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Friday, October 05, 2007

Fed's Kohn: Economic Outlook

by Calculated Risk on 10/05/2007 01:29:00 PM

From Fed Vice Chairman Donald L. Kohn: Economic Outlook. A few excerpts (video of speech at bottom of post).

... Our policy action will not be able to avert all of the weakness in the economy that may be in train for the next several months. Monetary policy works with a lag, and the effects of our easing action will have their maximum effect only after several quarters. In particular, housing markets are likely to remain depressed in coming months as housing demand is restrained by the difficulty in obtaining mortgages and perhaps also by spreading expectations on the part of buyers that house prices will fall, as they already have in a number of markets. And, although builders have reduced housing starts sharply, they have made very little progress in reducing the number of unsold new homes on the market. As a result, even absent a further deterioration in sales, residential construction would probably decline further in the months ahead, imparting a significant drag on overall growth in real gross domestic product.

Beyond housing, it is too early to tell what effect financial market turmoil is having on household and business spending, though very preliminary and partial information suggest that thus far the effects seem to be limited. Moreover, the available data indicate that the economy entered this period still expanding at a moderate pace. For example, consumption held up well this summer supported by solid growth in real incomes. And, the recent data on orders and shipments of capital goods and on nonresidential construction indicated further growth in capital outlays in August. That said, credit availability is likely to be tighter than before, consumer confidence is down, and businesses will probably be a little more cautious for a while, suggesting that these components of aggregate demand could become more subdued in coming months.

... To be sure, households are likely to start to save more out of their current incomes as they come to realize that they cannot count on a rise in the value of their real estate to build their retirement nest eggs. However, households have been surprisingly resilient to recent economic shocks, and any rise in the saving rate probably would be gradual. More generally, consumer spending should continue to be supported by ongoing growth in employment and income. In the business sector, balance sheets are in good shape, and most firms are not likely to face an appreciable tightening of credit availability. As a result, I anticipate that they will expand their investment spending to keep pace with rising household demands and with strength in export markets. In sum, once we get through the near-term weakness caused by the extra downleg from the housing contraction and any spillover from tighter credit conditions, I am looking for moderate growth with high levels of employment.

But you should view these forecasts even more skeptically than usual. The FOMC emphasized the considerable uncertainty in the outlook.

... Of course, we would not have eased policy if the outlook for inflation had not been favorable. The recent data on consumer price inflation have been encouraging. ... And, it will be critical for inflation expectations to remain well contained.

That said, I do not want to minimize the upside risks to inflation either. Rates of resource utilization are still relatively high, and the slower rates of productivity growth over the past two years, coupled with a pickup in compensation growth, have led to a noticeable acceleration in unit labor costs. Moreover, the decline in the exchange value of the dollar has put upward pressure on prices of imported goods, which have both direct and indirect effects on overall consumer prices.
Bloomberg

Click image for video.

Kohn Says Fed Must Be `Nimble' in Setting Interest Rates: Video October 5 (Bloomberg) -- Federal Reserve Board Vice Chairman Donald Kohn speaks at the Greater Philadelphia Chamber of Commerce Annual Meeting in Philadelphia about the Fed's half-point reduction in the benchmark lending rate to 4.75 percent last month, the outlook for the U.S. economy and the need for policy makers to be "nimble" in setting interest rates. (Source: Bloomberg)