Laurence H Meyer: Before and after
Remarks by Mr Laurence H Meyer, Member of the Board of Governors of the US Federal Reserve
System, before the National Association of Business Economics, St. Louis, Missouri, 27 November
2001.
* * *
To promote macroeconomic stability, monetary policy must respond to changing economic conditions.
On that premise, I always start my thinking about monetary policy by identifying what I like to call the
outlook context. Is inflation likely to be stable, or will it rise or fall? Is the economy losing momentum
rapidly or will it likely grow at or above trend?
The outlook context today must include both the state of the economy before September 11 and the
implications of the events of September 11. At this point, of course, it is impossible to fully disentangle
the contributions of the pre-September 11 momentum and the post-September 11 impact. Moreover,
neither contribution is crystal clear--especially the latter, for which we have only early data.
Conceptually, however, assessing economic prospects today requires us to blend the two
considerations.
Then I will turn to the challenges policymakers face as a result of the complex forces identified in the
outlook context. Here I will address three questions: Has monetary policy been less effective recently
compared with earlier periods of aggressive easing to counter sharply slower growth or the onset of
recession? What are the implications of facing a significant adverse shock at an already-low nominal
federal funds rate? What is the appropriate relationship between monetary and fiscal policies, in
general and today?
Let me remind you, before I proceed further, that my remarks today reflect my own views of the
outlook and challenges facing monetary policy. I am not speaking for the Federal Open Market
Committee or the Board of Governors.
Challenges facing the Fed immediately after the events of September 11
Before I turn to the outlook and the challenges faced by monetary policymakers, I want to discuss the
Federal Reserve's reaction to the disruption of financial transactions and the increased demand for
liquidity and bank lending that resulted from the events of September 11. When we think of September
11, we will always, first and foremost, remember the thousands whose lives were lost or were
irreparably harmed--the personal tragedies. Immediately after the attacks, many others worked hard to
restore a normal course of business, essential to avoid compounding the personal tragedies with
economic dislocations. Doing so was especially a challenge for those involved in the financial services
industry. The area in New York City hit by the attacks - including the two World Trade Center
towers - housed many financial firms and constituted an important part of the infrastructure of financial
markets. The events of that day could have disrupted those markets and the activity that they financed
for a considerable time.
Instead, we learned once again that the financial sector is enormously resilient. In many cases, people
needed only a cubicle and a computer to return to work. In contrast, restarting an airplane factory or
an auto factory if its production had been disrupted would have taken an extremely long time. Such
resumption of business by financial firms depended on careful planning in advance, on backup data,
on software, and so forth. To be sure, securities markets and transactions, particularly the clearing and
settlement in the government securities markets, were disrupted for a period. But financial markets
and firms adapted and responded, contributing to the quick resumption of normal business.
The Fed, too, had many challenges at that time. One was that Vice Chairman Roger Ferguson was
the only Board member in Washington D.C. on September 11. The Chairman was in Basel, I was in
Beijing, and the two other Governors were elsewhere in the United States. This didn't diminish the
ability of the Federal Reserve System to respond quickly and effectively. The Vice Chairman, together
with the Reserve Bank presidents and staff members at the Board and the Reserve Banks, did a
superb job.
We wore many hats on that day and the days immediately following. First, we acted as the provider of
liquidity. Normal channels of borrowing and payments were disrupted. Some banks that were counting
on receiving funds had to rely on the Federal Reserve instead. Security firms and businesses impeded
in their usual borrowing turned to the banks, and, for primary dealer firms, to Federal Reserve open
market operations, increasing the need for extra Federal Reserve liquidity.
The Vice Chairman issued a brief statement immediately after the attack that signaled the Fed's
readiness to supply liquidity as needed: "The Federal Reserve is open and the discount window is
available for meeting liquidity needs." We used every existing vehicle for injecting liquidity and even
invented a new one--the use of large swap lines with foreign central banks to inject dollar liquidity.
Discount window loans soared instantly from around $200 million to a peak of about $45 billion on
September 12 and later, as markets began to function better, Federal Reserve repurchase
agreements soared from $25 billion to nearly $100 billion. Second, we used monetary policy to counter
what was sure to be a sharp adverse shock to demand and to bolster confidence that the Fed would
do what was necessary to support the economy.
As supervisors, we and our sister banking agencies asked banks to work with their customers to meet
legitimate credit needs. We benefited from our diverse financial system - one in which a strong
banking system complements a dynamic capital market. When one is ailing, the other will often
be - and in this case was - ready to take up the slack. And the banking system did its part admirably.
We surveyed banks about whether they were limiting the drawdowns on pre-existing lines of credit.
They informed us they were not. And we sought to understand the exposure of the banking system to
the industries most immediately affected, such as airlines, insurance, travel, entertainment, and
lodging.
We also had to focus on our own operational responsibilities, ensuring the continuation of vital
payment services, including electronic transfers and check clearing. Finally, we had to work with
market players to resolve clearance and settlement disruptions as a result of damage to telephone and
other physical infrastructure. We were in touch with the banks and other participants in financial
markets, we were in touch with the other banking and security regulators, and we were in touch with
each other within the Federal Reserve System.
The Fed and other banking and financial supervisors have received much praise for their quick and
effective response. Though pleased with our ability to cope, we recognize that the country now faces
contingencies for which no one specifically planned. So, like many other organizations, we are looking
for lessons to be learned and actions to be taken.
The outlook context
Of course, coping with the implications of the terrorist attacks for our financial infrastructure has been
only a part of the difficult job we faced in recent weeks. Assessing the condition of the economy and
the appropriate course for monetary policy have remained central concerns at the Fed. The outlook
today is a complicated mixture of the momentum and forces at work before September 11 and the new
set of forces as a result of the events of that day.
Forecasters today often begin by almost apologizing for even offering a point forecast of economic
activity over the coming year, given the prevailing uncertainties. But we all have our jobs to do,
including forecasters. Forecasters can offer us a careful assessment of the forces at work and some
plausible scenarios of how they may interact. Policymakers have to begin with a best guess about the
outlook to guide their policy response.
The uncertainties we face today reflect at least three considerations. First, we were still struggling to
understand the severity of the slowdown and the prospects for recovery before September
11. Second, the effects of September 11 depend, to a major degree, on the psychological influences
on households and businesses. I am often asked, by the way, whether I believe that the economy
drives psychology or psychology drives the economy. I always respond that I believe the economy
drives psychology; and that, if I believed the reverse, I would have become a psychologist. I will return
to the role of psychology in a minute, and even admit its potentially important role in shaping the
nearterm prospects. The third consideration is that unexpected events - from additional terrorist incidents
at home to how well the war on terrorism is going abroad - may be especially important in shaping the
outlook.
The state of the economy before September 11
We need to integrate two aspects of the state of the economy before September 11 into the current
outlook. First, and perhaps most obvious, is the momentum of the economy and specifically how close
the economy was to a rebound. Second, the strength of the rebound will ultimately depend importantly
on the pace of underlying productivity growth and hence the average rate of growth possible once the
economy reaches full employment.
Momentum before September 11. At least two schools of thought about the economy's momentum
existed just before September 11. Some believed that economic expansion would resume within a
quarter or two, while others foresaw a more protracted period of weakness. Though I viewed economic
growth as perhaps bottoming out after slowing to a near-zero rate in the second and third quarters, I
expected growth to build only slowly and therefore expected the pace of recovery through the first half
of 2002 to be disappointing.
To understand the sharpness of the slowdown that still gripped the economy at the time, we have to
begin with the period of exceptional performance in the second half of the 1990s. Many interpreted
this experience as suggesting that old rules no longer applied and, as a result, discounted
longstanding regularities between resource utilization rates and inflation and worried less about limits to
sustainable growth. I was not inclined to this view. To be sure, higher productivity growth was likely for
a considerable period. But the initial adjustment to the acceleration in productivity also brought
temporary bonuses that were not likely to persist over the longer run. They took the form of a
temporary spurt in demand growth - pushing the unemployment rate progressively lower - and a
temporary disinflationary impetus, preventing the increased utilization rates from immediately raising
inflation. The persistent above-trend growth and progressive increase in utilization rates suggested to
me a danger of overheating and higher inflation. This concern encouraged a series of tightening
moves in an attempt to slow economic growth at least toward the new higher trend and thereby
prevent still higher utilization rates. In my view, a period of below-trend growth was likely to be
required to unwind what I viewed as an unsustainably high rate of resource utilization.
As a result of a coincidence of forces, the economy slowed much more steeply than the Fed expected
or intended. Besides the effect of monetary policy, a sizable rise in energy prices over 1999 and 2000
and into early 2001 contributed to an erosion of aggregate demand. But most important was the shock
that hit the economy in late 2000 and early 2001 - a reassessment of the profitability of producing and
owning high-tech equipment. This shock was manifest in both the financial markets and in the real
economy. It resulted in a sharp correction in equity prices in the technology sector - the bursting of the
technology bubble - and, at the same time, it led to a sharp retrenchment in the demand for and
production of high-tech equipment. The economy slowed to the point where real GDP was nearly flat
in the second quarter of this year and likely would have been nearly flat in the third quarter, even
without the events of September 11.
The pre-September 11 prospects for recovery reflected the cumulative easing by the Fed, a sizable
fiscal stimulus already in train, declining energy prices, and the normal internal dynamics that
contribute to recoveries. I will return to these prospects for recovery in a moment.
Long-term growth prospects. The strength of the rebound expected before September 11 also was
being shaped by the underlying pace of productivity growth. Recent revisions to the National Income
and Product Accounts and other data, as well as the sharpness of the retrenchment in high-tech
investment, had forced a reassessment of the prospects for longer-term productivity growth. The
revisions suggested that, while that performance was still impressive, it was less exceptional than it
had appeared before the revisions. In particular, the revisions had lowered the rate of productivity
growth from 1998 through 2000 and, as a result, trimmed most estimates of the sustainable rate of
economic growth going forward.
Before the annual NIPA revisions earlier this year, many had revised their forecasts of underlying
productivity growth progressively upward to near 3 percent or even slightly higher, compared with the
1-1/2 percent rate achieved during the twenty-five years before the mid-1990s. The revisions
suggested that underlying or structural productivity growth peaked at closer to 2-1/2 percent - still a
remarkable improvement over the pre-1995 average but not quite as spectacular as many had
thought. In addition, some of the earlier productivity growth, reflecting the frenzied pace of investment
in high-tech equipment, now appears to have been unsustainable.1 Consensus estimates of
longerterm productivity growth were revised downward to a range of 2 percent to 2-1/2 percent.
The effects of September 11
In thinking about the effects of the September 11 events, I find focusing on three subperiods to be
useful. The first subperiod includes the third and fourth quarters and perhaps the first quarter of next
year. The second is the remainder of a typical monetary policy forecast period, in this case through
2003. And the third is the longer run, beyond 2003.
The near-term effects. The near-term effects are dominated by the disruption to certain industries
- airlines, in particular, but also other travel-related industries such as hotels, entertainment, and
tourism - and the psychological effects on households and businesses. Policymakers can do very little
over this timeframe to affect the outcome, other than to bolster consumer and business confidence by
what they do and say.
We have a variety of measures of consumer sentiment. In normal times, these measures, in my view,
offer relatively little predictive power for household spending. That is because the economy usually
drives psychology and mostly not the other way around. As a result, we can predict consumer
confidence with the same variables we use to predict household spending. Measures of consumer
confidence have relatively little incremental value in explaining consumer spending in such periods.
During the Gulf War, however, we learned, if we did not already know, that in extraordinary times
consumer confidence can change abruptly in a way not foreshadowed by the incoming economic
indicators. Another way of saying this is that sometimes the equations we use to predict consumer
confidence make dramatic forecast errors. Such errors may indicate an "exogenous" psychological
shock and thus provide additional information to forecasters.
In the aftermath of September 11, it was widely expected that consumer sentiment would plummet and
that the data would provide information about the severity of the psychological shock and help to
forecast the projected cutback in consumer spending. Even before these data were available, many
forecasters were calibrating the impact on consumer spending in terms of the Gulf War experience.
The two leading measures of consumer confidence rendered something of a split decision after
September 11. The University of Michigan measure slid in September, but most of the decline
occurred before September 11 and was broadly consistent with the deterioration shown by the
incoming economic data. This measure has remained fairly stable since then. The Conference Board
measure, on the other hand, declined sharply in October, but this sharper drop in the Conference
Board measure brought it into closer alignment with the cumulative decline in the Michigan Index. So,
surprisingly, at this point, whether September 11 significantly affected consumer confidence is unclear.
At least, the effect is smaller than what many had expected.
We don't have good measures of business sentiment, but it is generally reasonable to mark down
business spending plans in anticipation of a negative psychological effect if you are doing so for
households. In the current case, businesses have apparently made an especially grim assessment of
the near-term strength of the economy and orders for nondefense capital goods have plunged,
resulting in further cutbacks in investment and downward revisions to the forecast in the near term. On
balance, the magnitude of the further declines in consumer and business spending as a result of the
events of September 11 is unclear. It seems, in my view, to have had a material effect on business
spending and, perhaps, a somewhat smaller effect on consumer spending.
Of course, at times of high of uncertainty, the signals are typically mixed. So they are today. We have
some signs of quite remarkable resilience. For example, the stock market plummeted immediately
after September 11, but it has already returned to its pre-September 11 level. The exchange value of
the dollar, measured against the currencies of a broad range of our trading partners, has remained
remarkably stable, despite the presumption that the September 11 shock would disproportionately
affect the United States relative to our trading partners. Auto sales soared to record levels in October,
prompted, to be sure, by zero-interest rate financing. They likely will fall back once the incentives are
reduced, but, in any case, the surge signals that households are still willing to make large long-term
commitments despite the uncertainty and risks of a recession. Moreover, non-auto retail sales have
recovered some--though not all, to be sure--of the ground they seem to have lost in the immediate
aftermath of September 11.
The rest of the short-run forecast. The consensus forecast today is generally described as
V-shaped, starting from September 11. This description refers to the pattern of an outright decline in
output for a couple of quarters, followed by a quick move to above-trend growth. The forces of
recovery include an unusually aggressive macroeconomic policy response, including this year's easing
of monetary policy to date and the stimulus associated with a series of fiscal policy actions--including
those already implemented and those still under consideration. Until recently, I would have said "under
consideration and expected," but recent developments have forced a reassessment of the certainty of
a further stimulus package. I will return to the fiscal policy story in a moment.
But more stimulative policies are far from the only factor that should contribute to a rebound.
Recoveries also reflect powerful internal dynamics. For example, the amplitude of declines in output
during recessions is often determined to a major degree by the severity of inventory liquidation. Once
firms have reduced their stocks to desired levels, they quickly raise production to avoid a further
decline in stocks. Doing so helps kick-start recoveries. All the natural forces we expected to contribute
to recovery before the events of September 11, while perhaps delayed, are likely to become part of the
recovery in 2002. Aside from a rebound in inventory investment, these include the end of the
retrenchment under way in high-tech investment. Just the return to flat investment spending, from the
sharp declines of recent quarters, will give the economy an important boost. Such a rebound will likely
be reinforced by a dissipation of gloom and resulting rebound in consumer confidence. Together these
factors suggest the potential of a return to more solid rates of growth next year.
Forecasters, at such times as this, like to remind their audiences that they are making conditional
forecasts. That is, their forecasts are based on certain assumptions. Of course, a forecaster has to be
held accountable for his or her judgment about assumptions, as well as the forecast given the
assumptions. But, in this case, a typical assumption is that the terrorist attack was a one-time event
and is not followed by other disruptive and destructive events. Of course, the anthrax mail-attacks are
another form of terrorism and may have already had an incremental effect on consumer and business
psychology and behavior. They will divert additional resources into provision of security rather than
production of final output. Until the last few weeks, most of the events that could materially affect the
economy seemed more likely to be "bad" events damping near-term confidence and spending. But the
more-rapid-than-expected progress of the war in Afghanistan reminds us of the possibility of upside
surprises as well. In any case, we must recognize the heightened uncertainty to the forecast
associated with the unusual degree of "event risk."
Longer-term considerations. The possible effects of September 11 on productivity growth are the
major issues over the longer term. Three sets of forces could lower longer-term productivity growth.
The first is a reallocation of resources toward security away from the production of other goods and
services. The purchase of increased security by a firm shows up as an added expense of producing
goods. That is, business costs increase without resulting in higher measured output. Costs associated
with security definitely are rising noticeably. In addition, some firms may diversify the location of their
workers, increasing security at the expense of higher production costs. Financial firms, as well as firms
in some other sectors, may build in redundancies to ensure continued operations in the event of future
terrorist attacks. Firms may also add a larger buffer in the form of inventories to mitigate the supply
disruptions that might follow terrorist attacks, retreating somewhat from just-in-time inventory
management.
Many productivity shocks, in my view, are probably more to the level of productivity than to the growth
rate of productivity. Of course, if the adjustment to the level occurs over a protracted period, it may feel
like a shock to the growth of productivity. With a technological innovation, for example, the higher level
of productivity is likely to emerge only gradually, as the innovation is disseminated through the
economy. In addition, such a technological advance may not really be a one-time event but may be
based on a continuing series of innovations. In any case, such innovations are likely to result in higher
growth over a number of years. The effects of higher business costs associated with security are (we
can hope) a one-time decline in the level of productivity. I expect the level effect to be completed
within only a year or two, given the immediacy of the need. The result in this case is, therefore, a
transitory effect on the growth rate of potential output for a year or two, followed by a return to the rate
of productivity growth that would have prevailed in the absence of the higher costs for security.
The second set of forces that could lower long-term productivity growth relates to the federal budget.
The increased spending on defense and homeland security are unlikely, in my view, to be offset fully
by cuts in government spending for other programs or by higher taxes. As a result, budget surpluses
will likely be lower over the longer run than otherwise. To the extent that they are, national saving will
be lower, real interest rates will be higher, and private capital formation will be lower. As a
consequence, the level of productivity will be lower than otherwise, with the growth effect spread over
a considerable period. Given the link between national saving and productivity and the dimension of
the expected effect, I expect that the resulting decline in productivity through the crowding-out effect
would be small, perhaps not more than 1/10 percentage point a year for a while.
Third, a wide variety of other indirect behavioral responses are possible. For example, firms in general
may be somewhat more averse to risk and less willing to make long-term commitments. Households
may want a larger cushion of accumulated wealth, perhaps increasing the saving rate for a time. They
may also reallocate their wealth toward safer and more-liquid assets.
These developments, on balance, would take a toll on longer-term productivity growth. Nevertheless,
in my view, they are not large enough to alter the conclusion that the pace of innovation in information
technology and other industries has raised underlying productivity growth to a rate faster than
prevailed in the twenty-five years prior to the mid-1990s.
Still, the productivity story is exceptionally complex. On the one hand, we can take some comfort that
underlying productivity growth should continue at a pace above that achieved from the early 1970s to
the mid 1990s. On the other hand, the economy is suffering the consequences of a more recent
decline in underlying productivity growth--a decline from the higher rate of underlying productivity
growth enjoyed in the late 1990s and into early 2000.
Challenges facing monetary policy
Monetary and fiscal policymakers face many challenges under the circumstances. I will focus on the
challenges facing monetary policymakers. One of these is calibrating monetary policy appropriately in
light of fiscal policy.
Is monetary policy less effective than previously?
Monetary policy before September 11 had eased by 300 basis points, the most aggressive easing
over a comparable period in almost twenty years. However, many see the effect of that easing as
disappointingly small. As a result, a question often asked today--indeed, almost always asked when
the economy is in the midst of a recession or pronounced slowdown--is whether monetary policy is
less effective today than it used to be. One explanation is the normal lags in response of spending to
monetary policy actions. We would not, for example, have expected much effect through the second
quarter and only a modest effect in the second half, based on past experience and the forecasts of our
models.
But other factors, too, have contributed to the perception that monetary policy is less effective. These
include the fact that the shocks weighing on the economy have been larger in magnitude and spread
out in time and, partly as a result, forecasters in general have been continually revising down their
forecasts of economic activity. Many have been surprised, in particular, by the sharpness and
persistence of the retrenchment in high-tech investment and by the degree to which economic activity
abroad slowed along with that in the United States.
Perhaps the most important consideration has been the evolution in overall financial conditions as
monetary policy has eased. Monetary policy does not work through the effect of a decline of the
federal funds rate itself on spending. Indeed, there is no direct effect here at all. Monetary policy works
through the so-called transmission mechanism, through channels that include short-term private
interest rates, longer-term private interest rates, equity prices, and the exchange rate. The effects on
other rates and asset prices depend on the changes in the target funds rate relative to expectations
already embedded in the financial markets and on changes in those expectations as a result of policy
actions, statements accompanying those actions, and other developments. Other things being equal,
a decline in the funds rate will lower short- and long-term private interest rates, raise equity prices, and
depreciate the dollar. The combined effects can be quite powerful. In the current episode, however,
other things have not been equal, and the dollar has not depreciated nor has the stock market
appreciated. Of course, monetary policy presumably wouldn't have eased so much if the dollar had
depreciated or the stock market had risen. At any rate, there has been painfully little pass-through
from the funds rate to the operative channels, other than declines in private short-term interest rates.
The absence of pass-through does not reflect a change in the fundamental effectiveness of monetary
policy so much as the offsetting effect of other financial shocks that were occurring at the same time
the Fed was easing.
One way of quantifying the degree of pass-through is to compute a financial conditions index that
combines the effects of all the transmission channels into a single number. Goldman Sachs and
Macroeconomic Advisers have developed differing methodologies for computing such an index.
Basically, they weight changes in various financial conditions by their relative importance as
determinants of private spending. The message from such indexes is that financial conditions have not
improved since the Fed began to ease and, indeed, may even have deteriorated.
The response of overall financial conditions to monetary policy easing in this episode has been
unusual, if not unique. In previous recession periods, financial conditions have generally improved as
the Fed has eased, reflecting the pass-through to lower short- and long-term private rates, higher
equity prices, and a lower exchange rate. The major reason for the failure of financial conditions to
improve in this case is that one of the major shocks--the reassessment of the profitability of owning
and producing high-tech equipment--was, at the same time, a shock to financial markets and to
aggregate demand. The financial shock was the revaluation of equity values as a result of this
reassessment--the bursting of the equity bubble in the technology sector. In addition, the dollar
appreciated rather than depreciated, for reasons no one seems to fully understand. So two of the key
channels in the transmission of monetary policy behaved differently than expected.
Whether or not long-term interest rates have fallen as much as would have been expected from
historical regularities is more difficult to assess. One reason is that part of the decline in long-term
rates occurred before the Fed began to ease, but in anticipation of that easing. In addition, the limited
effect on long-term government rates may partly reflect the offsetting upward pressure from the
change in long-term budget implications of recent and prospective fiscal policy measures. These
include the large tax cut passed earlier this year, the effect on spending of the fiscal measures already
passed in response to the events of September 11, and effect of further spending increases and
further tax cuts now under consideration. The fiscal policy effects appear to be contributing to
expectations of a robust recovery and a relatively quick and aggressive reversal of monetary policy.
This presumption can be seen in the federal funds futures market, from which we can extract a
forecast of the expected funds rate over the next year and a half. The market expects the funds rate to
begin rebounding in mid-2002 and to rise significantly over the following year. Finally, rising risk
spreads have boosted longer-term private rates, especially on below-investment-grade securities.
On balance, a number of factors have combined to restrain the economy, despite the sizable
cumulative decline in the federal funds rate. I would not conclude, however, that monetary policy is in
general less effective because of structural changes that may have occurred. But I do believe that the
financial shocks that have occurred -including the shocks to equity prices and the dollar - have
required monetary policy to move more aggressively than otherwise would have been the case.
The implications of an initial low federal funds rate: hold our powder or respond especially
aggressively to adverse shocks?
On September 11, the federal funds rate was already low - 3-1/2 percent. Since that time, the funds
rate has been reduced another 1-1/2 percentage points. Indeed, on September 11, there was less
room to maneuver than in previous post World War II recessions