Comments to New England Realtors Conference
It is a pleasure to be here with you today to share my views and also to hear yours. The residential and commercial real estate markets are always key contributors to the health of the economy. But, as I am sure you all know, the real estate sector-and particularly the housing market-is one of the bigger question marks policymakers face in managing the risks to the likely course of economic activity over the next year or so. So I am especially glad to have a chance to be here and to exchange views. And, of course, the views I will share are mine and not necessarily those of others on the Federal Open Market Committee.
The good news is that, in my view, the short- to medium-run likely course of the economy is quite positive. Economic data taken over short periods of time are always bumpy, and the impact of hurricanes, energy shocks, and the on-again, off-again effect of auto sales incentives on consumption acted to make the end of 2005 more than normally bumpy. But overall, the four-quarter growth rate for last year was quite solid, and I and others expect 2006 to be the same. Indeed, when Chairman Bernanke addressed the House and Senate Banking Committees in mid-February, he discussed the 2006 economic projections of the members of the Board and the Reserve Bank Presidents. The central tendency was for real GDP growth of about 3-1/2 percent, unemployment in a low range of 4-3/4 to 5 percent, and core inflation at about 2 percent. Altogether, a very positive picture for a highly developed, nearly $13 trillion economy well into its fifth year of expansion. There are short-term questions to be sure -- the impact of changes in residential housing markets and the prospects for inflation are two -- but, overall, the economy in 2006 seems likely to be very well-behaved.
But what about the longer term? Despite our economy's resilience and relatively high rates of productivity growth, I am concerned that we have been living beyond our means. Personal savings rates have declined sharply. Using reasonable assumptions about longer-term revenue and spending streams, federal fiscal deficits, while moderating as a share of GDP in 2005, are poised to grow sharply as baby boomers retire. And, of equal concern, this country's external deficit has grown as well reflecting surging U.S. demand for imported goods. Such demand contributed significantly to the growth of foreign economies, and their continuing desire to invest their dollars in our country's debt and equity markets has helped minimize the impact that might otherwise be caused by our country's savings/investment imbalance. Indeed, just as one example of the variety of foreign investment here, there are anecdotes of significant foreign purchases of both residential and commercial real estate in some markets, and maybe you have witnessed this first hand.
But being the world's biggest debtor has its downsides. It puts us at risk that foreign investment desires may change, with potentially harmful effects on the stability of our financial markets. The best guess is that any such change would happen slowly given the reliance of other countries on U.S. imports for growth. But past experiences in other countries with large external deficits leaves one cautious about being too sanguine. Indeed, if our current account deficit continues to grow faster than GDP, there will be a continued deterioration in our net international investment position. That creates an obligation to pay increasing amounts to foreign owners of U.S. debts, and eats into our very ability to invest in our future. I believe the best place to start in reining in our external deficit is to increase national savings, most specifically by working to reduce government dissaving. I want to use some of my time today to talk to you about the longer-term challenges facing this country. But first, let me focus on the outlook for next year.
As I noted earlier, while growth was a bit slow at the end of 2005, much of this reflected relatively transitory issues. For one, the quarter suffered from post-Katrina effects, as well as a slump after incentive-driven automobile spending in the third quarter. A jump in energy costs also affected the end of the year. But energy costs have declined a bit after the Q4 jump, rebuilding after Katrina has begun, and government and private spending has strengthened. As a result, early '06 has gotten off to a strong start.
The economy added more than 240,000 jobs during February, bringing the average pace of job growth over the most recent three months to 186,000, in excess of the number needed to absorb new entrants to the labor force. As a result, the unemployment rate declined over the past three months to 4.8 percent, the first time it has reached that level since the late '90s.
Sustained consumer spending this year will depend importantly on sustained employment growth. This is especially the case if, as I expect, there is some flattening in the rate of increase in household wealth coming from residential real estate. Consumption is a key component to the Bank's outlook, so we were heartened to see the recovery in consumer confidence following the hurricanes and the spike in oil prices. I view this as confirmation of a solid foundation to consumption spending.
Turning to investment, I expect businesses to continue their 2005 solid pace of spending on equipment and software, as at least some of the capital goods acquired in the spending boom of the late '90s are replaced and new capacity is added. Clearly, the "fundamentals" for investment spending -- expectations of productivity growth, overall business profitability, and accommodative debt and equity markets -- are there. Indeed, the data we see on shipments and orders suggest that near-term capital spending is already off to a strong start early in 2006.
One of the greatest areas of uncertainty in the Bank's outlook is one near and dear to you, the residential housing sector. As rising interest rates and high prices have made home buying more expensive, sales of new and existing homes have slowed nationally -- and even more so in the Northeast. Despite slower sales, construction of new homes, while receding from record highs, continues at quite high levels, a situation which has been the subject of many news reports.
The resulting rising stock of unsold new homes will likely bring about a modest decline in construction, probably accompanied by a gradual flattening of house prices. As construction of new homes slows and the pace of growth in housing wealth eases, economic activity will be restrained. The question is "How much?" Residential investment is now slightly over 6 percent of GDP, a higher fraction than in the past 10-15 years. Most forecasters -- FRB Boston included -- expect that share to decline somewhat as the construction of new homes tails off. Obviously, such a contraction in residential investment will slow GDP growth over what it might have otherwise been.
Of more significance, perhaps, is the effect on consumption of a decline in the growth rate of household wealth related to a change in house prices. Housing equity is under a third of total household net worth, but recently the relatively rapid growth in house prices has accounted for much of the upward movement of overall wealth. Generally speaking, when household wealth increases, consumption does as well, on the order of 3-4 cents on the dollar of increased wealth. Thus, most analysts believe U.S. consumption over the last several years has been bolstered by increases in household wealth brought about by rising home prices.
What happens if home prices flatten or even decline? The theory would suggest that consumers will reduce their spending by about 3-4 cents for every dollar of wealth reduction that ensues, all other things being equal. Moreover, some have argued that mortgage market conditions in general, and new types of mortgage instruments in particular, have made borrowing out of home equity easier. This may have augmented consumption as house prices rose -- thought this is difficult to see in the data -- and as prices flatten or decline, might contribute to a larger contraction in spending than might otherwise be the case.
From a macro perspective, it makes sense to worry about the potential impact on overall GDP growth of a combination of a reduction in housing construction and a decline in household wealth. The Bank's baseline forecast takes what might be seen as a rather conservative perspective here. We see construction diminishing somewhat and real estate prices flattening, not declining, and those assumptions are built into the solid GDP growth rate I referred to earlier. Clearly, however, we could be wrong on the magnitudes. Real estate prices could actually decline (though this has never happened for the nation as a whole at least on a nominal basis) and construction activity could retrench more than we expect. And rising mortgage rates could impede consumption more than our forecast predicts. Thus, changes in residential real estate present a source of downside risk to growth. I should also note here that in recent times residential real estate markets have often outperformed expectations, a fact with which this audience is more than familiar.
But the risks are not all in the direction of slower growth. Stronger growth and somewhat higher inflation are well within the realm of possibility as well. Consumption could be less affected by waning real estate markets than we expect, particularly if more consumers are working. With unemployment rates at their recent levels, some possibility exists that labor costs will begin to rise faster than productivity, which in turn could put pressure on inflation. That hasn't happened yet in the aggregate and we expect healthy productivity growth to continue after its Q4 drop-off. Indeed, at the Boston Fed we have begun to hear anecdotes about skilled labor being even harder to find and more expensive than earlier, but this is usually in the context of a continuing emphasis by businesses on working harder and smarter in the face of keen competition. It is also true that rather low labor force participation nationwide could suggest labor markets are less tight than the unemployment rate suggests. However, judging the precise extent of resource utilization is difficult and there is a need here for some vigilance.
Moreover, worldwide GDP growth in 2006 is expected to maintain the robust levels of recent years, with resulting resource pressures. Demand from the rapidly growing developing nations, especially China and India, has pushed up commodity prices, though overall non-oil import price growth has been moderate. Even before the hurricanes, energy prices were rising, reflecting world demand. While prices are generally off their hurricane peaks, they remain high simply as a result of the pressure of demand over available supply. Given the current geopolitical unrest in oil producing regions, new energy price spikes are clearly possible, though this is understandably hard to predict. In our baseline forecast, high productivity, healthy profit margins, and well-anchored inflation expectations are expected to keep core inflation growth around 2 percent. There are risks to this inflation forecast to be sure, just as risks exist that growth will be slower. As a result, I believe monetary policymakers need to watch how evolving economic activity affects the balance of these risks to assess what actions are necessary.
To end our economic overview closer to home, the New England economy ended 2005 with employment levels just a bit above year-end 2004. Massachusetts accounts for about half of the region's jobs, and was particularly hard hit by the end of the late '90s telecom bubble and the overall slowdown in the tech sector. This state has seen slower employment and income growth than the rest of the country since 2001. Still, as of January, state unemployment rates in New England are all at or below the national average. While manufacturing in the region continues to lose jobs, as it does most everywhere in the U.S., employment across New England is expanding solidly in professional and business services, financial activities, education and health services, and leisure and hospitality. And recently, we have also begun to see some life in the Boston downtown and suburban commercial real estate markets, as class A vacancy rates have come down somewhat and rents have begun to increase.
Is New England likely to feel the sting of cooling residential housing in a more significant way than the rest of the country? To be sure, home prices in New England are higher than most of the rest of the country, and the pace of appreciation has been greater here at least until the last couple of years. However, unlike the late '80s, residential construction has not boomed, and there has been little speculative building. Various studies of the New England market do see some overvaluation relative to fundamentals such as personal income, density, and environmental restrictions, but the amount is relatively small. The question is how much will prices fall? So far, the data on this are not clear. In one set of monthly numbers, Massachusetts residential real estate prices fell in early '06; other data suggest only a sharply slower pace of growth. But even in the early nineties, home prices fell much less than they had appreciated in the decade earlier.
I should also point out here that much has been written about the new forms of mortgage financing that have been rapidly increasing as a share of mortgage originations. As key players in residential real estate markets, I am sure you have seen interest-only loans, and loans whose low initial required payment amounts can create negative amortization. Many are worried that the combination of these new mortgage instruments and borrowers who may be both highly leveraged and low to moderate income could result in real problems as interest rates escalate in conjunction with softening prices. There is no doubt that some potential exists for consumer hardship. At present, both national and regional bank credit quality and foreclosures remain at historically very low levels, though a very recent slight deterioration is evident. Indeed, recent bank supervisory guidance issued for comment by all the federal regulators has suggested caution on the part of both residential and commercial lenders in assessing credit quality of borrowers, the appropriateness of the loans extended and loan concentrations. I am concerned about the impact on some consumers of mortgages that become too costly, and the possible implications for lenders and markets. However, at this point, I do not view this as likely to be a major issue to the overall New England economy. My sense is that Massachusetts and New England will experience some sustained cooling in real estate markets, and some flattening of prices, but this trend is not likely to affect the region overly negatively, and likely not more than the nation as a whole.
So, if we are at all accurate, 2006 will be a year of solid growth, perhaps faster in the first half as Katrina rebuilding occurs and energy prices stabilize, and slower later on as hurricane-related fiscal stimulus ebbs and housing activity tapers off, but strong overall. There are risks to be sure, but as you know monetary policy is all about risk management.
So that's the good news for the next year or so. Now I would like to look out in time a bit farther and talk about the potential consequences of running large federal budget and current account deficits. Let's start with the federal budget deficit, which reached $318 billion in 2005, a large and somewhat sobering number.
To begin with, it's probably more informative to measure the deficit relative to the overall size of the economy's productive capacity or GDP. Just as a household can safely handle more debt as its income rises, the U.S. economy can generate the extra tax revenue needed to pay the interest on its debt without raising tax rates as long as national income is also growing in proportion. From this perspective, the budget situation seems less dire; the deficit was about 2.6 percent of GDP in 2005, a decline over 2004 (when it was 3.6 percent of GDP) and relatively low as compared to 1983 (when it was 6 percent of GDP).
Unfortunately, several factors make today's fiscal situation much more serious than indicated by the current ratio of the deficit to GDP. First, the deficit would be much larger, 4.1 percent for fiscal 2005, if it were not for a sizable surplus in Social Security -- a surplus that is the direct result of the increase in payroll tax rates designed to prepare the Social Security system for the surge in benefit payments that will result as baby boomers retire. These surpluses have been deposited into social insurance trust funds and accumulated in nonmarketable Treasury securities. In essence, the trust funds are providing a loan to the rest of the federal government - a loan that will have to be paid back with interest as baby boomers collect their Social Security benefits. The Social Security surplus is forecast to gradually diminish, and, beginning in about 2018, Social Security will start to pay out more in benefits than it receives from payroll taxes. Once this happens, Social Security will start exerting upward pressure on the unified federal budget deficit.
The situation for Medicare is similar and, potentially, even more serious. Although payroll taxes to cover Medicare expenditures are also currently in surplus, over time Medicare spending is expected to increase more rapidly than related tax revenues, creating a deficit problem that analysts see as potentially greater in size and more difficult to control than that associated with Social Security.
Unless something in this scenario changes, these forces will require a steep increase in government borrowing as expenditures will greatly exceed tax receipts. The resulting rising deficit and debt-to-GDP ratio could pose challenges to the level of private investment in this country, and to future improvements in its standard of living.
So far, the political process has failed to enact measures that might credibly be expected to bring the budget back closer to balance. The budget deficits of the 1980s resulted in legislative actions that by the early 1990s moved toward reducing those deficits. Indeed by 1998 the federal budget was in surplus. Since then, however, a combination of tax cuts, and new spending on a wide range of efforts -- the Iraq war and post 9/11 security among them -- have created a new deficit problem. A case can be made that the tax cuts of 2001 were well timed to facilitate the recovery from the recession. Now actions similar to those of the 1980s and early 1990s are needed to bring about the fiscal discipline required to address the demographic challenges of the next decade.
Let me now turn to our external, or current account deficit, which is estimated at $800 billion in 2005, or 6.5 percent of GDP. This is a large deficit for a major developed country, certainly measured by size alone, and in reference to GDP as well. The current account primarily reflects the difference between the value of the goods and services we sell abroad and the value of those we import. Running a current account deficit means that domestic spending exceeds what is produced in this country. It also means that we must borrow from abroad to cover the difference. Thus, the surging U.S. current account deficit has made us increasingly dependent on borrowing from abroad in recent years.
The two deficits, the federal fiscal deficit and the current account deficit are often referred to as "twins." As my former colleague Ned Gramlich has pointed out, they are not literally twins, but they certainly share a lot of DNA -- DNA in the form of national savings. National savings is the sum of all private savings -- that is saving or dissaving by households and businesses -- and government saving or dissaving. When national savings are low, as has been the case recently, with only business saving modestly in the black, either dependence on foreign savings increases, or national investment must decline. The growth in our current account deficit reflects the growing dependence of U.S. investment on foreign savings.
Although there is considerable controversy about when, and how, narrowing of the current account and federal budget deficits will occur, there is a broad consensus that the projected growth in both deficits relative to GDP is not sustainable. We cannot continue to run a federal budget deficit that raises our debt-to-GDP ratio indefinitely, without diminishing private investment through higher interest rates, thereby reducing productivity and long term growth.
The current account deficit is also not sustainable at its existing size and rate of growth. If the amount we must borrow from abroad to finance spending is rising faster than GDP, at some point paying our debts will eat into our standard of living. As the U.S. issues ever larger amounts of debt, foreign purchasers would likely require higher interest rates to continue investing, threatening either investment levels or U.S growth, or both. Many argue that given the depth and liquidity of our markets, and the attractiveness of the U.S. as a place to invest, some level of U.S. current account deficit is sustainable. But even those who are sanguine about our current position are troubled about the future.
How to reduce the current account deficit is a matter of significant debate as well. By definition, it can only be reduced through some combination of increased exports and decreased imports relative to GDP. But few if any of the paths to current account reduction are cost free since, again, by definition, a slower pace of import growth suggests a slower pace of U.S. output growth. Perhaps the closest to a "win-win" would entail stronger economic growth in our major trading partners, leading to an increase in demand for U.S. exports. Indeed, achieving parity in the growth rates of our major trading partners and ourselves could go a long way toward a gradual and orderly reduction of the U.S. external deficit. It would, however, require strong, self-sustaining domestic-led growth in our major trading partners, something that has proven elusive, at least for the Euro-zone and Japan.
It is also true that the current account deficit would be reduced if foreigners decided they were no longer willing to invest their U.S. dollars in our country -- in other words, they could stop lending to us to make up for our lack of national savings. This could have serious consequences. Indeed, when developing countries have run external deficits of this relative size the results have usually involved major financial and economic crises.
Of course one should not make hasty comparisons between the United States and developing economies. The strength and resilience of our economy, and the fact that our external debt is largely in our own currency should help to ward off the most significant negative consequences going forward. Moreover, the benefits of international trade accrue to both sides. U.S. consumers and businesses have benefited from buying foreign goods; foreigners have benefited as well from access to our liquid markets to purchase debt and equity with a desirable balance of risk and return. Thus, it is in U.S. interests, and in the interests of our major trading partners, to address trade imbalances in reasonable ways. But recognizing this, how can policy help ensure such an outcome?
There are no easy answers here. Suffice it to say that policies aimed at increasing national savings are the best response to both rising fiscal and current account deficits. Given the expected waning of housing activity, consumers may well begin to save more. To be sure, that would be a good thing but it won't be enough. A great additional step would be to narrow the prospective federal fiscal deficit -- that is, reduce government dissaving -- through bringing the federal budget into balance. The federal deficit should be reined in before it begins to balloon as a share of GDP reflecting demographic change. While this is not a perfect solution, and it has real near-term costs, in the end it may be the only way to engineer a gradual way out of our debt burdens.
In sum, the short-run picture is a good one. With another year of solid growth at home and around the world, the economy will continue on a firm footing. The longer run poses challenges. One way to address these challenges is to increase our level of national savings. Personal savings rates need to rise, but a credible start on reining in our fiscal deficits is even more important. It won't be cost-free to be sure, but now is the time to start.