Economic Letter

Historically, oil and natural gas prices have moved hand in hand. However, in the past few years, while oil prices climbed to near record peaks, natural gas prices fell to levels not seen since the mid-1970s as a result of new hydraulic fracturing technology. U.S. consumer energy expenditures are still mainly driven by oil prices, so household energy bills got little relief as natural gas prices fell. Moreover, even though the United States has trimmed crude oil imports, they still equal a substantial share of gross domestic product.

The pace of economic growth has been frustratingly slow and the recovery has lost momentum in recent months. The economy is weighed down by the ongoing European sovereign debt crisis and fiscal tightening in our own country. In these circumstances, it is essential that the Federal Reserve provide sufficient monetary accommodation to keep our economy moving towards the central bank’s maximum employment and price stability mandates. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the Idaho, Nevada, and Oregon Bankers Associations on July 9, 2012.

Textbook monetary theory holds that increasing the money supply leads to higher inflation. However, the Federal Reserve has tripled the monetary base since 2008 without inflation surging. With interest rates at historically low levels and the economy still struggling, the normal money multiplier process has broken down and inflation pressures remain subdued. The following is adapted from a presentation by the president and CEO of the Federal Reserve Bank of San Francisco to the Western Economic Association International on July 2, 2012.

Aggregate state, local, and federal fiscal policy was expansionary during the Great Recession and the initial stages of recovery, providing a tailwind to economic growth. Federal fiscal policy in particular was more expansionary than usual, according to a historical analysis, even when the weakness of the economy is taken into account. However, during the past year, aggregate government budgetary policy has reversed course. Over the next few years, as federal fiscal policy shifts toward austerity, it is likely to be a headwind against economic growth.

In the aftermath of the global financial crisis and the Great Recession, research has sought to understand the behavior of house prices. A feature of all bubbles is the emergence of seemingly plausible fundamental arguments that attempt to justify the dramatic run-up in prices. Comparing the U.S. housing boom of the mid-2000s with ongoing Norwegian housing market trends again poses the question of whether a bubble can be distinguished from a rational response to fundamentals. Survey evidence on expectations about house prices can be useful for diagnosing a bubble.

The recent recession and recovery raise important questions about the relative weight of structural and cyclical factors in the economy. A recent San Francisco Federal Reserve Bank conference explored the extent to which different economic variables behaved in a standard cyclical fashion during this episode or were scarred in a more permanent, structural manner. Both cyclical and structural effects appear evident in the recession, suggesting that some features of the U.S. economy can benefit from stimulatory monetary and fiscal policy, while others are more permanently damaged and unlikely to respond to such policies.

The European sovereign debt crisis has created tensions in the global corporate debt market. Investors increasingly hold international assets and companies issue bonds in many countries. Thus, shocks to the European corporate bond market are readily transmitted to the U.S. corporate bond market. However, the rate of transmission is less than one-to-one. Moreover, different segments of the U.S. market vary in the magnitude of their response to European shocks. In particular, higher-rated nonfinancial borrowers and lower-rated financial borrowers are less affected on average.

Past rounds of large-scale asset purchases by the Federal Reserve have lowered yields not only on the targeted securities, but also on various private borrowing rates. In particular, yields on corporate bonds and primary mortgage rates decreased in response to Fed asset purchase announcements. Notably, however, the link between rates on mortgage-backed securities and actual mortgage rates has weakened in the wake of the financial crisis.

The 2007–08 financial crisis was the biggest shock to the banking system since the 1930s, raising fundamental questions about liquidity risk. The global financial system experienced urgent demands for cash from various sources, including counterparties, short-term creditors, and, especially, existing borrowers. Credit fell, with banks hit hardest by liquidity pressures cutting back most sharply. Central bank emergency lending programs probably mitigated the decline. Ongoing efforts to regulate bank liquidity may strengthen the financial system and make credit less vulnerable to liquidity shocks.

Commodity prices have soared several times in recent years, raising concerns that overall inflation could rise substantially. However, crops, oil, and natural gas make up only about 5% of the cost of U.S. consumer goods and services. Thus, about one percentage point of the 10% cumulative inflation since 2007 reflects price rises in these important commodity categories. When the contribution of these commodities is subtracted from overall inflation, the resulting pattern is remarkably similar to that of core inflation, which excludes food and energy prices.