In a recent speech at the Boston Federal Reserve, Fed chair Janet Yellen shed some light on the Federal Open Market Committee’s assessment of the current U.S. economic situation, saying the Fed was “struggling” to understand the nature of the employment and inflation risks. She suggested that conventional thinking about the economy might need to be adjusted due to the tremendous depth of the Great Recession.
A review of the relationship between aggregate supply and demand may be necessary, she said. While short-run supply has often been affected by demand, it seems that the lingering effects of the recession may have created longer-term effects not seen in the past. Thus, though the labor market is tight, perhaps interest rates should stay low longer to stimulate more consumer spending and spur a very slow business recovery. However, she issued the counter warning that low rates for too long can lead to financial and price instability and suggested more study of this theory was needed.
As the economy has recovered, Yellen noted, U.S. households and businesses have been far from homogeneous, and economic models must recognize that fact. Monetary policy consisting of interest rate changes and quantitative easing will have different effects on different parts of the economy. (Interest rate increases will affect small businesses and less-wealthy households in a more negative manner. Interest rate decreases will have a less positive effect on the same groups.) Yellen reminded the audience that fiscal policy must also be used to correct a recession.
The Fed chair went on to question the relationship between the financial sector and the rest of the economy. Is there a specific formula to measure the effect of excessive leverage on real estate values? How can monetary policy and financial oversight reduce the frequency and severity of recessions and crises in the future? How do changes in underwriting standards and other credit factors interact with interest rates to affect consumer and business spending? All these questions need research.
In a clear signal that labor data may be losing its importance in interest rate judgments, Yellen suggested that labor conditions seem to be “losing their ability” to influence inflation. She suggested a study as to whether short- or long-term inflation expectations influence inflation more, and questioned whose inflation expectations—consumers, business or investors—were more relevant for wage and price setting. In a nod to the Fed’s attempts at transparency, Yellen posed the chicken-or-egg question: Does monetary action bring inflation to a level for a long enough period that it becomes expected—or do announcements of interest rate goals affect expectations enough to move inflation toward target goals? She suggested the answer probably is somewhere in the middle.
Yellen also acknowledged that more study was needed on the question of the interaction of monetary policy worldwide. When interest rates change here, what is the effect globally, and what is the rebound effect on our economy? How does changing monetary policy abroad affect our GDP?
She suggested the necessity to continue research on all these questions, saying the global economy may continue to experience historically low interest rates, making short-term rate reductions an unlikely answer to a future recession.
My take on the speech: It was a solid attempt to explain the FOMC’s stance to remain cautious about raising the federal funds rate in the present economic climate, and a call to investigate new processes to meet the Fed’s goals.
There remained a hint of inflation in recent data. The consumer price index rose 0.3 percent in September, as gasoline soared 5.8 percent, medical commodities rose 0.6 percent, and shelter rose 0.4 percent. The good news was that food prices were flat, new autos fell 0.1 percent, and used autos dropped 0.7 percent. One-year CPI remains calm at 1.5 percent, but core CPI was at 2.2 percent as those pesky service prices keep rising. The producer price index of total final demand rose a healthy 0.3 percent in September as gasoline jumped 5.3 percent and food increased 0.5 percent. That September increase merits watching, but one-year wholesale inflation remained a modest 0.7 percent.
Business data still showed little improvement. Industrial production had a scant 0.1 percent increase and remained 1 percent below year-ago levels as the weakness in energy-related spending continued. Capacity utilization at the country’s mines, manufacturers and utilities remained well below historical levels. Durable goods orders fell again, down 0.1 percent, but the primary weakness was in defense aircraft. Auto and non-defense aircraft improved, but year-to-date comparisons with 2015 still showed a 0.4 percent decline in all durable goods orders. The Fed’s Beige Book of anecdotal information from business segments continued to show a “modest or moderate” rate of expansion, tight labor markets and little inflation.
Housing data remained mixed. September housing permits rose 6.3 percent from August levels, with emphasis remaining on multifamily starts. Housing starts in September fell 9 percent from August levels, and are down 11.9 percent from year-ago levels, due to weakness in multifamily starts. There’s much more regulation and paperwork to get “multis” underway. Existing home sales in September had a good month, up 3.2 percent from August, but only up 0.6 percent from September 2015 levels. The median price rose 5.6 percent to $234,200, reflecting an ongoing shortage of inventory. New home sales rose 3.1 percent over August and a snappy 29.8 percent over September 2015 levels. The median price of $313,500 was up 1.9 percent from year-ago levels.
A pleasant surprise was the first estimate of third-quarter GDP growth, which rose a robust 2.9 percent after the dismal first-half growth of just over 1 percent. While consumer spending eased a bit from the second quarter, business spending on inventories turned positive, and good advances were reported from exports.
Gregory MacKay is economic consultant to Canandaigua National Bank.
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