Mr. Kelley gives an economic assessment of the countdown to Y2K  (Central Bank Articles and Speeches, 29 Oct 98)
Central bank: fed | Type: speech | Date: 1998-10-29

Mr. Kelley gives an economic assessment of the countdown to Y2K Remarks by Mr. Edward W.

Kelley, Jr., a member of the Board of Governors of the US Federal Re System, at the Annual Economic Symposium at Houston Baptist University on 29/10/98.I am pleased to be back with you today to participate in this annual ec symposium hosted by the Houston Baptist University and the Federal Reserve Bank of Da These are challenging times for economic policymakers, and there are many issues cu facing our nation's central bank.

One of them is the Year 2000 computer problem, and th subject for today.

Much has been written on this topic, and I am sure that everyon familiar with the basic issue - specifically, that information generated by compute inaccurate, or that computers and other electronic systems may malfunction because they correctly process Year 2000 dates.

I will dwell no further on the nature of the problem rather attempt to focus on the likely economic impact of this problem.

The economic st very large, and the spectrum of possible outcomes very broad, ranging from minim extremely serious.

For the truth of the matter is that this episode is unique: We reall previous experience with a challenge of this sort to give us reliable guideposts.Although the lack of a precedent may be unnerving, that certainly does not from the obligation to attempt to analyze how the millennium bug is affecting and will economy.

This economic puzzle has many complex pieces - some of them quite inscruta before the event - and my task this morning is to assemble for you the tidbits of infor we do have into a coherent picture of where the Y2K problem appears likely to take us. turn first to the reasons why the Year 2000 problem is so difficult to manage.

Then I s the actions that are being taken by government and businesses to deal with the millen and the effects these measures are having on economic activity at the present time.

Fin turn - not without some trepidation, I might add - to the spectrum of plausible outcom Year 2000, as I see it.

As you shall shortly hear, I believe the Y2K pessimists hav recognized the attention that is being given to this problem and the significant progr already been made.

Given what we know today, I am cautiously optimistic that the mill bug will not cause major economic disruptions when it bites.

## The Difficulty of Managing the Y2K ProblemWhy

has it been so difficult for people to come to terms with the Year problem?

At the most basic level of any organization - be it public or private, large o Y2K problem was all too easy to ignore.

It is a hidden threat, cloaked in the arcane l computer programs and in embedded microchips.

As such, it was difficult at first fo management in the corporate world and the public sector to recognize the serious natu problem.

This was compounded by the fact that the costs and benefits of the situatio individual operation are not easily quantified nor are they attractive.

But after an in denial, the majority of US business leaders now have recognized the problem and are action to correct it.

Nonetheless, given the pervasiveness of the problems involved, I even the most thoroughly prepared organizations are worried that something important m missed.

Indeed, many organizations are developing elaborate workarounds and other conti plans as insurance against Y2K disruptions.

Thus, uncertainty about the ultimate effect Y2K remediation programs already is affecting corporate investment and production pla obviously will be with us until at least January 2000.The second feature of the millennium bug that makes it so difficult to ana the interrelated character of many computer systems.

An individual company may be satthat it has done all it can to fix its own systems, but it still may feel very vulnerab taken by its suppliers and customers.

In an environment where just-in-time inventory and electronic data interchanges (EDI) have linked economic activities very closely tog firm's failure has the potential to ripple through significant segments of the chain o services, and distribution.

Thus, greater coordination of Y2K remediation activities w benefits for everyone.But it is clearly impossible to coordinate the Y2K activities of mill individual establishments.

To help fill this void, numerous organizations have eme clearinghouses of information, and I have high hopes for efforts such as 'National Y2K Week', which was just sponsored by the Small Business Administration (for the Presi Council on the Year 2000), together with a number of private groups.

Other institut functioning as vehicles for system testing.

Witness this past summer's inception of Reserve payment system testing with its depository institution customers, and similar the Securities Industry Association.

Bank supervisors, including the Federal Reserve, a their banks accountable for the effectiveness of their Y2K efforts, and I can assure yo will be consequences for banks that do not fulfill their obligations.

But many organi on their own to test their critical systems with their key suppliers and customers.Because this situation is both complex and fragmented, it is a very difficu quantify the aggregate costs of Y2K remediation.

Similarly and perhaps more important also have no national scorecard on how effective our economy is being in our remed efforts.

Under these circumstances, it is not hard to understand why the millenniu viewed as such an unpredictable phenomenon, and why it has attracted so much gloom and commentary.

## What is Being Done?So, what is being done?

The short answer is a lot is being done.

Let me with you our understanding of the status of efforts by the private sector, government e the world community to deal with the Year 2000 problem.

As far as the private se concerned, efforts to deal with the millennium bug have been intensifying.

In my te before Congress in April, I suggested that the private sector might spend approxima billion over the next two years to tackle the Y2K problem.

This figure was based on a r the available corporate filings with the SEC as well as our own guestimates for firms are private, did not discuss Y2K expenditures in their 10-K reports, or stated that programs were not having a 'material' influence on their bottom line.

We have updat research using the latest quarterly reports, and we were pleased to find a larger pe firms discussing the costs of their Year 2000 strategies, and I am confident these fund used effectively.

While our estimate of the '$50 billion bug' seems still to be reason expect to see this figure move upward over time.I also perceive that the tools available to companies to address Y2K issu increased substantially.

Over the past six months, most major computer hardware and s companies have released documentation of the Y2K readiness of their products on thei sites.

Similarly, most of the major computer publications now have elaborate 'how to' g their web pages that will aid consumers and small businesses in their efforts to m systems Year 2000 compliant.

Commercial software producers also have been busy, and software products are becoming available to aid programmers in repairing code.

I ho believe people are availing themselves of these new resources.

To paraphrase an old ad have brought the Y2K horse to water, and he appears to be drinking!'As far as financial institutions are concerned, I am encouraged by the progr has been made over the past year, and there is every reason to be confident that our system will be ready.

Based on a review of all depository institutions completed b banking regulatory agencies, the vast majority are making satisfactory progress in t 2000 planning and readiness efforts.

About four percent were rated 'needs improvement fewer than one percent were rated 'unsatisfactory'.

In these cases, the agencies hav intensive supervisory follow up, including restrictions on expansionary activities by deficient organizations.

While we can be confident institutions are addressing the pro important to recognize that regulators cannot be responsible for ensuring or guarant Year 2000 readiness and viability of the banking organizations that we supervise.

Ra boards of directors and senior management of banks and other financial institutions responsible for ensuring the institutions they manage are able to provide high qu continuous service in January 2000.The Federal Reserve System has itself made significant progress on Y2K iss meeting all of the goals that we have set for ourselves.

In addition to completing an i of the Y2K readiness of all banks subject to our supervisory authority, we have renov own mission-critical applications, nearly completed work on all others, and are completion of our internal testing.

As mentioned, we have opened our mission-critical s customers for testing with us and have progressed significantly in our contingency efforts.

This has required much hard work on the part of many people, but it is pay visible ways.As in the private sector, activity to fix computer systems maintained by the government is intensifying.

Progress has been made in many areas, but the President's on the Year 2000 agrees that much work still needs to be done.

Reviews of federa programs have highlighted needed areas of improvement, and the Congress has budgeted a $5½ billion for Y2K fixes.

Legislation also has been enacted that would facilitate the Y2K information among businesses and clarify the legal liability of reporting Y2K re information.

All of these are positive developments.With the notable exception of the recent dress rehearsal in Lubbock, I must that far less is known about the effectiveness of the Y2K preparations by state governments.

Attention often is focused on high-profile systems such as the nation's control computers or the electric power grid, but there are many smaller, yet quit electronic systems maintained by states and municipalities that also are very vulne example, innumerable vitally important computer-controlled utility systems are operated government units.

And, as any Washington commuter will tell you, one or two malfuncti traffic signals can cause serious congestion, confusion, and delay, and the complete b of traffic management systems likely would cause near total gridlock.

To try to get a Y2K remediation activity at the state level, we surveyed the web pages of all fifty st District of Columbia and Puerto Rico.

As best we can tell, the states that reported Y2K are budgeting $1 to $2 billion for this purpose.

However, five states had no referen preparedness and 23 states did not cite the cost estimates for their programs.

Thus, b and other anecdotal evidence I have seen, I suspect that much work still needs to be d area as well.On the international level, there is both good news and bad.

The governmen various industrialized nations have stepped up their own internal Y2K awarenesremediation programs over the past six months, and international cooperation is int through efforts such as the Joint Year 2000 Council, chaired by my colleague Federal Governor Roger Ferguson.

Most large multinational corporations report they are well a their preparations worldwide.

However, the conversion to the euro and world financial obviously are deflecting all too much attention away from Year 2000 issues, and I wo time will simply run out for some countries - particularly in the developing world.

A risks exit for some level of disruption to international trade and capital flows.

## How are Year 2000 Preparations Affecting the Economy?Corporate efforts to deal with the Y2K problem are affecting economic activ a

variety of ways.

On the positive side, an important element in some Y2K programs accelerated replacement of aging computer systems with modern, state-of-the-art hardwa software.

Such capital expenditures should raise the level of productivity in those and, in general, the need to address the Y2K problem has increased the awareness on th senior executives of the complexity and importance of managing corporate inform technology resources.

The increased replacement demand also has contributed to the spec recent growth in this country's computer hardware and software industries.

But, ultima are largely shifting the timing of these investment expenditures: Today's added growth 'borrowed' from spending at some time in the future.

And, while accelerating some sy investments, many institutions will 'freeze' their systems in the middle of 1999 forgoing the installation of major new hardware and software systems as we approac millennium.

This certainly will also influence spending on technology - shifting some o 1999 and into 2000.While a shift in the timing of investment spending may help to solve the 2000 problem for some firms, it certainly will not be sufficient.

Most organizations d the option of simply scrapping their existing computer systems and replacing them wit new 'turn-key' hardware and software.

To one degree or another, we all rely on el proprietary software systems that have been developed over many years, and these pro must be debugged by a skilled programmer.

This obviously is a very labor-intensiv time-consuming process, and organizations have had to boost their IT staffs to carry work.

The good news is that many got an early start on this problem and are now well a their repair and testing programs.

The bad news is that there is no corresponding incr firm's marketable output, and this lowers the overall level of productivity in the boosts its costs, and reduces its profitability.One area in which uncertainty about Y2K readiness is likely to have notic effects on economic activity in 1999 is in the management of inventories.

As the mil approaches, I expect businesses will want to hold larger inventories of goods as insura Y2K-related supply disruptions.

Such a shift from 'just-in-time' inventory managemen 'just-in-case' posture is likely to prompt an increase in orders and production dur These stocks subsequently would be run off in the first half of 2000.

We at the Fed, fo will do precisely that in our management of the production of new currency.While Year 2000 preparation efforts may give a temporary boost to econom activity in some sectors, the net effect on the aggregate economy probably is negative. the obviously very valuable ability to maintain its operations across the millenn quantifiable benefits accrue to the firm - and overall productivity gains are reduced hours devoted to reprogramming and testing.

Conservative estimates suggest that the netY2K remediation efforts might shave a tenth or two a year off the growth of our nation' labor productivity, and a more substantial effect is possible if some of the larger Y2K costs turn out to be accurate.

The effects on real gross domestic product are li somewhat smaller than this but could still total a tenth of a percentage point or so a next two years.

## What is the Spectrum of Plausible Outcomes for Economic Activity in 2000?As we have discussed, a great deal of work either is planned or is under deal

with the Year 2000 problem.

But what if something slips through the cracks, experience the failure of 'mission critical' systems?

How will a computer failure in o the economy affect the ability of others to continue to operate smoothly?

How severe the consequences of Y2K problems emanating from abroad?

The number of possible scenario this type is endless, and today no one can say with confidence how severe any Y2K disr could be or how a failure in one sector would influence activity in others.

That said, turn to a discussion of the spectrum of plausible outcomes for economic activity in 2000.What will happen as the millennium rolls over?

A few economists already suggesting that Y2K-related disruptions will induce a deep recession in 2000.

That prob stretch, but I do not think we will escape unaffected.

I anticipate that there wil production problems and disruptions to commerce, and perhaps some public services, th reduce the rate of GDP growth early in 2000.

Certainly a mild inventory cycle seems ve to develop.

But, just like the shocks to our nation's physical infrastructure periodically, I would expect the Y2K shock to our information and electronic infrastructure is most likely to be short-lived and fully reversed.We have many examples of how economic activity has been affected by disruptions to the physical infrastructure of this country.

Although the Y2K problem unique, some of these disruptions to our physical infrastructure may be useful in orga thinking about the consequences of short-lived interruptions in our information infrast early 1996, a major winter storm paralyzed large portions of the country.

Commerce grou halt for up to a week in some areas but activity bounced back rapidly once the roads we again.

Although individual firms and households were adversely affected by these disrup the aggregate, the economy quickly recovered most of the output lost due to the storm instance, the shock to our physical infrastructure was transitory in nature, and, c recovery process was under way before any adverse 'feedback' effects were produced. year's strike by workers at the United Parcel Service is a second example.

UPS is a maj in the package delivery industry in this country, and the strike disrupted the shippin many businesses.

Some sales were lost, but in most instances alternative shipping serv found for high-priority packages.

Some businesses were hurt by the strike, but its economic activity was small in the aggregate.Obviously an important element in any forecast for the Year 2000 is the deg which the failure of the computer system at one institution causes ripple effects on th others.

If the disruptions that occur are not isolated events, as I have assumed, but key sectors of the economy by interacting with each other, then an outright decline in in the first quarter of 2000 could be a plausible outcome.The more dire of the Y2K scenarios would involve, among other things, perpetuation and intensification of these feedback effects.

In such an event, p disruptions could turn out to be a national or international phenomenon and could spr one industry to another.

Under these circumstances, the decline in economic activity wo to be longer lasting, and a recession - typically defined as a decline in real gross dom in two consecutive quarters - could ensue.

But let me quickly stress that I do not recession scenario has a very high probability.

It is possible, but a lot of things hav for it to occur, and much is being done to prevent its occurrence.

## What can Monetary Policy Do About the Millenium Bug?What can monetary policy do to offset any Y2K disruptions?

The truthful ans is 'not much'.

Just as we were not able to plow the streets in 1996 or deliver package the central bank will be unable to reprogram the nation's computers for the year 2000. problem is primarily an issue affecting the aggregate 'supply' side of the economy, wh Federal Reserve's monetary policy works mainly on aggregate 'demand'.

We all understand creating more money and lowering the level of short-term interest rates gives a boost t sensitive sectors (such as homebuilding), but these tools are unlikely to be very e generating more Y2K remediation efforts or accelerating the recovery process if s experiences some type of Year 2000 disruption.

We will, of course, be ready if people hold more cash on New Year's Eve 1999, and we will be prepared to lend whatever sums ma needed to financial institutions through the discount window under appropriate circumst to provide needed reserves to the banking system.

And, if a serious Y2K disruption sho significant feedback effects on aggregate demand - as I outlined in the recession scen obviously would be a role for the Federal Reserve to play in countering the downturn. is nothing monetary policy can do to offset the direct effects of a Y2K disruption.

## ConclusionIn summary, as I stated at the outset of my remarks, I am cautiously optimis the

United States will weather the Year 2000 storm without major disruptions to ec activity.

Some of the more frightening scenarios are not without a certain plausibil challenge were being ignored.

But it is not being ignored - as this symposium toda illustrates.

An enormous amount of work is being done in anticipation of the rollov millennium.

As the world's largest economy, the heaviest burden of preparation falls United States.

But it is truly a worldwide issue, and to the extent some are not prepared and experience breakdowns of unforeseeable dimension, we shall all be af accordingly.

We at the Federal Reserve intend to do our utmost, and we hope and trus will do likewise.