Fed's Bies: Stage Set for Easing Inflation

DES MOINES, Iowa -- Steady but slower-than-trend U.S. economic growth should lead to more slack in the job market and set the stage for a decline in worrisome inflation though that outcome is not assured, Federal Reserve Governor Susan Bies said Thursday.

"In my judgment, inflation appears poised to decelerate in coming months as energy prices stabilize and resource pressures ease. But the risks to that outlook seem tilted to the upside," Bies told an audience at Drake University.

Bies noted that U.S. economic growth had slowed this year as the housing market cooled off. However, she said much of the slide in housing activity had already taken place, although some further softening may lie ahead.

Mortgage interest rates that remain relatively low by historical standards, income growth and households flush from stock market gains should limit how much further housing slides, she said.

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In addition, weakness in homebuilding has not, so far, spilled over into other sectors of the economy, Bies added.

In the past, housing slowdowns have coincided with sharp economic pullbacks. But that is not the case in the current circumstances, the former banker said.

"The picture painted here is one of an economy that has been growing solidly, albeit at a rate below its potential," Bies said.

The Fed has kept benchmark interest rates on hold at its past three meetings after a more than two-year-long campaign during which it ratcheted borrowing costs steadily higher.

While Fed officials have said they remain focused on inflation risks, many financial market participants think the U.S. central bank's next move may be to lower interest rates to buffer the economy.

Even though the economy has slowed, tight labor markets could continue to push inflation pressures up, Bies said, adding that an acceleration in consumer prices excluding food and energy over the past year was "clearly a concern."

However, Bies also said the scene appears to be set for a deceleration in prices, as cooler growth eases job market pressures and frees up industrial capacity.

High energy prices are stabilizing at lower levels, which should also help curb inflation, she said. Firms may also have a buffer in high profit margins to prevent passing higher labor costs on to customers, she added.

Bies said policy-makers faced the challenge of trying to determine the U.S. economy's noninflationary speed limit at a time when an aging population was likely to lead to slower labor force growth and a lower speed limit.

She cited a Fed study released earlier this year that found the U.S. labor force participation rate, or the percentage of the population in the labor force, could decline by 0.2 percentage points in 2007 and drop further in coming years.

If the participation rate dropped by that amount, the "equilibrium" growth rate of employment - the increase in jobs consistent with a stable unemployment rate - would fall to 110,000 per month from its current level around 140,000, she said.

While a decline in the participation rate was likely to dampen the economy's potential growth rate in coming years, Bies said the impact might not be as great as Fed researchers suggested since workers increasingly appear to be putting off retirement.

She also said productivity growth, which along with labor force growth determines the noninflationary speed limit, was likely to remain strong.

Overall, Bies said, the combination of forces was likely to lead to "a modest deceleration in the growth of potential output."

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