by Calculated Risk on 9/07/2006 03:09:00 PM

Janet L. Yellen, President and CEO of the Federal Reserve Bank of San Francisco spoke today in Boise, Idaho: Prospects for the U.S. Economy. Here are her conclusions on future Fed policy:

The bottom line is this. With inflation too high, policy must have a bias toward further firming. However, our past actions have already put a lot of firming in the pipeline. With the lags in policy we haven't yet seen the full effect of our past actions. These will unfold gradually over time. By pausing, we allowed ourselves more time to observe the data and more time to gauge how much, if any, additional firming is needed to pursue our dual mandate.

And here are her comments on housing:

... we already have seen clear evidence of cooling in the housing sector. Nationally, housing permits are down noticeably—by more than 20 percent—from a year ago. In addition, inventories of unsold houses are up significantly, sales of new and existing homes are off their peaks, and surveys of homebuyers and builders are showing much more pessimistic attitudes. Even in a market that has been as hot as Boise's, some recent evidence points to cooling in the pace of home sales and residential construction activity.

The national data on residential investment reflect all of these developments and enter directly into the calculation of real GDP growth. After adjusting for inflation, (real) residential investment dropped at nearly a 10 percent annual rate in the second quarter following two small declines in the prior two quarters.

The effects of the housing slowdown go beyond their direct contribution to GDP. In particular, what happens to house prices could have important effects on consumer spending, which is a very big part of the economy—roughly 70 percent. As we all know, the pace of house-price appreciation has definitely moderated, after rising at heart-stopping rates in recent years. And there are signs that it may continue. For example, rents are finally moving up more vigorously after a long period of stagnation. This may reflect, in part, expectations that house-price appreciation will continue to slow, as landlords raise rents to try to maintain the total rate of return on rental properties and as those in the market for housing grow more inclined to rent than to buy.

Slower increases in house prices could weaken consumer spending in a couple of ways. Both of them have to do with what I'm going to call the "piggy bank" phenomenon. To be honest, I've stolen this term from some news stories I've seen, but I think the crime is worth it because the description is apt. Back when house prices were rising so fast, people saw that more and more equity was being built up in their house values; in other words, they saw their houses as piggy banks that got fuller and fuller, faster and faster, by just sitting there. Insofar as the piggybank of house value makes up a good chunk of many households' portfolios, they might well have felt that they could afford to spend pretty freely. In economic terms, this is called the "wealth effect." A second factor stimulating spending relates to the ease with which households can now pull money out of the piggy bank. With home equity loans, refinancings, and so on, the piggy bank is now pretty simple to access. So it's no surprise that homeowners seized the opportunity and drew some of the money out to support their spending. Now, with the pace of house-price appreciation slowing, of course, the piggy bank is not getting so full so fast anymore, which may weaken the growth in consumer spending.

While it's likely that the slowdown in the housing sector will have only moderating effects on economic activity and will continue to unfold in an orderly way, I should note that we can't ignore the risk that a more unpleasant scenario might develop. In particular, we have heard a lot in recent years about the possibility that there is a house-price "bubble," implying that prices got out of line with the fundamental value of houses and that the current softening could be just the beginning of a steep fall. While I doubt that we'll see anything like a "popping of the bubble"—in part because I'm not convinced there is a bubble, at least on a national level—it is a risk we have to watch out for.