• Real GDP growth will slow to below potential.
• Housing is not as much of a risk now - can expect less drag in 2007.
• Slowing in the economy will likely come from the consumer sector.

Inflation seen coming down
Seventeen consecutive increases in the Fed funds rate (ending this past June) is finally having an impact on moderating the economy and inflation. This is seen in recently lower core CPI numbers, putting the annualized rate at or below 2 percent, compared to nearly 3-1/2 percent during mid-2006.

Recent statements by Fed officials also indicate that the lower inflation trend is not fully established. This is seen in the volatility in the 3-month-ago annualized changes in the CPI. The view that a lower inflation trend has not yet been fully established is bolstered by the volatility in the core CPI index. On the margin, core CPI has ranged from 3 percent in late 2005 to 2-1/4 percent in early 2006 to 3-1/2 percent during mid-2006 and then down to 1-1/2 percent briefly at the end of 2006.

Yellen sees lower levels of oil prices now reversing their earlier boost in the core trend during early 2006. Crude oil prices were an adverse factor on inflation during the first half of 2006 as the price per barrel went from about $57 in mid-February to about $77 per barrel in July and August. Prices have since dropped back to a range of $50 to $60 per barrel for the most part. The lower level of oil prices has cut costs for many businesses and is reducing pressure on the core CPI rate. However, the price of oil has been rising in recent weeks and some industry experts are forecasting $70 per barrel by the end of 2007. While the San Francisco Fed president's outlook for oil prices is still mainstream, this part of the easing scenario for core inflation is very much at risk.

Another key factor that is expected to affect the core rate is the rent component - including owners equivalent rent. Yellen anticipates that inflation for rents will slow as home purchases become more affordable this year and as more multifamily housing units come on line. Improvement in housing affordability reduces the demand for rental housing.

Based on past inflation cycles, the owners equivalent rent component is a lagging component. During the last inflation cycle this component eased after a decline in interest rates. This should not be surprising since it is housing affordability that eases pressure on rents. So, a decline in this component in the core CPI may depend not on the Fed continuing to pause - holding interest rates at the cyclical peak - but to actually cut interest rates.

What about labor markets?
The San Francisco Fed president acknowledged that tight labor markets are still a concern. The unemployment rate is low and employment growth has been on the high side. She expects employment growth to moderate along with the overall economy.

Interestingly, the Fed's semiannual report to Congress has the fourth quarter 2007 unemployment rate at 4-1/2 to 4-3/4 percent (the Fed states its forecast in a range). Yellen's forecast for slower employment growth is not inconsistent with the little change in the unemployment rate if labor force growth slows as is likely based on demographics (slowly rising retirement rates). Over the last three years, household employment growth has slightly outpaced labor force growth, reducing the unemployment rate and this will need to reverse to get some softening in labor markets.

A key unstated point that falls out of this forecast for slowing employment growth is an implicit forecast for slowing growth in income. Generally, slowing employment growth coincides with slowing income growth. This also would help ease inflation.

Yellen and the Fed's forecast for an easing in inflation with unemployment still well below 5 percent challenges or at least re-estimates the NAIRU (non-inflationary rate of unemployment) view of inflation. In recent years, such an unemployment rate has been seen as at 5 percent or even higher - meaning that 4-3/4 percent unemployment should be inflationary. However, the Fed has established a reputation for thinking in terms of what makes each business cycle different and the internationalization of various markets may be a factor in the Fed 's forecast for a still low unemployment rate and easing inflation.

Evidence that the transmission mechanism from labor markets to inflation is not as tight as in the past is seen in some employment cost measures - as noted by Yellen.

"The employment cost index, is showing remarkably restrained increases of only 3-1/4 percent over the past year, up only slightly from the prior year, and this development would seem to belie tight labor markets. The other measure, compensation per hour, gives a higher reading of about 5 percent. However, this measure includes compensation methods like stock options that are more akin to profits than wages. So part of the strength in this measure may not actually indicate a tight labor market."

Undercurrents in real growth
The San Francisco Fed president anticipates a slowing in GDP growth to below potential for a somewhat extended period. Quantitatively, this means below 3 percent annualized growth. This puts her in line with the Fed's consensus forecast for 2007 Q4/Q4 real GDP of 2-1/2 to 3 percent - although the upper end of the forecast range is not below potential.

What are some expectations about components of GDP? Yellen commented primarily about two sectors - housing and the consumer. Residential investment posted sizeable declines last year and the last two quarters subtracted 1-1/4 percent from GDP growth. Housing has played a key role in slowing the economy.

Yellen sees housing beginning to level off, citing supply coming back in line. More recent housing sales numbers support her view. But initially the improvement is merely not being as much of a drag on GDP growth as opposed to actually posting positive growth rates.

A rebound in existing home sales in January hinted that the view of housing being near bottom may be correct - although warm weather may have just temporarily boosted sales. If housing is no longer pulling GDP down by this magnitude, what will slow GDP growth? Yellen sees the consumer sector slowing.

The consumer sector typically makes up about two-thirds of GDP. Growth in personal consumption and GDP are closely tied. Indeed, if the consumer sector slows, it is very likely that GDP growth will decelerate.

What does the San Francisco Fed president see behind a modest deceleration in the consumer sector? First, "diminishing impetus from household wealth" will be a factor as housing prices increase less rapidly. Lagged effects from higher interest rates also should slow growth in household wealth. She also sees the consumer being uncomfortable with the extremely low level of saving and the consumer pulling back on spending to boost savings. However, she acknowledges that counting on a change in saving patterns is not a high probability position.

Although not stated, slower employment growth would support reduced growth in both personal income and in personal consumption.