Cathy Minehan

Spells of unemployment remain stubbornly high for an expansion that is in its fourth year. Yet, I continue to hear anecdotes about skilled labor being expensive and hard to find. So the labor market presents a puzzle.

Economic growth could well tighten pressure on resources faster than I expect, but right now most of the ways we have to gauge whether that is occurring -- rates of employment and wage and salary growth, unit labor costs, profit margins and labor force participation -- suggest we have some way to go before we reach the yellow -- much less the red zone -- regarding inflation.

The most likely answer is the economy will grow again at about 4 percent or so.  I also expect to see some acceleration in job creation as the economy continues to expand.  And inflation seems likely to be well behaved, at least over the near term. 

The strong balance sheets and cash positions of many firms suggest the possibility of more rapid capital spending. But will businesses continue to defer such spending as they had earlier in the cycle?...Some firms still have a fair amount of unused capacity embodied in the computers and other equipment they bought during the tech and Y2K spending booms of the late '90s.

The current high rate of increase in house prices cannot continue indefinitely. If housing prices increase at somewhat slower rates, this source of wealth creation will provide less support to consumer spending.

Core inflation picked up about a percentage point in 2004, reflecting the pass through of rising oil and gas prices into core goods and services which use energy as an input to production. The decline in the dollar may have also contributed, though our estimates suggest there has been a very limited pass-though from this channel.

The pace of private sector hiring has been relatively modest, and growth in household disposable income—a major factor determining consumption—relatively muted. This raises a question about whether the consumption spending that is needed to support GDP growth at its current pace is achievable without a pick up in hiring and/or wages.

We may be expecting too much if we think we can return to the late 90’s combination of unemployment in the low 4’s and low inflation.

There are good reasons to believe that the impact of last year’s oil and gas price increases will be transient...It is unlikely that we will experience the pace of oil price appreciation this year that we did last year.

Household income has grown nicely while unemployment has remained low, and, together with low mortgage interest rates, these factors have contributed to appreciation in home values.

On the whole, these continue to be favorable times for the financial services providers, whether commercial banks or credit unions.

With oil prices now back above $50 a barrel, one can expect to see continued effects on headline and, to a lesser extent, core inflation.

I see real GDP growth of about 4 percent or so this year [2005]. I also expect to see a continuation of the recent acceleration in job creation as the economy continues to expand. And inflation, while elevated over its pace from a year ago, seems likely to be well behaved on the whole.

[It is possible] that in light of Sarbanes-Oxley and the increased scrutiny that firms face as a result of ongoing corporate and accounting scandals, companies have become more risk averse and less willing to commit themselves to new expenditures of capital or labor without a good deal of confidence that they will still “make their numbers.” Certainly, I hear anecdotes about the time, attention and resources senior management must now apply to these issues, especially as the rules regarding how financial controls are monitored and managed are put into place.

If we were to issue an economic report card, the nation would get great grades on its current performance, but would fail on what is necessary for the future—a strong rate of national savings. Households are barely saving at all, and the federal government is spending well beyond its means...This is one of the most important macroeconomic problems confronting the U.S.—its current and persistent low level of net national savings.

The prices of energy, employee benefits, and raw materials have posed challenges to businesses for several years now. To date, these cost increases have been largely buffered by rising productivity and sizable profit margins, so their pass-through to final goods prices has been limited. But more recently, I have heard stories from my business contacts telling me that increased prices can now be passed along. These stories may well only portend increasing prices for intermediate goods, with the final goods prices continuing to be well contained by productivity and profitability. But to my ear, these stories modestly raise the risk of rising inflation.

A more robust and self-sustaining economy, together with some modest upside risks to inflation imply less need for policy accommodation. How and when such accommodation is reduced, however, will depend on how the economy evolves.

In the long run, raising the low rate of national savings in the U.S. may be one of the best things that could be done to ensure lasting prosperity both here and around the world. Finding ways to curb the federal government deficit may be the best place to start on that laudable objective.

I am comfortable with my baseline assessment that some resource slack remains and that the pace of inflation will taper off. But...the range of uncertainty around this assessment is wide enough that we should recognize the possibility that the economy has somewhat less running room, which could imply a bit steeper trajectory for inflation.

Unavoidable economic logic suggests that eventually this situation will prove unsustainable: our deficit and other countries’ surplus positions will come into better balance. The question is how...National savings need to grow. One way to increase savings is to cut the federal deficit...Another source of adjustment would be an increase in the personal savings rate...Rising productivity also could help us grow out of the problem...But it is likely wishful thinking to rely on faster productivity alone even if it is sustained at current levels...A strong case can be made to begin to address this issue sooner rather than later. And personally, I would start with the federal budget deficit.

I believe the most likely course for inflation is to settle around its current level in 2005.

Evidence supporting the view that slack remains [in the labor market] includes the relatively muted increases in wages and prices to date, as well as low labor force participation rates. Participation rates for prime-age workers – especially women – are lower than one would expect given the growth of the overall economy.

[We are] in reasonably good shape for the rest of 2005—expecting relatively strong growth, continued hiring, solid business investment, and reasonably low inflation—albeit with a number of questions and concerns and some risks on both sides of that projection.

Overall, a more electronic payments system will benefit society and will help improve payments system efficiency...However, the payments industry will have to rely more heavily on key telecommunications networks and computing systems. Mitigating the risk associated with greater reliance on electronic processing is vital and should be a top priority for the payments industry.

Regarding communicating central bank policy changes have evolved considerably over the 30+ years I have worked in the Federal Reserve System, and I believe there can be no doubt this has been a good thing...In several steps the Committee evolved to its present policy of announcing its action after every meeting, disclosing the vote and any dissents, and publishing the minutes of the meeting after three weeks. In my view, this level of communication has helped the public understand Fed policy, and has been useful recently in assuring jittery markets that policy accommodation could remain for “a considerable period”, and then be removed at “a measured pace”.

It is clear that communication by policymakers, whether in the statement itself or in speeches or testimony, can be quite powerful. Even when carefully crafted, it risks the interpretation of a pre-commitment to action when that is not the intent. I recognize forward-looking language from a central bank can help to anchor markets, but, absent unusual circumstances, I wonder whether the resulting sense of policy certainty that can be conveyed is appropriate given the fact that often the next move of the Committee is not a foregone conclusion. Is there a risk that such communication will limit the flexibility of monetary policy setting? Or, conversely, could such communication produce policy inertia? I do not know the answers to these questions but they do nag at me.

The federal deficit should be reined in before it begins to balloon as a share of GDP reflecting demographic change. While this is not a perfect solution, and it has real near-term costs, in the end it may be the only way to engineer a gradual way out of our debt burdens.

Few if any of the paths to current account reduction are cost free since, again, by definition, a slower pace of import growth suggests a slower pace of U.S. output growth. Perhaps the closest to a “win-win” would entail stronger economic growth in our major trading partners, leading to an increase in demand for U.S. exports. Indeed, achieving parity in the growth rates of our major trading partners and ourselves could go a long way toward a gradual and orderly reduction of the U.S. external deficit. It would, however, require strong, self-sustaining domestic-led growth in our major trading partners, something that has proven elusive, at least for the Euro-zone and Japan.

Several factors make today’s fiscal situation much more serious than indicated by the current ratio of the deficit to GDP. First, the deficit would be much larger, 4.1 percent for fiscal 2005, if it were not for a sizable surplus in Social Security ...The situation for Medicare is similar and, potentially, even more serious. Although payroll taxes to cover Medicare expenditures are also currently in surplus, over time Medicare spending is expected to increase more rapidly than related tax revenues, creating a deficit prob­lem that analysts see as potentially greater in size and more difficult to control than that associated with Social Security.

We cannot continue to run a federal budget deficit that raises our debt-to-GDP ratio indefinitely, without diminishing private investment through higher interest rates, thereby reducing productivity and long term growth. The current account deficit is also not sustainable at its existing size and rate of growth. If the amount we must borrow from abroad to finance spending is rising faster than GDP, at some point paying our debts will eat into our standard of living.

It makes sense to worry about the potential impact on overall GDP growth of a combination of a reduction in housing construction and a decline in household wealth. The Bank's baseline forecast takes what might be seen as a rather conservative perspective here. We see construction diminishing somewhat and real estate prices flattening, not declining, and those assumptions are built into the solid GDP growth rate I referred to earlier. Clearly, however, we could be wrong on the magnitudes. Real estate prices could actually decline (though this has never happened for the nation as a whole at least on a nominal basis) and construction activity could retrench more than we expect. And rising mortgage rates could impede consumption more than our forecast predicts. Thus, changes in residential real estate present a source of downside risk to growth.

If we are at all accurate, 2006 will be a year of solid growth, perhaps faster in the first half as Katrina rebuilding occurs and energy prices stabilize, and slower later on as hurricane-related fiscal stimulus ebbs and housing activity tapers off, but strong overall.

My sense is that Massachusetts and New England will experience some sustained cooling in real estate markets, and some flattening of prices, but this trend is not likely to affect the region overly negatively, and likely not more than the nation as a whole.

At the Boston Fed we have begun to hear anecdotes about skilled labor being even harder to find and more expensive than earlier, but this is usually in the context of a continuing emphasis by businesses on working harder and smarter in the face of keen competition. It is also true that rather low labor force participation nationwide could suggest labor markets are less tight than the unemployment rate suggests.

I expect businesses to continue their 2005 solid pace of spending on equipment and software, as at least some of the capital goods acquired in the spending boom of the late '90s are replaced and new capacity is added. Clearly, the “fundamentals” for investment spending -- expectations of productivity growth, overall business profitability, and accommodative debt and equity markets -- are there.

Being the world's biggest debtor has its downsides. It puts us at risk that foreign investment desires may change, with potentially harmful effects on the stability of our financial markets. The best guess is that any such change would happen slowly given the reliance of other countries on U.S. imports for growth. But past experiences in other countries with large external deficits leaves one cautious about being too sanguine. Indeed, if our current account deficit continues to grow faster than GDP, there will be a continued deterioration in our net international investment position. That creates an obligation to pay increasing amounts to foreign owners of U.S. debts, and eats into our very ability to invest in our future.

Yet, as near as we in Boston can tell, the best baseline forecast is that U.S. growth will moderate from its average of around 4 percent in the first half of 2006 to something slightly below its potential of a bit less than 3 percent over the next year or so.

Globally, growth is solid as well. U.S. exports have increased and trade is at least for now marginally supportive of growth. 

To summarize — I see growth for the next year or so in the high 2’s, approximately full employment, and core inflation subsiding.  Not a bad picture, particularly given the challenges I mentioned a moment ago.

The next obvious question concerns risks — where are they and how likely are they to materialize?  In my view, risks have grown over the summer on both sides of this forecast.  Growth could be slower or inflation could be higher and more persistent -- or both.  I take both of these risks seriously.

[T]he so-called “wealth effect” that links increases and decreases in house prices with rises and falls in consumer spending may not be as strong as some analysts suggest.  In our estimation, the run-up in housing values over the past several years did not spur much of a bigger-than-expected increase in consumer spending — if anything, the response was a bit on the low side compared to the historical average. So we wonder about how large a spending effect one should expect to accompany a fall in housing prices, if that were to occur. Clearly mortgage equity withdrawals have been sizable during the housing “boom,” but many of these withdrawals were used to reduce other forms of consumer debt and to make one-time improvements in the housing stock.  Indeed, as a result, overall household balance sheets today continue to look fairly strong.

The Bank’s baseline forecast assumes that if energy prices stabilize as indicated in the futures market, core inflation will gradually subside.  That is my best guess at this point and, based on inflation expectations measured in a variety of ways, private-sector individuals, businesses, and financial markets appear to agree.  But, as others have said repeatedly, monetary policy is about risk management.  A key risk is that inflation will continue to rise or persist at high levels and embed itself in consumer and business plans.  Managing that risk is clearly important, and a matter about which central banks need to be quite vigilant – as I believe the FOMC has been and will continue to be.

By 2030, almost one in five U.S. residents will be 65 years or older.  Well before then, beginning in about 2018, Social Security will start to pay out more in ben­efits than it receives from payroll taxes.  Even before that, -- in the neighborhood of 2010 -- Social Security will start exerting upward pressure on the unified federal budget deficit as its surplus diminishes, with a consequent reduction in net public saving, absent changes in the program itself, increased taxes, or reduced spending on other government programs.  

The situation for Medicare is similar and, potentially even more serious.  Payroll taxes to cover Medicare expenditures are currently in surplus.  Over time, however, Medicare spending is expected to increase more rapidly than related tax revenues, creating a deficit prob­lem that analysts see as potentially greater in size and more difficult to deal with than that associated with Social Security.   Thus, despite the relatively benign federal deficit we currently see, it is clear the situation will worsen dramatically over the next decade.  And, unlike the late '80s when deficits became a national concern, there seems to be no political consensus on the nature of this problem or its resolution -- a fact that should be a concern to all of us.

The Center for Retirement Research (CRR) has developed a National Retirement Risk Index to measure the share of working-age households that are in danger of being financially unprepared for retirement. Their findings are sobering.  They report that almost 45 percent of all such households are “at risk” of falling well short of the amount estimated to be necessary to maintain the household’s pre-retirement standard of living.  Younger households are particularly vulnerable, as are low-income households and those with neither a defined benefit pension nor a 401(k) plan. 

Among the reasons for the growing urgency attached to financial literacy are a proliferation of sophisticated financial products and new financial services providers. I must say that even I need a little tutoring to understand all the potential pitfalls of the new mortgages that have become commonplace offerings by banks and nonbank providers in the U.S., so I have a lot of sympathy for the first time low or moderate income home buyer. And technological change has made the lending process at once easier and perhaps less transparent. Lenders may or may not be regulated as banks, adding another layer of potential complexity.

In addition, changes in corporate retirement plans and health insurance systems are shifting responsibility for planning for workers’ long term financial security from businesses to the workers themselves. Even relatively well educated, relatively affluent households find themselves challenged by this shift and the need to take more responsibility for their financial future.

Our best guess at the Boston Fed is that 2007 will bring continued moderate growth, with GDP at or a bit below potential, unemployment likely remaining below 5 percent, and core inflation gradually declining.

Reports on housing activity have consistently come in a little worse than expected, though very recent data on home buying attitudes, new home sales, mortgage applications and slowly declining inventories of unsold homes suggest some bottoming out may be at hand. As of now, our best estimate is that the housing slowdown will shave a percentage point or so off GDP in the second half of 2006.

In fact, at least until quite recently when measures of business spending weakened, non-residential construction served to offset a portion of the impact of the housing investment slowdown.

As you know, while the costs of food and energy are important to all of us, such costs can spike temporarily due to shortages, such as those that occurred with the devastating hurricanes in the fall of 2005. What concerns policymakers is if these cost spikes feed through to the broader economy -- to prices of non-oil goods and services -- as a result of lengthy supply problems or burgeoning demand or some combination of the two. Thus, the strength in both U.S. and global demand in '05 and '06, combined with rising energy costs, heightened Federal Reserve concerns about inflation.

Many suggested, however, that business purchases of high-tech goods were off, in part, as a result of the delay of the new Microsoft operating system.

Thus, as the year ended, the economy seemed to have completed that difficult down-shift in tempo, often referred to as a soft landing. On the inflation front, pressures seemed to ease a bit as November headline CPI grew at an annual pace just under 2 percent and core CPI was flat for the month. But for the 12-month period as a whole, core remained close to its third-quarter high, suggesting inflation may be slow to taper off.

And there are other signs beyond housing that may be flashing yellow on growth vulnerability. Certainly, many have focused on what long-term Treasury yields of 50 basis points below the overnight federal funds rate might be telling us about the probability of a downturn. There are several possible alternative explanations for this phenomenon, but it does raise one's antennae.

The decline in oil prices we saw last year [2006] was certainly welcome, and helped to bring inflation down from its mid-year peak. But absent further declines, lower energy costs won't bring about much of an additional decrease in inflation this year.

Inflation has been and remains a challenge, though recent data provide a bit of assurance that price pressures may be beginning to ebb.

Very recent indicators of business spending such as the inventory buildup have been less-than-sparkling.

Credit derivatives can be useful instruments aiding the cause of financial stability.  In the midst of surging growth in the number of credit derivative products and their value, and the growing diversity of market users, there has been progress in strengthening the underlying infrastructure around the instruments to make them more resilient in times of stress.  Despite this, and of primary importance, they have yet to be tested in a real environment of financial shock.  To me, that suggests that concerns about how their underlying risks will play out in such circumstances are warranted.

As reported by Bloomberg News

I'm also concerned about women and their declining rates of labor force participation, particularly in the key years of 30 to 45 or so.  Women make up more than half of our graduate schools and even in such areas as business and engineering, thier numbers are growing.  That's a lot of brainpower to lose if participation rates drop just as those women become experienced in their working situations.

As reported by Bloomberg