Remarks by Jeffrey M. Lacker

President, Federal Reserve Bank of Richmond

It is a pleasure to be with you today to discuss the economic outlook for the region. I work, as Barbara's kind introduction noted, at the Federal Reserve Bank of Richmond. The fact that our nation's capital lies within the Richmond Federal Reserve District, rather than the other way around, is an odd byproduct of decisions made over 90 years ago. When establishing the Federal Reserve System as the nation's central bank, Congress created a confederation of regional banks, rather than a single, centrally located bank. The founding organizers then made Richmond the headquarters for the Fifth Federal Reserve District, which covers the area from West Virginia and Maryland in the North down to the Carolinas in the South. The founders' motivating vision was that the nation was better served by an institution that was closely linked to the diverse economies that make up our country. And so, one of our key responsibilities at the Reserve Banks is to understand local economic conditions around our Districts. Of course, the Fed is well represented inside the beltway, since Washington is the home of the Board of Governors of the Federal Reserve System, the entity that oversees Reserve Bank activities. They are kind enough to let me roam Washington at will, and we are kind enough to cut their paychecks for them.

I plan to discuss economic conditions in our Federal Reserve District, with a particular focus on conditions in the Washington metropolitan area. But because our region's economy is so tightly linked with national economic trends, I will spend some time talking about the overall economic picture as well. As always, my remarks reflect my own views, and do not necessarily reflect the views of my colleagues within the Federal Reserve System, but you probably gathered as much from my recent voting record. To set the stage, let us start at the national level. The U.S. economy currently is in a period of transition. Looking back over the last three years, real gross domestic product -- our broadest measure of total economic activity -- grew at a 3.75 percent annual rate. That's a very healthy growth rate to sustain over a number of years, and it coincided with a significant improvement in the labor market, with 5.3 million new jobs created and the unemployment rate falling by a full 1.5 percentage points. Now that labor market conditions are fairly firm, the economy is transitioning to growth at a trend rate of around 3 percent per year -- a pace at which job growth will match the growth in the number of workers over time.

I should note at this time that it would not be unusual for the transition to trend growth to be a little bumpy. That occurred back in 1995, for example. Growth in the first half of that year dipped below 1 percent at an annual rate before returning to a healthy pace that was sustained for the next five years. And this time around, there is an obvious reason to expect growth to drop below average for a time, namely, the end of the boom in residential housing. I'll talk more about this later on, because how the adjustment in the housing market plays out is an important source of uncertainty in the outlook, both regionally and nationally.

The other major source of uncertainty in the outlook is inflation. Price stability is the central responsibility of the Federal Reserve -- we contribute best to economic growth when we keep inflation low and stable. That is widely viewed as requiring inflation to average between 1 percent and 2 percent, as measured by the core price index for personal consumption expenditures. Inflation, by that measure, has drifted up to 2.5 percent this year. Inflation is likely to moderate over the near term, but there is some uncertainty as to how long that will take. Should inflation persist around the current elevated level, firmer monetary policy would be required to restore price stability. As a result, I believe policymakers will need to remain quite vigilant in the period ahead, to ensure that inflation moderates at a sufficient pace.

The overall outlook for the Fifth District's economy is positive, though perhaps somewhat less so than if I had been giving this talk earlier in the year. Employment has grown over the twelve months ending in August at a solid 1.7 percent rate, better than the 1.3 percent growth rate for the U.S. Employment growth has slowed since the spring, similar to the national pattern. The combined unemployment rate for the six jurisdictions in our District has been steady near the current 4.5 percent rate, which is comparable to the 4.6 percent unemployment rate for the U.S. as a whole. Household financial conditions are also consistent with the national figures, with second quarter personal income expanding 2.2 percent against a 2.7 percent annual rate of growth nationally. And recent data on household finances indicate that those living in our region are not facing any unusual difficulties servicing mortgages or otherwise meeting financial obligations.

This overview of the District's economic picture masks significant differences between several unique economies within the Fifth District. The Carolinas, along with the southern edge of Virginia, for example, is a region that has historically been dependent on manufacturing, particularly textiles and furniture. These industries have shifted much of their production overseas in recent years. Six years ago, employment in textiles and apparel comprised 23 percent of all manufacturing employment in the region. As of August of this year, that share is down to just 16 percent. Despite this tremendous structural change, economies in these areas are currently experiencing job growth at over 2 percent per year, greater than the national average, and employment in the Carolinas has recently reached new peaks. Driving this rapid growth is the continuing expansion of construction jobs -- I'll say more about this later -- added strength in service sector jobs, and a lessening of manufacturing job losses. In fact, new manufacturing operations requiring more highly skilled workers are offsetting some of the decline of the old-line, low-skill industries. On the service side, we are seeing strong growth in the education and health services category. This mirrors the national picture, likely reflecting greater need for health services as we age.

Another big factor, though, is financial services. In the year ending in August (the latest data available), growth in financial sector employment has been about double the rate of overall job growth in the Carolinas. Some of this is attributable to the recent rapid growth of jobs in Charlotte, which is by some measures the nation's second largest banking center. The Charlotte area accounts for about one-fifth of all the jobs created in North Carolina in the past two-and-a-half years. In contrast, South Carolina still has counties -- mostly rural -- with double-digit unemployment rates, signaling perhaps that the state still has some catching up to do and that growth in the services sector has not necessarily been as robust in those parts of the state that have been losing manufacturing jobs. In many ways, the southern tier of Virginia is broadly similar to the economy of the Carolinas and it shares some of the economic issues of those states. An exception is the greater Norfolk -- Virginia Beach area, which has a large military component in addition to tourism and services. This area has recently posted strong employment growth of 1.7 percent.

Looking westward within the Fifth District, West Virginia has also been shifting to a services economy, with nearly half of the state's residents residing in officially designated metropolitan areas -- those in the eastern panhandle being part of the Washington metropolitan area. Outside of the panhandle, however, many areas of West Virginia still rely heavily on manufacturing or mining. Those industries continue to exhibit a pronounced cyclical nature, making the state's economy somewhat more volatile than other areas of our District. Nevertheless, recent expansions by Japanese car manufacturers, combined with the boost to natural resource industries from relatively high energy prices, have paid dividends to the state in recent years.

Closer to home for you, northern Virginia, Washington, D.C., Maryland and portions of eastern West Virginia make up the third broad economic region of our District. This region is composed primarily of service-oriented urban areas that have historically outperformed other regions in our District, as well as the national economy. The federal government has served as a major source of job growth for the region, and has traditionally acted as an economic stabilizer. This region was affected much less than the rest of the country by the recession earlier in this decade, for example. And employment growth has continued to outpace the nation; Washington metro area employment grew 2.5 percent in the year ending August, adding more jobs than any other large metro area outside of New York and Phoenix. Growth in recent years has been powered by defense spending and the ramping up of homeland security. The Washington area receives a substantial share of federal government procurement dollars, and a substantial portion of that spending is technology-related. The job growth has been concentrated in government and professional services and has been in relatively high-skilled, high-pay occupations. But the appropriate question to ask is whether job growth will continue at a breakneck pace. I hesitate to forecast federal policy with a hotly contested election right around the corner, but it seems reasonable to suppose that the real growth in defense and security spending will taper off somewhat in the years ahead. Fortunately, a substantial portion of the recent job increases have come in the private sector, and a substantial portion of these have been in sectors associated with technological innovation. We believe that total metro area employment should continue to expand at a healthy pace, but at a rate that gradually declines over the next couple of years.

On balance, even with the regional differences, the broad outlook across the Fifth District economy remains solid going forward, though there are risks for the regional economy, much as there are for the national economy. Housing is easily the most widely discussed economic risk at the moment. Because home prices in the Washington area have been notoriously high in recent years, I would imagine that the housing market commands even more attention hereabouts. And with good reason. Washington experienced a more rapid price appreciation than most of the nation during the recent housing boom, and has seen a sharper downturn in recent months.

But to understand any given local housing market, it is important to understand several macroeconomic factors affecting housing markets nationwide. So I would like to talk a bit about these macro factors, and then come back to the local housing market. First, remember that the recent housing boom has been very large by historical standards. A couple of numbers help illustrate the magnitudes involved. In 2005, almost 2 million new homes were built in the U.S., which is about a 50 percent increase from the average number built each year in the 1990s. Last year the average price of a home sold in the U.S. rose 13.3 percent; back in the 1990s, the average increase was 2.8 percent per year. The acceleration was even greater in the Washington area, where price appreciation ran as high as 25 percent last year versus around 2 percent in the 1990s.

Some of the concern about the housing outlook is motivated by the observation that large swings in residential housing activity, often in response to movements in interest rates, have played a big part in the post-war business cycles. But if you look carefully at the data, you see a big change beginning in the 1980s. Before that time, the way financial institutions were regulated contributed to extreme volatility in housing markets. Most home purchases then were financed by thrift institutions, who raised the bulk of their funding through retail deposits that were subject to interest rate caps. When interest rates rose in the course of a business cycle, money would tend to flow out of regulated financial institutions in search of higher returns, a process known as disintermediation, which caused severe disruption to the home financing system. This regulatory structure made housing activity much more interest rate sensitive, and much more volatile, than it otherwise would have been. The regulations capping deposit rates were eliminated in 1980, and the housing market's role in the business cycle has been quite different since then. In addition, cyclical interest rate movements were substantially larger prior to the mid-1980s. One should be cautious, therefore, about comparing the current housing cycle to historical episodes, particularly to episodes prior to the mid-1980s.