Worry Is Interest Paid on Trouble
Worry is interest paid on trouble before it falls due.
——W.R. Inge (1860–1954), The Observer
(London, February 14, 1932)
Although still in the throes of a major housing market correction, the U.S. economy ended 2006 in much better shape than many analysts had expected. According to the Bureau of Economic Analysis, real GDP expanded at an annual rate of 3.5 percent in the fourth quarter, and consumption spending clocked in at 4.4 percent. December’s unemployment rate of 4.5 percent is quite low by historical standards, and the January 2007 employment report revealed that the 2006 economy generated nearly one million more jobs than were originally reported. As if this were not enough, recent inflation data have been encouraging: The core PCE price index advanced at an annualized rate of only 1.7 percent from September to December.
So why should a central banker be worried? One good reason is that worries are sometimes well founded.
Consider the housing situation. The residential construction slide has been steep, but housing prices have held fairly steady in most markets. Mortgage applications even picked up in the last few months of the year. Despite these signs of stabilization, caution is required. Most housing data are seasonally adjusted, and the weather was unusually mild in many parts of the country earlier this winter. Might we soon discover that some of the strength we see melts with the snow? Second, many people may be keeping their homes off the market at this time of stress, a tactic that temporarily restricts supply. If home sales pick up, will they put their houses up for sale, prolonging the time it takes to normalize inventories? To clear the market, prices might have to adjust more than they already have. And third, how will market developments affect owners’ willingness and ability to treat their homes as piggy banks?
If further housing retrenchment appears unlikely today, recall how quickly the stock market collapse and the investment spending bust seemed to materialize out of thin air in 2000. Admittedly, housing and equity markets differ in important ways, not the least of them that people can live in their homes—a fact that in itself could diminish the speed of adjustment, acting as a circuit breaker against fire sale prices.
Perhaps we have not yet read the last chapter of the housing market mystery. The odds favor a relatively happy ending but, in that genre, a few more bodies are often discovered before the last page is turned.
If housing risks don’t seem too worrisome, consider the inflation risk. Although both CPI and PCE inflation looked good in the fourth quarter, November’s 0.0 percent change was what drove the results. To judge from a broad array of inflation estimators, the underlying CPI inflation trend seems to be in the range of 2 percent to 2-1/2 percent. Core goods prices have been flat lately, a sign that rising service prices are carrying the inflation impulse. Core service prices, which comprise about half of the CPI, have been increasing at a 3.7 percent rate over the last 12 months.
To increase the difficulty of interpreting trend inflation, the distribution of the component price changes has been unusually bimodal for the past year. For example, on an expenditure-weighted basis, the prices of most CPI components in December either declined or rose at rates greater than 3 percent. Hardly any prices increased at the arithmetic average rate.
Movements in inflation rates over short periods of time, even a year or two, are heavily influenced by the process through which price shocks affect individual markets. Over time, however, inflation conforms to the rate of money growth set by the Federal Reserve as well as by the process that governs inflation expectations. Surprisingly little is known about the mechanism for transmitting monetary impulses through the structure of relative prices. We might expect inflationary episodes to vary according to differences in labor, product, and financial markets at various points in time, as well as on differences in people’s beliefs about future inflation.
At the end of its last meeting, the FOMC issued a statement announcing its decision to maintain the federal funds target at 5-1/4 percent, along with a brief description of its rationale. The statement concluded by reiterating a point the FOMC has been making since last June, namely, that some inflation risks remain. Inflation has not worsened since then, an outcome that was still in doubt at the time, but it has not convincingly improved either. Worries exist in two directions—that the rate will edge back up, and that the rate will fail to edge down.
But let’s put these concerns in perspective. What about the prospects of inflation becoming unacceptably high? Fortunately, very few are worried about that!