Monday, January 8, 2007

Fed Governor Kohn's Remarks on the Economy

Uncertainty about where we stand in the housing cycle remains considerable. In part, that is because this housing downturn has differed from some of those in the past in important ways. It was not triggered by a restrictive monetary policy and high interest rates; indeed, relatively low intermediate and long-term interest rates are helping to support the stabilization of this sector. But the current contraction in housing did follow an unusually large run-up in sales and construction and, even more so, in prices relative to the returns on other financial and real assets. Our uncertainty about what pushed home prices and sales to those elevated levels raises questions about how the market will adjust now that expectations of the rate of house price appreciation are being trimmed. And changes in the organization of the construction industry, with activity more concentrated in the hands of large, publicly traded corporations, may also affect the dynamics of prices and activity in response to the inventory overhang.

In my own judgment, housing starts may be not very far from their trough, but the risks around this outlook still are largely to the downside. Although house prices nationally have decelerated noticeably and appear to have fallen in some markets, they are still high relative to rents and interest rates. Building permits decreased substantially again in November, and inventories of unsold homes have only started to edge lower. We also do not know whether the possible stabilization that seems to be taking hold would be immune to a rise in longer-term interest rates should term premiums increase or the federal funds rate fail to follow the downward path currently built into market expectations. Even if starts stabilize at close to current levels, those levels are sufficiently low that overall construction activity would remain a negative for the growth of economic activity in the first half of this year.

While the downturn in housing was steepening during the third and fourth quarters, domestic producers of cars and light trucks slashed output in an effort to reduce their elevated inventories, particularly of light trucks (minivans, SUVs, and pickups). In October, light motor vehicles were assembled at the slowest pace in more than eight years. However, production rebounded in the final two months of the year, and, with inventories having come down from their highs last summer, available monthly schedules suggest that vehicle manufacturers anticipate maintaining the pace of assemblies during the first quarter at about the average rate in November and December. Thus, with sales reasonably well maintained through December, the drag from this sector's inventory correction should be ending.

1.) Note Kohn's statements about the housing market imply a bubble exists. He stated that interest rate increases were not the primary cause of the correction. Instead, home price increases, ran up higher "in prices relative to the returns on other financial and real assets." He next states there is uncertainly about what sent prices up. This statement is a bit baffling coming from an economist. When the Fed lowers rates to the lowest level seen in a generation, demand will increase. That's simple supply and demand in action.

2.) "but the risks around this outlook still are largely to the downside". That's not a very encouraging statement, but I believe it is very accurate. Inventories are high, sales are low and household debt is at an all-time high. Short version: there's a ton of supply on the market and buyers are dwindling.

3.) He notes that domestic car dealers cut back production in the fall but has since rebounded. This is what happens when car dealers rely on large, gas-guzzlers as their primary source of revenue during a period of increasing has price.

On inflation:

So, despite the recent favorable price data, I believe it is still too early to relax our concerns about whether the run-up in price pressures in the spring and summer of last year is truly unwinding and whether it is unwinding rapidly enough to forestall a pickup in inflation expectations. Even with the opening of some slack in the manufacturing sector and in homebuilding, labor markets generally seem to have stayed fairly tight, with the unemployment rate at only 4-1/2 percent. Although recent data indicate that labor costs were not rising as rapidly in 2006 as first estimated, labor compensation does appear to have increased more quickly over 2006 than over 2005. Last year's increase in compensation also appears to have outpaced overall consumer price inflation. That development in and of itself does not necessarily indicate an increase in inflationary pressures, especially if it represents a process in which real compensation begins to catch up with the rapid increases in labor productivity earlier this decade. What would be problematic would be a pickup in the growth of nominal hourly labor compensation that was passed through to prices over the next several quarters, or one that was not matched, over a sustained period, by a comparable pickup in the growth of productivity. Eventually, the resulting faster growth of unit labor costs would pose a serious threat to price stability.

Core inflation is still higher than it was just a year ago, and, as I noted, some of the very recent decline may result from one-time changes in relative prices rather than an easing in underlying inflation pressures. A very gradual decline in the trend rate of inflation continues to be the most likely outcome, but that path is still by no means assured, and in my judgment such a decline remains critically important to the sustained prosperity of the U.S. economy.

Translation: We're not lowering rates anytime soon if I have anything to say about it.

He concludes:

In sum, conditions appear to be in place for a good year for the U.S. economy, one marked by growth that is moderate and sustainable and by inflation that will be lower than last year's. The economy appears to be weathering the downturn in housing with limited collateral effects, and inflation appears to be easing with the aid of lower energy prices, well-anchored inflation expectations, and competitive labor and product markets. I am a central banker to my core, so I know that somewhere, somehow, something will go wrong, but you will have to rely on the new president of the Federal Reserve Bank of Atlanta to explain to you next January just what happened and what the implications are for 2008.

I found his speech to directly contradict his conclusion. He mentions that housing's most likely direction is downward. He notes that several regional manufacturing surveys have showed weakness. He notes that future manufacturing expectations are bullish, but it's hard to see people answering a future expectations negatively unless the economy is already in a recession. Inflation is down because of one-time events. There were a ton of negatives in his speech that are difficult to ignore.

Here's a link to the speech. Let me know what you think.