Sandra Pianalto
President and CEO
Federal Reserve Bank of Cleveland
Dayton Business Journal Economic Forum
Sinclair Community College
Dayton, Ohio
January 18, 2007
National and Regional Economic Conditions
Introduction
Even though it is already the third week of January, I still find myself wishing people a Happy New Year. We can define a happy new year in many ways - good health, prosperity, and personal success are a few of the obvious choices. But as a Federal Reserve monetary policymaker, I am also hoping for a happy new year for our nation's economy - that is, an economy that continues to grow without the damaging effects of higher inflation.
This morning, I would like to talk with you about our prospects for a happy economic new year - both nationally and regionally. I will begin by giving you a brief background on the monetary policy process. Then I will discuss how we as a nation are transitioning to a slower, but more sustainable, pace of economic growth, and I will describe a couple of the risks I see to this outlook. Finally, I will talk about some of the challenges that we are facing as a region.
Please note that the opinions I express here today are mine alone. I do not presume to speak for any of my colleagues in the Federal Reserve System.
The Monetary Policy Process
Let me begin by sharing a bit about the monetary policy process with you. Most of the time, when you read a news story about the Federal Reserve, it is generally focused on whether the Fed is going to raise interest rates, lower them, or keep them steady.
Actually, the Federal Reserve does not directly raise or lower market interest rates at all. The interest rate we target is the federal funds rate. The Federal Reserve manages monetary policy for the country by adjusting the target for the federal funds rate - which is the interest rate that banks charge each other for overnight loans. Changes in this rate, in turn, affect a host of other short-term interest rates and economic variables. So the federal funds rate is critical to the Federal Reserve's ability to influence market interest rates and the money supply.
The responsibility for deciding whether to change the federal funds rate rests with the Federal Open Market Committee, or FOMC. The FOMC consists of the seven members of the Federal Reserve Board of Governors, headed by Chairman Ben Bernanke, and the 12 Reserve Bank presidents. The Committee meets in Washington eight times a year.
In deciding whether to change the federal funds rate target, the Committee always keeps in mind its two main objectives: to maintain price stability over the long term - that is, to keep inflation under control-and to promote maximum sustainable economic growth. These two objectives are known as the FOMC's "dual mandate."
Transitioning to a Slower Pace of Economic Growth
With these two objectives in mind, I would like to spend a few minutes explaining my view of the national economy - an economy that is transitioning to a somewhat slower pace of growth than we saw from 2003 through the first half of 2006.
When I think about how our economy grows quarter by quarter, year by year, and decade by decade, I find it useful to separate that growth into two components: one that reflects longer-term supply and demand factors, and one that reflects short-term changes in supply or demand. Both of these components affect the economy's performance at any given time.
Identifying the longer-term factors - and assessing how they may be changing - can give us a baseline for estimating longer-term economic growth. Two of the most important forces in our economy that affect longer-term growth are the number of people working and how productive they are. In simple terms, these two factors alone determine how much an economy can produce. When the workforce grows, so too does our economic output. Likewise, when we are more productive, we can generate more goods and services.
Consider the second half of the 1990s. Innovations in information technology generated productivity gains that were a full percentage point greater than they had been over the previous two decades. At the same time, labor force participation - the share of the working-age population who choose to be in the labor force - was at a record high. The result was the "roaring '90s," when the economy grew much faster than its historical average.
Although I expect productivity growth to remain strong, growth in our workforce has started to slow a bit. Our population is aging, the baby boom generation is increasingly heading into retirement, and the youngest adults are waiting longer to join the workforce. So we cannot take the economic boom that we saw at the end of the 1990s as an appropriate guide for what to expect in the years to come. If the labor force grows more slowly and productivity growth remains unchanged, then by definition we can expect to see a somewhat slower baseline rate of economic growth. This would not mean that the economy is performing poorly, but that there are structural limitations to how rapidly it can expand.
So what about the short-term fluctuations in economic activity I mentioned? These are changes in economic activity that temporarily push the economy off its baseline growth path. They can appear in the form of booms or busts.
The housing sector offers a perfect example. The United States enjoyed a housing boom for the past few years. More than 7 million new homes were built since 2000. This resulted in the highest homeownership rates in U.S. history. During the past year, home building has fallen off sharply, with a particularly steep decline in the third quarter of 2006. The supply of unsold homes on the market recently rose to levels we had not seen in more than 10 years.
The latest data show that prices of new and existing homes are no longer falling, and inventories of unsold homes have dropped a bit. However, a sharp decline in building permits still suggests that investment in new housing will remain weak at least through the first half of this year, as the adjustment process continues. This current housing slump is temporarily pushing overall economic growth below its longer-term growth path.
Looking out just a bit further, as a result of the labor force and productivity trends I mentioned earlier, I see the economy growing at a more moderate pace over the next few years than we saw in the past couple of years. But there are risks to this outlook. The first risk is that the weakness in the housing sector spills over to other sectors of the economy, depressing overall growth. The second risk is that inflation remains stubbornly high.
Housing
Let me speak to the housing risk first. If further declines in the housing sector are more extensive, we could see spillover effects in other parts of the economy.
We are already seeing some effects on the manufacturing sectors that are closely tied to home building, such as appliances, furniture, and carpeting. I am more concerned, however, with potential effects on broader consumer spending. During the late 1990s and early 2000s, homeowners often tapped into the appreciating value of their houses by refinancing and taking out home equity lines of credit. Some homeowners also may have felt wealthier, so they saved less and spent more than usual. If home prices fall further, we may see this wealth effect translate into weaker consumer spending. So far, however, I do not see that scenario playing out.
In addition, other areas of the economy appear relatively sound. Businesses have been very profitable overall, and companies are continuing to invest in new plants and office buildings. Foreign economic activity also remains strong, which provides an additional source of demand for our goods and services. Certainly the tone in labor markets has been very positive lately, despite some regional differences. Continued hiring suggests a high level of business confidence about our economic prospects.
One sector that is struggling is the auto industry, as everyone in the Miami Valley knows too well. The automotive sector is continuing to work through difficult issues. Some of these issues are cyclical, and others reflect longer-term adjustments.
Inflation
The second risk to the economic outlook is the increase in inflation we have seen over the past few years. Inflation, as measured by the Consumer Price Index, has risen from about 1½ percent in 2002 to about 2-1/4 percent in 2006. That might not seem like much, but inflation has a corrosive effect on long-term economic growth. Inflation has also been pretty volatile during the past few years. Surging energy prices took the inflation rate over 4 percent during the first half of 2006.
Generally speaking, brief periods of elevated inflation rates do not pose immediate threats to economic growth. However, if inflation rates remain high for a prolonged period of time, people might reasonably believe that inflation has permanently shifted higher, and then adjust their behavior accordingly. If that happens, the whole inflation environment could change for the worse - distorting investment, reducing productivity growth, and affecting economic growth.
The most recent price statistics have been encouraging, but not convincing. The last three reports show core consumer price inflation - which excludes energy and food items-increasing at an annual rate of about 1.5 percent over the past three months. That has been welcome news indeed. However, the price statistics have been unusually difficult to interpret lately. We are seeing a lot of extremes within the Consumer Price Index. Prices of some items in the index are rising at rates of 10 percent or more, while prices of other items are falling by more than 10 percent. Very few prices are increasing at the relatively low rates consistent with price stability. With so much price dispersion, it is difficult to know where the inflation trend will settle out.
Fortunately, consumer and business expectations about inflation have remained fairly stable, despite the run-up in inflation over the past couple of years. We have several measures of inflation expectations to look at, and they all generally suggest that long-term inflation expectations are holding steady. This suggests that financial markets are confident that the Federal Reserve's monetary policy will bring the inflation trend back down.
But there is still a risk that the underlying inflation trend will not continue to improve; in which case, the FOMC will need to respond with the appropriate policy actions.
Transformation in the Regional Economy
Those are my thoughts on our national economy. I will now turn to a topic that I know interests all of us: our regional economy.
Throughout the current economic recovery, job creation in Ohio has been among the worst of the 50 states. And as difficult as Ohio's situation is, Dayton has faced even greater challenges. In fact, both Ohio and the Dayton area have fewer jobs today than they did six years ago, during the last recession. Many people think that manufacturing trends can account for this state of affairs, but that is not the whole story.
Historically, manufacturing has been the engine driving Ohio's economy. Even today, our state is still much more heavily invested in manufacturing than the nation as a whole. Roughly 15 percent of Ohio's employment is in manufacturing versus about 10 percent for the nation. But these proportions are about half of what they were just a few decades ago. While we have watched the manufacturing sector become a smaller share of our employment base for many years, these trends seem to have accelerated noticeably in recent years.
The conventional explanation for these changes is that increased globalization has shifted production outside the United States. But the data tell a different story. Between 1995 and 2002, the United States and every other developed nation saw their manufacturing employment decline.
What could tie these common experiences together? The answer is technological change. Specifically, changes in production technology have made manufacturing dramatically more efficient. As a result, the manufacturers that remain need fewer workers to create the same amount of output. While we as a society benefit from this technological transformation, the costs are not borne equally across the nation. The consequences for us as a region are easy to see.
But, as I mentioned, the manufacturing explanation only goes so far. The fact is, both service-sector employment and manufacturing employment in Ohio have been growing more slowly than the nation. Clearly, our region faces some challenges that extend beyond industrial transformation.
What can we do? We can't stop the changes that are taking place. What we can do is try to create and cultivate new sources of comparative advantage. Our economy increasingly runs on ideas and information. The obvious investment to make - as we attempt to restore our region's economic vigor - is in our human capital.
More and more research supports this view. Ed Glaeser from Harvard University has pointed out that in 1980, Boston and Detroit looked an awful lot alike in terms of economic well-being. Since then, those cities have followed very different economic paths. Glaeser attributes Boston's success to stronger rates of educational attainment, which allowed the area to adjust more easily to the types of changes we are also struggling with. A National Bureau of Economic Research article states that: "Possessing or attracting a large population of skilled, educated workers appears to be the key factor in determining whether declining urban areas . chart a path back to prosperity or remain relatively stagnant."[1]
Economists at the Federal Reserve Bank of Cleveland have come to similar conclusions. In fact, Mark Schweitzer, who will moderate the economic discussion here this morning, co-wrote a study that was featured in our Bank's annual report last year. This study attempted to isolate why some states have performed better than others over the past 75 years. Mark and his co-authors found that "knowledge stock," as measured by levels of educational attainment and patents, has been the best predictor of a state's ranking in terms of per capita income levels since at least the 1940s.
These studies send a clear message confirming what most of us already suspect -- namely, that education and innovation matter. Standing still is not good enough. In a global economy that puts an increasing premium on highly skilled workers, the most successful regions will be those that improve their knowledge stocks. Our region can have an economic future that is as enriching as our past, but only if we increase our investment in innovation and education - the two key factors in promoting economic success.
Conclusion
I hope that my remarks this morning have shed some light on monetary policy and economic conditions, both nationally and regionally. Mindful of the risks in the housing sector and inflation that I have identified, I expect that the new year will bring our nation's economy continued growth.
--------------------------------------------------------------------------------
[1] Edward Glaeser and Albert Saiz, "The Rise of the Skilled City," National Bureau of Economic Research, NBER Working Paper No. 10191, December 2003.
President and CEO
Federal Reserve Bank of Cleveland
Dayton Business Journal Economic Forum
Sinclair Community College
Dayton, Ohio
January 18, 2007
National and Regional Economic Conditions
Introduction
Even though it is already the third week of January, I still find myself wishing people a Happy New Year. We can define a happy new year in many ways - good health, prosperity, and personal success are a few of the obvious choices. But as a Federal Reserve monetary policymaker, I am also hoping for a happy new year for our nation's economy - that is, an economy that continues to grow without the damaging effects of higher inflation.
This morning, I would like to talk with you about our prospects for a happy economic new year - both nationally and regionally. I will begin by giving you a brief background on the monetary policy process. Then I will discuss how we as a nation are transitioning to a slower, but more sustainable, pace of economic growth, and I will describe a couple of the risks I see to this outlook. Finally, I will talk about some of the challenges that we are facing as a region.
Please note that the opinions I express here today are mine alone. I do not presume to speak for any of my colleagues in the Federal Reserve System.
The Monetary Policy Process
Let me begin by sharing a bit about the monetary policy process with you. Most of the time, when you read a news story about the Federal Reserve, it is generally focused on whether the Fed is going to raise interest rates, lower them, or keep them steady.
Actually, the Federal Reserve does not directly raise or lower market interest rates at all. The interest rate we target is the federal funds rate. The Federal Reserve manages monetary policy for the country by adjusting the target for the federal funds rate - which is the interest rate that banks charge each other for overnight loans. Changes in this rate, in turn, affect a host of other short-term interest rates and economic variables. So the federal funds rate is critical to the Federal Reserve's ability to influence market interest rates and the money supply.
The responsibility for deciding whether to change the federal funds rate rests with the Federal Open Market Committee, or FOMC. The FOMC consists of the seven members of the Federal Reserve Board of Governors, headed by Chairman Ben Bernanke, and the 12 Reserve Bank presidents. The Committee meets in Washington eight times a year.
In deciding whether to change the federal funds rate target, the Committee always keeps in mind its two main objectives: to maintain price stability over the long term - that is, to keep inflation under control-and to promote maximum sustainable economic growth. These two objectives are known as the FOMC's "dual mandate."
Transitioning to a Slower Pace of Economic Growth
With these two objectives in mind, I would like to spend a few minutes explaining my view of the national economy - an economy that is transitioning to a somewhat slower pace of growth than we saw from 2003 through the first half of 2006.
When I think about how our economy grows quarter by quarter, year by year, and decade by decade, I find it useful to separate that growth into two components: one that reflects longer-term supply and demand factors, and one that reflects short-term changes in supply or demand. Both of these components affect the economy's performance at any given time.
Identifying the longer-term factors - and assessing how they may be changing - can give us a baseline for estimating longer-term economic growth. Two of the most important forces in our economy that affect longer-term growth are the number of people working and how productive they are. In simple terms, these two factors alone determine how much an economy can produce. When the workforce grows, so too does our economic output. Likewise, when we are more productive, we can generate more goods and services.
Consider the second half of the 1990s. Innovations in information technology generated productivity gains that were a full percentage point greater than they had been over the previous two decades. At the same time, labor force participation - the share of the working-age population who choose to be in the labor force - was at a record high. The result was the "roaring '90s," when the economy grew much faster than its historical average.
Although I expect productivity growth to remain strong, growth in our workforce has started to slow a bit. Our population is aging, the baby boom generation is increasingly heading into retirement, and the youngest adults are waiting longer to join the workforce. So we cannot take the economic boom that we saw at the end of the 1990s as an appropriate guide for what to expect in the years to come. If the labor force grows more slowly and productivity growth remains unchanged, then by definition we can expect to see a somewhat slower baseline rate of economic growth. This would not mean that the economy is performing poorly, but that there are structural limitations to how rapidly it can expand.
So what about the short-term fluctuations in economic activity I mentioned? These are changes in economic activity that temporarily push the economy off its baseline growth path. They can appear in the form of booms or busts.
The housing sector offers a perfect example. The United States enjoyed a housing boom for the past few years. More than 7 million new homes were built since 2000. This resulted in the highest homeownership rates in U.S. history. During the past year, home building has fallen off sharply, with a particularly steep decline in the third quarter of 2006. The supply of unsold homes on the market recently rose to levels we had not seen in more than 10 years.
The latest data show that prices of new and existing homes are no longer falling, and inventories of unsold homes have dropped a bit. However, a sharp decline in building permits still suggests that investment in new housing will remain weak at least through the first half of this year, as the adjustment process continues. This current housing slump is temporarily pushing overall economic growth below its longer-term growth path.
Looking out just a bit further, as a result of the labor force and productivity trends I mentioned earlier, I see the economy growing at a more moderate pace over the next few years than we saw in the past couple of years. But there are risks to this outlook. The first risk is that the weakness in the housing sector spills over to other sectors of the economy, depressing overall growth. The second risk is that inflation remains stubbornly high.
Housing
Let me speak to the housing risk first. If further declines in the housing sector are more extensive, we could see spillover effects in other parts of the economy.
We are already seeing some effects on the manufacturing sectors that are closely tied to home building, such as appliances, furniture, and carpeting. I am more concerned, however, with potential effects on broader consumer spending. During the late 1990s and early 2000s, homeowners often tapped into the appreciating value of their houses by refinancing and taking out home equity lines of credit. Some homeowners also may have felt wealthier, so they saved less and spent more than usual. If home prices fall further, we may see this wealth effect translate into weaker consumer spending. So far, however, I do not see that scenario playing out.
In addition, other areas of the economy appear relatively sound. Businesses have been very profitable overall, and companies are continuing to invest in new plants and office buildings. Foreign economic activity also remains strong, which provides an additional source of demand for our goods and services. Certainly the tone in labor markets has been very positive lately, despite some regional differences. Continued hiring suggests a high level of business confidence about our economic prospects.
One sector that is struggling is the auto industry, as everyone in the Miami Valley knows too well. The automotive sector is continuing to work through difficult issues. Some of these issues are cyclical, and others reflect longer-term adjustments.
Inflation
The second risk to the economic outlook is the increase in inflation we have seen over the past few years. Inflation, as measured by the Consumer Price Index, has risen from about 1½ percent in 2002 to about 2-1/4 percent in 2006. That might not seem like much, but inflation has a corrosive effect on long-term economic growth. Inflation has also been pretty volatile during the past few years. Surging energy prices took the inflation rate over 4 percent during the first half of 2006.
Generally speaking, brief periods of elevated inflation rates do not pose immediate threats to economic growth. However, if inflation rates remain high for a prolonged period of time, people might reasonably believe that inflation has permanently shifted higher, and then adjust their behavior accordingly. If that happens, the whole inflation environment could change for the worse - distorting investment, reducing productivity growth, and affecting economic growth.
The most recent price statistics have been encouraging, but not convincing. The last three reports show core consumer price inflation - which excludes energy and food items-increasing at an annual rate of about 1.5 percent over the past three months. That has been welcome news indeed. However, the price statistics have been unusually difficult to interpret lately. We are seeing a lot of extremes within the Consumer Price Index. Prices of some items in the index are rising at rates of 10 percent or more, while prices of other items are falling by more than 10 percent. Very few prices are increasing at the relatively low rates consistent with price stability. With so much price dispersion, it is difficult to know where the inflation trend will settle out.
Fortunately, consumer and business expectations about inflation have remained fairly stable, despite the run-up in inflation over the past couple of years. We have several measures of inflation expectations to look at, and they all generally suggest that long-term inflation expectations are holding steady. This suggests that financial markets are confident that the Federal Reserve's monetary policy will bring the inflation trend back down.
But there is still a risk that the underlying inflation trend will not continue to improve; in which case, the FOMC will need to respond with the appropriate policy actions.
Transformation in the Regional Economy
Those are my thoughts on our national economy. I will now turn to a topic that I know interests all of us: our regional economy.
Throughout the current economic recovery, job creation in Ohio has been among the worst of the 50 states. And as difficult as Ohio's situation is, Dayton has faced even greater challenges. In fact, both Ohio and the Dayton area have fewer jobs today than they did six years ago, during the last recession. Many people think that manufacturing trends can account for this state of affairs, but that is not the whole story.
Historically, manufacturing has been the engine driving Ohio's economy. Even today, our state is still much more heavily invested in manufacturing than the nation as a whole. Roughly 15 percent of Ohio's employment is in manufacturing versus about 10 percent for the nation. But these proportions are about half of what they were just a few decades ago. While we have watched the manufacturing sector become a smaller share of our employment base for many years, these trends seem to have accelerated noticeably in recent years.
The conventional explanation for these changes is that increased globalization has shifted production outside the United States. But the data tell a different story. Between 1995 and 2002, the United States and every other developed nation saw their manufacturing employment decline.
What could tie these common experiences together? The answer is technological change. Specifically, changes in production technology have made manufacturing dramatically more efficient. As a result, the manufacturers that remain need fewer workers to create the same amount of output. While we as a society benefit from this technological transformation, the costs are not borne equally across the nation. The consequences for us as a region are easy to see.
But, as I mentioned, the manufacturing explanation only goes so far. The fact is, both service-sector employment and manufacturing employment in Ohio have been growing more slowly than the nation. Clearly, our region faces some challenges that extend beyond industrial transformation.
What can we do? We can't stop the changes that are taking place. What we can do is try to create and cultivate new sources of comparative advantage. Our economy increasingly runs on ideas and information. The obvious investment to make - as we attempt to restore our region's economic vigor - is in our human capital.
More and more research supports this view. Ed Glaeser from Harvard University has pointed out that in 1980, Boston and Detroit looked an awful lot alike in terms of economic well-being. Since then, those cities have followed very different economic paths. Glaeser attributes Boston's success to stronger rates of educational attainment, which allowed the area to adjust more easily to the types of changes we are also struggling with. A National Bureau of Economic Research article states that: "Possessing or attracting a large population of skilled, educated workers appears to be the key factor in determining whether declining urban areas . chart a path back to prosperity or remain relatively stagnant."[1]
Economists at the Federal Reserve Bank of Cleveland have come to similar conclusions. In fact, Mark Schweitzer, who will moderate the economic discussion here this morning, co-wrote a study that was featured in our Bank's annual report last year. This study attempted to isolate why some states have performed better than others over the past 75 years. Mark and his co-authors found that "knowledge stock," as measured by levels of educational attainment and patents, has been the best predictor of a state's ranking in terms of per capita income levels since at least the 1940s.
These studies send a clear message confirming what most of us already suspect -- namely, that education and innovation matter. Standing still is not good enough. In a global economy that puts an increasing premium on highly skilled workers, the most successful regions will be those that improve their knowledge stocks. Our region can have an economic future that is as enriching as our past, but only if we increase our investment in innovation and education - the two key factors in promoting economic success.
Conclusion
I hope that my remarks this morning have shed some light on monetary policy and economic conditions, both nationally and regionally. Mindful of the risks in the housing sector and inflation that I have identified, I expect that the new year will bring our nation's economy continued growth.
--------------------------------------------------------------------------------
[1] Edward Glaeser and Albert Saiz, "The Rise of the Skilled City," National Bureau of Economic Research, NBER Working Paper No. 10191, December 2003.
