NEW YORK – The economy is recovering, and it should be sustainable, even with stimulus programs beginning to be wound down Federal Reserve Bank of Philadelphia President and Chief Executive Officer Charles I. Plosser said today, noting that the Federal funds rate should be allowed to rise as real interest rates grow.
But not all is rosy. “Uncertainty still looms large,” Plosser told the 31st Annual Economic Seminar in Rochester, N.Y., according to prepared text released by the Fed “Large fiscal deficits and the prospects for significantly higher taxes to fund new programs have made many businesses reluctant to undertake new investments or to rehire workers. This may not diminish until greater clarity is offered by Congress and the administration about the prospective path of fiscal policy. This policy uncertainty could contribute to a weaker than otherwise recovery and its resolution may affect longer term prospects for the economy.”
Good monetary policymakers, Plosser said, need to anticipate since monetary policy works with a lag. “Setting policy that is appropriate for where the economy is today, or has recently been, is not likely to deliver the kind of economic outcomes we desire,” he said. “Anticipating where the economy is headed is important because monetary policy actions affect the economy with long and variable lags. The major impact of policy often comes only after several quarters, or sometimes several years.”
But, projecting where the economy will go is not an exact science and policymakers need to revise their outlook as the data and the economy evolve, Plosser noted.
While Plosser told the conference last year that the first-half would be weak, with a pick-up in the second half, he said, “the very sharp decline in real GDP in the first quarter of this year was larger than I expected. As a result, growth for the year will be lower than what I projected a year ago. Nevertheless, growth declined only slightly in the second quarter, increased at a 2.8% annual rate in the third quarter, and is continuing to grow at a similar pace in the fourth quarter.”
While pointing to the positives in the economy – housing appears to have bottomed out, manufacturing and industrial activity have become more positive in recent months – Plosser noted that commercial real estate has yet to turn around.
“The strength of consumer spending, however, is harder to judge,” he said. “In part, that is because auto sales were pulled forward into the summer months by the cash-for-clunkers program. Moreover, this rebate program likely diverted some spending toward automobiles and away from other goods and services that households may have been planning to buy. So, it remains unclear exactly how much the cash-for-clunkers program actually stimulated total spending, as some claim, or whether it just redistributed it. Thus, determining the underlying trend in consumer spending is difficult.”
Personal income, which Plosser called “the most important factor for consumer spending,” has been flat since early this year. “I am not expecting very strong growth in consumer spending in the coming quarters, since unemployment will remain high for some time, which will restrain income growth. Even so, recent monthly data have shown some increases in consumer spending outside of autos and gasoline, which is encouraging.”
Forecasting 3% GDP growth from the fourth quarter of 2009 until the fourth quarter of 2010 and similar growth in 2011, Plosser said, “These rates of growth are more modest than what some forecasters anticipate, but they are slightly above what I believe is the underlying trend growth of the economy of about 2 ¾%.”
Additionally, Plosser said he expects the unemployment rate to edge up slightly before declining gradually. “Keep in mind that changes in the unemployment rate and employment growth typically lag output growth, so even with better real GDP growth over the next few quarters, the unemployment rate and payroll employment will take a little more time to show much improvement.”
Financial market recovery contributes to the better outlook, he added, noting, “The recovery of financial markets from this crisis, however, is not complete and more time will have to pass before we can be fully confident in the health of the financial sector. Indeed, we probably will not be able to determine how well the financial system has healed until the Federal Reserve withdraws the extraordinary amount of support it has provided. By design, many of the liquidity facilities were priced so that they would be less attractive as markets improved. So I have been encouraged as banks and other borrowers have relied less on the Fed’s lending facilities and have relied more on financial market funding over the last six months or so.”
Also uncertain is the inflation outlook. “At the beginning of this year there were growing concerns that falling prices, not rising prices, were the more serious risk. Headline CPI, after all, fell at an 8% annual rate in the fourth quarter of 2008 and at about a 2.5% annual rate in the first quarter of 2009,” Plosser said.
“On the surface, these were extraordinary numbers. But in my view, they largely reflected the reversal of the dramatic rise in oil prices from late 2007 and the first half of 2008. Oil prices went from about $70 a barrel in mid-2007 to more than $130 by mid-2008 and then back down to about $40 in January 2009. Since then, oil prices have risen again, but have been fluctuating between $60 and $80 since the spring. The stabilization in oil prices led to the end of the deflation seen in the first quarter,” Plosser added. “For the second and third quarters of this year headline CPI inflation averaged about 2.5% at an annual rate — a vast difference from the over 5% deflation of the previous two quarters. What we call core CPI, or CPI excluding food and energy, exhibited a similar but, as you would expect, a less dramatic pattern. Core CPI inflation averaged just 1% over the last quarter of 2008 and the first quarter of 2009, but in the second and third quarters of this year, core CPI inflation averaged about 2%. On a year-over-year basis, it seems to be settling in at around 1.5%.”
Plosser said deflation fears were “probably exaggerated in early 2009.” “So, we should all be pleased that the near-term prospects for either deflation or inflation seem mostly benign. Unfortunately, the prospects for inflation over the next two to five years are much more uncertain, in my view, and apparently in the view of the market as well.”
Noting that current monetary policy is extraordinarily accommodative, and the federal funds has been near zero for a year, with the Fed more than doubling its balance sheet in that time, Plosser warned, “Without appropriate steps to withdraw or restrict the massive amount of liquidity that we have made available to the economy, the inflation rate is likely to rise to levels that most would consider unacceptable. The great challenge facing the Fed is getting those `appropriate steps’ right.”
But getting it right is difficult because there are many different economic forecasts.
