Laurence H Meyer: The New Economy meets demand
Speech by Mr Laurence H Meyer, Governor of the Board of Governors of the US Federal Reserve
System, before the Boston Economics Club, Boston, on 6 June 2000.
* * *
I often draw the themes for my talks from the questions I hear about the intersection of the economic
outlook and monetary policy. This evening, I begin with two questions that are central to the
economy's prospects and the challenges facing monetary policy. First, Is there a new economy? And
second, What role, if any, do traditional economic principles, specifically the role of supply and
demand, continue to play in today's economy?
Before I proceed to those questions, I want to emphasize why the answers matter. It almost - and I say,
almost - goes without saying. Nevertheless, I can't stress too often that we care about the balance of
supply and demand in the economy because we care about promoting both full employment and price
stability and, thereby, maximum sustainable growth. We want to contain inflation because doing so
has been crucial for sustaining the economic expansion that we now enjoy and for providing an
environment conducive to private decision-making and longer-term planning so critical for taking
advantage of new technological opportunities. Containing inflation has, I am sure, contributed to the
length and strength of the economic expansion we now enjoy - an expansion, by the way, that is the
longest in our nation's history. And I need not remind you that the low inflation we now have was
dearly purchased in the late 1970s and early 1980s with the highest interest rates since the Civil War
and the highest unemployment rate since the Depression.
Precisely because inflation is the critical issue that hangs in the balance of new economy possibilities
and old economy regularities, I will offer some observations on how I read the recent data on labor
compensation and price inflation. My comments are in the spirit of inflation reports that many central
banks with explicit inflation targets regularly issue.
Before proceeding, let me remind you that the views expressed on the outlook and on monetary policy
are my own. I am not speaking on behalf of the Board of Governors or the Federal Open Market
Committee.
Is there a New Economy?
So, is there a "new economy"? The answer is: it depends. It depends on how you define new economy,
and it depends on where you live.
There are broader and narrower definitions of the new economy. The narrow version defines the new
economy in terms of two principal developments: first, an increase in the economy's maximum
sustainable growth rate and, second, the spread and increasing importance of information and
communications technology. The latter is presumably the major contributor to the acceleration in labor
productivity that, in turn, is the principal source of the increase in trend growth in real GDP. A third,
and perhaps related, development is a possible increase in the economy's sustainable utilization rates,
specifically a decline in the non-accelerating-inflation rate of unemployment (NAIRU).
Our laboratory for the new economy is the United States, given that there is very little evidence
outside the United States for even this narrow definition of the new economy. In the case of the United
States, however, there is little doubt that the underlying rate of productivity growth has increased
significantly in the second half of the 1990s.
From 1974 to 1995, labor productivity advanced at about an annual rate of 11⁄2%. Productivity then
accelerated to a rate of about 21⁄2% in the second half of the 1990s. This acceleration appears to have
been spread out over the second half of the 1990s, so that the average rate over that period understates
the rate of productivity growth at the end of the period.
Productivity typically grows faster than its longer-term trend when GDP growth is rising and falls
below trend when GDP decelerates. This pattern simply reflects lags in adjusting employment to
changes in GDP growth. Measuring productivity growth over a long period, such as 1974 to 1995,
effectively eliminates this shorter-run component of productivity growth. And because GDP growth
was relatively stable during the second half of the 1990s, shorter-run dynamics appear not to have
been an important contributor to the higher productivity growth in that period. Moreover, careful
econometric attempts to isolate the short-run dynamic and longer-run structural components generally
have concluded that structural productivity growth increased from about 11⁄2% in the earlier periods to
around 21⁄2% to 3% by the end of the decade. That would put the sustainable rate of GDP growth up to
31⁄2% to 4%.
Still there is considerable uncertainty about trend productivity growth, including whether it might be
accelerating, especially given the brief period over which higher and rising structural productivity
growth has been experienced. Important questions about the measurement of productivity aggravate
this uncertainty.
And there is also considerable uncertainty about how long the higher productivity growth will persist.
For example, periods of more rapid productivity growth might be best understood as a transition to a
higher level of productivity that is based on major technological developments. The persistence
question is more important for assessing longer-run fiscal prospects - including the solvency of Social
Security - than to monetary policy decisions that are made in the context of a one to two year period.
Using the neoclassical model, and disaggregating capital into information and communications
technology and other capital, Dan Sichel and Steve Oliner of the Board staff decomposed productivity
growth into contributions from capital deepening (the growth arising from an increase in the ratio of
capital to labor) and multifactor productivity growth (the growth in output that cannot be accounted
for by increases in labor and capital inputs) and into the contributions from the use of information
technology and from increased efficiency in the production of computers. According to their estimates,
a bit less than half of the productivity acceleration was due to a pickup in capital deepening and a bit
more than half to an increase in multifactor productivity growth. More than 90% of capital deepening
came from information and communications technology equipment, and nearly 40% of the increase in
multifactor productivity growth came from increased efficiency in the production of computers and
embedded semiconductors. Altogether, therefore, information and communications technology
accounted for slightly more than two-thirds of the increase in productivity.1
Besides the direct effects of information and communications technology through capital deepening
and the more efficient production of computers, this technology may also indirectly raise productivity
through spillover effects. If the use of information and communications technology generates
externalities throughout the economy - for example, through new efficiencies from e-commerce - the
overall efficiency in production will increase. In a traditional growth accounting setup, these effects
would show up in multifactor productivity growth. Evidence of spillovers is extremely sparse. Some
back-of-the-envelope calculations by Oliner and Sichel suggest that such effects have been quite small
to date, though the explosive growth of e-commerce, particularly in the business-to-business segment,
suggests a potential for a more important contribution over time.
But do these developments - specifically higher trend productivity growth and the spread of
information and communications technology - alone justify the "new economy" label? We could, for
example, explain recent US economic performance in terms of "new parameters in the old paradigm".
Specifically, we could increase the estimate of trend productivity growth, based on higher multifactor
productivity and capital deepening - both due in large part to information and communications
technology - and have a fairly good explanation of the remarkable performance of the US economy.
This approach would explain the recent productivity performance without denying the continued
relevance of old economy regularities, including the role of supply and demand imbalances as a source
of inflation dynamics.
The alternative - and the broader interpretation that often seems to underlie the new economy label - is
that we are witnessing a more fundamental change in the paradigm. The old rules no longer apply.
Throw out the NAIRU. Heck, throw out supply and demand. No limits, no business cycles. All right,
this is a bit of an exaggeration, but you get the point that I am not especially partial to the broader
interpretation of the new economy concept!
Still, to be fair, there are other potential and perhaps more far-reaching implications of the spread of
information and communications technology, including the role of the Internet and e-commerce.
Today, these are, in my view, best expressed as questions about future prospects rather than as
principles underlying the present economy. For example, do these developments increase the
competitiveness of markets, and, if so, how does this affect inflation dynamics? They appear to
increase the speed and effectiveness of price discovery. What does this imply for pricing leverage and
inflation dynamics? Do they contribute to a permanent increase in sustainable utilization rates, perhaps
by increasing the efficiency of the matching of available workers with available jobs? Do they result in
rapidly growing sectors dominated by increasing returns to scale, where increases in demand lower
cost and hence prices? These are all provocative and important questions, but none of these
developments, in my view, are powerful enough at this moment to support the notion that labor and
other utilization rates can rise ever higher without triggering accelerating prices - the broader version
of the "new economy".
So, is there a new economy? As I said, it depends. For my part, I accept the proposition that there has
been a significant improvement in underlying productivity growth in the United States, that it is very
closely tied to improvements in information and communications technology, and that it is likely to
spread around the world. But I resist the new economy label because it seems to encourage a
disrespect for the old rules that could seriously undermine our success in taking advantage of the new
opportunities. This brings me to my second topic.
Welcome back supply and demand
I was startled by the bold title of an article that appeared in The Wall Street Journal on 31 December
1999: "So Long, Supply and Demand". But it illustrates the unbounded optimism - some might even
call it irrational exuberance - about economic prospects and a willingness to abandon time-tested
economic principles that offer cautions and imply constraints on economic opportunities.
I was rather certain that confidence in supply and demand would make a comeback, and so I was
The Wall Street Journal
delighted to see the front-page story in on 16 May 2000 - the day of the last
FOMC meeting. The title this time was "Firms Start Raising Prices, Stirring Fears of Inflation
Fighters," and it began: "Even in the new economy, at least one old rule still applies: if demand
exceeds supply for long enough, sellers will raise prices." So let me count the ways that supply and
demand help us to understand the recent experience and the challenges facing monetary policy today.
First, a productivity shock affects aggregate demand as well as potential supply and may initially have
an even larger effect on demand than on supply. In early discussions about the productivity shock, the
emphasis was, not surprisingly, exclusively on its supply-side implications - specifically a faster rate
of productivity growth and hence of sustainable GDP growth. The natural corollary seemed to be that
a faster growth of supply than of demand would be a powerful disinflationary force.
But during the period over which productivity has accelerated, demand has grown faster than potential
supply. The demand effects - to the extent that they are directly related to the productivity shock
likely reflect the more favorable investment opportunities, the effect of expected profitability on equity
prices and hence household wealth and consumption, and the effect of the increase in expected future
labor income on current consumption. Demand, it appears, received an additional boost over this
period from a run-up in equity prices that the higher productivity growth alone could not fully account
for.
The balance between supply and demand can be inferred from movements in utilization rates,
specifically in the unemployment rate. When actual output is expanding at the same pace as potential,
the unemployment rate will be stable. When output growth outpaces the growth of potential, the
unemployment rate declines. And the unemployment rate has declined almost 0.4 percentage points a
year for the past four years. This translates into excess demand growth of 0.75 to 1 percentage point
relative to potential supply growth.
The second insight - and enduring old economy wisdom - is that a proximate source of changes in
inflation is an imbalance between the levels of aggregate supply and aggregate demand. This can be
expressed as an imbalance between actual and potential output or as a divergence of the
unemployment rate from the NAIRU. The imbalance between the growth rates of aggregate supply
and demand is, of course, the source of changes in the balance between the levels of aggregate demand
and supply. But inflation is related directly to the levels not to the growth imbalance. And, even in the
new economy, excess aggregate demand ultimately drives up inflation. Thus the limits may have
changed, but the consequences of overtaxing the limits remain the same.
Do we have excess aggregate demand? In my judgment, we have excess demand conditions in the
labor market. The central tendency for my estimate of the NAIRU is in the range of 5% to 51⁄4%,
compared to the 4.1% current unemployment rate. This estimate is consistent with most large-scale
macroeconometric models and with the estimates of the NAIRU that underlie the economic and
budget projections of both the Council of Economic Advisers and the Congressional Budget Office,
but there is nonetheless legitimate uncertainty about the estimate of the NAIRU. This uncertainty has
been, in my view, an important consideration in the way monetary policy has responded to recent
economic developments. Obviously, whether the NAIRU is closer to 4% or to 5% affects the difficulty
associated with rebalancing supply and demand to contain the risk of higher inflation.
But why has inflation remained moderate if there is persistent excess demand in the labor market?
This is still another supply and demand story. The economy is subject to two fundamental types of
aggregate economic shocks: supply shocks and demand shocks. These two types of shocks give rise to
different challenges for monetary policy.
Supply shocks come in two varieties: relative price shocks (such as changes in the relative price of oil)
and productivity shocks. Earlier in this episode, the economy benefited from a series of favorable
relative price shocks and, throughout the last several years, has been adjusting to an increase in
productivity growth. Both of these developments have had a temporary disinflationary effect. Together
they suppressed inflation for a while, countering the potential inflationary consequences of the
progressive increase in aggregate demand relative to potential supply. Once the disinflationary
impetus from supply shocks begins to dissipate or to reverse, the inflationary consequences of the
supply-demand balance will begin to show through. The disinflationary effect of an increase in
productivity growth begins to dissipate once productivity growth stabilizes at a higher level. So unless
productivity accelerates further, its disinflationary effect should continue to erode for a time.
When favorable supply shocks dominate, growth in demand is stimulated and utilization rates rise, but
inflation tends to moderate. The result is offsetting implications for the setting of the nominal funds
rate and, thus, monetary policy may be left with little work to do. This accounts for the relative
inactivity of monetary policy from 1996 through the end of 1999, at which point the federal funds rate
was within 1/4 percentage point of where it was at the beginning of the period.
But once the disinflationary effects of the favorable supply shocks dissipate or reverse, the challenge is
more like one that accompanies demand shocks. Excess demand, evidenced by utilization rates above
sustainable levels, will put upward pressure on inflation, and monetary policy must restrain aggregate
demand to bring it into balance with potential supply to avoid rising inflation.
A brief inflation report
But is there any evidence that inflation pressures are in fact building? Of course, overall inflation has
clearly increased significantly over the last year. The consumer price index, for example, has increased
at a 3% rate over the last twelve months, compared with a 2.3% rate over the previous twelve months.
Similar trends are evident in the PCE and in the GDP price index. But this increase in overall inflation
reflects mainly the rise in oil prices over 1999 and into 2000. Assuming that oil prices stabilize, the
effect will dissipate, and overall inflation will return toward, and indeed dip slightly below, the core
rate (the rate net of food and energy prices). So, looking forward, the core inflation rate is the more
important consideration.
The core CPI advanced at a 2.2% rate over the last twelve months, a rate equal to that over the
previous twelve months and only about 1/4 percentage point above the cyclical low reached in
January. These numbers suggest that inflation pressures remain well contained. But digging a little
deeper, the evidence, in my judgment, supports the conclusion that core inflation has moved modestly
higher over the last six to nine months.
First, the introduction of a methodological change in measuring the CPI in January 1999 lowered CPI
inflation relative to the earlier period. As a result, on a methodologically consistent basis, core CPI
inflation in the last twelve months has actually been up a couple tenths of a percentage point. But,
more important, the higher-frequency data provides some evidence of a rising trend in core inflation.
For example, at an annual rate, core CPI inflation is 2.4% over the last nine months, 2.5% over the last
six months and 3.2% over the last three months. So I conclude that the underlying trend for core CPI
inflation has moved up to close to 21⁄2% today.
The core PCE and the GDP price indexes also have accelerated over the last six to nine months. The
core PCE index increased at a 1.4% rate over 1999. Over the last year the rate was 1.6%, over the last
six months 1.9%, and over the last three months 2.4%.
The higher core inflation could be explained by a pass-through to the core of earlier increases in oil
prices. However, whether such a pass-through leads to a one-time increase in the price level or to
continuing inflation depends on whether or not monetary policy accommodates the higher inflation.
Whether such accommodation occurs, in turn, depends on how policy deals with the excess demand
that will be felt in the first instance in wage pressures in a very tight labor market.
I therefore turn to an assessment of the pressures coming from labor compensation. Here the data are
even more confusing. For example, consider the trend in year-over-year growth rates for the three key
measures. For the employment cost index, the trend is decidedly up; for average hourly earnings,
however, the year-over-year growth rate has been flat; and for compensation per hour in the
productivity and costs report, the trend is actually down. Again, we need to dig a little deeper, but this
excavation will not allow us to reach a definitive judgment from this extraordinarily mixed set of
indicators.
Until the May employment report, the recent monthly data clearly pointed to an acceleration in
average hourly earnings - given the 41⁄2% rate posted over the first four months of the year after a 31⁄2%
rate over 1999. But the unexpectedly small increase in May left the year-over-year increase in average
hourly earnings at just 3.5%, about the same as over the previous twelve months. Year-to-date,
average hourly earnings has increased at a 3.8% rate - still an acceleration, but one that is far less
definitive than that based on the data through April. There will be considerable interest in the next
report for further evidence on the degree of upward trend in this measure.
There are, in my judgment, some grounds for discounting the productivity and cost measure. During
the last benchmark revision, this measure was adjusted up sharply. I will have more confidence in the
recent data for this measure of labor compensation if the deceleration remains intact after the next
revision. In addition, this measure tends to use trends instead of real-time data for benefit costs
although the Bureau of Economic Analysis does adjust the trends judgmentally in response to the
real-time ECI data on benefit costs. Lately, the benefit component of the ECI has rebounded sharply.
Even if the evidence for an acceleration in nominal labor compensation were more definitive, the
implications for inflation are not altogether straightforward. If the trend in the growth of labor
compensation is upward, it could be a response to the uptick in overall inflation last year or to overly
tight labor markets or to a catch-up to the higher rate of productivity growth. Just as the slowing in
overall inflation in 1997 and 1998 contributed to a moderation in nominal wage demands, the higher
overall inflation in 1999 and 2000 would be expected to boost nominal wage demands. But any
rebound in nominal labor compensation could also reflect a catch-up to higher productivity growth. If
nominal compensation is just matching the higher productivity growth, this source of acceleration in
nominal compensation would not itself be inflationary. But there is an important caveat here. The slow
initial response of nominal compensation to higher productivity growth is the source of the temporary
disinflationary effect of a productivity shock. Therefore, once the catch-up is under way, this
disinflationary impetus gradually disappears. And at this point, the pass-through from higher inflation
and the effect of tight labor markets have no offset and will begin to dominate. So even the catch-up
story plays a role in the upward trend in inflation.
A second reason that nominal compensation is so difficult to factor into an inflation forecast is that
compensation practices are changing. For example, our measurement has not caught up with the
increased importance of stock options. Stock options are incorporated, based on gains upon exercising
the options, in the productivity and cost measure, but not in the ECI. In addition, many ways in which
firms are recruiting and retaining workers - such as in-house fitness and child care centers, flexible
hours, educational assistance, on-site personal services, and in-kind payments - are not reflected in
compensation measures (although hiring and referral bonuses will be included in the ECI in the next
release). Finally, the growing importance of variable pay and of temporary workers may have
important implications for wage dynamics that are not fully understood.
So what is the outlook for inflation, and how does it relate to the interplay of new economy forces and
traditional supply and demand considerations? In my judgment, we took the benefits of both the earlier
favorable relative price shocks and the productivity shock, partly in a decline in the unemployment
rate below the NAIRU and partly in a decline in inflation. This is not a statement about what
policymakers planned, but rather about what evolved as we responded to unexpected developments in
inflation and growth. At any rate, we could have taken more of the benefits of the favorable supply
shocks in lower inflation, but given that inflation was already so low, the combination we ended up
with seems, after the fact, to have been reasonable. At some point, however, when the temporary
disinflationary impetus of the favorable supply developments dissipate, not only will there be some
rebound in inflation, but unless a transition is made back to sustainable utilization rates, there will be a
risk of a continuous upward movement in inflation. During that transition, at least some of the earlier
decline in core inflation will be reversed.
To be sure, it has been difficult to be precise about both sustainable utilization rates and the path of
inflation because of uncertainties about the NAIRU and other aspects of inflation dynamics in a period
of significant structural change. But I believe the qualitative story that I have set out is the right one.
Given our uncertainty about sustainable utilization rates and wage-price dynamics in the new
economy, however, policy setting must remain flexible and responsive to new information about both
the supply and the demand sides of our economy.
Conclusion: the challenge facing monetary policy
This analysis suggests that monetary policy does face a challenge - rebalancing aggregate supply and
demand to contain the risk of higher inflation. I believe that we have been moving effectively to get
this job done. The major question in this respect is whether slowing the economy to trend alone will
get the job done or whether we need a period of below-trend growth to unwind an imbalance between
the levels of aggregate demand and supply. If the task is only slowing the economy to trend - because
the NAIRU turns out to be close to 4% - the task is not as challenging, and inflation will remain stable
near current levels. If the NAIRU turns out to be closer to 5%, then the task is more demanding, and
growth will have to slow to below trend for a while, and inflation is likely to rise somewhat further
until the rebalancing is complete. If successful, in either scenario, the payoff from monetary restraint
will be both to contain the risk of higher inflation and to extend the life of this remarkable expansion.
Several considerations provide some optimism that the outcome will be a benign one - a soft as
opposed to a hard landing. First, we are now in a high-growth rather than a low-growth economy.
Even if we have to slow growth to below trend for a period, the resulting growth rate could remain
well above the average growth rate over the previous 25 years and still get the job done. Second,
supply forces could smooth the transition. If oil prices have now at least peaked - and, better yet, if
they decline at least modestly over the next year and a half, as suggested by expectations reflected in
futures markets - the upward impetus to overall inflation from oil prices will dissipate or even reverse.
In this case, overall inflation is likely to decline next year, and this decrease could help moderate the
rise in core inflation into the following year. Third, long-term inflation expectations remain firmly
anchored, reflecting considerable confidence that monetary policy will contain any threat of higher
inflation. This should damp the rise in inflation in the short term. Fourth, monetary policy got a head
start on containing inflation by beginning to tighten last June, before the signs of building inflation
pressures were evident. Fifth, the tighter monetary policy is now contributing to a less accommodative
set of financial conditions throughout the economy - including higher short- and long-term private
interest rates, lower equity prices, a stronger dollar, and more stringent lending conditions at banks. If
these tighter financial conditions remain in place, we will have made significant progress in
establishing the foundation for slower growth.
References
Gordon, Robert, J, "Does the New Economy Measure Up to the Great Inventions of the Past", Journal
of Economic Perspectives (forthcoming).
Jorgenson, Dale W, and Kevin J Stiroh, "Raising the Speed Limit: US Economic Growth in the
Information Age", 1 May 2000.
Macroeconomic Advisers, "Productivity and Potential GDP in the 'New' US Economy", September
1999.
Oliner, Stephen D, and Daniel E Sichel, "The Resurgence of Growth in the Late 1990s: Is Information
Technology the Story?" working paper, Federal Reserve Board, February 2000.