Michael Moskow

The Chicago Purchasing Managers’ report indicates that the overall index as well as the prices paid and the supply and delivery components moved down in December, but all three components remained well above the 50 percent level. I would remind you that these data should be treated confidentially, as they won’t be released until December 30th.

Remark made at December 21 FOMC meeting

An important reason that the U.S. economy is dynamic and productive, and generates a higher standard of living for us all, is that we embrace change. Now there will be people who suffer from such changes. But because these losses are part of the dynamic process that makes us all better off, society can and should help these people find their place in the new workforce.

The pace of change in the economy has increased the risks that workers' skills will become obsolete, and they will lose their long-held jobs...This increased rate at which experienced workers have been losing long-held jobs is one of the factors that monetary policy makers have to think about in judging the extent of inflationary pressures currently facing the economy.

When productivity grows at a faster rate, the economy can grow faster—resulting in higher incomes and producing more goods and services for all of us to enjoy—without generating inflationary pressures. This ultimately makes our job at the Federal Reserve easier, because our mandate is to set monetary policy to support maximum sustainable economic growth and price stability.

My own judgment is that there still are excess resources in the economy, both certainly in the labor market side and facilities, plants, and equipment...So I personally think that there still is an output gap. I think it is closing. I think we are growing both at potential growth, but I don't think it has closed at this point, but it's something we have to keep monitoring on a regular basis.

But businesses owned by women and minorities remain relatively small, undercapitalized, and underrepresented in the more capital-intensive sectors of the economy. Greater access to capital and credit are widely reported to be the number one obstacle to faster growth for these firms, with greater access to opportunities in the corporate supply chain a close second.

If the gap is still significant, lingering slack resources will diminish inflationary pressures, and policy accommodation can be removed at a gradual pace. However, if the output gap has nearly closed and inflation becomes more of a threat, then monetary policy can respond accordingly.

Of course, we will respond appropriately to any indications of a threat to price stability. Price stability, as you well know, is essential for obtaining long run maximum sustainable growth. So, in order to give the current expansion its greatest chance to last for an extended period of time, we must keep inflation under control.

There is certainly more ground to cover, because even with these increases, policy remains accommodative. But given the low level of inflation, well-contained inflationary expectations, and the remaining slack in the economy, we believe we can remove the remaining policy accommodation at a pace that is likely to be measured.

The Federal Reserve must monitor inflationary pressures and expectations carefully, and be prepared to act if they threaten price stability. Thus far, though, we have seen little evidence that long-run inflationary expectations have risen.

The participation rate has fallen 1.5 percentage points over the last five years. If all of these people instead had been looking for a job, the unemployment rate would be over 7 percent. Although this is an important consideration, this calculation most likely exaggerates the amount of slack in the labor market. The drop in the participation rate may well have been from an unsustainable level...We don't believe that the official unemployment rate understates the amount of slack in the labor market by a large margin.

Suppose oil prices stop rising and stay at their current high levels. Once the cost adjustments in the economy are complete, there will be no reason for prices to rise further, and inflation should return to its earlier rate...There would be a temporary spike in the overall inflation rate. This process, however, may take time to work through the economy, so that inflation may be elevated for more than a short period.

The current account deficit as a percentage of GDP has been rising and is close to 6%. That's unsustainable. It can't rise indefinitely...High national savings will help reduce the current account deficit.

Inflation targeting is not something you can move into right away.

This transition from an expansion supported by accommodative fiscal and monetary policy to one broader-based is essential for the expansion to be self-sustaining.

[I] want to emphasize the uncertainty of this assessment and how difficult it is to quantify the output gap. So, while we don't think that the gap has fully closed, we must be vigilant for any signs of emerging resource constraints generating inflationary pressures.

As the economy continues to expand, the [labor] participation rate will increase, providing some additional buffer against the kind of shortages and bottlenecks often associated with rising inflation. ...This means that there is somewhat more slack in the labor market than the unemployment rate suggests—but not much more. Combined with the moderate slack in other sectors of the economy, this suggests that the current level of output is only modestly below the level of potential output.

Now that the expansion is solidly in place, the issue of inflation becomes increasingly important.

I still think there is slack in the economy.  I still think that we can grow above potential to reduce that slack before we get back on a long-term sustainable growth path.

I think you have to say...that there are some concerns about inflation now...I think overall underlying inflation is will contained, but there are some areas of the economy where there are more concerns: energy, import prices, and we've heard some anecdotes about greater pricing pressures as well.

Well, it's less of a conundrum now than when Chairman Greenspan made that statement.  But I think there still is a puzzle as to why long-term interest rates have been as low as they have been during this period.

With a mandate to promote maximum sustainable economic growth as well as stable prices, Fed policymakers must be constantly vigilant. When the economy gathers strength and overcomes a ‘soft patch’ or recession, inflation concerns typically become more pressing.

The art of business lending has changed. Business borrowers have clearly benefited from this new financial environment, which delivers a wider and more affordable menu of credit possibilities...These ongoing changes have important implications for the structure and performance of the financial industry, for innovation and risk in the financial system, for the creation of credit and its distribution, and for macroeconomic growth and stability.

We still have more ground to cover [in the removal of monetary accommodation]. Otherwise, we risk that some of the increased pressures we have seen recently from higher costs for energy and other items will become permanently embedded in the inflationary mentality of firms and households. So far, this has not happened, and we still believe that monetary accommodation can be removed at a measured pace. But if inflationary prospects do worsen, we will act as necessary to fulfill our obligation to maintain price stability.

Workers who had held their jobs for a substantial period of time but lost them through changes beyond their control—such as technological change leading to a plant closing or reduction in force. The fact that job loss rates have been high, even though unemployment has been relatively low, suggests that the pace of change in the economy has increased. It also means that a larger-than-normal fraction of the unemployed face difficult challenges in finding new employment.

With more of the unemployed lacking the needed skills to fill available jobs, there could be more shortages of certain kinds of workers, leading to upward pressure on labor costs. On the other hand, an environment in which job displacement is more common may make workers reluctant to press for large wage increases, which would tend to restrain labor cost pressures...So far at least, wage pressures have not been higher than one would expect on the basis of the usual measures of labor market slackness.

We still have a little bit of an output gap.  We have unused resources.  If we move towards closing the gap, [that] means our growth rate could be a little bit above potential.

Job displacement is affecting an increasingly diverse group of workers. If we do not attend to the needs of displaced workers, concern about their future may block policies that help improve our overall standard of living. And this could have costly consequences for the economy as a whole if it were to stifle technology and competition.

If a firm gives longer notice of impending lay-offs or offers outplacement services, then it may have an easier time retaining other workers. But if the firm treats laid-off employees poorly, then other workers are more likely to leave as soon as they get an attractive offer.

Many displaced workers have skills that are highly specific to their employer or industry, and the value of those skills often disappears along with their jobs. Displaced workers often take a long time to find a new job, which translates into large chunks of lost income. More importantly, even after they find new jobs, displaced workers earn about 17 percent less, on average than in the job they lost.

While other countries have suffered sluggish growth to achieve lower inflation, the US did not.  This is because our disinflationary monetary policy could be made against the backdrop of a step up in productivity growth.  We were also successful because monetary policy did not adhere to a rigid mechanical rule, but adapted to the incoming evidence on inflation and output.

Suppose a central bank successfully adopted a formal inflation guideline that respects a dual mandate by flexibly adjusting the time horizons for achieving the guidelines.  Would this policy look any different from current Fed policy?

In some instances, the injection of liquidity ran counter to the inflation risks that the Committee perceived just before the crisis.  But as events bore out, such flexible monetary policy responses did not jeopardize the pursuit of our long-run goal of price stability.  An important element in this disciplined approach to flexibility is that our long-run policy goals generally have been clearly articulated and are understood by the public.

The Fed thinks that the price index for personal consumption expenditures excluding food and energy is the best measure of underlying trends in consumer inflation.  But does that mean it's the best index for a guideline?  For example. the total CPI is used in many pricate contracts as well as the inflation adjustments in many tax and transfer programs.  So should we be concerned about the CPI as well?  Also, in a period of rapidly rising energy costs--such as the present--will the public have confidence in an inflation guideline that excludes energy prices?  Would such a guideline achieve its claimed advantage of reducing risk premia?

As both an employer and an economist, it is clear to me that the relationship between education, productivity, and economic growth has never been more closely linked. While states and regions once prospered based on an abundance of physical capital and natural resources, today the quality of a region's human capital is paramount.

Universities have been unable to maintain the implicit "social compact" that once defined the relationship between universities and the public. This compact was based on a belief that education was largely a public good and, as such, government support was warranted. This notion has eroded over time. Today, many argue that higher education is a private good whose benefits primarily accrue to the student who is able to use his or her higher education to achieve a more satisfying quality of life and often significantly higher wages...Therefore, it should be primarily financed by the individual. I believe for universities to flourish, they need to revisit this "social compact" and make a clearer case for the public good content of education. In order to do this, universities will need to be more transparent in their operations so that the public can have a better sense of what the value of the institution is to society. 

Although energy prices are still high, they have been falling recently, and futures markets expect energy prices to continue falling modestly next year.

Housing has been an area of strength throughout this business cycle, and we've seen strong increases in home prices...Many analysts warn that housing is overvalued. One way we can judge this is by looking at the price-to-rental ratio for housing...Nationally, the price-to-rental ratio has been rising sharply since the mid-1990s and currently is at its highest level ever. However, the price-to-rental ratio has risen only modestly in Chicago and most Midwestern cities; the largest increases have occurred in cities such as Miami, San Francisco, and Las Vegas. These differences highlight the local nature of housing markets. There is little tendency for housing price declines in a particular region to spill over to a more general drop in prices at the national level...If housing does prove to be overvalued and home prices fall, residential construction would be adversely affected. But history suggests that the impact on overall consumer spending would be more modest. Moreover, the changes in wealth and any related spending adjustments likely would be gradual. 

Over the last two years real Gross Domestic Product has been growing an average of 3.7 percent each year. This is somewhat faster than potential, or the rate of GDP growth that can be sustained without creating inflation pressures.

 The economy needed to grow faster than potential in order to eliminate the slack labor and capital resources that had built up during the recession in 2001 and early stages of the recovery, which were sluggish...But now, much of the slack has been eliminated. The unemployment rate has fallen to 5 percent; at the Chicago Fed, we think that such a level is roughly consistent with an economy operating at potential. In addition, the capacity utilization rate in manufacturing is only slightly below its historical average. This indicates that there may be some slack remaining in manufacturing, but probably not much. Finally, core inflation has changed little in recent months. Currently we're not seeing the kinds of disinflationary forces that would be associated with a substantial degree of resource slack like we did a couple years ago.

For the national economy...it appears that the negative effects of the hurricanes are modest. Furthermore, rebuilding efforts will boost economic activity.

The latest reading of the core price index for personal consumer expenditures, the Fed's preferred measure of inflation, shows an increase of 2 percent over the last 12 months. This is at the upper end of the range that I feel is consistent with price stability.

We know some of the ways in which we can build a higher quality teacher workforce. It will require a system that starts with more selective hiring, includes a lengthy apprenticeship with comprehensive evaluation, and follows up with regular, rigorous personnel evaluations with pay-for-performance rewards. In addition, we should have higher pay for teachers in subject areas where it is more difficult to find qualified instructors, such as math and science.

The gaps in wages and unemployment rates between the skilled and less-skilled workers in the U.S. economy have widened dramatically since the late 1970s. Currently, unemployment is only about 2.5 percent among those with a college degree, but it's over 8 percent for high school dropouts. Furthermore, research shows that each additional year of education tends to raise incomes by about 10 percent. And these returns are not merely private. Researchers are finding that education raises the productivity of other workers, lowers crime, and raises public involvement in the policy process. Some believe that these social benefits alone may exceed the 10 percent per year private return.

As monetary policy makers, we are constantly tracking productivity growth because it is a key determinant of our standard of living. And an important factor driving productivity growth is worker quality, which includes the education and the experience of the workforce.

Education is essential for citizens to participate in a responsive democracy, and it has meant growth and progress for Americans. Historically, gains in educational achievement have gone hand-in-hand with the adoption of new technologies and improvements in our standard of living. And in our increasingly complex society, education is essential to making wise saving, investment, and occupational decisions that determine our life's financial prospects and economic well being.

The United States has nearly the highest spending per pupil in the world.  Yet there is a great deal of dissatisfaction with the results, particularly in the dismal outcomes generated by many of our urban schools.  We must spend the money more wisely and achieve a substantially greater return on our investment.

The unemployment rate has fallen to 5 percent; at the Chicago Fed, we think that this rate is roughly consistent with an economy operating at potential.

But there is another very important point to emphasize. Even if the funds rate were at neutral, further changes in policy may be appropriate. My view is that inflation will likely remain contained. Energy prices have come off their highs, and solid underlying trends in productivity should keep overall production costs in check. But there are risks to this scenario. With inflation at the upper end of my comfort zone, an unexpected increase in inflation would be a serious concern, while a decline in inflation would be beneficial.

Conceptually, it's easiest to think about the neutral—or equilibrium—rate as being the rate consistent with an economy growing steadily along its potential growth path over a long period of time. One can make rough estimates of the neutral real rate by using historical averages of the real federal funds rates from comparable periods. ... Of course, this is a crude estimation. ... For example, all else equal, stronger trends in productivity would raise the equilibrium real rate; in contrast, increased willingness of foreigners to invest their savings in the U.S. would lower the rate.

Recently, Hurricanes Katrina and Rita slowed economic growth. Clearly, the storms were devastating in terms of lost lives and property destruction, and they created large losses for the local economies. For the national economy, however, it appears that the negative effects of the hurricanes are limited. Furthermore, rebuilding efforts will boost economic activity. 

According to the Blue Chip consensus, GDP is expected to grow by 3.5 percent in 2005 and by 3.3 percent in 2006—numbers on the high side of recent estimates for potential.  

At the Chicago Fed, we've spent a good deal of time analyzing the long-term demographic trends, and our best judgment is that we will not see a big rebound in participation. This suggests that the current low levels of labor force participation are not indicative of a slack labor market.
 

Given the large amount we spend on imported energy... [t]he price increases act like higher taxes, negatively affecting economic growth. So why haven't we seen a slowdown in U.S. economic growth over the past couple of years? First, solid productivity growth and accommodative monetary policy have offset some of the negative effect of rising oil prices. Second, the increase in crude prices, after adjusting for inflation, is smaller than during the 1970s, and the level remains well below the peak reached in 1980 of $86 per barrel in 2005 dollars. And third, the U.S. economy is less dependent on oil today.

The latest reading of the core price index for personal consumer expenditures, the Fed's preferred measure of inflation, shows an increase of 2 percent over the last 12 months. This is at the upper end of the range that I feel is consistent with price stability.

There is another worry, however. If we indeed start to see a string of higher inflation numbers, then people may begin to expect permanently higher inflation. ... Fortunately, current financial market data and consumer surveys suggest that long-run inflation expectations remain contained.

Nonetheless, it will take appropriate monetary policy to keep inflation and inflation expectations contained. For me, at this time such policy likely entails further removal of policy accommodation.

I am deeply concerned about one possible fallout from the large and persistent U.S. current account deficit. This is the possibility of protectionist legislation in the U.S. Such barriers to the trade of goods and services and restrictions on international investment in the U.S. would result in a substantial welfare loss, both for the U.S. and for other countries as well.

The most likely scenario is for a slow decline in the net saving rate by the rest of the world that would induce a gradual contraction in the U.S. current account deficit. This probably would not have a major impact on U.S. price pressures or growth, so there is little reason to think that monetary policy would need to react significantly.

No one can say when this adjustment away from such high current account deficits will begin. But I expect that when it does, the adjustment will be gradual, without a major disruption to U.S. economic performance. One reason is that many of the forces driving investment and saving in the U.S. and the rest of the world are long-lived developments driven by fundamental economic factors.

The low real interest rates throughout the world over the last several years suggest that the most important factors underlying the recent increase in the U.S. current account deficits have been shifts in the desired net savings by the rest of the world. Reductions in desired U.S. net saving may have played a role as well. But if a fall in U.S. desired saving was dominant, interest rates would have risen, not fallen.

Research by economists at the Federal Reserve Board of Governors suggests that an exogenous $1 reduction in the U.S. fiscal deficit would cause the current account deficit to decline by less than 20 cents. So, this evidence suggests the growing fiscal imbalances do not explain the bulk of the change in U.S. net saving or the current account.

There is also the possibility, however, that housing markets will remain solid—for example, because of support from the continued low level of long-term interest rates. This would then heighten the risk of above-trend GDP growth and the further development of pressures on resources.

Much of this decline [in fourth quarter 2005 GDP growth], however, reflects fluctuations in government spending, imports, and motor vehicle output that look to have been temporary. Indeed, the most recent monthly indicators of activity have been favorable, and we think that growth in output is rebounding smartly from the low fourth-quarter number.

Over the longer-term, if we want to keep improving our standard of living, we must make sure that productivity growth remains robust. Faster productivity growth generates faster GDP growth. This boosts our well-being. It also helps make the adjustments to the current account and fiscal deficits a much smoother process than if we were facing them from a base of lower GDP growth.

There has been a good deal of discussion about froth in housing prices, and most forecasts of GDP that you see factor in some moderation in home price appreciation and residential investment. Indeed, the slowdown in housing should be an important factor in bringing growth back to potential. So far, housing has been moderating in a way that is broadly consistent with these forecasts. But if housing markets soften more appreciably, we could see a more significant negative effect on overall spending.

Sound underlying economic fundamentals are supporting self-sustaining economic growth. Importantly, the fourth quarter aside, the underlying trends in productivity are quite solid.

We at the Chicago Fed think that after a strong rebound in the first quarter of 2006, real GDP growth will average somewhat above three percent over the next couple of years. We expect that the unemployment rate will change little from its current level and that inflation will remain contained. However, inflation currently is near the upper end of the range that I feel is consistent with price stability. As such, I believe monetary policy must be vigilant. We need to make sure that increases in resource utilization or prices of energy and other commodities do not add to inflationary pressures or increase inflation expectations.

The [auto] industry and its traditional core region face a painful adjustment.

Though seemingly unrelated, financial education and the current account deficit are two long-term issues that we must focus on if we want to ensure that the economy remains strong in the future. Both topics at their core deal with understanding how current spending—by the individual or by the nation—must be balanced against future income prospects and future needs.

An economy the size of the U.S. cannot run large current account deficits indefinitely. For it to do so, the rest of the world would have to run persistently high net saving rates. Eventually, these countries will want to consume or invest more in their own countries. With fewer funds available, the U.S. current account deficit would fall.

No one can say when this adjustment away from such high current account deficits will begin. But I expect that when it does, the adjustment will be gradual, without a major disruption to U.S. economic performance. One reason is that many of the forces driving investment and saving in the U.S. and the rest of the world are long-lived developments driven by fundamental economic factors.

The last recession was a mild one partly because these financing innovations continued to facilitate the growth in mortgage lending and refinancing, supporting growth in residential investment and household consumption during the downturn and early recovery.

To be sure, we are seeing some softening in housing markets, and home prices are increasing at a slower rate. But it seems unlikely that prices will actually decline nationwide...Even if there were large price declines in some cities, there probably would be little spillover to a more general drop in prices nationwide...But if prices did decline nationwide, history suggests that the impact on overall consumer spending would be modest and gradual.

For most of the past year core PCE inflation has been running close to 2 percent, which is at the upper end of the range that I feel is consistent with price stability.

Higher energy prices do not necessarily imply a persistent rise in inflation. Suppose energy costs stabilize, as the oil futures market predicts. Once businesses adjust their own prices to cover the higher costs, prices would not have to rise faster than increases in the cost of other inputs, and overall inflation would return to its earlier rate. Thus, the energy price increases we have seen to date should result in a one-time increase in prices and a temporary rise in the core inflation rate, not a sustained higher rate of core inflation. Indeed, this pattern can be seen in the slightly lower range for most core inflation forecasts in 2007 compared to 2006.

Personally, my comfort zone for core inflation is between 1 and 2 percent—that's the range of inflation rates I consider to be consistent with price stability. But that doesn't mean that I view the 1 to 2 percent range as a "zone of indifference." I think it's better to be in the middle of the range. In fact, some research suggests that an inflation figure of about 1.5 percent strikes a good balance between avoiding the negative effects of inflation with the value of being able to push short-term real rates into negative territory in periods when the economy is weak.

Solid underlying trends in productivity should keep overall production costs in check. But, as I mentioned earlier, there are risks to the inflation outlook—namely, the potential for energy cost pass-through, pressures from increases in resource utilization, and rising inflationary expectations. With inflation at the upper end of my comfort zone, an unexpected increase in inflation would be a serious concern, while a decline in inflation would be beneficial. So I think monetary policy should be calibrated to bring us back to the middle of the range over time.

The FOMC will react to changes in economic prospects. Future policy is not predetermined, nor will it be a mechanical reaction to the next number on inflation or employment.

With overall population growth continuing to slow and labor force participation not expected to rise, we probably need to adjust our benchmarks for what level of employment growth is consistent with economic growth near potential and a steady unemployment rate. It used to be that increases in payroll employment that averaged 150,000 per month were consistent with flat unemployment. Now that number may be closer to 100,000. These developments also imply that, in the absence of changes in productivity growth, our estimates of potential GDP growth should be revised down 2 or 3 tenths of a percentage point to a range of 3 to 3-1/4 percent.

Suppose a central bank successfully adopted a formal inflation guideline that respects a dual mandate by flexibly adjusting the time horizons for achieving both its guidelines. Would this policy look any different from current Fed policy? Some academics who study inflation- targeting central banks say no. They say that, effectively, the Federal Reserve does engage in flexible inflation targeting. This is a bit puzzling since there are no announced explicit guidelines. Still, financial markets and the public do not seem to be overly bothered by the lack of an explicit number for future inflationary expectations, and at the present time, inflationary expectations are well anchored. Our actual policy appears to have successfully obtained one of the most important benefits ascribed to a regime based on formal guidelines.

So the trends in both the growth of the population and labor force participation point to slower growth in the labor force. This has important implications for our benchmarks for the monthly employment statistics. Earlier in the decade, most economists estimated that job growth of about 150,000 per month was consistent with an economy expanding near potential. However, research at the Chicago Fed and elsewhere suggests that, given the slower growth in the labor force, monthly increases of roughly 100,000 are most likely consistent with potential. This transition has not yet been fully appreciated by market observers. In each of the past three months, financial markets have expected job growth of about 160,000 on average. When actual job growth averaged just above 100,000, many analysts interpreted this as a sign that the economy is growing slower than its potential. In contrast, we at the Chicago Fed see these numbers as actually consistent with an economy moving ahead at about its potential.

These changes in labor force growth also imply that, in the absence of changes in productivity trends, our estimates of potential GDP growth should be revised down 2 or 3 tenths of a percentage point to near 3 percent.

Taking all of these factors into account, my assessment is that the risk of inflation remaining too high is greater than the risk of growth being too low. Thus some additional firming of policy may yet be necessary to bring inflation back into the comfort zone within a reasonable period of time.

Furthermore, there are some very important fundamentals that should continue to support housing demand. First, productivity growth should continue to bolster gains in wealth and income—some of which will be spent on housing. Second, the financial innovations that have led to more efficient mortgage markets and increased access to credit are here to stay. Third, financial conditions are not very restrictive—after all, 30-year mortgage rates currently are under 6-1/2 percent. Furthermore, there are no "extra" factors reducing the supply of credit—contrast today's environment with the 1960s and 1970s when there were regulatory ceilings on interest rates or with the early 1990's when there was the "capital crunch."

Over the next year, I expect the economy to expand, on average, somewhat below its long-run sustainable growth rate.

Some declines in residential investment could be large, and could contribute to some volatile numbers for overall GDP growth on a quarter-by-quarter basis. But currently we do not see the slowing in housing markets spilling over into a more prolonged period of weakness in the overall economy. So on balance, we expect GDP growth to average somewhat below potential over the next year or so...

But we cannot forget the plus side of the ledger. Outside of housing, there do not appear to be any imbalances that would foreshadow large adjustments in spending in other sectors. And, as I noted earlier, income growth and spending should be supported by the trends in productivity, recent oil price declines, and improved growth prospects for many of our trading partners.

Finally, instruments such as sub-prime mortgages, interest-only loans, and hybrid ARMs have opened up financing to borrowers who previously could not obtain it at all or could not borrow as much as they would like. True, these instruments are riskier than traditional mortgages. Still, to the extent that both borrowers and lenders understand the risks involved and markets have priced this risk properly, they represent a net gain to society. Here, there is a role for public policy: On the part of the Fed, we are promoting financial literacy efforts for borrowers and supervising lenders with regard to both the disclosure of terms and costs to borrowers and to the risks of carrying such non-standard loans on their books.

Over the past six months, employment has been increasing at about 120,000 per month, a bit above its long-run sustainable pace.

Looking ahead, it's likely that core inflation will come down somewhat over time. The recent declines in oil prices clearly are a positive factor. And the expected deceleration in economic growth will help avoid sustained pressures from resource constraints. Still, there is a risk that core inflation could run above 2 percent for some time. We could be wrong about reduced pressures from resource constraints, or we could see further cost shocks. And perhaps most importantly, if actual inflation continues at high levels, it could cause inflation expectations to run too high.

Taking all of the factors into account, my current assessment is that the risk of inflation remaining too high is greater than the risk of growth being too low. Thus, some additional firming of policy may yet be necessary to bring inflation back to a range consistent with price stability in a reasonable period of time. But that decision will depend on how the incoming data affect the outlook.

However, research at the Chicago Fed and elsewhere suggests that, given the slower growth in the labor force, monthly increases of roughly 100,000 are most likely consistent with potential. This transition has not yet been fully appreciated by many market observers.  1

The changes in labor force growth also imply that, in the absence of changes in productivity trends, our estimates of potential GDP growth should be revised down somewhat to around 3 percent.

On balance, the 95 percent of the economy outside of housing remains on good footing. Employment has been increasing near its long-run sustainable pace. Productivity trends remain solid. Recent declines in oil prices should give household budgets a boost. Economic growth in other countries should increase demand for our exports. And current financial conditions are not very restrictive by historical norms.

My baseline forecast is that GDP growth will pick up from the weak third quarter and average somewhat below its potential growth rate over the next year or so. Of course, that's an average—I do expect to see some volatility in the numbers.

By my standards, inflation has been too high. I prefer to see it between 1 and 2 percent. But the 12-month change in the price index for personal consumption expenditures excluding food and energy, also known as core PCE, has been running at or above 2 percent for 30 months, and in September it was 2.4 percent. In part, core inflation has been elevated because businesses have raised their prices in response to earlier increases in energy costs. High levels of resource utilization also have added more generally to inflationary pressures.

Looking ahead, it's likely that core inflation will come down somewhat over time. The recent declines in oil prices clearly are a positive factor. And the expected deceleration in economic growth will help avoid sustained pressures from resource constraints. Still, there is a risk that core inflation could run above 2 percent for some time.

Taking all of the factors on growth and inflation into account, my current assessment is that the risk of inflation remaining too high is greater than the risk of growth being too low. Thus, some additional firming of policy may yet be necessary to bring inflation back to a range consistent with price stability in a reasonable period of time. But that decision will depend on how the incoming data affect the outlook.

Taking all of the factors on growth and inflation into account, my current assessment is that the risk of inflation remaining too high is greater than the risk of growth being too low. Thus, some additional firming of policy may yet be necessary to bring inflation back to a range consistent with price stability in a reasonable period of time. But that decision will depend on how the incoming data affect the outlook.

"One month doesn't make a trend,'' Moskow told reporters after a speech to American Business Media in Chicago. ``{The CPI} is moving in the right direction. The key is whether that can be sustained and how quickly we can move to rates that are within the range that is commensurate with price stability. We are certainly not there now.''

Taking all of the factors on growth and inflation into account, my current assessment is that the risk of inflation remaining too high is greater than the risk of growth being too low. Thus, some additional firming of policy may yet be necessary to bring inflation back to a range consistent with price stability in a reasonable period of time. But that decision will depend on how the incoming data affect the outlook.

  Since the mid-'90s, the housing capital stock, which reflects - that's the number of homes in the U.S., as well as their size and quality - the housing capital stock has been growing around three percent per year...

     Over the past decade, the size of a typical new home increased nearly 20 percent in the United States, and many homeowners invested in home improvements and renovations. So, today, many middle-class homes are - have bigger kitchens, more bathrooms, and it's not uncommon to see state of the art media rooms. So, you've seen more homes being built, and larger homes being built.

     Nonetheless, with underlying housing demand growing at three percent per year, these very large gains that we've seen in residential investment, which averaged 8.5 percent a year between 2001 and 2005, they clearly could not continue indefinitely.

     Moreover, housing demand may slow to less than three percent, as demographics point to slower growth in household formation. So, as a result, we at the Chicago Fed accept some further weakness in residential construction.

Now, currently, we don't see the slowing in housing markets spilling over into a more prolonged period of weakness in the U.S. economy overall. On balance, the 95 percent of the economy outside of housing remains on good footing. Employment has been increasing near its long run sustainable path. Productivity trends remain solid. Recent declines in oil prices should give household budgets a boost. Economic growth in other countries should increase demand for our exports. And current financial conditions are not very restrictive by historical norms.

     So, my baseline forecast is that GDP growth will pick up from the weak third quarter and average somewhat below its potential growth rate over the next year or so. Of course, that's an average. And I expect to see some volatility in those numbers.

...

Our estimate is for '07..., as I mentioned, growth would be slightly below potential, but it should be coming back to potential as we exit '07 and go into '08.

So, taking all these factors on growth and inflation into account, my current assessment is that the risk of inflation remaining too high is greater than the risk of growth remaining too low. And as reflected in the minutes of the October meeting, the Federal Open Market Committee agreed that inflation risks remained the dominant concern.

Thus some additional firming of policy may yet be necessary to bring inflation back to a range consistent with price stability in a reasonable period of time. But that decision will depend on how the incoming data affect the outlook for the economy.

Now, within the U.S. economy, the sector with the most dramatic acceleration in productivity has been manufacturing...  One snack maker, Procter & Gamble, even used a supercomputer to study the aerodynamics of its potato chips - Pringles Potato Chips. It found that, as they were manufacturing potato chips - why would they use a supercomputer for that?   Well, as they were manufacturing these potato chips, they found that too many of them were just flying off the assembly line. So, they used the supercomputer to study the aerodynamics to figure out how to keep them on the assembly line and be more efficient in the production of Pringles.

"We would expect some monthly ups and downs, but when you look at the broad trend in the economy, there's a lot of strength there."

"Overall, I still think the economy is solid." 

Moskow said that the Chicago Fed is expecting gross domestic product growth to be "somewhat below trend," citing a forecast for 2007 of a 2.8% expansion.  "I don't think that the data we have seen are out of line with that forecast," he added.

From a CNBC interview.

In the mid- to late-1990s, when I had been at the Chicago Fed for only a short time, one of the big questions was whether inflation would increase given the tightening labor market. The unemployment rate had fallen from 7-3/4 percent in 1992 to 5-1/2 percent in early 1995. Conventional thinking at the time was that the natural rate of unemployment was around six percent. So when unemployment went below that six percent level, a number of people worried that accelerating inflation was just around the corner...  Most analysts have since revised their estimates of the natural unemployment rate, putting it in the range of five percent.

...Demographic changes also are a factor in the decline in the natural rate of unemployment. As the baby boom generation acquired more working experience, their ability to find jobs improved. It happens to every generation. Experienced workers have more employable skills, know more about what jobs match their skills, and have built a broader network to help them conduct a job search. Since 1960, the unemployment rate for 25-34 year olds has been about two percentage points higher than the unemployment rate for 45-54 year olds, on average. In the late 1980s, about 15 percent of the labor force was 45-54. This share has since trended up and now appears to be peaking at 23 percent. In turn, the natural rate of unemployment for the entire economy should be lower because of the relatively higher employability of these workers, who now constitute a larger portion of the workforce.

One challenge is understanding what the various different wage measures are telling us about this dynamic process. Over the last several years, changes in compensation practices likely have caused these measures to send conflicting signals about labor costs. For example, the total compensation series, from the BLS's Employment Cost Index, has grown by roughly 3-1/2 percent per year over the last decade. Over the same time, the compensation per hour figure, based on the National Income and Product Accounts and reported in the BLS's productivity report, has grown by just over 4-1/2 percent per year. But in the decade and a half prior to 1996, each grew at nearly identical rates of around four percent per year.

One reason why the two series may have diverged is that pay practices have changed. The NIPA-based measure includes stock-option realizations and lump-sum bonuses, while the ECI total compensation measure does not. As you know, these and other forms of variable pay now have a more prominent role in compensation. Indeed, recent studies suggest that stock-option realizations account for about one-quarter to one-half of a percentage point per year of the growth in compensation per hour during the late 1990s.

"The long-term picture of manufacturing is really impressive in the United States," Moskow said in a question-and-answer session following a speech to the Labor and Employment Relations Association.

As reported by Dow Jones News

My predominant concern remains the risks to the inflation outlook. We've seen some welcome easing in inflation in the past couple of months, and I'm hopeful this development will continue. But there is still the risk that resource pressures or other factors, such as elevated inflation expectations, could prevent actual inflation from falling in a timely fashion.

Looking ahead, my baseline forecast is that GDP growth will pick up and over the next year or so will average a bit below its potential growth rate—where potential refers to the rate of growth the economy can maintain in the long run without generating increasing inflation pressure. Of course, that's an average—I do expect to see some volatility in the numbers.

Subprime mortgages, interest-only loans, and hybrid ARMs have opened up financing to borrowers who previously could not obtain it at all or could not borrow as much as they would like. True, these instruments are riskier than traditional mortgages. Still, to the extent that both borrowers and lenders understand the risks involved and markets have priced this risk properly, these instruments represent a net gain to society. Here there is a role for public policy. On the part of the Fed, we are supervising lenders with regard to the disclosure of terms and costs to borrowers and with regard to the risks of carrying such nonstandard loans on their books. We are also promoting financial literacy efforts for borrowers.

Skilled workers often find it more productive to continue to commute from home to office to exchange information, despite having the technical ability to work at home with the Internet and personal computers. Such information is often ambiguous, in the sense that it must be interpreted and often creatively advanced through business meetings face-to-face, often in a group setting, and often with rapidly changing groups of people located far and wide. As urban economist Ed Glaeser stated during his recent visit to Chicago, technical advances have only magnified the value of face-to-face communication. In today's information economy and in its advanced information industries, "who we converse with on the Internet are also those who we find we must meet with face-to-face."

In setting policy, the Federal Reserve needs to be mindful of the risks to the outlook for both growth and inflation. In my judgment, while some risks to the outlook for growth remain a concern, these have diminished noticeably in recent months. Housing will likely still be a negative for growth during the first half of this year, but it has shown signs of stabilization. And the risks of spillovers to other parts of the economy do not appear to be unduly large.  

I prefer inflation to be between 1 and 2 percent—that's the range that I consider to be most compatible with the Fed's goal of price stability. The monthly inflation rates did come in lower toward the end of the year, and I was pleased to see the improvement. However, it is much too early to say that inflation is no longer a concern. So as I look ahead to this year, I see the economy with some solid underlying momentum behind it and inflation running too high.

We have seen tentative signs that housing has begun to stabilize. Housing starts ticked up in November and December, new home sales increased in the fourth quarter, and applications for home-purchase mortgages have been running higher than they did last fall. And the same factors that supported the housing boom—strong productivity trends, improved access to credit, and low mortgage rates relative to historical norms—are still in place. These factors likely put a floor under how far housing will decline.

But after ticking up in November and December, housing starts declined sharply in January. These numbers can be highly volatile—especially during the winter months. Indeed, permits for home building also fell, but by a much smaller amount. But these data highlight that downside risks remain. Although demand is improving in some parts of the country, the progress is uneven. One national home builder recently reported that it has yet to see any stabilization in some Midwest markets, including Chicago and Detroit. Moreover, nationwide inventories of unsold homes remain much higher than they were a year ago. It will take some time for the excess inventory of homes to be sold. So while I think homebuilding will stabilize as we move through the year, I don't expect to see any noticeable increases, either.

High levels of energy prices spurred ongoing strong growth in mining and drilling activities. But the recent declines in energy prices make it less likely that we will see further large increases in such expenditures going forward. So some slower growth in structures investment may be expected in 2007.

I've heard more than a few stories of shortages of highly skilled workers, but thus far the increases in overall compensation have been relatively moderate. Furthermore, firms often tell me that productivity gains have given them a great deal of flexibility to produce without generating cost pressures.

The FOMC outlook anticipates further declines. The central tendency forecast expects inflation of 2 to 2-1/4 percent for 2007 and 1-3/4 to 2 percent for 2008. If inflation were to come in at the middle or bottom of such ranges, that would represent good progress toward price stability.

Taking all of these factors into account, my assessment is that the risk of inflation remaining too high is greater than the risk of growth falling too low. Thus, some additional firming of policy may yet be necessary to address this inflation risk.

Currently, however, concern is growing over the increase in foreclosures.   ... [But] nontraditional mortgages have resulted in increased delinquencies because they have been used by consumers with higher risk profiles who may not fully recognize the risks inherent in these mortgages.  Some of the more exotic mortgages, which have payments that start low but can increase sharply in certain situations, may not be suitable for the average borrower.  

...I still think that the underlying economic fundamentals are conducive to a pickup in growth as we move through 2007 and 2008.  So I am not prepared to significantly change my projections at this time.

I expect the economy to continue to operate at a high level relative to its potential, which could eventually lead to the emergence of increased inflationary pressures. In addition, if actual inflation does not show clear enough signs of returning to the center of the range I associate with price stability, there is a danger that expectations of inflation could run too high, which would likely be a self-fulfilling prophesy. Taking all of these factors into account, my assessment is that the risk of inflation remaining too high during the forecast period is greater than the risk of growth falling too low. Thus, some additional firming of policy may yet be necessary to address this inflation risk.

The same factors that supported the housing boom—strong productivity trends, improved access to credit, and low mortgage rates relative to historical norms—are still in place. These factors likely put a floor under how far housing will decline. So I think home building will stabilize as we move through the year, but I don't expect to see any noticeable increases, either.

I prefer inflation to be between 1 and 2 percent—that's the range that I consider to be most compatible with the Fed's goal of price stability. The monthly inflation numbers did come in lower toward the end of the year, and I was pleased to see the improvement. But the most recent couple of readings on inflation have been higher. So clearly, it is much too early to say that inflation is no longer a concern.

Also, not through any specific policy or initiative, but perhaps just by its culture, the Fed has always placed a premium on uniting around the consensus policy action. While some in the FOMC might have expressed a different opinion from the consensus during the policy discussion, most of our votes are unanimous. At other central banks, such as the Bank of England, dissent is much more common, and 5 to 4 votes are not out of the ordinary.

In addition to monetary policy, the Federal Reserve performs other duties to help achieve our broad mandate of supporting a safe and efficient monetary and financial system. In our market economy, we rely on private banking and financial markets to mobilize and channel savings to productive investments. So we promote public confidence in this system and improve its efficiency through bank supervision and by our active involvement in the operation of our nation's payments system.

A key question for the outlook is: What will be the full extent of the housing slowdown?

The most recent data on housing have been mixed and downside risks remain...

That said, the longer-term fundamentals for housing in the U.S. remain positive. The same factors that supported the housing boom—strong productivity trends and low borrowing rates relative to historical norms—are still in place. These factors likely put a floor under how far housing will decline. So I think home building will stabilize as we move through the year, but I don't expect to see any noticeable increases, either.

We expect to end 2008 with an unemployment rate only somewhat higher than it is now.  Core inflation should gradually come down, moving closer to the levels I view as being consistent with price stability.  

Nonetheless, during my tenure at the Fed, the FOMC has had to react to a number of important and difficult challenges: the Asian financial crisis, the Russian debt default, major movements in asset prices, the acceleration in productivity, Y2K, 9/11, and the risk of deflation. All of these issues generated policy questions that did not fit neatly into any familiar textbook framework. They exemplify how, when making tough decisions in unusual circumstances, it's important to follow sound policy-making principles:

• Look at a wide range of data and information, instead of one or two summary indicators;
• Use cogent economic theory to shape analysis;
• And respect the risks of undesirable outcomes for growth or inflation, even in environments that appear benign.

Over the last 12 months, the core PCE price index, the Fed's preferred measure of inflation, rose 2.4 percent, up from the 2.0 percent rate of the prior 12-month period. By contrast, I prefer inflation to be between 1 and 2 percent—that's the range that I consider to be most compatible with the Fed's goal of price stability.

More recently, some home builders have reported tentative signs of stabilization in demand, and some data—for example, applications for mortgages and sales of existing homes—are consistent with this assessment. Furthermore, conventional mortgage rates remain low by historical standards, lending support to housing demand. However, other data are weaker, such as the inventory of unsold new homes, which has increased further this year. Unless sales rebound dramatically (and unexpectedly), construction will be depressed for some time in order to reduce inventories to more desirable levels.

...After considering the various developments, including the problems in the subprime mortgage market, I expect that residential construction will stabilize as we move through 2007. However, it could be next year before we see any noticeable increases in home building.

Over the last year, however, productivity growth has slowed. If this were the start of a longer-term trend, it would have important implications for the outlook for both growth and inflation. So this development deserves careful monitoring. But our take is that most of the recent slowing is likely a relatively transitory cyclical development. Firms may be finding that some of the very rapid productivity increases they experienced in the earlier years of this decade were simply unsustainable. Output may have been increased at the expense of activities such as maintenance that can be put off for only so long. In addition, given the current difficulty in recruiting qualified workers, firms may be reluctant to significantly slow their pace of hiring, even in the face of somewhat softer demand. Such "labor hoarding" is often a feature of mature expansions. We expect these developments to run their course over the next few quarters.

Taking all of these factors into account, my assessment is that the risk of inflation remaining too high is greater than the risk of growth falling too low. Of course, whether policy will need to be adjusted and the degree of any adjustment will depend on the data we see in the months to come and how that data influences our forecast of the economy.

I see the economy improving as we move through this year.  Our expectation is that inflation rates will continue to come down as well during this period and I would expect the unemployment rate will not go up a great deal.

As reported by Bloomberg News

I'd like to see [core] inflation rates running lower at this point and more toward the center of that [1 to 2 percent] zone.

As reported by Bloomberg News

Moskow declined to explicitly state what the ideal inflation rate or funds rate would be. "I don't want to try a number -- five and a quarter is the appropriate rate at this particular time," he said. 

From a MarketNews summary of a CNBC interview

``We still have a ways to go before we get to the level of inflation that I'm comfortable with on a longer-term basis,'' Moskow said in an interview today on CNBC television. ``Inflation is the predominant risk that I see in the economy.''

As reported by Bloomberg News

I should say, however, that while 100,000 [net entrants to the labor force] per month appears to be the right benchmark for the next year or two, there is a lot of uncertainty about this benchmark, particularly in the longer run. Some of this uncertainty revolves around the participation of the baby boomers. People are living longer, healthier lives, which may allow baby boomers to work until they are older. Moreover, wages for all workers may change in response to these trends, convincing some to work more, and others to work less, than they would otherwise.

....Putting together our best estimates of the trends of labor force growth and productivity growth, we at the Chicago Fed think potential GDP growth is lower than it was five years ago, and currently is somewhat below 3 percent.

However, it is also possible that the market may be underpricing risk. The long period of financial stability, may be leading investors to expect a similarly benign environment in the future, and therefore to underestimate the probability of the next major disruption. Indeed, conventional applications of risk management tools such as "value-at-risk" typically incorporate only the previous few years of data into their statistical models. A period of sustained stability will cause such models to reduce their estimates of probable losses going forward.

I for one do not think that we have entered a new era of permanent financial moderation. Though our shock absorbers are better, financial volatility has not been abolished. If markets are underpricing risk, then market participants may be too sanguine about their leveraged positions and more vulnerable than they think to the next financial shock. Needless to say, continued vigilance on the part of policymakers and supervisors is needed.

But while core inflation has proven to be a useful tool for gauging underlying inflation trends, it is only a tool. The ultimate responsibility of the Federal Reserve is to achieve low and stable total inflation—not core inflation. Total inflation fully reflects how all price changes erode standards of living. So people's judgment of the Fed's commitment to price stability will be reflected in their long-run expectations of total inflation. In turn, these expectations will be based on the persistent movements in all of the components of consumer prices, including food and energy.