Are We There Yet?

The Fed is quite pleased with the economic outlook, at least as viewed through the eyes of Jeffrey Lacker, president of the Richmond Fed. There are worries, housing and energy prices foremost among them, and a little more tinkering  may be necessary to make sure inflation and inflation expectations are contained, but in general the trajectory is encouraging:

The Economic Outlook for 2006, by Jeffrey M. Lacker, Richmond Fed President: It is a pleasure to ... discuss the economic outlook for 2006 and beyond... because the economic outlook is fairly encouraging. Growth is on a solid footing ...  employment has resumed expanding at a healthy pace, consumer spending continues to grow briskly, and business investment spending is robust. Granted, housing activity seems to be softening, and at least some potential price level pressures remain, so it may be too soon to break out the eggnog. But inflation expectations remain contained, and we at the Fed are well-positioned to resist inflation pressures, should they emerge...

The really striking feature of the current outlook is the extent to which economic activity in general and consumer spending in particular has rebounded from the shock of the hurricane season. ...  With healthy income growth ahead and a reasonably strong overall job market, the outlook for consumer spending looks good. Housing market activity has been very strong over the last several years. The historically low level of inflation-adjusted mortgage interest rates explains much of that strength. ... In recent months, we have received widespread anecdotal reports of ... "a return to normalcy" in several housing markets in our District. ... At the same time, the aggregate measures of housing activity have so far shown only limited pull-back from their peaks and remain at historically high levels. Still, ... I would expect housing price appreciation to flatten out next year and aggregate residential investment to stop growing or perhaps even decline.

The fundamentals for business investment in equipment and software look quite sound. ... Productivity has grown at surprisingly strong rates ... - 3.4 percent since the end of 2000 - despite significantly lower rates of capital formation. Gains in labor productivity ... ultimately pass through to real incomes. ... If productivity growth continues at or above trend, as seems likely, then we should see healthy growth in real income next year... Labor markets have recovered from the recession of 2001. Although employment was stagnant for a time following the downturn, hiring picked up in 2003...

The overall outlook therefore is for a healthy expansion next year. Real GDP should grow at about 3.5 percent. ... but naturally there is some uncertainty attached to it. Economic fundamentals could depart from their anticipated trajectories in any number of ways ... For example, spot oil prices - or other commodity prices for that matter - could well turn out either above or below the path embodied in futures prices. ... Commodity price surprises in either direction could alter aggregate supply conditions and either add or subtract from output growth.

On the demand side, there is some uncertainty regarding the rate at which housing activity is likely to cool in the coming year. Although I do not think that a sharp fall in housing investment is likely, a range of forecasts from flat to moderately declining seem reasonable. And ... it is difficult to foresee with any certainty the scale of investment that businesses will find profitable to undertake, so spending growth in this category could well deviate from expectations...

Core inflation has been low and relatively steady in the last several years. ... within the 1-to-2 percent range that I and others have proposed as an announced target. ... Monetary policy should respond to energy shocks by remaining focused on price stability. ... While the lack of an upsurge in the core PCE inflation figures for September and October is somewhat encouraging, I think it is too soon to declare that pass-through risk is entirely behind us. ... Thus far, market participants appear to believe that core inflation will remain contained. ... Measures of expected inflation derived from ... inflation-protected U.S. Treasury securities drifted up a bit this fall, but ... have returned to mid-summer levels. To maintain credibility for price stability, it is essential that monetary policy should respond vigorously to any visible erosion in inflation expectations.

Assuming output growth remains healthy, the Fed is waiting to see if core inflation does indeed continue to moderate, in which case it considers pausing, or if higher energy prices pass through and begin showing up in incoming data, in which case it meets the price hikes aggressively. The Fed needs to be convinced, and it isn't there quite yet, that pass through of energy prices to core inflation is not a problem.