Below is the full text of a prepared speech by Federal Reserve Vice Chairman Donald L. Kohn on The U.S. Economy and Monetary Policy given on February 26, 2008:
When, at the end of July, I accepted Tom Simpson's invitation to speak to you today on the economy and monetary policy, little did I realize the challenges I would face. For one, the economy and financial markets have taken some unexpected twists and turns over the intervening seven months, and we are still in the midst of a rapidly evolving and highly uncertain situation. For another, when we set the date, I had expected that Chairman Bernanke would have already given our Monetary Policy Report to the Congress, and I could simply develop some of the themes he had laid out. However, that testimony will be tomorrow, and I must emphasize that the views you are about to hear are my own and not necessarily shared by any of my colleagues on the Board or the Federal Open Market Committee (FOMC).1
Several major developments are shaping current economic performance, the outlook, and the conduct of monetary policy. The most prominent of these developments is the contraction in the housing market that began in early 2006. Both the prices and pace of construction of new homes rose to unsustainable levels in the preceding few years. For a time, the resulting correction was largely confined to the housing market, but the consequences of that correction have spread to other sectors of the economy.
The financial markets are playing a key role in the transmission of the housing downturn to the rest of the economy. In the first half of 2007, investors became concerned about the likely performance of many subprime adjustable-rate mortgages made from late 2005 through early 2007. Lenders turned away from subprime mortgages and some other investments as the magnitude of the losses on those mortgages began to emerge, as uncertainty about the ultimate size of the losses and who would bear them mounted, and as these experiences undermined confidence in a variety of other credit instruments, especially those with complex structures. Those tendencies have intensified as risks of a spillover to the broader economy have risen. The increase in expected losses along with the unwillingness of investors to fund some types of credits has led to pressures on banks and other financial intermediaries as well as on prices and liquidity in securities markets. The result has been a substantial tightening in credit availability for many firms and households.
At the same time, continued sizable increases in the prices of food, energy, and other commodities have raised inflation. To some extent, those increases have resulted from strong demand in rapidly growing emerging-market economies, like China and India. But the increases likely also reflect conditions such as adverse weather in some parts of the world, the use of agricultural commodities to produce energy, and geopolitical developments that threaten supplies in some petroleum-producing centers. The higher prices have eroded the purchasing power of household income, adding to restraint on spending.
In my remarks today I will trace the effects of these developments in more detail, discuss the response of monetary policy, and talk about the implications for the future path of the economy.
Recent Economic and Financial Developments
The pace of real economic activity stepped down sharply toward the end of last year and has remained sluggish in recent months. Real gross domestic product (GDP) is estimated to have risen only slightly in the fourth quarter. The contraction in the housing market continues to drag down economic growth. Declines in real residential investment subtracted nearly 1 percentage point from the overall increase in real GDP in 2007. Even so, the inventory of unsold new homes remains unusually high, because the demand for housing has fallen about as rapidly as the supply. Problems in the subprime market have virtually cut off financing in this sector. Prime jumbo mortgages are being made, but the lack of a secondary market has caused the spread between rates on these mortgages and on those that have been eligible for purchase by Fannie Mae and Freddie Mac to widen substantially. Even the standards for conforming mortgages have been tightened of late. Weak demand, in turn, is leading to widespread declines in the actual and expected prices of houses, further discouraging buyers. Starts of new single-family homes continued to fall in January, dropping to fewer than 750,000 units--a level of activity more than 1 million units below the peak in early 2006. Judging from the further decline in permits last month, additional cutbacks in construction are likely. It appears that the correction in the housing market has further to go.
For the better part of the past two years, the trouble in the housing market was contained; however, over the past several months, the weakness appears to have spread to other sectors of the economy. Tighter credit, reductions in housing and equity wealth, higher energy prices, and uncertainty about economic prospects seem to be weighing on business and household spending. Labor demand has softened in recent months. Private nonfarm payrolls were little changed in January, and the unemployment rate moved up to 4.9 percent, on average, during December and January, after remaining around 4-1/2 percent from late 2006 through most of 2007. The higher level of weekly claims for unemployment insurance suggests continued softness in employment this month.
Apart from the labor market, the hard data on economic activity in the first quarter are limited, but, on the whole, the data suggest economic activity has remained very sluggish. Retail sales were up moderately in nominal terms in January, but after adjusting for the rise in prices of consumer goods, real spending on non-auto goods appears to have been little changed last month. In addition, unit sales of new motor vehicles weakened. Total industrial production rose just 0.1 percent in January for a second consecutive month, and manufacturing output was unchanged. Much of the other information about the current quarter has come in the form of surveys of business and consumers--and most all of it has been downbeat. That said, I can still see a few bright spots. One is that the level of business inventories does not appear worrisome at present. Another is that international trade continued to be a solid source of support for the economy through the end of last year. The worsening financial conditions and slower growth in the United States have had some effect on the rest of the world, but the prospects for foreign growth remain favorable.
The most recent news on inflation--the January report on the consumer price index (CPI)--was disappointing. Once again, total or headline CPI was boosted by a jump in energy prices and relatively large increases in food prices; last month's rise left the twelve-month change in the overall CPI at 4.3 percent--twice the pace a year ago. In addition, the January increase of 0.3 percent in the CPI excluding food and energy was slightly higher than the average monthly rate in 2007. Nonetheless, the twelve-month change in this measure of core inflation, at 2-1/2 percent, was still slightly below the rate one year earlier. The recent readings on core inflation suggest that the higher costs of energy, a pickup in prices of imported goods, and, perhaps, the persistent upward price pressures in commodity markets may be passing through a bit to core consumer prices.