July 1, 2008

Difficult Adjustments and Decisions

Those of us who live and work in the United States are contending with three challenging economic adjustments.

First, global imbalances that built up during the late 1990s and early years of this decade now need to be stabilized or unwound. This process will impose sacrifices on U.S. consumers.

Second, it has become apparent that certain financial innovations that seemed to better match borrowers and lenders resulted, instead, in a mispricing of risk and excessive home building. Legacies of this mispricing include financial distress and a weakened banking system.

Third, strong overseas growth has put upward pressure on the relative prices of raw industrial materials and basic consumer goods. These price changes are forcing us to re-evaluate how we conduct our businesses and live our lives.

Adjustment #1: Learning to Live Within Our Means
The fraction of GDP devoted to household consumption and home construction surged between 1997 and 2005 to the highest level on record (Chart 1). This surge was accompanied by an almost exactly matching increase in the size of the U.S. trade deficit. In other words, our high living was financed entirely through increases in overseas borrowing. Such increases are not indefinitely sustainable: Were they to continue, our ability or our willingness to service the resulting debt would eventually be called into question. The implication is that we will need to produce more for export and less for domestic use in coming years.

Part of this adjustment is an increase in the relative price of imports. We can expect the prices we pay for our purchases to rise faster than the prices we receive for our products. Indeed, the purchasing power of our production—the amount we can afford to buy with what we produce—is now growing by a full percentage point less than real GDP and has recently turned down (Chart 2). The decline helps to explain why it feels like we’re in recession, even though GDP is still rising.

Adjustment #2: The Collapse of Subprime Mortgage Lending
Financial institutions, seeking to preserve profitability as the yield curve flattened, increasingly funded mortgages and other loans by creating and selling short-term securities with tailored risk characteristics rather than by lending out bank deposits. But proper quality-control incentives were lacking in subprime mortgage lending. Now that the pitfalls of these loans are better appreciated, risk spreads have widened and nonconventional mortgage lending has nearly disappeared. Banks, forced to bring supposedly off-balance-sheet activity back onto their books, are short of capital and sharply tightening credit standards.

Adjustment #3: Shifts in Relative Prices
The 1970s saw increases in the relative price of energy caused, in part, by oil producers’ conscious decision to restrict production. The increases in food and energy prices we’ve seen over the past nine years (Chart 3) are, in contrast, driven mostly by rising living standards in developing countries and by rapid growth in developing countries’ manufacturing output.

Relative price changes are challenging. First, they are disruptive, forcing households and businesses to scrap certain equipment and scale back or eliminate certain operations. Frictional unemployment increases as jobs shift from some industries and regions into others. Second, countries that are net importers of the higher-priced commodities face a drag on their purchasing power (as shown in Chart 2). Finally, policymakers must assess whether the relationship between trends in headline (that is, total) inflation and core inflation (inflation excluding food and energy) have been altered.

The Policy Debate
The Congressional Budget Office estimates that the U.S. economy’s real growth potential is about 2.75 percent per year. If inflation is to be held below 2 percent over the long-term, it follows that nominal spending cannot consistently grow at a rate exceeding 2.75 + 2 = 4.75 percent. Nominal consumer spending has gradually decelerated toward this limit. Recent food and energy price increases, however, have driven actual inflation well above 2 percent, and real purchases have consequently been squeezed (Chart 4).

Some commentators argue that food and energy price increases will soon abate. With both spending growth and core inflation under control, monetary policy is on the right track.

Others, however, argue that reducing the U.S. trade deficit will require that real consumer purchases continue to increase more slowly than real GDP and that rapid development overseas will continue to put upward pressure on food and energy prices. According to this view, maintaining current trends in spending growth and core inflation will not be enough to return headline inflation to an acceptable level acceptably fast.

—Evan F. Koenig

About the Author Koenig is a vice president and senior policy advisor in the Research Department at the Federal Reserve Bank of Dallas.