Jack Guynn

I would say that our recent output growth has been and should remain pretty doggone good.

Although the basic direction of policy has been more obvious than usual for the last year or so, it will likely become less clear and perhaps more difficult to communicate as we approach the equilibrium or neutral interest rate that is consistent with economic activity at its potential and with low and stable inflation.

I read a report in the media just a few weeks ago that referred to the Fed “keeping its pledge” for a “measured pace” of rate increases. Guess what? I don’t think the Fed ever made such a pledge, and I think it’s unfortunate that our effort to offer some insight into our policy inclination is sometimes misconstrued.

My personal view is that if the economy stays on the present path of solid growth, then rates have not yet returned to equilibrium. As I noted earlier, I do not see an imminent threat of inflation, and I am comfortable with our gradual monetary policy adjustments—at least for now.

The FOMC like everyone else can be surprised by events. And it is vital that we maintain the flexibility to respond with the best policy action that comes from each FOMC discussion, even if sometimes that has the potential to surprise some in financial markets.

The movement back toward a more neutral interest rate environment should contribute to a more sustainable and balanced economic environment. I might describe our recent policy actions as a form of preventive maintenance that helps to ensure low inflation in the future while facilitating a transition toward other desirable outcomes such as less borrowing and more saving.

Although I do not think a significant pickup in inflation is imminent, I continue to be struck by talk of price increases that my business contacts say they are planning as the economy expands. Low capacity utilization is often cited as a factor that helps to keep prices down. But capacity utilization has been rising steadily and may be underestimated given the number of obsolete factories that have been shut down and are not expected to reopen. Moreover, there probably is a limit to how long businesses can leverage productivity gains to hold prices down.

Let’s keep in mind that many of our oil supplies and future oil reserves are found in parts of the world that are not the most politically stable. All of these factors suggest we continue to keep a wary eye on energy as a pivotal economic issue and potential source of risk.

Other potential inflationary pressures in the year ahead could come from past energy cost increases and higher prices of some imported goods. Labor costs are yet another variable. Although we still have a large supply of unemployed workers, I am now hearing more about shortages of skilled workers and that wages for some of those jobs are beginning to climb.

Our country is going deeper into debt to pay for consumption instead of investment, and in my view this trend is undesirable and at some point unsustainable. If our current account deficit continues to grow, foreign investors can’t be counted on to keep lending to the United States on the same terms as in the past...These pressures are made even more worrisome because we are using part of the proceeds from borrowing abroad to finance our current account deficit while we are also using part to finance our growing domestic fiscal deficit—the other twin.

In 2005, our fiscal policymakers have an excellent chance to strengthen the nation’s economic foundations by demonstrating a renewed commitment to reducing the federal budget deficit. Also, we face the more daunting task to confront looming deficits for Social Security and even more costly medical programs.

I’m comfortable with consensus forecasts for annualized GDP growth for this year of about 3 ½ to 4 percent.

If my expectations about the path of the real economy over the next year or so are [met], we still have got a ways to go...If we stay on the path we're on and withdraw some of the accommodation we've had in place...we'll be at a point it's not quite as clear how much more we need to do and how quickly we need to do it.

You can imagine not too far down the road where some things in the statement aren't going to be appropriate.  And we need to decide how and when to change some of that wording.

In hindsight I'd have to admit the fact we were able in our statements to give some [clue] of where policy was headed has turned out to be helpful...up to this point.  It's helped financial markets and others be prepared for, and adjust smoothly, to what we've done so far...It's probably reduced volatility in financial markets around the time of our policy actions.

As a policymaker, these anecdotal reports [of price increases] remind me to stay alert. But it’s important to keep in mind that isolated price increases are not the same as an unwelcome rise in average prices as measured by our inflation indexes. Because of fierce competition, many businesses that compete globally are in fact reluctant to pass along higher input costs. These pressures have made price increases for domestic services more prevalent than those for consumer goods.

The trick to guarding against an unwelcome run-up of inflation is to prevent the spread of price increases across sectors where they show up in a basket of all prices. And that means preventing the emergence of the expectation of rising inflation, an insidious cycle where people rush to buy before prices rise further. In my view, the policy path we’ve been on has helped to restrain inflationary pressures—at least for now.

I think the idea of private accounts are a fascinating possibility that hopefully will get lots of discussion.

At some point, if financial markets expect large deficits to continue, they will very likely build into long-term interest rates a larger inflation premium. We haven't seen that yet...[But] if left undealt with, large and continuing and growing deficits will lead to higher long-term interest rates, and that's certainly not in the interest of the economy.

The accumulation of ever larger amounts of debt entails a level of risk that makes me uncomfortable. I believe it’s important to implement policies that encourage greater savings in our country so that we do not overextend ourselves and weaken our bargaining power.

Energy markets are hard to predict; and sustained high oil prices have a negative impact on the economy. Even though energy prices are largely controlled in the short term by others, we’ll have to continue to see how things develop.

As price pressures begin to build, I believe appropriate increases in the fed funds target rate will help to prevent rising inflation and encourage desirable outcomes such as increased saving. The Fed must be willing to make the necessary policy moves.

After going through a foggy stretch of road with potholes and sharp turns, the economy seems to be in a stretch of more open highway. While there can always be surprises around the next corner, I would add that my near-term forecast is for more of the same: GDP growth in the 3 to 4 percent range, continued strong business spending growth, steady employment gains along with a continuing decline in the unemployment rates and low inflation as measured by the Consumer Price Index in the range of 2 ½ to 3 percent.

By most measures, overall inflation today continues to be within the range I find consistent with the definition of price stability.

In my opinion, the present fed funds rate is still accommodative, and with an economic expansion that now seems to be well established I believe the FOMC still has a ways to go in recalibrating monetary policy.

To illustrate my point, let me use a football analogy. That is, the best defense is a good offense that maintains control of the ball. What does that mean for the Federal Reserve? I believe it means we must constantly anticipate and act to prevent problems from emerging. And if we are successful, we should never see problems with out-of-control rising prices. Our opponent is an unwelcome level of inflation, and in that game we don’t want to play catch-up.

As we keep an eye on prices, it’s important to keep in mind that monetary policy acts with a considerable lag, and economic circumstances can and do change quickly. If you wait to see concrete evidence that inflation has taken hold, then it’s already too late to stop it.

[Low inflation or price stability] is sometimes taken for granted but is probably the single most important factor in our country’s strong and long-lasting economic growth over the past two decades.

In the aftermath of recent scandals, I’ve heard a number of young people express skepticism about investing in equities. Given the huge losses in recent years, it’s understandable that folks are being more cautious in how they allocate their hard-earned savings.

[The Sarbanes-Oxley Act] brings a very substantial cost...Based on anecdotal reports, I do have the sense that the extraordinary attention devoted to the new corporate governance rules very likely delayed strategic business decisions and capital investment decisions that we would have seen earlier as the economy recovered from the 2001 recession...The money to pay for improved corporate governance comes out of corporate profits and represents another price we are all paying for corporate fraud and deception.

Given my current outlook for the economy, my personal view is that we’ve not yet reached a neutral policy stance.

I believe our strategy to act before the appearance of widespread price increases is sound and necessary to keep inflation and inflation expectations firmly in check. The gradual rate hikes at this stage of the economic recovery also reduce the chances that the Fed will later need to take a more painful path of steep hikes. The Fed is not raising rates to stifle economic growth, but to ensure an environment of stable prices and sustainable growth over the long term.

Excessive fiscal spending tends to boost output in the short run but eventually adds risks to our economy and restricts the effectiveness of monetary policy. The fundamental issues of how to deal with Social Security and rising retiree health care costs only serve to complicate our challenges with fiscal policy.

I’m often asked what the end game is for the policy adjustment process. Going forward, we are approaching an increasingly uncertain time for monetary policy.

Labor market developments have improved considerably...We’ve seen solid job growth in business services, leisure and hospitality, and retail, among other industries. These additional paychecks are crucial to keeping growth on track.

I expect GDP growth will remain on a very positive path. I think the forecast I made early this year of growth for all of 2005 in the range of 3.5 to 4 percent still seems reasonable.

Some businesses during the early part of this year may have postponed certain investment spending decisions because of high energy costs. But there has been no sense of panic. Rather, more recent data suggest investment spending—and business spending plans—remain firm.

Oil futures markets are indicating that higher energy prices may well be with us for quite a while. And how businesses and individuals react to this energy price outlook—both short and long term—is a key economic uncertainty.

In several markets across the country, housing prices in the past year have appreciated more than 30 percent, a rate that in my view is unsustainable. There are submarkets...where you hear about speculators buying housing units—sometimes multiple units—just to flip them for a quick profit. And it seems like every week brings new stories about aggressive financing arrangements that encourage and enable such real estate transactions. I have to tell you that some of these stories we’re hearing about residential speculation make me uncomfortable.

While I see no signs of an imminent and substantial pickup in inflation, we will need to be especially sensitive to incoming data and new developments on prices.

It now appears there has been more pass through of energy costs than I earlier expected. My point is that all of the inflation measures over the past seven or eight quarters show a similar—but distinct—upward tilt.

I am inclined to attribute at least some of the recent softness in growth to general skittishness about the springtime run-up of energy prices.

I don't raise that issue [in the housing market] as something we have a tool to deal directly with...Our free market economy has a tough-love kind of way of dealing with excesses.

I don't think we should stick our head in the sand and say that we don't have to worry or think about unit labor costs at this point.  It's one of those things we have to continue to watch very carefully and be sure that in addition to the other cost pressures we get, that we don't at some point begin to see labor cost pressures that would add to the inflationary pressures that I talked about.

I too share the concern that with rates having been so low for so long, that we do have some stretching for yield.

Unit labor costs so far have been of less concern than I might have expected a couple of years ago. Productivity gains have certainly helped.

I am reluctant to bet against the strength of the American consumer. But with gasoline at or near $3 a gallon recently and other energy costs such as natural gas almost doubling in the past year, consumers may face tough choices in how they allocate their spending. In the final months of 2005, consumer spending could slow a bit if caution causes households to reduce borrowing or increase the rate of savings.

Rising energy costs probably won’t lead to a persistent and broad-based rise in inflation if—as is the case, in my view—the marketplace does not perceive the general price level to be increasing.

Looking ahead, it’s my belief that—despite the effects of the hurricanes—the most likely path of the economy for the next several quarters is ongoing respectable growth of GDP, employment, and income. That pattern suggests to me that we should continue to move toward a neutral setting for monetary policy. The Fed already has moved interest rates a long way toward a more normal level consistent with sustainable growth. By most conventional measures, however, policy is still accommodative.

I want to note that our recent post-FOMC meeting statements came with a caveat that reads: “The Committee will respond to changes in economic prospects as needed to fulfill its obligation to maintain price stability.” To me, this language means that while we’re working to gradually remove the remaining policy accommodation in this time of elevated inflation risks, we also must watch carefully for unexpected developments in the economy, especially how individuals and businesses respond to the continuing rise in energy costs.

GDP grew at only about 1.6 percent in the fourth quarter last year—about half the pace of the previous 2 ½ years. The analysis done by my staff and others suggests this relatively weak reading was an aberration that does not imply a loss of momentum going forward.

The much-anticipated slowdown in housing activity appears to be playing out in an orderly way.

Despite volatility in energy prices, we used to think that oil would settle back over time to around $25–$30 a barrel. But our experience for the past two years has changed that expectation, at least in the view of futures markets

With oil prices persistently above $70 a barrel, households and businesses face new costs that must be absorbed, offset, or passed along if possible. Although difficult to measure, these higher energy costs have forced households to reallocate spending and could dampen consumer spending in the future.

While energy is increasingly cited as a justification for price increases, many businesses—especially goods producers—can’t or won’t pass along higher costs. In part, that’s because global competition helps keep prices down and thus induces businesses to improve efficiency to maintain profits. The result is higher productivity, which helps to offset increased costs, including energy.

Core CPI was 2.8 percent for the first three months of 2006, and another measure we often use, core personal consumption expenditures, or core PCE, was about 2 percent measured on a year-over-year basis. On the other hand, three- and six-month measures have edged up recently. While these measures are still relatively low, I don’t want to see inflation move measurably higher.

My staff and I have pored through reams of data and talked to many business contacts to try to determine the extent of energy cost pass-through. We’re finding the impact on transportation costs is large, and the spillover effect of higher energy costs affects various industries in different ways.

If—and I emphasize if—my most likely forecast of sustainable output growth and modest inflation is right, then I am of the view that we are very close to having Fed policy properly calibrated for now.

Looking ahead, continued job growth and underlying demographics suggest the underpinning for housing over the longer term is solid. But the market is changing, and the impact of the housing adjustment on overall economic activity is not yet fully evident. Some slowdown in housing is built into almost everyone’s forecast. But housing could turn out—once again—to be more resilient than expected, or the adjustment could turn out to be more extensive than anticipated.

Headline measures of inflation of late have been bothersome, with higher oil prices contributing to much of the run-up in those broad readings. Core inflation, which excludes volatile food and energy costs, has moved into the upper end of—or beyond—the range I consider acceptable over time.

If we’re on target with our present forecast for growth to moderate to a sustainable pace and for inflation to fall back within acceptable bounds, I would say that monetary policy is now close to where it should be.

I view current inflation risks to be elevated for three reasons. First, we have been expecting and have not yet seen secondary pass-through of energy prices to core inflation. Secondly, some key components of core inflation such as services have been moving at rates that warrant continued concern. Finally, some measures of inflation expectations recently have edged upward.

Part of this moderation in growth is coming from some easing in the extraordinary pace of home construction, sales, and price appreciation—a development we’ve been expecting for some time. Don’t get me wrong. I do not expect a sharp residential real estate correction, but I believe we should recognize that a slowdown in housing activity is very likely—and may have begun already.

As home price escalation slows, consumers can be expected to feel less confident about gains in wealth and may well begin to feel inclined to save more and spend less. These indirect effects of a housing slowdown are embedded in my forecast of some slowing in the growth of consumer spending.

Many jobs depend on home-related construction and mortgage businesses, and important industries in our regional economy such as durable goods and carpet production also rely on housing construction. But even if there were no growth in housing construction, the level is high enough now to support strong ongoing demand for home products and related goods. Furthermore, consumers will continue to remodel existing homes and replace worn-out appliances and furniture. Looking at the broader context of our diverse and dynamic economy, direct residential investment is only about 6 percent of GDP.

On a macro level I believe the housing adjustment most likely will be orderly and with a limited impact on the overall economy...For one thing, depository institutions in the United States are well capitalized and hence well positioned to absorb any housing lending losses they may incur...More and more of the credit- and interest-rate-related risks associated with mortgage finance can be easily traded and have gravitated to those institutions best positioned to manage the risks.

And I expect the Fed will keep trying new and different ways to communicate important views and actions, including perhaps establishing targets for acceptable levels of inflation.

I’m leaving the FOMC confident in the Fed’s commitment to keep inflation at bay. I’m sure future policymakers will remember the lessons we learned in the past 40 years about what happens when you start down the slippery slope of trading inflation for growth.