Glenn Rudebusch of the Federal Reserve Bank of San Francisco with his view on the current economy and the economic outlook:
FedViews, by Glenn Rudebusch, Federal Reserve Bank of San Francisco: The FOMC statement released after the June meeting provides a useful summary of the recent past data on economic growth and inflation and the current outlook. Some key phrases from that statement are “Economic growth appears to have been moderate during the first half of this year…The economy seems likely to continue to expand at a moderate pace over coming quarters…sustained moderation in inflation pressures has yet to be convincingly demonstrated…the Committee’s predominant policy concern remains the risk that inflation will fail to moderate as expected.” This wording suggests that the FOMC anticipates a soft landing with a slow convergence to trend growth and low inflation. (It also suggests the need for a thesaurus.)
The final estimate of real GDP growth during the first quarter was an anemic 0.7 percent at an annual rate, but given the data in hand, it appears that the economy rebounded strongly in the second quarter and posted growth in excess of 3 percent. Much of this quarterly volatility reflects sizable swings in net exports and inventory investment, and averaging through such transitory noise gives a clearer picture of economic growth of about 2 percent so far this year. Looking ahead, we anticipate growth averaging about 2-1/2 percent over the remainder of this year and into next year—a pace a bit below trend. Importantly, this forecast assumes that the housing market will start to recover after a few quarters. Specifically, we anticipate that residential construction will continue to contract through early next year but then slowly turn around. In other sectors, consumer spending will likely decelerate a bit, but opportunities should improve for business investment and U.S. exports.
Continued growth in labor demand is one signal that businesses have some optimism about prospects for future growth. Payroll employment increased at an average rate of 145,000 jobs per month in the first half of this year—a rate about 20 percent lower than the pace set in 2006. The recent job gains have been boosted by strong hiring in the service sector, while manufacturing employment has declined.
Job growth in 2006 helped boost wage income and consumer spending. More recently, a surge in the price of gasoline has squeezed real incomes and helped slow the growth in consumer outlays. Notably, sales of cars and light trucks have edged down, perhaps curtailed as well by the recent volatility in the price of gasoline and greater uncertainty about its future path.
Business spending on capital equipment appears to be recovering from its mini-slump at the end of 2006, which may have reflected the deceleration of business output or unusual business caution. Recently, shipments have improved for high-tech goods (boosted perhaps by the introduction of Microsoft’s Vista operating system), industrial machinery, and ventilation, mining, and oil field equipment. We expect further increases in capital investment going forward.
Another bright spot for prospective growth is demand from abroad. So far this year, the outlook for economic growth has improved significantly for some of our major trading partners. In particular, forecasters appear much more optimistic about Europe, and the economic expansion in Japan appears to be back on track.
Housing demand has shown little sign of stabilizing, although we think that the most precipitous declines are over. So far, the spillover effects to the rest of the economy from the housing contraction have been limited. However, a further significant drop in home sales with an associated decline in home prices could induce households to revise their wealth assessments downward and scale back their consumption. Such a deepening housing slump with associated large spillovers to consumption poses a significant risk to the outlook.
The continuing decline in home sales has depressed residential construction activity, and new permits and construction starts have slipped further this year. Given that the number of unsold new homes on the market has soared relative to the level of new home sales, it is possible that homebuilders may have to reduce the pace of construction even further. (The true inventory overhang may even be higher than the published figures indicate, because new homes with cancelled sales contracts are not returned to the count of unsold homes.)
Both Treasury yields and fixed mortgage rates are up about one-half of a percentage point over the past two months. The jump in mortgage rates has come during an important transition period for the housing sector, which is struggling to stabilize. Mortgage rates had already risen for subprime borrowers, and the latest increase in prime conventional rates and the short-term rates underlying adjustable mortgages will further depress housing demand. Interest rates with maturities longer than a year rose in part because investors revised up their expectations for the future path of monetary policy. In addition, term premiums appeared to move up, which also may damp future growth (see “Macroeconomic Implications of Changes in the Term Premium.” Federal Reserve Bank of St. Louis, Review, 2007, July/August, pp. 241-269). Still, for the broader economy, long-term interest rates, which returned only to last year’s level, seem unlikely to be a substantial restraint on overall economic growth.
Energy prices remain a critical risk to the outlook. Crude oil prices have jumped back up to about $70 per barrel, partly reflecting concerns about oil supply in a variety of countries (including Iran, Iraq, Venezuela, and Nigeria). In addition, stronger worldwide demand for oil has boosted prices. On top of higher crude prices, a variety of problems at U.S. refineries have held down domestic production and led to price hikes for refined products. In particular, gasoline prices have been elevated relative to crude oil prices. Although gasoline prices are expected to edge down, higher energy costs will boost headline inflation and have some potential to push up core inflation.
The various indicators of resource utilization provide a range of views about how tight labor and product markets are, but, on balance, the current level of resource utilization appears a bit high relative to historical benchmarks.
Typically, tight labor markets have resulted in faster wage growth, but overall labor costs have not accelerated over the past few years.
In 2004 and 2005, headline price inflation was boosted by the effects of higher energy costs. After a brief respite last year, we anticipate that the latest jumps in crude oil prices will have the same effect. However, we anticipate little pass-through to other prices and, hence, to core inflation. Indeed, we anticipate that core inflation will fall and remain below 2 percent this year and next.