on costs, margins, and prices in coming months may shed some light on which of these two
scenarios is likely to be the better description of events.
During the early part of this decade, the Federal Reserve sharply eased the stance of monetary policy
to help bring the economy out of recession and to foster a durable economic expansion. Once the
expansion had clearly gained firm footing, the FOMC began a process of normalizing interest rates
that involved seventeen consecutive increases in overnight rates of 25 basis points each. In August of
this year, and again in September and October, the Committee left interest rates unchanged so as to
assess the effects of its previous policy actions, and because of indications that economic growth was
moderating and that inflation pressures might be diminishing somewhat. At the same time, the
Committee has continued to emphasize the upside risks to inflation and the high costs that would be
associated with a failure of inflation to moderate gradually as expected. Needless to say, we will
continue to monitor the inflation situation closely. Whether further policy action against inflation will be
required depends on the incoming data and in particular on how these data affect the FOMC's
medium-term forecasts of both inflation and output growth.
I have focused today on the near-term prospects for the economy and the risks to the economic
outlook. However, in reviewing the economic developments of recent years, one cannot help but be
impressed by the dynamism and resilience of the U.S. economy. I have confidence, therefore, that
however events play out in the short term, in the longer term the economy will grow at a healthy pace,
raising living standards in the process. The Federal Reserve will continue to play its part by
implementing policies designed to achieve its mandate of fostering price stability and maximum
sustainable employment.