Mr Ferguson reviews last year's economic performance in the United States and comments on topics related to macroeconomics and monetary policy  (Central Bank Articles and Speeches, 3 Jan 99)
Central bank: fed | Type: speech | Date: 1999-01-03

Mr Ferguson reviews last year's economic performance in the United States and comments on topics related to macroeconomics and monetary policyRemarks by Mr Roger W.

Ferguson, Jr., a member of the Board of Governors of the US Fed Reserve System at the National Economic Association Forum in New York on 3/1/99.

## Looking Forward, Looking Back: Thoughts on the Start of a New YearThank you very much for giving me the chance to join you to start the New Year.

While m our fellow citizens are relaxing with family and friends, it is nice to know that t braintrust of the United States is busily and happily at work here in New York.

I means the science of economics will be off to a fast start again this year, and in today I shall raise several important issues that I think warrant greater attent profession.The end of one year and start of another is a natural time to focus on accomplishments to create a list of things to do or understand better.

In the spirit of old year ending beginnings, I would like to review last year's economic performance, highlight some p for the upcoming year's economic performance, and, finally, raise some topics relate underpinnings of macroeconomics and monetary policy.Of course, the views that I am about to express are my own, and do not reflect tho FOMC nor those of the Board of Governors.

## Last Year's Economic PerformanceThe last twelve months have been a most challenging time in general, and particularly standpoint of monetary policy.

We started the first half of the year with a focus o winds of strength and international weakness that seemed to be buffeting the Unite economy.

Domestic demand was particularly strong, led by consumption expenditures, wh grew at a 6 percent annual rate in both the first and second quarters of the year consumption was not the only engine driving the spectacular performance of the first 1998.

Business fixed investment, paced by spending on producers' durable equipment, r more than a 22 percent annual rate in the first quarter and by nearly a 13 percent an the second quarter.

Additionally, the housing sector expanded at a robust 15 percent a or more in both the first and second quarters.

These latter two sectors were und supported by relatively accommodative financial conditions.

During much of 1997, long interest rates had trended downward, and by early 1998 rates on fixed-rate mortgages we to their lowest levels in twenty-five years.

Similarly, the rise in equity prices over and the first half of 1998 provided ample incentive for consumption by raising the household assets and improving the general sense of financial well-being of our citizen as lowering the cost of capital faced by businesses.This domestically driven good news was counterbalanced by a sense of foreboding from During the first half of 1998, the net export drag, due in large part to the turm subtracted about 2 percentage points from GDP growth.

The trade deficit grew to well ov billion, again at an annual rate.For the March through July FOMC meetings last year, the Committee maintained a bias to raising interest rates, but did not actually take action.

The sense of the FOMC wa tightness in labor markets and general growth of demand would be likely to createpressures on wage growth and eventually on the rate of inflation.

However, uncertainty the degree and timing of impact from the Asian crises, and the fact that inflation w subdued, allowed us to adopt a 'wait and see' posture.The second half of 1998 provided a very different configuration of events that, as y created the need for some monetary policy action.

Interestingly, the catalyst for thi policy decision was not directly Asia or a slowing economy from net export drag.

Rather the indirect impact of Asia, working through a Russian debt moratorium and ruble deval which provided the impetus for an easing in U.S. short-term interest rates.

By the end financial markets in the United States had become quite unsettled, with an open and flight to quality and liquidity creating a risk of undue credit tightening for p borrowers.

As we said in October in an inter-meeting rate reduction that brought the the federal funds rate target to 50 basis points, 'Growing caution by lenders and conditions in financial markets more generally are likely to be restraining aggregate the future.' The flight to liquidity, which was evidenced in unusually wide spreads bet government securities of similar risk characteristics, and the flight to quality, w through in unusually wide spreads between securities of differing risk characteristic defining factors for much of August, September and October.

More recently, we have seen signs of easing of financial market stresses and some unwinding of the associated quality.

These moves have been encouraged, in part, by policy actions of many centra around the world, and, in part, by a stronger sense that the world's major industrial c G7, are beginning to address a number of the factors that have contributed to uncert volatility in financial markets around the globe.

## Outlook for 1999At present the consensus view seems to be that growth in the second half of 1998 was pr bit slower than the rapid pace of the first half, but that real GDP growth still averag 3 percent on a fourth quarter to fourth quarter basis.

The consensus is that this year' will abate further, perhaps to about 2 percent, which would eventually produce a 'soft of sustained growth near the economy's potential and low inflation.

It's not hard to im to both sides of this scenario, especially with financial markets still not having down, and I can see that 1999 will require a continued high level of vigilance for policOne of the factors that I find most interesting as we start this year is the likely upcoming century date change.

As you may know, I am Chairman of the Joint Year 20 Council, which is a group of financial regulators from around the world that has spen nine months focusing on the Year 2000 computer problem.

In an international context, t 2000 is likely to have differing impacts across different regions.

Here in the United colleague Governor Mike Kelley has stated that we are likely to see some disrupt economic activity because of Year 2000 problems but the effects are likely to be tempo quickly reversed.

I believe businesses already are planning to manage their inventories 2000 considerations in mind.

Later this year, many firms will want to hold larger inve goods as insurance against Year-2000-related supply disruptions and these are likely t those stocks in the first half of 2000.

Households concerned about the viability of som mechanisms could well desire to hold more cash, and both the Federal Reserve and depo institutions are preparing for this contingency.Overseas, Europe is about to convert to the euro, and we shall see tomorrow how success preparations have been.

It is now important for senior management of major Euro institutions to turn their attention to preparations for the Year 2000.

In Asia tomarkets should focus energy on preparing for Year 2000.

The events of the last eighteen have probably distracted their attention from this problem.

However, as we get closer of this year, market participants will require more information on the Year 2000 prepa counterparties.

Those that are not prepared, or do not disclose their state of prepar find that credit is harder to obtain.

It is in everyone's interest that we not become we face this last twelve months before the start of the new millennium.

## Observations and Open Issues From Recent ExperiencesAgainst this backdrop, I want to raise four issues important to the conduct of monetary your consideration and study.The

first two issues involve the supply side of the economy and grow out of the conjuncture in recent years of rapid growth and high resource utilization with lo declining, inflation.

One is the proper measurement of resource tightness.

The two measures of resource tightness, capacity utilization in manufacturing and the unemployment, have historically moved fairly closely together over the cycle.

Howeve have diverged in the past several years, in part as the surge in investment has help capacity utilization in the manufacturing sector while labor markets have become tig tighter.

We need a better understanding of the causes of this divergence, and, if i clearer sense of which measure of resource utilization best foreshadows the emergence pressures.A second, and related, issue is whether the nature of 'capacity' has changed.

Many o have argued that in the 1940s and 1950s manufacturing capacity was more norma characterized by large-scaled units of fixed machinery, such as blast furnaces and asse This capacity took long lead times to manufacture, test and install, so available ca easier to measure and slower to change.

Therefore, high levels of capacity utilization predictors of resource tightness that was likely to translate into pricing pressure.

N capacity in manufacturing is more technology intensive and can be adjusted more easily t supply and demand conditions.

This relatively 'elastic' supply of manufacturing capacity that capacity utilization may not become 'tight' by historical standards, and capacity is therefore a less certain early warning signal of potential pricing pressure.

I have of the assertion that the nature of manufacturing capacity has changed, although the of the last several years suggests that this might be so.

Any research that you can br this issue would be very beneficial.A third issue on my mind is valuations in equity markets, the role they should play making, and whether old relationships have changed.

Many observers have asked if I thi the Federal Reserve can or should have a fixed view on the proper level of equity mar me the answer is that the Fed cannot target specific levels in equity markets.

Equity p by the give and take of supply and demand, with participants buying and selling based own information.

Investors can and should be influenced by several factors, in expectations of corporate earnings, attractiveness of alternative investments, both do international, differing valuations of underlying assets, and differing appetite for risk as opposed to 'creditor' risk.

I believe that the Federal Reserve's tools, primari interest rates, are too blunt to attempt to achieve specific levels of stock market va do I believe that policy makers should necessarily attempt to put their judgments o values above those of the market.However, equity markets send important signals to policy makers and have spillover effe the real economy.

As you know, economists often speak of the 'wealth effect,' and econo modeling indicates that consumers ultimately tend to spend about 2-to-4 percent of inc wealth.

In addition, consumer sentiment is tied to feelings of financial well being.

T of these channels, the so-called wealth effect and the more general impact on c sentiment, equity valuations can and do have an impact on consumption and on macroecon performance.

Additionally, equity markets are an important source of investment capi valuations in the stock market are one determinant of the cost of capital for b Therefore, equity prices have an impact on business fixed investment, a major drive economy.

Finally, equity markets are of interest to policy makers because we h responsibility for macro-stability.

We have seen in other economies that bubbles and financial markets can create unsettled conditions that affect real economic activity. maintaining healthy market conditions are of concern to policy makers.The questions I have with respect to equity markets go to the issue of valuation and effect.

Economists propose numerous approaches to determining the 'correct' level of prices.

One such approach compares equity market valuations (namely earnings/price rat the return on fixed income securities, generally the ten-year U.S.

Treasury bond. observers have suggested that this measure of 'correct' stock market valuation may no l accurate.

Some suggest that the nature of equity markets has changed, with the introd new instruments that allow for better management or sharing of risks.

Therefore, these would assert, lower risk premia over risk-free returns are appropriate, and old re between E/P ratios and the return on Treasury instruments no longer hold.

Others woul that in this world of service firms and high-tech companies, and knowledge-intensive i our accounting treatments do not accurately reflect underlying asset values, and measures of 'correct' stock valuations do not capture economic reality that market par see.

These assertions need scientific investigation that perhaps someone in this perform.With respect to the 'wealth effect,' 1998 was unusual in having several months with a published savings rate.

The existence and persistence of this phenomenon was widely rep the financial press.

Though the focus on this 'negativity' of the savings rate is mispl of measurement issues, what is evident is that the savings rate is low and has substantially.

This experience calls into question whether we have accurately measu feedback of wealth on consumption.

When we look back on this period, we may determine there are periods in which the 'wealth effect' is noticeably greater than the 2-to-4 appears to be the norm.

Economic research also might focus some attention on whether in in wealth have a long lag time in reaching full impact on consumption, and the degree 'long-term' wealth gains are treated differently from 'shorter term' gains that might to be more transitory.Finally, I will turn to the role of international developments and exchange rates in mandate gives priority to price stability and maximum sustainable employment, which I t the right elements for us to consider in policy deliberations.

Therefore, I believe that economic considerations, like stock market valuations, should receive only indirect f are not a closed economy, so we should recognize that our actions have effects o economies and that those effects might, in turn, spill back into the United States.

H are not the world's central bank, and we cannot manage aggregate demand in all parts globe.However, exchange rates are clearly one transmission mechanism for monetary policy.

L interest rates lead to a lower exchange rate for the U.S.

dollar, making our prod competitive relative to those of other countries.

This promotes exports, damps imports to more rapid growth.

In addition to those effects on real economic activity, exchange an influence on inflation.

As we saw last year, a strengthening U.S.

dollar leads domestic inflation by reducing the price of imports and restraining pricing power i competing industries.

One might argue that a change in the foreign exchange value of t should have a one-time effect on the price level, rather than a continuing impact on t rate.

But price level changes do become imbedded in the inflation rate when they alter expectations.

It seems likely to me that the persistent weakness in import prices of has helped to damp inflation expectation and hence have had a persisting damping effec inflation rate.Recognizing the importance of exchange rate movements, there has also been much discu and speculation of coordinated interest rate moves.

Again, I believe that each central focus on its own domestic economic setting, and structure monetary policy to mainta economy at full, sustainable employment with stable prices.

Any other approach, I belie attractive to those that write newspaper stories, is not realistic.Finally, in the international sphere, I note that several countries have an explicit mandate in monetary policy.

In effect, they have given up a measure of independenc sovereignty in their monetary policies.

It is not clear whether these countries have worse record with respect to inflation and growth than countries that do not put suc weight on exchange rates in policy decisions.

I suspect it varies widely across coun additional research on the circumstances in which such regimes are successes and failur be welcome.

I believe that the approach we follow currently, which puts greater we observations and projections of the direct measures of economic performance in the States, is the best for us.

However, if other countries have achieved better results b indirect measures, such as exchange rates, we should be aware of that success.

## ConclusionAs you can see, these are interesting times to be a central banker.

The macroeconomic c evolved quickly during the course of the last twelve months.

The economic outlook slowing, but still positive, growth, but in the context of contained inflation and markets.

To manage this complex set of forces requires continued vigilance on ou Additionally, the last twelve months have raised an important set of questions r measures of real economic performance, the behavior of inflation, financial market in and the growing globalization of today's economy.

I have enjoyed immensely having to g with these issues, but recognize that we at the central bank do not have all the answ consider you research agendas, I ask you to keep in mind the potential positive contri can make to the Nation's welfare by focusing some of your efforts on these policypuzzles, and sharing your results with me and my colleagues.