Roger Ferguson

The consensus is that this year's real growth will abate further, perhaps to about 2 percent, which would eventually produce a "soft landing" of sustained growth near the economy's potential and low inflation. It's not hard to imagine risks to both sides of this scenario, especially with financial markets still not having fully settled down, and I can see that 1999 will require a continued high level of vigilance for policy makers.

Although much work has been done within the United States and around the globe in anticipation of the century date change, we should not be complacent. There is still work to be done in terms of contingency planning and public communication. The Federal Reserve will continue its ongoing monitoring of progress. We also intend to have close contact with the markets and financial institutions through the date change. While we cannot know with certainty what the century rollover will bring, we should, based on what we know today, experience a smooth transition, perhaps even business as usual.

I don't believe that our meeting schedule was set with any sort of divine intervention.  It's not as though we knew that the dates we chose last year would be ideal for making decisions about macroeconomic conditions of this year.  Therefore, while I would prefer not to move between meetings, I frankly don['t believe that we necessarily have to wait for a crisis either.  I think we should be willing to move, particularly if the period between meetings is uncomfortably long, as the data start to mount and as a consensus on the outlook starts to emerge.

If the monetary authority can be clearer about what it is doing now and what it plans to do--not in the sense of setting future moves in stone, but rather in terms of explaining risks that might influence future policy--then market participants can improve their expectations of future short rates. Also, less uncertainty about monetary policy might reduce the premium for uncertainty. Thus, transparency ought to bring the rates that matter most for the macroeconomy into closer alignment with the intentions of monetary policymakers. In effect, greater transparency allows policymakers to work with the market, not against it.

If the public is unclear about the strategy and objectives of the central bank, the credibility of monetary policy may suffer. Current economic developments or policy actions directed toward short-run concerns could have an outsized influence on perceptions regarding the more distant future--especially long-run inflation expectations and, therefore, long-term interest rates. Because such changes in perceptions could be counterproductive, concern about triggering them might discourage a central bank from taking action that otherwise could have been appropriate and beneficial for the economy in the near term. Lack of transparency and lack of credibility, in this sense, could reduce the effectiveness of monetary policy in stabilizing the economy against transitory shocks.

In our case, stating a numerical target for the inflation rate of some specific price index, for instance, might not enhance transparency but instead diminish it. One could argue that, despite the best efforts of government economists and statisticians, inflation measures based on our various price indexes are not sufficiently refined to offer an accurate basis for defining price stability.

In evaluating risks with respect to our price stability objective, I believe that it is preferable to consider all the various measures and not be unduly influenced by a numerical target for any specific index. Obviously, under these circumstances, changing policy just because a single, specific price index is out of line might not always be sensible, especially if doing so might have detrimental consequences for our other objectives. For this reason, it seems to me that defining our price stability objective in terms of a numerical target for the rate of inflation of some specific price index could well be problematic.

But what interest rates will be associated with a return to healthy growth in spending remains an open question. Incoming data have remained mixed, but on balance suggest that the economy has been expanding very slowly...All in all, I think it is too early to have a strong conviction that the economy is reaching the end of this period of quite slow growth. As the FOMC noted yesterday, the risks remain toward economic weakness.

The public has a right to know what its unelected, as well as elected, officials are doing, and why. And this is the reason that transparency is so important for supporting the independence of the central bank. Transparency facilitates a broad understanding of what the central bank is doing and thereby gives the public the tools to hold the independent central bank accountable. Transparency, in fact, can play a valuable role in reinforcing the institutional independence of a central bank

In fact, central banks have a number of other means at their disposal to stimulate spending should nominal interest rates hit the zero bound. A central bank can increase the supply of reserves to the financial system through regular open-market operations even after short-term nominal interest rates have hit zero. Such actions may demonstrate a resolve by the central bank to keep short-term interest rates at zero for a prolonged period of time, with the intention of raising inflation expectations and lowering real interest rates.

Arguably, a more effective approach to combating deflation--and a relatively straightforward extension of current operating procedures--would be for a central bank to stimulate aggregate demand by lowering interest rates further out along the maturity spectrum. A central bank could expand its open market purchases of longer-term government securities, in sizable quantities if necessary, to drive term premiums lower. Of course, because long-term interest rates incorporate term premiums as well as discounted expectations of future short-term interest rates, the success of operations focused on influencing parts of the yield curve would be bolstered by a credible promise to move the short-term policy rate along a trajectory consistent with the targeted longer-term yields.

Alternatively, as economists have long recognized, a central bank could influence expectations of future short-term interest rates directly by committing to keeping the policy interest rate at zero for a specified and relatively long period of time or until some intermediate macroeconomic target--such as the termination of declining prices--was achieved. As a practical matter and to underscore its commitment to boosting aggregate demand, a central bank could write options that would, for a pre-specified time, make its raising interest rates costly, or it could operate in the forward interest rate market.

By heightening competitive forces and thus incentives for productivity and innovation, international trade has likely accelerated the process of "creative destruction" by which outdated and less productive activities are replaced by new technologies and more dynamic enterprises.

Measures of inflation expectations obtained from financial asset prices clearly indicate that market participants expect that the Federal Reserve will maintain low and stable inflation. For example, although the difference between the yields on nominal inflation-indexed and Treasury securities is an imperfect measure that includes complicating factors such as inflation risk and liquidity premiums, the five-year break-even inflation rate five years ahead has averaged about 2-1/2 percent over the past five years and has fluctuated in a narrow range of about 1-1/2 to 3-1/2 percent. Survey measures confirm that inflation expectations over this period have been subdued and well anchored.

Detecting asset-price overvaluations and undervaluations is controversial in hindsight and arguably impossible in real time. As a result, although asset-price booms and busts are often linked to recessions, a clear-cut policy response to suspected waves of exuberance cannot be suggested.

Prudential regulation coupled with good risk management meant that financial firms limited their exposure to risk during the boom years of the late 1990s. This approach paid off handsomely when the asset-price break occurred. Despite the recession, banks remained well capitalized, and their strength eliminated the threat of a vicious credit crunch or the risk of fragility in the system.

Preparation for a potential problem seems to be the best course of action. Prudential supervision and good risk management in banking, and the pursuit of fiscal prudence and price stability during booms, may ultimately serve as the best insurance for dealing with the inevitable occasional asset-price breaks observed in our modern economy.

Asset-price-bust recessions do not appear to be necessarily more costly than other recession episodes...Recessions that follow swings in asset prices are not necessarily longer, deeper, and associated with a greater fall in output and investment than other recessions. That said, particular industrial segments and classes of investment...may suffer disproportionately during such recessions.

By pursuing fiscal prudence and price stability during booms, policymakers greatly enhance their ability to take swift, effective countercyclical action when it is needed most.

Relative to other recessions, this recession was shallow and did not appear to impart an unusual drag on investment, despite the sharp asset-price correction.

So, how much of the enlargement of the U.S. current account deficit can we attribute to improved international intermediation? This is difficult to answer because it is hard enough to measure a concept as amorphous as international financial intermediation, let alone to gauge its effect on the current account. As a step in this direction, however, we reasoned that any reduction in home bias by foreign investors toward the United States would show up as a decline in the risk premium these investors demand for holding U.S. assets. This decline in the risk premium, in turn, would lead to a greater demand for U.S. assets and a rise in the dollar.

Based on an estimate of the decline in the risk premium that occurred since the mid-1990s, our macroeconomic model suggests that the decline contributed importantly to the rise in the dollar, and, therefore, to the widening of the trade deficit. Assuming that the lower risk premium can be attributed to growing international intermediation, this latter development apparently exerted an important influence on the U.S. current account.

Government policies such as budget-cutting or encouragement of private saving are unlikely, by themselves, to correct the current account deficit, much as they might be desirable for other reasons. Such policies probably do not address all or even most of the root causes of the current account deficit...[but] reducing our budget deficit can ease the adjustment process by releasing resources that can be channeled into higher net exports, so that a reduced trade deficit does not require a curtailment of investment.

The budget deficit has probably been only a small factor in the emergence of the large U.S. external imbalance. Of course, even if it does not narrow the current account deficit by much, reducing the budget deficit would be highly desirable for other reasons: It would free up resources for private investment, and it would reduce the burden on future taxpayers of repaying the federal debt.

Some of the largest industrial economies in the world--Japan and the euro area--have been running current account surpluses while experiencing very subdued growth...By depressing perceived rates of return abroad, the weakness in foreign demand explains a considerable portion of the run-up in the dollar

The larger the current account deficit becomes, the greater the number of observers who believe that a correction, and one with significant implications for the U.S. economy, is imminent. Such expectations have contributed to, and in turn have been reinforced by, the slide in the dollar over the past few years.

Because the current account deficit reflects the excess of our country's imports over our exports, the deficit's descent into record territory has helped crystalize fears that the economy is losing competitiveness and that U.S. jobs and incomes are suffering as a result.

Should adjustment prove disruptive to sustainable growth and stable prices, the Federal Reserve will certainly be prepared to act. However, my sense is that the implications of current account adjustment for U.S. economic growth and inflation will most likely be benign.

I would argue that the Federal Reserve's ongoing process of transparency may also reflect the highly developed state of our financial markets and a growing recognition that, against that financial backdrop, shaping the expectations of market participants can on occasion be an important adjunct to monetary policy.

Monetary policy arrangements do, and should, adjust over time to changes in the economic and financial environment.

As the conduct of monetary policy has changed over time, it has become increasingly important that the central bank communicate in an effective and transparent manner. The Federal Reserve's communications efforts are a work in progress, with several significant advances being implemented over the past few years.

Explicit coordination of policy setting across countries is not likely to happen in the foreseeable future, and I would argue that such explicit policy coordination would not be desirable. Policymakers have to be able to react quickly in many circumstances... Experience has shown that the best outcomes are achieved when each country's policy focuses on domestic stabilization.

Currently, bond yields in Europe, the United States, and Canada are quite similar and are at low levels not seen in decades. Globalization may have played a role in this convergence, though the channel is not clear. I suspect that the convergence of inflation rates and inflation expectations to common low levels is an important factor.

Globalization has progressed in conjunction with a substantial narrowing of inflation differentials across countries over the past twenty years, as the number of countries with high inflation has declined. It may be that globalized financial markets are more effective at punishing inflationary policies and that increased competition in goods markets helps to tame inflationary pressure.

Just as our economy would be a lot poorer if we had protected horses and buggies by outlawing automobiles, so it will be poorer if we protect specific industries that cannot compete with cheaper foreign products.

Rising asset prices support household consumption, whereas falling asset prices damp consumption. In a scenario of collapse, the damage to balance sheets and private wealth could go as far as undermining the soundness of the financial system and threatening stability of the real economy.

Right now, housing prices in many markets in the United States are relatively high when judged by conventional valuation measures. To know if housing is fairly valued requires assessing whether today's valuations are consistent with unobservable future rents, interest rates, and returns--concepts for which we have only rough proxies. However, in some markets the most prudent judgment is that the growth of house prices will slow from the rapid pace experienced most recently.

Not all situations in which asset prices are rising rapidly under seemingly easy monetary conditions are worrisome. Some are quite benign and even signal a healthy economy.

Asset price movements that are discontinuous or extreme can affect the policy process...Because they are interest-sensitive, asset prices are primary components of the channels by which monetary policy is transmitted to the real economy. If these transmission channels are disrupted, the reliability and the effectiveness of policy are degraded. In the worst case, policy's room for maneuver may be narrowed or even severely compromised, and risks of a policy blunder are heightened.

Central bankers would benefit from a better understanding of asset price movements--particularly more extreme movements--so that we do not mistakenly facilitate in some way potentially harmful outcomes.

In contrast, the link between monetary growth, as measured by M3, and changes in real house prices appears to be more definite. The bottom panel of figure 1 shows a similar scatter plot for the same group of countries and periods as in the upper panel, but for changes in real house prices. The two series exhibit a small positive correlation that is statistically significant. Moreover, various tests have shown that the correlation is not just a recent phenomenon or confined to a few countries; it is evident in varying degrees both over time and across our sample of sixteen countries. Again, this finding is consistent with findings from a number of other academic researchers.

Many markets may perhaps be underpricing risks going forward.  Events of policy mistakes that heighten perception of risks could significantly alter current conditions.  In this regard, a resurgence in inflation could alter expectations about the path of short-term interest rates.  Signs that higher oil prices are weakening growth, along with the maturing of the credit cycle, could alter perceptions about credit quality and widen credit spreads.

In this environment of somewhat faster growth in aggregate spending and greater upward pressure on prices, the Federal Open Market Committee (FOMC) raised its target for the federal funds rate to 3-1/2 percent in early August. At the same time, the Committee reiterated its belief that, with the appropriate monetary policy actions, the upside and downside risks to the outlook for sustainable economic growth and price stability were roughly equal and that the removal of monetary accommodation could proceed at a "measured pace." Thus, before the hurricanes, the outlook was relatively benign: continued moderate economic growth accompanied by little change in the underlying pace of core inflation.

House prices have risen to levels that, in some areas of the country, seem high relative to the economic fundamentals. The market for second homes seems especially strong, raising the fear that some homeowners are speculating on further increases in home prices. The greater use of innovative forms of mortgage finance adds to the concern that the residential real estate market may well be vulnerable to a flattening of home prices, and in certain markets, perhaps a decline. I do not think that a significant and widespread drop in home prices is the most likely outcome, but the situation will require careful monitoring in the months ahead.

At this point, it seems likely that the hurricanes had, at most, a small effect on the supply side of the economy. The losses of productive capital, while devastating in the regions directly affected, appear to be small relative to the overall size of the national capital stock.

The hurricanes have...adversely affected the outlook for inflation. The damage to production and refining facilities has significantly boosted the prices of natural gas and gasoline. Consumer energy prices are projected to rise substantially in the second half of this year, and some spillover into the prices of non-energy goods and services looks likely as well.

A large, long-lasting increase in the relative price of energy will affect inflation for a time. Although short-run swings in firms' energy costs might be absorbed in their profit margins, a persistent increase is likely to be fully passed on to the consumer...However, if households and businesses believe that the central bank is committed to preserving price stability, the likelihood that inflation expectations will become unanchored decreases. Thus, the preservation of the credibility of the central bank's resolve to contain inflation is one of the key elements in the adjustment to a higher relative price of energy.

Studies have shown that adjustments by households and businesses in response to higher energy prices reduce the long-run level of potential output in the economy. This reduction mainly reflects the tendency of production to become more labor intensive in response to the increase in the relative price of energy. In essence, labor productivity grows more slowly after an energy price shock and that effect lowers the trajectory for potential output. If higher energy prices induce scrappage of parts of the business capital stock, this would lower the growth of capital services and further lower the path for potential output.

We simulated FRB/US using the path for crude oil prices that futures market participants in December 2003 expected to prevail over the following three years. We also simulated the model with the revisions to futures prices that occurred subsequently over 2004 and through mid-September of this year. Based on a comparison of these simulations, we estimate that real GDP growth was held down 1/2 percentage point in 2004 and 1 percentage point this year relative to what it otherwise would have been. The drag on real GDP growth next year would be comparable to that in 2004. As higher energy prices are passed through to the prices of other goods and services, prices for core personal consumption expenditures (core PCE) are estimated by the model to have been boosted 1/4 percentage point last year and more than 1/2 percentage point in 2005. Given the lags in the inflation process, core PCE inflation rises a bit further relative to baseline next year.

Since it began withdrawing monetary accommodation in June 2004, the FOMC has repeatedly stated that its future policy actions will be governed by the expected performance of the economy. Monetary accommodation can be withdrawn at a faster pace if inflation pressures seem to be building to a greater extent than expected. Likewise, if economic weakness emerges, the trajectory of policy could be appropriately adjusted for these circumstances. For now, I believe that our policy of removing monetary accommodation at a "measured" pace is most likely to promote our broader objectives of price stability and maximum sustainable economic growth.

As a central banker, it makes sense to me that lower and more-stable inflation, by making the returns to saving and investment more predictable and by diminishing the likelihood of shocks to the financial system, should encourage economic growth.

Given the persistence of high energy prices that the global economy has confronted of late, policymakers cannot be complacent. Central bankers must reinforce their credibility and validate the confidence of market participants by actively leaning against inflationary pressures long before inflation itself builds. Again, the FOMC has done just that through its commitment to adjust policy as required to keep inflation at bay.

Although the data are suggestive, tests based on asset pricing models have not firmly established an empirical link between reduced macroeconomic volatility and higher asset prices. The ability to establish such a link is limited, in part because many of the fundamental concepts underlying asset prices, such as risk aversion and expected volatility of growth, are difficult to measure and the model outcomes depend greatly on assumptions regarding these key variables.

Without targeting asset prices, we need to be more attentive now to financial markets because asset prices affect spending to a greater degree than before and because asset prices provide us with a greater amount of timely information to guide policy. Moreover, we have become an even more receptive audience for research that enables us to better understand the links between the real economy and financial asset prices.

Now, I would like to explore some of the research that might explain whether and, if so, how the Great Moderation affected the level of asset prices. Structural models of asset prices provide a consistent framework for understanding both equity prices and interest rates. In these models, each asset price contains a risk premium that represents the additional return demanded by risk-averse investors for bearing risk. A reduction in macroeconomic volatility that reduces uncertainty about earnings or dividends could reduce the equity risk premium and, as a result, lead to higher equity prices. Less uncertainty about future inflation could lower the risk premiums on nominal Treasury bonds, lowering the risk-free interest rate. There is, however, a potential offset as well. Lower volatility may reduce the motive for precautionary savings and thus put upward pressure on interest rates and, all else equal, downward pressure on equities.

Interest rates also could potentially have been affected by the Great Moderation. Investors in Treasury bonds require a risk (or term) premium to compensate them for the risk of loss on longer-maturity bonds resulting from movements in interest rates. Term premiums could be lower when inflation expectations are well anchored or the macroeconomy is less volatile.

Macroeconomic volatility has declined over the past two decades. Some of this decline appears to have fed through to financial markets in the form of lower risk premiums and higher asset valuations. To some extent, the lack of a clear link between macroeconomic volatility and the level of asset prices in existing research and models should not be a surprise. Explaining asset prices is difficult because they are determined by many complex factors, such as risk aversion, expected future earnings, and expected earnings volatility, which are inherently difficult to measure. A more concrete finding is that the decline in macroeconomic volatility has not led to a decline in asset price volatility. News about corporate earnings appears to have become less volatile, but this factor explains only a small part of the reduction in the volatility of asset prices. Rather, existing research suggests that asset price volatility remains largely a reflection of variation in investors' discount rates rather than of changes in forecasts of fundamentals. On a micro level, financial innovations and new types of market participants appear to have led to greater market efficiency and liquidity.

By my reading, the incoming data suggest that the housing market has begun to cool somewhat, but they do not point to a sharper falloff. Sales of both new and existing homes have declined in recent months, although they remain at a high level; and after cutting though volatility likely related to swings in weather, housing starts appear to have softened recently. Moreover, other indicators of activity, along with anecdotal reports, also seem consistent with an easing, but not with a sharp downward correction.

All told, increases in energy prices over the past couple of years probably added about 1/2 percentage point to core inflation in 2005, and the lagged pass-through of past increases in energy prices appears likely to add roughly the same amount this year, provided that energy prices do not rise significantly further.

Historically, flat or inverted yield curves owing to unusually high short-term rates have tended to be followed by slowdowns, but that has not been the case for those episodes of inverted yield curves owing to relatively low long-term rates. And, in the current situation, the flatness of the term structure results largely from relatively low long-term yields.

All told, increases in energy prices over the past couple of years probably added about 1/2 percentage point to core inflation in 2005, and the lagged pass-through of past increases in energy prices appears likely to add roughly the same amount this year, provided that energy prices do not rise significantly further.

Econometric evidence suggests, however, that the pass-through of energy prices to core inflation has dropped by more than would be implied by the decline in energy intensity...

Although many factors could have led to these results, a likely explanation is that inflation expectations have become better anchored. In the 1970s, monetary policy unfortunately allowed large increases in energy prices to have a persistent effect on inflation, a policy that undercut the Fed's credibility and caused long-run inflation expectations to be more volatile.

All told, the U.S. economic expansion appears to be solidly on track. Nevertheless, the outlook for real activity faces a number of significant risks, including the possibility that house prices and construction could retrench sharply and that energy prices could rise significantly further.

A decline in consumer confidence is another channel through which a correction in house prices could affect the economy. In the current situation, a sizable deceleration in house prices could have an outsized effect on consumer confidence and thereby reduce household spending by more than is implied by conventional estimates of the wealth effect.

The possibility remains that the recent run-up in [housing] prices may be greater than can be justified by the fundamentals and that increases in house prices may moderate or undergo a sharper adjustment. The latest data on house prices--including the figures released this week--provide a hint that a moderation in house prices, and nothing more serious, may now be under way.

Although they are imprecise, simulations from the Federal Reserve Board staff's large-scale econometric model, which account for these effects, suggest that increases in spot and futures prices of energy from late 2003 to the present subtracted a 1/2 percentage point from real GDP growth in 2004 and more than 1 percentage point in 2005. The model suggests the subtraction this year will be about a 1/2 percentage point.

Looking ahead, the path of far-dated futures prices for oil indicates that markets are not expecting prices to rise significantly further. However, given strong global demand for energy resources and the ever-present risk of supply disruptions, additional increases in energy prices cannot be ruled out. Such increases would boost the overall inflation rate and might put additional upward pressure on production costs and inflation expectations, which in turn, could create forces that would tend to push core inflation up. If that were to occur, the Fed would need to be particularly vigilant to ensure that inflation remained under control.

Overall, the fundamentals appear sufficient to support continued economic expansion. Underlying productivity growth remains strong, the financial positions of households and businesses remain conducive to spending, and, if we have no further run-up in oil prices, the drag on activity from higher energy prices should diminish over time.

The occurrence of glitches in new markets and institutions need not reflect policy failures or provide evidence that an innovation is undesirable. Preventing all such occurrences would probably require us to stop all innovation. But neither is it desirable that growing pains in one market or at a few institutions spill over so strongly that the financial system as a whole could be destabilized.

Policymakers should be aware of any emerging stresses in the financial system, including those related to new instruments and institutions. Indeed, some central banks have created "financial stability" staff groups to oversee such monitoring and, in some cases, to publish regular financial stability reports. In the event that such monitoring suggests that the operations of some institutions or markets are under significant strain and, importantly, that the resulting pressures on businesses and households could have a material adverse effect on the real economy, the central bank may want to respond by adjusting the stance of monetary policy.

Financial firms may not consider the effects of their decisions on the stability of other firms or on the broader financial markets, and some may lack the incentives and ability to learn about and manage the risks induced by financial innovations. In such cases, policymakers may need to work with markets and their participants, and on occasion regulate them, to achieve the desired outcomes. However, policymakers should, wherever possible, avoid premature regulation that could stifle innovation.

While the risks to financial stability that arise from the creation of a small number of large and complex firms are obvious, there may be benefits as well. Greater concentration in financial services has the potential to have some positive impact on financial stability because lower costs can allow firms to build the capital reserves that help insulate them from shocks, and greater diversification can reduce firm risk.

The Federal Reserve Board endorsed the creation of a dormant bank, referred to as NewBank, which would be available for activation to clear and settle U.S. government securities. Such activation would occur if a credit or legal problem caused the market to lose confidence in an existing clearing bank and no well-qualified bank stepped forward to purchase that bank's clearing business.