Mr. Ferguson discusses the state of the US economy: near-term challenges and long-term changes  (Central Bank Articles and Speeches, 17 Sep 98)
Central bank: fed | Type: speech | Date: 1998-09-17

Mr. Ferguson discusses the state of the US economy: near-term challenges and long-term changes Remarks by Mr. Roger W.

Ferguson, Jr., a member of the Board of Governors of the US Federal Reserve System, at the Federal Reserve Bank of Kansas City on 17/9/98.It is a pleasure to be here today to discuss the state of the economy, because -- despite some turbulence of late in financial markets -- there is still g report.

We are now in the eighth year of economic expansion.

Production, employment incomes have all been rising briskly, and the unemployment rate has declined to its lo since 1970.

And at the same time, inflation has remained remarkably subdued.But the prudent central banker cannot afford to focus exclusively on the performance of the past.

He must constantly look as well to the future.

In that spirit, not only discuss our current economic situation, but I shall also comment on several a believe deserve particular attention in the period ahead.

Some of these areas involv risks to our fine economic performance, and some involve potentially important st changes to our economy.Before I begin, let me remind you that these views are personal and d necessarily reflect the views of other members of the Federal Open Market Committee Board of Governors.

## Recent Economic PerformanceAs you know, the United States has been experiencing a period of exceptio strong economic growth.

Real GDP rose nearly 4 percent over 1996 and again last yea fastest rates of increase, two years in a row, in fifteen years.

And activity maintaine of expansion over the first half of this year as well, although growth apparently did some in the spring.

This recent performance is especially impressive because it occur face of a substantial reduction in export demand associated with the crisis in Asia.This powerful economic growth has benefited American businesses throug soaring profits.

It also has benefited our governments -- federal, state, and local revenues that have come in above earlier expectations.

And it has benefited American w through higher incomes and lower unemployment rates than almost anyone predicted.

Our labor markets have had the tremendous dividend of giving job experience to people otherwise would be on the margins of the economy -- experience that will serve these well for many years to come.

Tight labor markets are welcome, even to central bankers they can be sustained without producing cost and price pressures that will undermine proThe driving force behind this sustained growth has been domestic demand, reflected in enormous increases in both consumption and investment spending.

Consump spending has been fueled by rapid growth of employment and incomes.

With some 6 mill people added to payrolls over the past two years, and with compensation gains well in inflation, consumers have had the means to boost their spending appreciably.

And the mo doubling in the value of the stock market since late 1994 -- only a small fraction of been reversed in recent weeks, I might add -- has made people more comfortable about sp out of current income -- and probably out of accumulated assets, too.

It should be no s surveys that measure consumer confidence have recorded historic highs, nor that thesaving rate has declined considerably.

The same factors, along with the lowest mortgage some time, have powered home sales to record levels.Favorable financial conditions, along with exceptionally large price decli computer equipment, have made it relatively cheap for firms to invest in new pla equipment.

And with sales in a solid uptrend, this has produced a remarkable boom in spending.

Business fixed investment was up nearly 10 percent last year, and it rose at pace in the first half of this year.

Even more strikingly, investment has averaged annual growth over the past five years, making this the most rapid sustained expan investment in thirty years.

As I shall discuss shortly, this investment may provide some to be optimistic about productivity growth in the period ahead.

But, without dou played an important role in helping to boost aggregate demand in recent quarters.One important question looking forward is whether the recent rapid growt demand can be sustained.

I am not a forecaster, but it is important to know what the among forecasters has been, and most have been expecting growth to slow from its recen One reason forecasters have expected growth to slow is that production for inventories rising at an extremely rapid pace that was unlikely to be maintained.

And indeed, investment did drop down a good bit in the second quarter, contributing importantly quarter's more modest GDP growth.

Still, most analysts believe that the rate of stockb at least outside the motor vehicle sector -- probably remained unsustainable and can be to slow further.A second reason forecasters have expected a slowdown is that the impetu consumer spending from annual gains of 25 to 30 percent in share values seemed unlikel sustained.

This may seem obvious after last month's drop in stock prices, but lookin earlier in the year even the most optimistic forecasters were expecting stock market well short of the rates seen in 1996 and 1997.

The impetus to spending from such increases in household wealth would be considerably smaller than was generated by las outstanding run-up in share prices.

And of course, last month's decline may provide reason to expect consumption growth to slow.

## International RisksA third important reason forecasters have expected slower growth ahead i continuing troubles overseas.

The problems faced by our Asian trading partners, inclu persistent weakness of the Japanese economy, and the accompanying strength of the already have led to a sharp reduction in the demand for our exports.

Indeed, in the f this year, the quantity of exports declined two quarters in a row for the first ti mid-1980s, with shipments to Korea and Japan down sharply.

Declines in exports of mach industrial supplies, and agricultural equipment were especially noteworthy.

When we inc effect of rising imports as well, net exports subtracted more than 2 percentage points growth over this period, and our trade deficit on goods and services widened t $175 billion at an annual rate in the second quarter.I should emphasize that not all of the effects on our economy of the Asian have been adverse.

Low prices this year of energy and other internationally traded com including many agricultural commodities such as soybeans and wheat, have benefited mu our nation -- although certainly not our oil industry or our farmers.

Those low price part, a decline in the demand from Asia.

To put it another way, those nations exportiother commodities have borne some of the brunt of the sagging Asian economies.

Further the favorable financial conditions in this country may have been aided by a 'flight to helped hold down our long-term interest rates and stimulate interest-sensitive se housing.

Thus, the seemingly fortuitous timing of extremely robust domestic demand th offset the reduction in our export demand has not been entirely coincidental.As with any financial crisis, it is extremely difficult to predict what the bring for the troubled Asian countries.

I remain guardedly optimistic that conditions w stabilize in the coming months, and that export demand will start to firm at least year.

But that is by no means a certainty.One particular risk is that the problems that have thus far been most severe may become more severe in other regions of the world.

We have already seen this in Russ financial difficulties in other countries as distinct as South Africa and Brazil em worries and uncertainties on this score.

For a variety of reasons, there could b 'contagion' to other countries.

First, investors' appetite for international risks ha following the Asian crises.

This has led to trouble for countries that are running cur deficits and so are dependent on foreign capital.

While most of Russia's problems a grown, for example, more cautious investors probably contributed to precipitating that crisis.

Indeed, over the last month it has become apparent that even US financial marke immune to perceptions that risk has increased.

Second, as some emerging-market countrie fixed exchange rates respond to market pressures by relaxing their exchange-rate arran those remaining countries attempting to peg their exchange rates may come under incr speculative pressures.

Third, countries that have close economic ties to the hardest nations certainly are feeling the repercussions of a reduction in demand for their ex greater economic slowdown in Asia could trigger financial problems in those countries, finally, as I noted earlier, countries that are heavy exporters of oil and other primar have been hard-hit by low prices.In short, international problems in Asia and elsewhere are proving to be profound and sustained than many, myself included, were guessing and hoping would be case.

Obviously, the effect of this drag on our ongoing economic expansion is an a deserves close scrutiny in the months ahead.

## Inflation DevelopmentsBut as I noted, the flip side of reduced export demand and a strong dollar the international situation is helping to hold down inflation here at home.

This help the remarkable fact that our strong economic growth and low unemployment rates coincided with exceptionally favorable news on the inflation front.

I cannot overemph importance of this story: rising inflation has sown the seeds of almost every cyclical the last half century.The consumer price index increased less than 2 percent over the past year.

T time consumer inflation was this low was in 1986 when, as in the present instance, co benefited from declining prices of energy products.

But even when we exclude volatile f energy items and focus on the so-called 'core' CPI, inflation has been running not much percent, the lowest rate in more than three decades.

And a broader measure of prices, price index, has increased only one percent over the past year, held down by rapid decl prices businesses pay for computers and communication equipment.This inflation performance has been better than most analysts had expected we should not exaggerate the extent of the surprise.

True, most economists believe current unemployment rate of 4½ percent is below the level consistent with stable infl indeed may already be exerting upward pressure on labor costs.

But almost all s economists have long realized that unemployment is not the only influence on inflati have emphasized, the strong dollar has led to falling prices for our imports, and low have led to low prices for gasoline and other energy products.

Low oil prices also ha hold down prices for petroleum-derived products like fertilizers and plastics, and reduced price pressures more generally by reducing firms' utility and transportati Furthermore, structural changes in the health care system have reduced the growth o health care costs.

These factors have all contributed to our benign inflation performan need to be vigilant because, just as these factors have worked to the benefit of lo recently, any or all of them may turn around and exert upward pressure on inflation in t

## Changes in the Labor MarketOne of the complexities in the inflation outlook involves changes that appe occurring

in labor market practices.

The extraordinary rise in labor demand a accompanying tight labor markets have led to labor shortages in some parts of the Shortages have been reported for a variety of jobs, with the supply of computer prof especially tight.To some extent, firms have been responding to these labor shortages by ra wages.

And indeed, compensation increases have been growing in size for the past two t years.

But firms also have responded to tight labor markets in ways other than simply larger base wage increases.

Firms have been making increasing use of various forms of pay, such as hiring and retention bonuses, as a way to attract and retain certain key without granting a general wage increase.

These targeted bonuses seem to be most preva information processing workers, but I sense that they are reasonably widespread beyond as well.

And these bonuses are often quite sizable.

It is not uncommon to hear of hiri of five to ten percent of base salary, or higher.Firms are changing their compensation practices in other ways, too.

Busin increasingly are relying less on base wage and salary increases, and are substituting so variable pay that is tied directly to performance, such as annual bonuses and profit sh or even stock options that extend well beyond senior management.These changing labor market practices have implications for the functioning economy that are both interesting and, potentially, quite important.

For one thing, man bonuses may not be adequately captured by our aggregate wage statistics, so if these bo becoming more prevalent, labor costs may be rising somewhat faster than the publishe would indicate.

Second, these practices may lead to changes in the cyclicality o compensation costs.

On the one hand, if firms now are able to use targeted bonuses t workers in place of generalized wage increases, this could hold down compensation costs labor markets, thereby making these costs less cyclical.

On the other hand, increasi variable pay will tend to make compensation more cyclical than it otherwise would hav Under a profit sharing system, for example, firms make larger compensation payments t employees when times are good than they do when business is slack.If the latter effect were to dominate, and compensation were to become cyclical, it would raise interesting questions about how this change might affect fir behavior.

To some extent, of course, firms probably smooth through the cyclical ups an in their costs when making price decisions in any case.

But such smoothing probably perfect, and increases in fixed pay probably would exert some upward pressure on Increased use of profit-sharing bonuses, however, would presumably lead firms to boo employees' compensation precisely when they can most afford to do so.

And, conversely, profits are being squeezed, the resulting decline in bonus payments would help ease t cost pressures.

Thus, there may be reason to believe that increases in variable com payments might not lead to the same price pressures as would increases in fixed compe payments.

In other words, increased cyclicality of compensation gains might not imp change in the cyclicality of price increases.Finally, the spread of variable pay could lead to changes in employment pa Pay that is more variable is more tied to profitability.

As profitability decli compensation, and it is possible that employment may not drop as much as it would in a which compensation is less closely tied to profits.

In any event, it will be fascinat these labor market developments unfold, and to try to sort out the implications macroeconomy.Of course, companies are not moving toward variable compensation schemes alter the macro-dynamics of the economy.

Firms are moving to variable compensation sch because they hope these changes will enhance their profitability, in part by raisi productivity.

By giving workers a larger and more direct stake in the fortunes of the firms are providing incentives for their employees to work more efficiently and to productivity-enhancing changes to the way products are made and business is conducted hard to know how successful these efforts will ultimately prove to be.

Many business pe convinced that variable compensation plans have paid off in terms of higher productivi others are less confident, and say that they hope the changes are boosting productivity is very hard to pinpoint the sources of productivity improvements.This discussion points to one final aspect of our economic outlook that d mention, namely, productivity growth.

In the long run, nothing is as important for our welfare as productivity growth, for this is what determines the pace of increase standards.

And the recent productivity data have been impressive: output per hour wor 1¾ percent in 1997 after an advance of more than 2 percent the year before.

The big qu whether this rapid productivity growth is temporary or is permanent -- that is, productivity has merely displayed its normal short-run response to a step-up in the activity, or whether the faster pace can be sustained for some time even as outpu moderates.The only correct answer, of course, is that we don't know yet.

I can cit reasons to be very cautiously optimistic that productivity may be on a more favorable than it was in the 1980s.

One reason is the changing incentives within the firm owing t pay that I just discussed, which at least some firms strongly believe has aided their performance.

A second reason for optimism is the investment boom that I discussed e Economic history teaches us fairly convincingly that growth in the amount of capital pe is an important determinant of gains in output per worker.Furthermore, some analysts have argued that the computerization of our econ is only now beginning to bear fruit, and that we may expect impressive productivity adv people learn to use the new technology effectively.

The economist Paul David notes tha several decades following the initial development of the electric motor for compa reorganize their production techniques to use the new invention efficiently.

By analogy argument hints that the largest benefits of computerization may be yet to come.This analogy is intriguing, but counterarguments certainly can be made as One reason it took electric power so long to yield benefits is that it took many years technology to gain widespread use, in part because of the huge expenditures requ reconfigure manufacturing plants to use electric power.

By contrast, the transition office equipment to mainframe computers, and then to desktop machines, often entails smaller adjustment costs and so has been comparatively rapid.

Furthermore, it is easy that, while computers account for a large share of investment, they account for only a of the overall capital stock, in part reflecting their rapid rate of depreciation. computers earn a considerably higher return than other investments that firms might m small share imposes some limits on the contribution computers could make to ov productivity growth.So, while we can be hopeful that the recent productivity increases may repr faster long-term trend, we should not count our chickens too soon.

But you certainly productivity to the list of items I will be following closely in the period ahead.

## ConclusionWith

strong output growth, low unemployment, low inflation, and rap productivity growth, these have certainly been good times to be a central banker.

But not mean that they are not interesting times, as a glance at the financial pages will Although our economy is basically very strong, we also face near-term and longe challenges, and I hope I have given you a sense of some of the issues that will be on my try to gauge our nation's economic performance in the period ahead.