Mr. Meyer remarks on the economic outlook and the challenges facing monetary policy  (Central Bank Articles and Speeches, 9 Apr 98)
Central bank: fed | Type: speech | Date: 1998-04-09

Mr.

Meyer remarks on the economic outlook and the challenges facing monetary policy Address by Mr. Laurence H.

Meyer, a member of the Board of Governors the US Federal Reserve System, presented at the Public Policy Meeting, Federal Reserv of Atlanta, on 9/4/98.Recent economic performance has been exceptional.

I want to focus on the f responsible for this performance and how much credit economic policy deserves fo outcome.

Then I will assess the crosscurrents shaping prospects going forward a sustainability of recent economic performance and give my perspective on challenges monetary policy.Let me emphasize that the views about the economic outlook and about moneta policy I present here are my own and should not be interpreted as the position of the Governors or the FOMC.

## Where We Are and How We Got ThereThree forces have driven recent economic performance.

First, there has been momentum in private domestic demand - the sum of consumption, private fixed investment residential construction - only partially offset by a decline in net exports.

The r consistent above-trend growth and a rise in resource utilization rates, particularly market.Second, the strength in the aggregate demand for goods and services has encouraged by favorable financial conditions.

Whereas, normally, financial conditions less favorable during an expansion and ultimately constrain demand, in this expansion conditions have become increasingly favorable and therefore have continued to s above-trend growth.

An important element in the favorable financing conditions has, o been the soaring stock market.Third, a coincidence of favorable shocks has enabled businesses to produce lower cost; in the short run, at least, this restrains inflation.

The result has been in the CPI and other measures of the overall price level, even as the economy has raced higher utilization rates.

The favorable shocks have included a decline in oil prices, import prices associated with the cumulative appreciation in the dollar, technological that have sped the reduction in computer prices, changes in medical care management th held down the increase in benefit costs, and improved crops that have damped food priceThe resulting economic performance has consistently exceeded expectations.

I said many times that if I had a dime for every time I have had to say faster-than-expec and lower-than-expected inflation, I would be a rich man today!

Growth over 1998 was 4%, the highest annual growth in about a decade.

The unemployment rate declined by ¾ percentage point last year to a quarter-century low.

And inflation declined to a 30-year low.There is much to like about this outcome and the policy that supported it.

M policy has helped deliver a low inflation environment and the strong economy and disc fiscal policy have delivered a balanced budget.

In the case of monetary policy, the l environment is one we believe encourages efficient resource allocation and perhaps high of saving and investment.

In the case of fiscal policy, the government is no longerwith the private sector for private saving, contributing to lower real interest rates a of capital formation.

In combination, monetary and fiscal policies have set a stable for private sector decision making.As good as policy has been, it clearly does not deserve all the credit exceptional recent performance.

I have a rule I religiously follow: If you didn't pre take credit for it.

We did not predict this exceptional performance and we should not credit for it than we deserve.

Still, there should be little question that policy important contribution to the exceptional performance.The net result of these forces has been that the economy has, in my view, beyond the point of sustainable capacity.

That is, output is above it's long-run susta Normally, this would result in rising inflation, but the favorable supply shocks hav prevented a rise in inflation, but have allowed inflation to decline.

Monetary accommodated the above-trend growth and rising utilization rates precisely because th been accompanied by declining inflation.

## ContradictionsI always appreciated, as a private sector forecaster, that, in any interpret economy, there were always some tensions or contradictions.

This reflects the realit interpretation of the data is never perfectly clear, always subject to some uncertaint is today.

Let me highlight three uncertainties.First, there is some question about whether or not or, at least, to what d economy is operating beyond the point of sustainable capacity.

The unemployment rate i the consensus estimates of the threshold consistent with stable inflation, althoug somewhat greater than normal uncertainty about this estimate.

This threshold is calle the nonaccelerating inflation rate of unemployment.

The President's Council of Ec Advisers estimates this threshold, for example, at 5.4%, Congressional Budget Office and I have used 5.5% as my best guess.

There is, at any rate, no question about labo being very tight.

On the other hand, the measures of resource utilization in the prod notably the capacity utilization rate in the manufacturing sector, do not suggest exce There is, in fact, an unusual discrepancy between the unemployment and capacity uti rates, compared to previous expansions; that is, the capacity utilization rate is lowe have been expected, based on past experience, at the prevailing unemployment rate. undoubtedly accounts for the perception of limited pricing leverage and has contribut restrained inflation, despite the low unemployment rate.

Nevertheless, the very t markets can be expected to put upward pressure on wage change and hence inflation, on special forces restraining inflation dissipate or reverse.Second, there is some question about how to assess the degree of restra stimulus associated with current monetary policy.

Although the nominal federal funds remained nearly constant, the decline in inflation has raised the real federal funds have observed the rise in the real federal funds rate to a level well above its histo and concluded that monetary policy is currently restrictive.

The implication is tha policy is already well positioned to slow the expansion.On the other hand, many other measures of financial conditions appear t indicating, to the contrary, that financial conditions are very favorable, highly s contained momentum in aggregate demand and perhaps becoming even more so.

This˝interpretation appears to be confirmed by the continued strength in aggregate demand i and in interest-sensitive sectors in particular.

Real long-term interest rates, ba measures of inflation, have been stable to declining, equity prices have been soari availability has been more than ample, underwriting standards may have eased some, pricing is aggressive, spreads between safe and risky assets have narrowed, and th supply is growing rapidly.

I conclude that, notwithstanding the recent rise in the funds rate, neither financial conditions in general nor monetary policy in particular restraining aggregate demand.Third, there has been a significant rebound in productivity growth over 19 1997, compared to the previous two years.

That is clear from the data.

The questio data do not immediately reveal is whether this rebound was a normal cyclical rebound or significant increase in trend productivity growth.

My view has and continues to be increase is predominantly a cyclical rebound.

This leads me into my next topic.

## StoriesIn

my last outlook talk I developed two 'stories' that provide alte explanations for the recent exceptional economic performance.

Each story carries wi implication about the sustainability of recent performance and a challenge for monetaryI call one story 'temporary bliss.' This story emphasizes the role of good fo the current exceptional performance and highlights the potential that we may not be maintain the recent rate of growth and the current high labor utilization rates for without ultimately suffering an increase in inflation.

The key to this story is favorable supply shocks that have, in my judgment, masked, for a time, the normal conse of very tight labor markets and permitted the economy to operate beyond the point of sustainable capacity without the usual inflationary consequences.

The challenge monetary policy, in this interpretation, is to facilitate a transition to a more su before the favorable supply shocks dissipate or reverse.The second story I call 'permanent bliss.' This story emphasizes the possibil structural changes have permanently altered what the economy is capable of delivering of both average growth and the unemployment rate consistent with stable inflation. interpretation, monetary policy must be careful not to interfere with the econom advantage of its improved potential.The truth, as I have noted previously, is likely some combination of the two I keep them separate to highlight the differences in policy implications between t supply shocks and permanent structural change.

I have said previously that I have lo estimate of NAIRU, for example, from 6% to 5 1/2%, in response to my reading of the ev of the last several years.

I have also raised my estimate of trend productivity -- f average rate for the 20 years prior to the current expansion to 1.3% or 1.4%.A tenth of this increase in trend productivity growth reflects the technical to the CPI which have lowered the chain measure of the GDP deflator by a tenth.

This increase in trend productivity in this expansion, relative to previous expansions, b upward revision to productivity growth over the entire postwar period, the mirror im decline in the upward bias to measured inflation.

It should be noted, nevertheles technical revisions to measured inflation do account for part of the appearance of economic performance.˝In addition, the data suggest to me, as to many private sector forecasters, might be a tenth or two increase in trend productivity, an improvement that is associated with capital deepening, an increase in the amount of equipment each worker h disposal, as a result of the strength of investment in this expansion.

As such, this in productivity growth may itself be transitory, part of a one-time increase in t productivity associated with a transition to a higher capital-to-labor ratio.

Neverth couple of tenths improvement in productivity growth, if sustained for some period, wo an important boost to higher living standards over time.But this upward adjustment in my estimate of the productivity trend plays negligible role in explaining how we have managed such exceptional economic performa over the last couple of years.

It goes in the right direction, but it is simply too much of the burden.

The major player in my view, in addition to the decline in NAIRU coincidence of favorable supply shocks.

The relative weights here are very important they affect the challenge for monetary policy.

## Challenges for Monetary PolicyThe

challenge for monetary policy, as always, is to sustain the best p economic performance.

The emphasis here is on the 'possible.' Sometimes we are expec deliver more than what is possible.

We aim for maximum sustainable growth and maxim sustainable levels of output and employment.

The emphasis here is on 'sustainable.' T do more threatens to introduce unnecessary instability into the economy and ultimate short an expansion that otherwise has the potential to continue for some time.

Trying threatens to give back some of the reduction in inflation that has moved the U.S. to very close to the Federal Reserve's objective of price stability.The bottom line is that it is essential that growth slow from the near 4% ove and perhaps below trend for a while to allow the economy to move toward a more susta state.

## ProspectsThere are two sets of crosscurrents that are likely to shape the outlook imm ahead.

First, there is a tug of war between the continued exceptional momentum in domestic demand and the external drag from the Asian crisis.

The latter shock also r the restraint that had been projected from a cumulative appreciation of the dollar th the Asian crisis.

The result should almost certainly be some slowing in the expansion, 1997.

Still, the sharper-than-expected decline in oil prices, the decline in long-ter and the further rise in equity prices in recent months are providing some offset to drag coming from Asia and the appreciation of the dollar.

The question is when and ho of a slowing results, and whether the slowdown takes growth to or below trend, or leave still above trend.

There is still considerable uncertainty about how these crosscu balance out.Second, there is a tug of war between the very tight labor market and the set that have been restraining inflation.

The forces restraining inflation have been w battle to date, and they have been reinforced this year by the sharper-than-expected de prices, by the even more extraordinary decline in computer prices in recent months, a decline in commodity prices and further downward pressure on import prices associated w crisis in Asia.

Nevertheless, at some point, the favorable supply shocks will dissipat˝As the economy entered 1998, continued momentum in private domestic demand was clearly evident, while the drag from Asia was less obvious.

But there was clear e the trade data among the Asian developing economies that a significant swing was under their trade balances and there is little doubt that the U.S. economy will bear the gre of this turnaround.

The March employment report was the strongest evidence to date slowing is under way, although it should be appreciated that there is often more noise in one month's data.

And, even with the unexpectedly weak March reading, hours wo advanced at a robust 4.8% annual rate in the first quarter.

So there is still uncertainty about whether the spillover from Asia and the earlier cumulative appreciat dollar will slow the expansion to or below trend immediately ahead.In terms of inflation, there is no evidence to date that wage pressures are relative to last year, and certainly no evidence of a pickup in inflation, though the r core CPI has hinted that the earlier downward trend may now be behind us.

At any appears likely, given the renewal of favorable supply shocks, that inflation will r contained this year.

But monetary policy has little ability to affect inflation th should, therefore, be focusing on inflation prospects for next year.

As I noted ea upward pressure on inflation is likely going forward as forces retraining inflation reverse, though a similar statement would have been in order at this time last year.

T persistence of the special forces restraining inflation is therefore an important con forecasting inflation and in assessing the appropriate course of monetary policy.

It that, as the forces retraining inflation dissipate or reverse, that this upward pressu is not reinforced by inflationary pressures generated from very high utilization rates.The key to sustaining the best possible performance going forward is makin transition from the current state where performance is exceptional but unsustainable t possible sustainable state.

That will require a slowdown in growth, preferably in the Asia may accomplish this, in which case it would substitute for monetary tightening th judgment would otherwise be required.˝