Presented by William H. Stone, Jr., First Vice President
Federal Reserve Bank of Philadelphia
Wayne Economic Development Corporation (WEDCO)
Annual Dinner Meeting
Bryn Mawr Conference Center
April 6, 2006
Good evening. It is a pleasure to be here with all of you at WEDCO's annual dinner meeting. Tonight, I will share with you my views on the progress and prospects of the U.S. economy. I will also focus a bit on how the economy in the region has been performing. I will close with some implications for monetary policy.
The U.S. economy enjoyed a year of solid gains in 2005. Likewise, economic activity in 2006 is off to a solid start. Our economy's performance has surprised some in light of several negative economic shocks we recently experienced. These shocks, of course, include the major hurricanes that hit the Gulf Coast, inflicting terrible loss of life and destroying infrastructure on a massive scale.
While the hurricanes did contribute to some uneven performance and deceleration of real GDP in the fourth quarter of 2005, recent evidence suggests this slowdown was indeed temporary and the economic expansion we have been experiencing over the past several years remains on course. In fact, the first quarter of 2006 appears to be one of the strongest quarters of growth in the past two years, with estimates from 4.5 to 5 percent.
Of course, another factor of which we have all been acutely aware over the past year or two is the rising price of energy. Heightened demand for oil around the globe and increased uncertainty in the Middle East have led to high and volatile energy prices. Also, disruption in local production in the Gulf Coast, due to the hurricanes, has also contributed to oil prices' rising to over $60 a barrel. We feel the effect of this run-up in oil prices every time we fill up at the pump or pay our home heating bills.
Nonetheless, thus far, the U.S. economy has proven relatively resilient to rising oil prices, surprising some who recall the oil-price shocks of the 1970s and the severe impact they had on our economy. Since that time, however, our economy has become more energy efficient, and as our output shifts from goods to services, it has become less energy intensive. These trends render the economy better equipped to handle rising oil prices.
As I said in my opening, despite these rising energy prices and devastating hurricanes, the U.S. economy has performed quite well. In 2005, real GDP increased over 3 percent; payroll employment rose by 2 million; and the unemployment rate fell below 5 percent. This is a true testament to the resiliency of the U.S. economy. Over the years, we have seen that the flexible and efficient nature of our markets has afforded us the ability not only to adjust to adverse economic conditions but also to continue to grow.
But even though our economy exhibited good performance, rising energy prices presented not only a challenge to our continued economic growth but also a risk to price stability. Sure enough, with rising energy prices, we did see some increased inflationary pressures last year, with headline inflation rising above 3 percent. Still, core inflation remained moderate, and long-term inflation expectations have remained well contained.
The relatively benign performance of core inflation, despite steep energy price increases, can be attributed to several factors.
One of the most important factors is the impact of worldwide competition, which restrains the ability to raise prices.
Over the past few decades, as I mentioned, the U.S. economy has become significantly less energy intensive. Therefore, expenditures on energy and energy-related goods make up a smaller share of the economy, and consequently, they have a smaller effect on the aggregate price level. Also, rapid advances in productivity — or output per hour worked — have allowed wages to increase but with a restrained impact on unit labor costs.
Another key factor in keeping core inflation low has been confidence on the part of the public and investors in the prospects for price stability. The Federal Reserve's aggressive fight against inflationary pressures from all sources appears to have worked. Today, we enjoy not only moderate inflation but also a reduction in the sensitivity of long-run inflation expectations to energy prices.
Now let me turn my attention to how I see the economy evolving over the next year or two. As Chairman Bernanke indicated in his congressional testimony earlier this year, FOMC members anticipate real GDP growth of about 3.5 percent for 2006 and 3 to 3.5 percent next year, with core inflation at or below 2 percent, and unemployment at or below 5 percent. I believe this outlook is both plausible and positive, as it represents a path of sustainable expansion consistent with the economy's long-run growth potential.
Let me now just provide a little more detail about how I think the economy will be able to continue at this pace. In essence, let me describe what the drivers of the economy will be.
As usual, consumers will do the bulk of the new spending that generates this growth. With the expansion well underway, solid job growth and rising household incomes are supporting steady growth in overall consumer spending now and will continue to do so into the future. This ought to be true even as energy prices remain elevated and the accumulation of home equity begins to moderate. These factors will, no doubt, slow growth somewhat, but with solid growth in the job market and wages rising, moderate growth in consumer spending is the most likely outcome.
At the same time, I expect businesses to continue contributing significantly to the overall increase in spending. Business-sector profits continued to rise last year at a solid pace, boosted in part by continuing advances in productivity. Strong corporate balance sheets, expanding sales, and favorable financial markets fostered a solid increase in spending on equipment and software. In this way, firms are positioning themselves for greater efficiency and greater productive capacity. Admittedly, investment is likely to be uneven across sectors. Manufacturing has had a less positive experience in this cycle, primarily because of increased global competition and pressures from the dollar. Nonetheless, going forward I anticipate that growth in business investment spending overall will continue to play a major role in aggregate economic growth.
Next, add to this pattern of private-sector spending the growth in government spending on goods and services. At this point, there is little evidence of an appetite for either a dramatic increase or a sharp decline in spending at the state or federal level. The drop in government spending in the fourth quarter of last year appears to be temporary. So at least for the near term, moderate growth in government spending appears to be a reasonable estimate.
Adding up all of these components of demand suggests a scenario of solid sustainable growth in domestic final sales. Of course, as we have all become aware, how much of that domestic demand translates into domestic production depends on what happens to our international trade balance.
For the past decade, a widening trade deficit has been siphoning off some of the growth in demand for domestic production in the U.S. and funneling it into our trade partners — Europe, Japan, and, most notably, China. For some time, economists have been predicting that the trade deficit would begin to narrow. The argument is that as foreign suppliers accumulated more dollars, their willingness to hold still more would diminish, causing the dollar to depreciate, and thus making U.S.-produced goods and services more competitive. Furthermore, global economic growth was expected to pick up, generating greater international demand for U.S.-produced output.
But, as we have seen, things have not gone as expected. The value of the dollar declined somewhat last year, but it has appreciated thus far this year. It seems that foreigners, including both private investors and central banks, have been more willing to hold dollars than we anticipated. Meanwhile, global economic growth has been more sluggish than expected, and our appetite for imports has been stronger than expected. Then, there was the rapid and unanticipated increase in the international price of oil. Rising oil prices increase the cost of our imports, and hence the size of our trade deficit, still further. Thus, the U.S. trade deficit continues to widen.
However, today there are signs that the global growth we have been anticipating over the past several years may be underway. Both Japan and Europe are beginning to show signs of renewed growth. Over the long run, this could lead to a gradual decrease in the trade deficit as demand for our exports increases. However, over the near term, the most likely scenario is a moderation in the rate at which our trade deficit grows.
Let me turn next to the labor market. Nonfarm payrolls have been growing for some time now. As those of you with children entering the labor force know, hiring is up and recruiters have returned to campus. In fact, over the past 12 months, nonfarm payroll gains have averaged 171,000 per month, a figure somewhat above what many economists believe is necessary to keep pace with growth in the labor force. As a result, the unemployment rate has slowly drifted down and now stands at 4.8 percent, which is relatively low by historical standards.
I expect employment growth to continue in the range of 150,000 to 175,000 jobs per month this year, but with the unemployment rate under 5 percent, we must also begin to ask how much slack remains in the labor market.
By at least one measure, there may not be much. Every quarter, the Philadelphia Fed conducts its Survey of Professional Forecasters, in which we ask prominent economic forecasters about their prognosis for the U.S. economy in coming quarters. Once a year, we ask the survey participants for their estimate of the economy's “natural rate” of unemployment, that is, the unemployment rate the economy can sustain without causing inflation to accelerate. In our most recent survey, the median of the estimates of the natural rate of unemployment was 5 percent. Add to this the anecdotal evidence I gather from around our District in which business leaders suggest difficulty in finding potential employees. This seems to indicate there may not be much slack left in the labor market at all.
With our prospects largely positive, the outlook for our economy is a good one. However, several risk factors will bear watching as we move ahead in the expansion. These are not new to you as they have been covered extensively in the news media. Let me discuss them briefly now.
First, while the housing market still remains at high levels, activity has, on balance, been a bit softer recently. As you are no doubt aware, housing prices have increased at a remarkable rate over the past several years. The reasons for this are economically justifiable, namely, low mortgage rates. However, the possibility remains that the recent run-up in prices may be unduly high given the fundamentals and that a moderation in housing price increases may be underway. The risk here is that house prices directly affect the value of housing wealth, thereby influencing household consumption and savings. For this reason, the Federal Reserve will continue to monitor this situation closely.
Further increases in energy prices are another risk to the economic outlook. Energy price hikes would have a contractionary effect on the economy in that they reduce households' purchasing power and restrain business profits outside the energy sector. Higher energy prices over the long term could also reduce labor productivity and potential output as firms adjust production processes to be less energy intensive. Of course, energy price increases also pose a risk to the inflation outlook. In this sense, the Fed remains vigilant to ensure inflationary pressures are under control.
Despite these risks and given the scenario I just laid out, I believe the economy is on course to converge smoothly to a pace of 3 percent growth in the near term. The economy is performing well. The expansion is moving ahead at a moderate pace, and the economy now seems to be close to full employment. The outlook is for real GDP growth to moderate a bit further over the course of this year and next, settling into that sustainable pace of 3 percent annual growth.
In keeping with its intent to support both a sustainable pace of economic expansion and a stable price environment, the Federal Open Market Committee has continued to move toward a neutral monetary policy stance, gradually raising its federal funds rate target to its current level of 4.75 percent.
Given the outlook I just described, with our economy continuing its expansion and the Fed maintaining a watchful eye over potential risk factors, it is imperative that the Federal Reserve remain vigilant to signs of inflation. But I believe it is now appropriate to allow incoming data on inflation and economic growth to guide our policy adjustments going forward.
Overall, I am optimistic that the U.S. economy is poised for a sustained period of economic expansion, marked by full employment and moderate inflation.
Now I would like to spend a few minutes a little closer to home by discussing some specifics of the economy here in Wayne County.
This region has weathered the recent business cycle well. Wayne County's unemployment rate averaged 4.8 percent in 2005. This was below both the national annual average of 5.1 percent and the statewide average of 5 percent.
Taking a longer-term view, the region's performance is quite remarkable. As you may know, Pennsylvania is the third slowest growing state in the country. However, the northeastern corner of the commonwealth has had a different experience. Pike, Monroe, and Wayne counties lead the way as the fastest growing counties in the commonwealth and are among the fastest growing nationally.
Several factors have contributed to this strong economic performance, and the good news is that those factors should continue to support strong performance in the years ahead.
The first — and perhaps most obvious — economic advantage Wayne County has is its location. You are near the New York and New Jersey metro communities. Because the county shares a large border with New York, it has experienced an in-migration of higher income individuals from the metro New York City area. In fact, according to the U.S. Census Bureau, one of the highest state-to-state migration flows in the U.S. recently has been from New York to Pennsylvania. This phenomenon has generated a great deal of residential investment and has contributed to the significant escalation in local real estate prices.
I would expect the New York-New Jersey area to continue to expand and Wayne County to continue to benefit from that growth. But when you consider Wayne County's location in a broader context, its advantage and upside opportunity is still greater. You are located centrally to the Northeast and mid-Atlantic regions with good transportation. This puts Wayne County in a good position to attract industries and firms that can reduce costs by being close to a large number of people — from distribution and warehousing, to specialized services, to leisure and entertainment.
This brings me to the second of Wayne County's advantages. Wayne County is a good place to live with relatively low costs of living and doing business — and you have a region that offers a very high quality of life to its residents.
Given these factors, Wayne County is well positioned to take full advantage of the nation's ongoing economic expansion.
With that said, this level of growth creates several challenges for the region. I will mention two key issues that will play an important role in the outlook for Wayne County over the next few years.
The first of these challenges is the ability to maintain an educated and skilled labor force.
The skills being demanded in the labor market today are shifting rapidly. Educated workers are best able to adjust to these changes. As the labor market tightens and the demand for an educated labor force outpaces the supply, this factor will become more and more important. Regions that can attract and retain an educated labor force will have a leg-up in the competition for businesses and economic activity.
Wayne County seems well positioned to cultivate an educated labor force. The population growth here that I mentioned earlier was especially evident in the under-18 demographic. Moreover, northeastern Pennsylvania is rich with colleges and universities that help generate an educated and skilled labor force. And the amenities here should be an attraction to young people as they consider where they would like to live and work. These factors suggest that Wayne County should be able to meet the challenge that today's evolving labor market presents.
The second challenge the region will have to face is preserving the natural beauty of the region that plays an important role in attracting people and businesses, even as the region continues to experience rapid economic growth. Infrastructure, such as roads, highways and schools, must be put in place to accommodate growth in the region. But at the same time, the region's environmental integrity and natural beauty must be taken into consideration if the quality of life here is to be preserved.
With that, let me close. With growth expected to continue, the county will be presented with unique challenges and opportunities in the months and years ahead. A growing residential population and business expansion can create demand for a variety of professional and personal services — demand that will act as a catalyst for attracting and retaining still more new and diverse businesses to Wayne County. Cultivating and nurturing that process of growth and prosperity is the important work of organizations like the Wayne Economic Development Corporation. I encourage you to continue expanding business opportunities in Wayne County and fostering the economic growth and development of the region.