Tuesday, May 13, 2008

San Francisco's Janet Yellen to speak about U.S. economic prospects

Janet L. Yellen speaks at a conference in Vancouver about, "Credit, Housing, Commodities, and the Economy". Her outlook for inflation is too optimistic for my liking but admits there are risks. In case she is wrong, she and her peers at the Fed face a "possible erosion of credibility".

Here is a condensed version:

I believe that the Fed’s liquidity operations, combined with its 325-basis-point cut in the Federal funds rate—a substantial easing of monetary policy—are having a beneficial effect on financial markets. Although overall financial conditions are still far from normal, there are some rays of hope that the strains may be easing a bit.

I’ve already discussed the precipitous fall in house prices nationally, so it’s striking to note that, even with these declines, the ratio of house prices to rents remains quite high by historical standards. That, of course, suggests that further price declines may be needed to bring housing markets into balance. This perspective is reinforced by futures markets for house prices, which expect further declines in a number of metropolitan areas this year. In particular, the Case-Shiller composite index for home prices shows a 15 to 20 percent year-over-year decline in the second half of this year.

The bottom line is that construction spending and house prices seem likely to continue to decline well into 2009.

Commodity Prices
Finally, some commentators have argued that commodity prices have been pushed up by investors shifting demands to commodities in the face of the current financial turmoil as debt and equity investments appear much riskier. However, if this factor were playing a significant role, I would expect to see big increases in inventories of commodities as investors were expecting to make profits on rising prices. So far, I have not seen the evidence that this is occurring.

Outlook for inflation
Under present circumstances, judging future changes in commodity prices is obviously an important part of any inflation forecast. As I noted, future markets generally are expecting these prices to flatten out and remain at around today’s very high levels. If this happens, then the effects of commodity prices on inflation will dissipate. In order to continue to put upward pressure on inflation—which, after all, is the rate of change of prices—commodity prices would have to do more than remain at today’s high levels. They would need to keep on rising.
(I absolutely disagree!!!)

Indeed, futures markets and some forecasts—for example, the IMF World Economic Outlook—expect many commodity prices to remain at around their current high levels rather than reverse course.

I see little reason to believe that we have entered, or are about to enter, such a period of stagflation. For one thing, although current data on growth and inflation have departed from desirable levels, matters looked far worse 30 years ago than they do now.

In addition, the slack in labor and product markets stemming from the weakening in economic activity that seems likely should put somewhat greater downward pressure on inflation going forward. Therefore, my forecast of the most likely outcome over the next couple of years is that total and core inflation will moderate from present levels.

While none of these measures are perfect indicators of inflation expectations, recent movements highlight the risk that our attempts to deal with problems in the real economy could lead to higher inflation expectations and an erosion of our credibility.

With core consumer inflation running at about the same rate, the real funds rate now stands at an accommodative level of around zero. These cuts in the target rate, along with the actions to foster greater liquidity in financial markets, have mitigated the worst effects of the credit crunch. But they have not resolved it. Indeed, my sense is that the process of resolution will unfold only gradually.

Under these circumstances, I consider the current level of monetary accommodation to be appropriate. That, together with the fiscal package, should be sufficient to promote a gradual step up to moderate economic growth later this year.

source: Credit, Housing, Commodities, and the Economy
Speech to the Certified Financial Analysts Institute, Annual Conference Vancouver
By Janet L. Yellen, President and CEO, Federal Reserve Bank of San Francisco
For delivery on May 13, 2008, 10:00 AM Pacific time, 1:00 PM Eastern

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