WASHINGTON (MNI) – While recent data have dimmed somewhat the
near-term outlook for U.S. growth, John Williams, director of research
at the San Francisco Federal Reserve, predicted that over the next year
or two he expects the wind to begin to fill the economy’s sails and for
unemployment to fall slowly. Inflation remains subdued, he said, and the
risks of sustained deflation or unacceptably high inflation appear
remote. The following are excerpts from his presentation to the joint
meeting of the San Francisco and Salt Lake City Branch Boards of
Directors:

Our forecast at the San Francisco Fed is for real GDP growth of
about 2-1/2 percent this year. We expect growth to pick up steam next
year to between 3-1/2 and 4 percent. Unfortunately, this growth
forecast implies only a very gradual decline in unemployment from its
current 9.6 percent rate. I don’t expect the unemployment rate to start
to fall until next year. And I expect it to remain above 8 percent
until sometime in 2012. It will likely take several more years for it
to return to more normal levels. That is the main reason why this
recovery doesn’t feel a whole lot better than recession. Growth itself
doesn’t provide great relief if the unemployment rate stays high and so
many families still are suffering.

Finally, I’d like to discuss the outlook for inflation. The
measure of inflation I follow closely is the core personal consumption
expenditure price index, released each month by the Commerce Department.
Over the past year, it increased 1.4 percent, somewhat below the 2
percent level that most FOMC members view as consistent with price
stability and about 1 percentage point below its level at the start of
the recession. The fact that inflation declined after a severe
recession is no surprise. In most recessions, slack in labor and goods
markets reduces inflationary wage and price pressures, resulting in
downward movements in inflation.

Actually, the surprise isn’t that inflation has fallen. The
surprise is that it’s fallen so little, given the depth and duration of
the recent downturn. Based on the experience of past severe recessions,
I would have expected inflation to fall by twice as much as it has.
What explains the muted response of inflation this time around?
Economic research shows that inflation has become much less persistent
in the past two decades.

That’s a dramatic break from the wage-price spirals and escalating
inflation of the 1970s. The key to this change in the behavior of
inflation is that, following the Fed’s successful reduction of inflation
starting in 1979, people have come to expect that prices will be stable.
We call that anchoring of inflation expectations. Unlike the 1970s, when
people lacked confidence that the Fed would move aggressively to control
rising inflation, today people expect the Fed to do its best to keep
inflation low and stable. As a result, people expect that movements in
inflation related to the business cycle or other influences will be
temporary and not lead to permanently higher or lower inflation.

This fundamental transformation of the behavior of inflation has
important implications for the inflation outlook. First, we expect
inflation to dip a bit lower to about 1 percent, reflecting the
continued weakness of the economy. But, with expectations well anchored,
the risk of slipping into a sustained period of falling prices, or
deflation, is very small.

In sum, recent data have dimmed somewhat the near-term outlook for
growth, but over the next year or two I expect the wind to begin to fill
the economy’s sails and for unemployment to fall slowly. Inflation
remains subdued and the risks of sustained deflation or unacceptably
high inflation appear remote. In any voyage, storms are to be expected,
even terrible gales like the one we’ve been through. But, with any luck,
the sailing will gradually become smoother as the recession recedes
behind us.

** Market News International Washington Bureau: 202-371-2121 **

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