Janet Yellen: "Rising Commodity Prices Don't Warant Policy Shift"

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First we had FRBNY Dove Bill Dudley talking up the Goldman party line that QE3 may, just may, be necessary (recall Goldman initially asked for $2 trillion in QE), and now the dove from the west coast makes news as San Fran Fed (also known as the Captain Obvious academy) president Janet Yellen basically says that rising commodity prices don't warrant policy shift. And by policy shift she means a change to the current easing regime. Some other dovish statements: "it would be difficult to get a sustained increase in inflation as long as growth in nominal wages remains low" which is wrong - how many billions do American consumers "save" by not paying their mortgages; "structural explanations cannot account for bulk of rise in unemployment during the recessions" ... so why do we need economic "explanations"? "structural explanations cannot account for bulk of rise in unemployment during the recessions" - yup: Captain Obvious class 101; "long-term inflation expectations remain well-anchored despite jump in short term expectations" - anchored to what - the Rudy von Havenstein inflation projection wall chart?  "decline in jobless rate reflects in part drop in labor force participation" - advance topics In Captain Obviousness; "real consumer spending slowed around turn of the year after brisk gains in autumn, consumer sentiment weaker in March" - but CNBC just spent all of last week telling us how strong the consumer was in March; and most importantly: "accommodative monetary policy stance still appropriate because unemployment too high, underlying inflation too low" and "inflation effects from higher commodity prices likely to be transitory but must watch inflation expectations" uhh, what happened to well-anchored? To rephrase: the QE lunacy will continue until morale (and hyperinflation) improves.

From Janet Yellen:

Commodity Prices, the Economic Outlook, and Monetary Policy

Good afternoon. For more than a century, the Economic Club of New
York has provided an influential forum for the discussion of social,
political and economic challenges facing the nation, and I appreciate
very much your inviting me to speak today. My comments will focus on
recent increases in commodity prices and the effects of those
developments on the outlook for inflation, the economic recovery now
under way, and the appropriate stance of monetary policy. Let me
emphasize at the outset that these remarks reflect my own views and not
those of others in the Federal Reserve System.1 

Since early last summer, the prices of oil, agricultural
products, and other raw materials have risen significantly. For example,
the price of Brent crude oil has risen more than 70 percent and the
price of corn has more than doubled; more broadly, the Commodity
Research Bureau's index of non-fuel commodity prices has risen roughly
40 percent. The imprint of these increases has become increasingly
visible in overall measures of inflation. For example, inflation as
measured by the price index for personal consumption expenditures (PCE)
moved up to an annual rate of about 4 percent over the three months
ending in February after having averaged less than 1-1/2 percent over
the preceding two years. Moreover, survey data suggest that surging
prices for gasoline and food have pushed up households' near-term
inflation expectations and are making consumers less confident about
their economic circumstances.

Some observers have attributed the recent boom in commodity
prices to the highly accommodative stance of U.S. monetary policy,
including the marked expansion of the Federal Reserve's balance sheet
and the maintenance of the target federal funds rate at exceptionally
low levels. Such an interpretation of recent developments naturally
leads to the conclusion that the Federal Open Market Committee (FOMC)
should move promptly toward firmer monetary conditions. Indeed, some
have even raised the specter of a return to the high inflation of the
1970s in arguing for the urgency of monetary policy tightening.

Increases in energy and food prices are, without doubt, creating
significant hardships for many people, both here in the United States
and abroad. However, the implications of these increases for how the
Federal Reserve should respond in terms of monetary policy must be
considered very carefully. In my remarks today, I will make the case
that recent developments in commodity prices can be explained largely by
rising global demand and disruptions to global supply rather than by
Federal Reserve policy. Moreover, empirical analysis suggests that these
developments, at least thus far, are unlikely to have persistent
effects on consumer inflation or to derail the recovery. Critically, so
long as longer-run inflation expectations remain stable, the increases
seen thus far in commodity prices and headline consumer inflation are
not likely, in my view, to become embedded in the wage and price setting
process and therefore are not likely to warrant any substantial shift
in the stance of monetary policy. An accommodative monetary policy
continues to be appropriate because unemployment remains elevated, and,
even now, measures of underlying inflation are somewhat below the levels
that FOMC participants judge to be consistent, over the longer run,
with our statutory mandate to promote maximum employment and price
stability.

While I continue to anticipate a gradual economic recovery in the
context of price stability, I do recognize that further large and
persistent increases in commodity prices could pose significant risks to
both inflation and real activity that could necessitate a policy
response. The FOMC is determined to ensure that we never again repeat
the experience of the late 1960s and 1970s, when the Federal Reserve did
not respond forcefully enough to rising inflation and allowed
longer-term inflation expectations to drift upward. Consequently, we are
paying close attention to the evolution of inflation and inflation
expectations.

Sources of the Recent Rise in Commodity Prices
Let me now turn to a discussion of the sources of the
recent increase in commodity prices. In my view, the run-up in the
prices of crude oil, food, and other commodities we've seen over the
past year can best be explained by the fundamentals of global supply and
demand rather than by the stance of U.S. monetary policy.

In particular, a rapid pace of expansion of the emerging market
economies (EMEs), which played a major role in driving up commodity
prices from 2002 to 2008, appears to be the key factor driving the more
recent run-up as well. Although real activity in the EMEs slowed
appreciably immediately following the financial crisis, those economies
resumed expanding briskly by the middle of 2009 after global financial
conditions began improving, with China--which has accounted for roughly
half of global growth in oil consumption over the past decade--again
leading the way. By contrast, demand for commodities by the United
States and other developed economies has grown very slowly; for example,
in 2010 overall U.S. consumption of crude oil was lower in than in 1999
even though U.S. real gross domestic output (GDP) has risen more than
20 percent since then. On the supply side, heightened concerns about oil
production in the Middle East and North Africa have recently put
significant upward pressure on oil prices, while droughts in China and
Russia and other weather-related supply disruptions have contributed to
the jump in global food prices.

In contrast, the arguments linking the run-up in commodity prices
to the stance of U.S. monetary policy do not seem to hold up to close
scrutiny. In particular, some observers have pointed to dollar
depreciation, speculative behavior, and international monetary linkages
as key channels through which accommodative U.S. monetary policy might
be exacerbating the boom in commodity markets. Let me address each of
these possibilities in turn.

First, it does not seem reasonable to attribute much of the rise
in commodity prices to movements in the foreign exchange value of the
dollar. Since early last summer, the dollar has depreciated about 10
percent against other major currencies, and of that change, my sense is
that only a limited portion should be attributed to the Federal
Reserve's initiation of a second round of securities purchases. By
comparison, as I noted earlier, crude oil prices have risen more than 70
percent over the same period, and nonfuel commodity prices are up
roughly 40 percent. Put another way, commodity prices have risen
markedly in all major currencies, not just in terms of U.S. dollars,
suggesting that the evolution of the foreign exchange value of the
dollar can explain only a small fraction of those increases.

A second potential concern is that U.S. monetary policy is
boosting commodity prices by reducing the cost of holding inventories or
by fomenting "carry trades" and other forms of speculative behavior.
But here, too, the evidence is not compelling. Price increases have been
prevalent across a wide range of commodities, even those that are
associated with little or no trading in futures markets. Moreover, if
speculative transactions were the primary cause of rising commodity
prices, we would expect to see mounting inventories of commodities as
speculators hoarded such commodities, whereas in fact stocks of crude
oil and agricultural products have generally been falling since last
summer.2 

A third concern expressed by some observers is that the
exceptionally low level of U.S. interest rates has translated into
excessive monetary stimulus in the EMEs. In particular, even though
their economies have been expanding quite rapidly, many EMEs have been
reluctant to raise their own interest rates because of concerns that
higher rates could lead to further capital inflows and boost the value
of their currencies. Some argue that their disinclination to tighten
monetary policy has in turn resulted in economic overheating that has
generated further upward pressures on commodity prices.

I do not think this explanation accounts for much of the surge in
commodity prices, in part because I believe that the bulk of the rapid
economic growth in EMEs mainly reflects fundamental improvements in
productive capacity, as those countries become integrated into the
global economy, rather than loose monetary policies. Irrespective of
monetary conditions in the advanced foreign economies, it is clear that
the monetary and fiscal authorities in the EMEs have a range of policy
tools to address any potential for overheating in their economies if
they choose to do so. Indeed, in light of the relatively high levels of
resource utilization and inflationary pressures that many EMEs face at
present, monetary tightening and currency appreciation might well be
appropriate for those economies.

The Outlook for Consumer Prices
Turning now to the outlook for U.S. consumer prices, I
anticipate that the recent surge in commodity prices will cause headline
inflation to remain elevated over the next few months. However, I
expect that consumer inflation will subsequently revert to an underlying
trend that remains subdued, so long as increases in commodity prices
moderate and longer run inflation expectations remain reasonably
well-anchored.

Underlying Inflation Trends
Focusing on inflation prospects over the medium term is essential
to the formulation of monetary policy because, due to lags, the medium
term is the timeframe over which the FOMC's actions can influence the
economy. For this purpose, economists have constructed a variety of
measures to separate underlying persistent movements in inflation from
more transitory fluctuations. These measures include "core" inflation,
which excludes changes in the prices of food and energy, and "trimmed
mean" inflation, which exclude prices exhibiting the largest increases
or decreases in any given month.

No single measure of underlying inflation is perfect, but it is
notable that these measures have exhibited a remarkably consistent
pattern since the onset of the recession: All show the underlying
inflation rate declining markedly to a level somewhat below the rate of 2
percent or a bit less that FOMC participants consider to be consistent
with the Fed's dual mandate. For example, core PCE price inflation stood
at less than 1 percent over the 12 months ending in February, down from
2-1/2 percent over the year prior to the recession. Trimmed-mean
measures of inflation have also trended down over the past couple of
years and are now close to 1 percent.

I want to emphasize that this focus on core and other inflation
measures that may exclude recent increases in the cost of gasoline and
other household essentials is not intended to downplay the importance of
these items in the cost of living or to lower the bar on the definition
of price stability. The Federal Reserve aims to stabilize inflation
across the entire basket of goods and services that households purchase,
including energy and food. Rather, we pay attention to core inflation
and similar measures because, in light of the volatility of food and
energy prices, core inflation has been a better forecaster of overall
inflation in the medium term than overall inflation itself has been over
the past 25 years.3 

In my view, the marked decline in these trend measures of
inflation since the intensification of the crisis largely reflects very
low rates of resource utilization. Strong productivity gains have also
played a role in holding down inflation because, together with low wage
inflation, they have markedly restrained the rise in firms' production
costs. With resource slack likely to diminish only gradually over the
next few years, it seems reasonable to anticipate that underlying
inflation will remain subdued for some time, provided that longer-term
inflation expectations remain well contained.

Longer-Run Inflation Expectations
In this regard, surveys and financial market data indicate that
longer-run inflation expectations remain reasonably well anchored even
though near-term inflation expectations have jumped in the wake of the
surge in commodity prices. For example, the Thomson Reuters/ University
of Michigan Survey of Consumers indicates that median inflation
expectations for the coming year moved up about 1-1/4 percentage points
in March, whereas the median expectation for inflation over the next 5
to 10 years increased only 1/4 percentage point. While such movements
obviously bear watching, I would note that such a combination--namely, a
substantial jump in near-term inflation expectations coupled with a
relatively modest uptick in longer-run expectations--has often
accompanied previous sharp increases in gasoline prices, and when it
did, those movements were largely reversed within a few months.4 

Information derived from the Treasury inflation-protected
securities (TIPS) market also suggests that financial market
participants' longer-term inflation expectations remain well anchored
even as the near-term outlook for inflation has shifted upward. In
particular, while the carry-adjusted measure of inflation compensation
for the next five years has increased about 1/4 percentage point since
earlier this year, forward inflation compensation at longer horizons is
roughly unchanged on net. Much of the increase in five-year inflation
compensation has been associated with the surge in food and energy
prices, and the level of this measure appears consistent with a normal
cyclical recovery after adjusting for those effects.

Commodity Prices and Inflation
Now I would like to explain in further detail why I anticipate
that recent increases in commodity prices are likely to have only
transitory effects on headline inflation. The current configuration of
quotes on futures contracts--which can serve as a reasonable benchmark
in gauging the outlook for commodity prices--suggests that these prices
will roughly stabilize near current levels or even decline in some
cases. If that outcome materializes, the prices of gasoline and heating
oil are likely to flatten out fairly soon, and retail food prices are
likely to continue rising briskly for only a few more months.
Consequently, the direct effects of the surge in commodity prices on
headline consumer inflation should diminish sharply over coming months.

Over time, I anticipate that the recent surge in commodity prices
will also affect the prices of a broader range of consumer goods and
services that use these commodities as inputs. Many firms are seeing
such costs escalate and will pass along at least part of these increased
raw materials costs to their customers. Nevertheless, I expect the
overall inflationary consequences of these pass-through effects to be
modest and transitory, provided that longer-run inflation expectations
remain well anchored. Moreover, labor costs per unit of output--the
single largest component of the unit cost of producing goods and
services in the business sector--are essentially unchanged since 2007,
owing to both moderate wage increases and solid productivity gains. I
expect that nominal wage growth and labor costs will continue to be
restrained by slack in resource utilization. Indeed, it would be
difficult to get a sustained increase in inflation as long as growth in
nominal wages remains as low as we have seen recently.

My expectation regarding the transitory effects of commodity
price shocks on consumer inflation is supported by simulation results
from the FRB/US model--a macroeconometric model developed at the Federal
Reserve Board and used extensively for policy analysis. Starting from a
situation in which inflation is running at 2 percent and households and
firms expect the FOMC to keep it there in the longer run, the model
predicts that a persistent increase of $25 per barrel in the price of
crude oil--that is, a rise similar to what we've experienced since last
summer--would cause the PCE price index to rise at an annual rate of
nearly 4 percent over the first two quarters following the shock. Beyond
that horizon, however, total PCE inflation drops quickly to about 2-1/4
percent and then declines gradually back to its longer-run rate of 2
percent.

These fairly modest and transitory effects of an oil price shock
are also consistent with the response of the U.S. economy to the
dramatic run-up in commodity prices from 2002 to 2008. Indeed, while oil
prices more than quadrupled over that period, measures of underlying
inflation remained close to 2 percent. In my view, that outcome was
crucially dependent on the stability of longer-run inflation
expectations, which in turn limited the pass-through of higher
production costs to consumer prices.

Risks to the Inflation Outlook
I have argued that recent commodity price shocks are likely to
have only a transitory effect on inflation. But even if such a
trajectory for inflation is most likely, some specific risks must be
considered. First, while futures markets suggest that commodity prices
will stabilize near current levels, these prices cannot be predicted
with much confidence. For example, oil prices could move markedly higher
or lower as a consequence of geopolitical developments, changes in
production capacity, or shifts in the growth outlook of the EMEs.

In addition, the indirect effects of the commodity price surge
could be amplified substantially if longer-run inflation expectations
started drifting upward or if nominal wages began rising sharply as
workers pressed employers to offset realized or prospective declines in
their purchasing power.

Indeed, a key lesson from the experience of the late 1960s and
1970s is that the stability of longer-run inflation expectations cannot
be taken for granted. At that time, the Federal Reserve's monetary
policy framework was opaque, its measures of resource utilization were
flawed, and its policy actions generally followed a stop-start pattern
that undermined public confidence in the Federal Reserve's commitment to
keep inflation under control. Consequently, longer-term inflation
expectations became unmoored, and nominal wages and prices spiraled
upward as workers sought compensation for past price increases and as
firms responded to accelerating labor costs with further increases in
prices. That wage-price spiral was eventually arrested by the Federal
Reserve under Chairman Paul Volcker, but only at the cost of a severe
recession in the early 1980s.

Since then, the Federal Reserve has remained determined to avoid
those mistakes and to keep inflation low and stable. It will be
important to closely monitor the state of longer-term inflation
expectations to ensure that the Federal Reserve's credibility, which has
been built up over the past three decades, remains fully intact.

The Outlook for the Real Economy
Turning now to the real economy, real gross domestic
product (GDP) has been rising since mid-2009 and now exceeds its level
just prior to the onset of the recession. While GDP growth during late
2009 and early 2010 was largely the result of inventory restocking and
fiscal stimulus, private final sales growth has picked up over the past
six months--an encouraging sign. At the same time, measures of business
sentiment have generally returned to pre-recession levels, factory
output has been expanding apace, and the unemployment rate has dropped
by a percentage point over the past few months.

Real consumer spending--which had been rising at a brisk pace in
the fall--slowed somewhat around the turn of the year, and measures of
consumer sentiment declined in March. Those developments may partly
reflect the extent to which higher food and energy prices have sapped
households' purchasing power. More generally, however, as the
improvement in the labor market deepens and broadens, households should
regain some of the confidence they lost during the recession, providing
an important boost to spending.

Broad Contours of the Outlook
Nonetheless, a sharp rebound in economic activity--like those
that often follow deep recessions--does not appear to be in the offing.
One key factor restraining the pace of recovery is the construction
sector, which continues to be hampered by a considerable overhang of
vacant homes and commercial properties and remains in the doldrums. In
addition, spending by state and local governments seems likely to remain
limited by tight budget conditions.

Moreover, while the labor market has recently shown some signs of
life, job opportunities are still relatively scarce. The unemployment
rate is down from its peak, but at 8.8 percent, it still remains quite
elevated. And even the decline that we've seen to date partly reflects a
drop in labor force participation, because people are counted as
unemployed only if they are actively looking for work.

Some observers have argued that the high unemployment rate
primarily reflects structural factors such as a longer duration of
unemployment benefits and difficulties in matching available workers
with vacant jobs rather than a deficiency of aggregate demand. In my
view, however, the preponderance of available evidence and research
suggests that these alternative structural explanations cannot account
for the bulk of the rise in the unemployment rate during the recession.
For example, if mismatches were of central importance, we would not
expect to see high rates of unemployment across the vast majority of
occupations and industries. Instead, I see weak demand for labor as the
predominant explanation of why the rate of unemployment remains elevated
and rates of resource utilization more generally are still well below
normal levels.

Commodity Prices and the Real Economy
As I have indicated, the recent run-up in commodity prices is
likely to weigh somewhat on consumer spending in coming months because
it puts a painful squeeze on the pocketbooks of American households.5 In
particular, higher oil prices lower American income overall because the
United States is a major oil importer and hence much of the proceeds
are transferred abroad. Monetary policy cannot directly alter this
transfer of income abroad, which primarily reflects a change in relative
prices driven by global demand and supply balances, not conditions in
the United States. Thus, an increase in the price of crude oil acts like
a tax on U.S. households, and like other taxes, tends to have a
dampening effect on consumer spending.6 

The surge in commodity prices may also dampen business spending.
Higher food and energy prices should boost investment in agriculture,
drilling, and mining but are likely to weigh on investment spending by
firms in other sectors. Assuming these firms are unable to fully pass
through higher input costs into prices, they will experience some
compression in their profit margins, at least in the short run, thereby
causing a decline in the marginal return on investment in most forms of
equipment and structures.7 Moreover,
to the extent that higher oil prices are associated with greater
uncertainty about the economic outlook, businesses may decide to put off
key investment decisions until that uncertainty subsides. Finally, with
higher oil prices weighing on household income, weaker consumer
spending could discourage business capital spending to some degree.

Fortunately, considerable evidence suggests that the effect of
energy price shocks on the real economy has decreased substantially over
the past several decades. During the period before the creation of the
Organization of the Petroleum Exporting Countries (OPEC), cheap oil
encouraged households to purchase gas-guzzling cars while firms had
incentives to use energy-intensive production techniques. Consequently,
when oil prices quadrupled in 1973-74, that degree of energy dependence
resulted in substantial adverse effects on real economic activity. Since
then, however, energy efficiency in both production and consumption has
improved markedly.

Consequently, while the recent run-up in commodity prices is
likely to weigh somewhat on consumer and business spending in coming
months, I do not anticipate that those developments will greatly impede
the economic recovery as long as these trends do not continue much
further. For example, the simulation of the FRB/US model that I noted
earlier indicates that a persistent increase of $25 per barrel in oil
prices would reduce the level of real GDP about 1/2 percent over the
first year and a bit more thereafter. The magnitude of that effect seems
broadly consistent with the estimates of professional forecasters; for
example, the Blue Chip consensus outlook for real GDP growth has edged
down only modestly in recent months.

Monetary Policy Considerations
Let me now turn to the stance of monetary policy. As you
know, monetary policy has been highly accommodative since the financial
crisis intensified. In December 2008, the FOMC lowered the target
federal funds rate to near zero and started to provide forward guidance
concerning its likely future path. As in its statements since March
2009, the Committee reiterated last month that "economic conditions,
including low rates of resource utilization, subdued inflation trends,
and stable inflation expectations, are likely to warrant exceptionally
low levels for the federal funds rate for an extended period." In
addition, the FOMC has purchased a substantial volume of agency debt,
agency mortgage-backed securities, and longer-term Treasury securities.
The Committee initiated a second round of Treasury purchases last
November and has indicated that it intends to complete those purchases
by the end of June. My reading of the evidence is that these securities
purchases have proven effective in easing financial conditions, thereby
promoting a stronger pace of economic recovery and checking undesirable
disinflationary pressures.

I believe this accommodative policy stance is still appropriate
because unemployment remains elevated, longer-run inflation expectations
remain well anchored, and measures of underlying inflation are somewhat
low relative to the rate of 2 percent or a bit less that Committee
participants judge to be consistent over the longer term with our
statutory mandate. However, there can be no question that sometime down
the road, as the recovery gathers steam, it will become necessary for
the FOMC to withdraw the monetary policy accommodation we have put in
place. That process will involve both raising the target federal funds
rate over time and gradually normalizing the size and composition of our
security holdings. Importantly, we are confident that we have the tools
in place to withdraw monetary stimulus, and we are prepared to use
those tools when the right time comes.

Of course, there are risks to the outlook that may affect the
timing and pace of monetary policy firming. In my view, however, even
additional large and persistent shocks to commodity prices might not
call for any substantial change in the course of monetary policy as long
as inflation expectations remain well anchored and measures of
underlying inflation continue to be subdued. As I noted earlier, a surge
in commodity prices unavoidably impairs performance with respect to
both aspects of the Federal Reserve's dual mandate: Such shocks push up
unemployment and raise inflation. A policy easing might
alleviate the effects on employment but would tend to exacerbate the
inflationary effects; conversely, policy firming might mitigate the rise
in inflation but would contribute to an even weaker economic recovery.
Under such circumstances, an appropriate balance in fulfilling our dual
mandate might well call for the FOMC to leave the stance of monetary
policy broadly unchanged.

That said, in light of the experience of the 1970s, it is clear
that we cannot be complacent about the stability of inflation
expectations, and we must be prepared to take decisive action to keep
these expectations stable. For example, if a continued run-up in
commodity prices appeared to be sparking a wage-price spiral, then
underlying inflation could begin trending upward at an unacceptable
pace. Such circumstances would clearly call for policy firming to ensure
that longer-term inflation expectations remain firmly anchored.

Conclusion
In summary, the surge in commodity prices over the past
year appears to be largely attributable to a combination of rising
global demand and disruptions in global supply. These developments seem
unlikely to have persistent effects on consumer inflation or to derail
the economic recovery and hence do not, in my view, warrant any
substantial shift in the stance of monetary policy. However, my
colleagues and I are paying close attention to the evolution of
inflation and inflation expectations, and we are prepared to act as
needed to help ensure that inflation, over time, is at levels consistent
with our statutory mandate.


1. I am indebted to Board staff members Christopher Erceg, Steven Kamin, David Lebow, Andrew Levin, Trevor Reeve, David Reifschneider, Stacey Tevlin, and William Wascher for their assistance in preparing these remarks. Return to text

2. Longer-dated futures suggest that
the prices of some important commodities, such as cotton, are expected
to fall or at least remain flat in coming years; there is little
incentive to speculate in commodities whose prices are not expected to
increase further. Return to text

3. Overall inflation and core
inflation regularly deviate from one another. When this has occurred
over the past 25 years, the tendency has been for overall inflation to
subsequently converge to core inflation, and not the other way around. Return to text

4. An example of this pattern was seen in the months following Hurricane Katrina in 2005. Return to text

5. It should be noted that commodity
price increases do boost the incomes of commodity producers. For
example, the recent surge in food prices has generally boosted the
incomes of farmers and others with ties to the agricultural sector. Return to text

6. Staff analysis at the Federal
Reserve Board indicates that a dollar increase in retail gasoline
prices--a little more than has occurred over the last year--reduces real
household disposable income by nearly 1 percent and hence tends to
exert a significant drag on consumer spending. Return to text

7. Increased investment in
energy-conserving technologies would likely provide a partial offset to
the various factors damping capital spending outside the
commodity-producing sectors. Return to text