Mr Meyer gives his views on the sustainability of
growth and on monetary policy in the United States
Remarks by Mr Laurence H Meyer, Member of the Board of Governors of the US Federal Reserve
System, before the National Economists Club and the Society of Government Economists,
Washington, D.C. on 20 January 2000.
* * *
Economic performance over the past several years has been exceptional. The economy is about to set a
record for the longest expansion. Economic growth has been proceeding at a rate that is close to
double what was generally viewed as the long-term trend when this expansion began. Inflation
remains modest, despite a decline in the unemployment rate to levels that many would have expected
to trigger a significant acceleration in prices.
But if you are a forecaster or a policymaker, rather than an economic historian, you must focus on the
next chapter. The fundamental question today, it seems to me, is whether the current set of
macroeconomic conditions - specifically, the growth of output and the unemployment rate - is
sustainable - that is, consistent with stable, low inflation. If it is, the expansion could continue on its
current path, unless disturbed by some shock or policy mistake. Otherwise, the challenge for monetary
policy is to guide the economy to a sustainable path while preserving low inflation.
This challenge is heightened by the unusual degree of uncertainty about the limits of capacity and
potential growth, related in part to ongoing structural changes in the economy. Concerns have also
been raised about potential imbalances in some sectors, for example, about the sustainability of equity
prices, the personal saving rate, the current account deficit, and debt burdens. These concerns about
sustainability and the challenges they pose for monetary policy are the focus of my remarks this
afternoon.
Let me remind you that, as always, the views I express are my own. I am not speaking on behalf of
either the Board of Governors or the Federal Open Market Committee (FOMC).
Varieties of landings
In figure 1, I present four plausible scenarios for future growth. Each has a quite different implication
for both the outlook and policy. In each case the economy faces an initial gap between actual output
(the dashed line) and potential output (the solid line). Such a gap is typical of conditions that follow a
recession. During the expansion phase, at least for a period, growth in production typically exceeds the
growth in capacity, so that the gap between actual and potential output is closed gradually.
For the moment, I shall focus exclusively on the concerns about sustainability related to the balance
between aggregate supply and demand. Later I shall turn to concerns about imbalances in equity
prices, the personal saving rate, the current account, and the household debt burden.
A soft landing
Figure 1.A depicts a soft landing scenario, the graceful transition from the initial output gap to a
sustainable growth path at full employment. A soft landing occurs if, as the level of output approaches
potential, the growth of actual output slows to the growth of potential output just as actual output
reaches potential. The line for potential output is, in effect, the runway. The line for actual output is
like the path of a plane coming in for a soft landing - at least if you stand on your head while looking
at the chart!
Steady inflation is generally one of the signs of sustainability. A simple model of inflation dynamics is
that changes in inflation are induced by excess aggregate demand or supply, as reflected in the output
gap. When actual output rises above potential, according to this model, the resulting excess aggregate
demand leads to rising inflation.
In the short run, supply shocks - including both relative price shocks and changes in trend productivity
- can also affect inflation dynamics. But these effects are temporary. Ultimately, inflation dynamics
will be driven by the output gap. At some point in any expansion, therefore, a soft landing is the
preferred path to preserve a healthy expansion. Such a slowdown in growth is desirable because the
alternative is higher inflation - indeed, continually rising inflation. Looking back, most recessions have
resulted from attempts by the policy authorities - yes, the Fed - to reverse increases in inflation
generated by overheating.
A reverse soft landing
Figure 1.B depicts an alternative scenario in which the above-trend growth in the expansion phase has
moved the economy beyond the point of its sustainable capacity to produce. Policymakers in this case
failed to execute a soft landing. What could they do in this case to best ensure the continuation of a
healthy expansion? The answer is to engineer the closest possible approximation to a soft landing, one
in which we glide to potential beginning from a position initially above rather than from below
potential. Because the convergence to potential is from above rather than below, I call this a "reverse"
soft landing.
In this case, because the economy is already operating beyond its sustainable capacity, the economy
may not be able to avoid some acceleration in inflation as policymakers try to engineer the soft
landing. Therefore, the return to the potential output path has to be achieved in a sufficiently timely
fashion to minimize any increase in inflation during the transition. Also, in the reverse soft landing
case, growth must slow, not just to trend but to below trend in order to close the output gap. As a
result, the unemployment rate must rise during the transition to full employment in this case. Hence,
whereas the soft landing outcome in figure 1.A involves a stabilization of the unemployment rate at its
low point and of inflation near its recent low, in the reverse soft landing case depicted in figure 1.B,
both inflation and unemployment rates are likely to rise during the transition.
The best-case scenario: supply meets demand
The first two scenarios I have described assume that demand has to adjust to a steady supply path to
achieve sustainability. There are natural equilibrating mechanisms, as well as policy adjustments, that
encourage such adjustment in demand relative to supply. An alternative scenario is that supply adjusts
to demand. This case is depicted in figure 1.C in which the growth of potential increases just as output
threatens to push beyond potential. In this scenario, the runway has fortuitously landed on the plane, as
it were. If this scenario describes the current episode, then the economy can continue to grow at 4%,
the unemployment rate can remain near 4%, and inflation can remain steady at its prevailing rate.
This scenario may seem farfetched. But it has the advantage of incorporating the role of supply-side as
well as demand-side forces that appear to be at work in this expansion, and it would at least help
explain the stability of inflation at prevailing growth and unemployment rates. Indeed, a possible
decline in the NAIRU and, especially, an increase in the growth rate of potential output appear to be
essential elements of this expansion. Still, even if we take into account the supply-side changes, we
should not expect a perfect balancing between supply and demand.
The worse-case scenario: hard landings
The worst-case alternative to a soft landing, to continue the analogy, is often referred to as a hard
landing. Despite, or perhaps because of, the recent exceptional performance of the US economy, some
see a growing danger of a hard landing.
A hard landing might seem like an oxymoron. A crash is a crash, after all, not a landing. But the key to
a landing is that it is required to ensure sustainability of an expansion. A soft landing is the preferred
course to ensuring a healthy, sustainable expansion, if it can be executed. A reverse soft landing is the
second-best option. Otherwise, a hard landing may be unavoidable, despite the best efforts of
policymakers. The upside of a hard landing is that it contributes to reversing imbalances and,
afterwards, allows policymakers to aim once again at achieving a healthy, sustainable expansion,
ultimately combining full employment, maximum sustainable growth, and price stability.
It is useful to distinguish two broad classes of hard landings. The first involves the reversal of an
imbalance between aggregate supply and aggregate demand. The classic example is the boom-bust
scenario. The second class involves the unwinding of sector or market imbalances that either initiate a
downturn in the economy or aggravate a downturn that would otherwise have occurred. A classic
example of this genre is a stock market correction. I will focus first on the boom-bust scenario to
complete my classification of paths to sustainable combinations of growth and the output gap.
In the boom-bust scenario, depicted in figure 1.D, above-trend output growth during the expansion
ultimately pushes output well beyond potential for a persistent period. The resulting overheating puts
upward pressure on inflation. The monetary policy response to reverse the inflation often yields a
decline in output, as depicted here, resulting in a period of economic slack and a reversal of the rise in
inflation. This is the scenario from which we draw the lesson that timely, typically preemptive, policy
restraint to avoid the excesses of a boom results in longer expansions and avoids unnecessary
fluctuations in both output and inflation.
Where are we relative to potential and do we need to land?
To identify whether the initial conditions today correspond to those in one of the panels of figure 1, we
have to assess where output is relative to its potential and whether growth is above or below trend.
This assignment is more difficult than usual because structural changes of uncertain dimension may
have raised both the level and the growth rate of potential output.
There is, for example, a consensus that the NAIRU has declined since the early 1990s. That decline
translates into an increase in the level of potential output at any given time or a decline in the output
gap for a given level of output.
There is also a consensus that the rate of growth of potential output is higher today than during the
twenty years preceding this expansion. However, the degree to which these two parameters have
changed is not a settled issue. In particular, some think that the rapid growth and low unemployment
rate of the past two years represent the economy's new equilibrium (case 1.C), but others believe that
the economy has still been running ahead of potential recently, despite structural changes. We should
not be surprised that a period of structural change would also be one of heightened uncertainty about
key parameters, such as the NAIRU and trend growth.
Table 1 offers various estimates of the NAIRU and trend growth, drawn from researchers,
model-based forecasts, assumptions incorporated in government budget projections, and surveys of
economic forecasters. These estimates suggest that actual output is above potential (the unemployment
rate is below the NAIRU) and that actual output growth has been above trend growth of potential.
Despite the uncertainties, the consensus estimates of the NAIRU and the growth of potential give us a
hint about what type of landing we should be aiming for and which of the scenarios depicted in
figure 1 best describe the economy's initial conditions and prospects. The answer, it seems to me, is
that no scenario in figure 1 does justice to the complex forces that have been in play during this
expansion. I believe that the prevailing macro configuration is best described by some combination of
figures 1.B, 1.C, or 1.D. That is, even after we incorporate the estimated decline in the NAIRU and the
higher rate of growth of potential (as reflected in figure 1.C), output is above potential and output
growth exceeds that of potential (as depicted in figures 1.B and 1.D). If output were above potential,
we still would not know whether the outcome would be a soft (1.B) or a hard (1.D) landing. To
complete the picture, we also have to rely on the temporary disinflationary effects of favorable
relative-price shocks and the increase in the productivity trend that have allowed the economy to
operate, for a while, beyond potential without suffering inflationary consequences.
Hard landings associated with the unwinding of sector and market imbalances
Much of the recent concern about the sustainability of this expansion is, nevertheless, not related
directly to the balance between aggregate demand and aggregate supply. Rather these concerns are
related to perceived imbalances in particular sectors or markets. Most notably, attention has focused
on equity prices, the personal saving rate, the current account deficit, and debt burdens. The unifying
theme among this class of imbalances is that they typically arise during an expansion, often as the
result of changing attitudes toward the perceived risk in the economy or as a result of increased
willingness to accept risk. Many, though not all, of these imbalances are financial in nature - for
example, increases in leverage or declines in liquidity and other margins of safety. These
developments typically play a role in supporting or financing expansions. The resulting imbalances do
not typically induce a downturn by spontaneously reversing. But they may act to magnify any
downward forces that hit the economy, increasing the depth and perhaps duration of downturns.
Hence, these factors play an important role in both phases of the boom-bust scenario.
I associate many of the second class of hard landing scenarios with the work of a former colleague and
friend, Hyman Minsky, who died in 1996. He emphasized the development of financial vulnerabilities
in expansions and their contribution to serious recessions. In his view, serious recessions are typically
the result of a coincidence of adverse shocks on an already vulnerable economy. Minsky emphasized
the role of vulnerabilities arising from financial imbalances, including excessive debt burdens or
increases in the price of risky assets relative to safe assets.
Historical perspective on market or sector imbalances
Figure 2 offers a historical perspective on equity prices, the personal saving rate, the current account,
and debt burden. In each case, I identify a preferred measure of each variable, scaling it relative to an
appropriate measure of output or income. I want to emphasize that we cannot reach a judgment from
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these charts about whether the perceived imbalance is real and serious, but we can at least understand
why concerns have been raised in each case.
The chart for the stock market, figure 2.A, shows the price-to-earnings ratio for the S&P500 index,
based on the trailing four-quarter earnings. The current p/e ratio of about 32 compares with an average
of 16 since 1957 and a high before this expansion of 22.3 in August 1987. The personal saving rate,
charted in figure 2.B, has declined in this episode to a record low. The current account balance,
pictured in figure 2.C, is measured as the ratio to nominal gross domestic product (GDP). This ratio
has also declined to a record low. In figure 2.D, I have charted the ratio of debt service costs to
disposable income for the household sector, a preferred measure of the household debt burden. It has
been rising since the mid-1990s but remains below the peak reached in the mid-1980s.
As I noted, none of these diagrams definitively demonstrate that there is an unsustainable imbalance.
The point of the exercise is to show why some have worried that there might be. It would take a more
detailed analysis than time permits to reach an informed judgment about the risks in each case. And
when we were done with this more detailed analysis, we could reasonably expect that we would still
be left with considerable uncertainty.
Common sources of recent developments
What I do want to focus on this afternoon are possible common sources for the developments pictured
in figure 2 and the relation of any imbalance between aggregate supply and demand to those
developments.
There are, I believe, some common sources of the developments pictured in figure 2. First, these
variables are all cyclically sensitive. During expansions, equity prices tend to rise, although they often
decline before a downturn in the economy. Discerning a consistent pattern for the saving rate during
an expansion from the chart is more difficult: too many other factors play a role. But regression
analysis indicates that the saving rate tends to move countercyclically. The current account balance
tends to deteriorate if the expansion in the United States outpaces that abroad, as has been the case in
recent years. After some point, the debt burden tends to increase sharply during expansions, although
it often turns before a recession. But this cyclical expansion is not ordinary. It is exceptional. The
unemployment rate, for example, has declined to a 30-year low. By some estimates, the output gap is
the widest since the early-1970s. The duration of the expansion is about to set a record. It is therefore
not surprising that cyclically sensitive variables are behaving exceptionally by historical standards.
Second, the composition of output gains in this episode has also contributed to the patterns in figure 2.
Private domestic demand typically is the driver of expansions, but its contribution has been even
greater than usual this time. The direct contribution of federal government spending and tax changes,
reflected in the swing in the federal budget from deficit to surplus, has been a net drag on growth. The
weakness of our trading partners and the crises among emerging market economies contributed to the
sharpness of the decline in net exports. So the pace of domestic private demand has been even stronger
than the growth in overall output. Private domestic spending has been driven, in part, by the wealth
effect arising from higher equity prices, a situation that also helps to explain much of the decline in the
personal saving rate, and has been financed by a higher household debt and by the tapping of foreign
saving.
Also the two types of imbalances - an imbalance between aggregate demand and aggregate supply and
sector or market imbalances - could be connected. Consider a situation in which growth is above trend
and output moves beyond capacity. If investors misread these developments as sustainable and,
therefore, extrapolate the exceptional conditions, exceptional and perhaps unsustainable movements in
equity prices, the saving rate, and debt burden might be encouraged. Alternatively, a rise in equity
prices that outstrips fundamentals might contribute to a pace of private domestic demand that
ultimately takes output beyond capacity; in this case, the market or sector imbalance would be what
contributed to the aggregate demand-supply imbalance. It also seems quite possible, indeed likely, that
both these directions could operate simultaneously and reinforce each other. Finally, market or sector
imbalances could possibly rise to worrisome proportions in the absence of an imbalance between
aggregate demand and supply.
This analysis leaves us with four possible combinations: (1) simultaneous imbalances in both
aggregate demand/supply and market/sector variables; (2) simultaneous balance in each class;
(3) aggregate demand/supply imbalance accompanied by balance in market/sector variables; and
(4) aggregate demand/supply balance accompanied by market/sector imbalances. There are clearly a
wide variety of opinions about which of these combinations best describes the current situation.
Indeed, many observers, including myself, are uncertain about which combination best fits the current
picture.
The problem in assessing the risks associated with market/sector imbalances is not only determining
whether or not prevailing levels of these variables constitute an imbalance in the first place but also
figuring out the circumstances and time frame over which any true imbalance might be unwound. In
addition, the effects on the economy as a given imbalance is unwound will depend importantly on
interactions with other imbalances and with events that trigger the unwinding of the imbalance, as well
as on the policy response. For example, a stock market correction is typically triggered by some
adverse event so that the effect on the economy will be the combined effects of the triggering event
and the stock market decline. A decline in the stock market might also, for example, reduce confidence
in the US economy and reduce the willingness of foreigners to accumulate the increment in US
liabilities associated with the current account deficit. And the net effect will also depend on the policy
response to the adverse effects of the unwinding of any imbalances. As a result of these
considerations, simple multiplier exercises, such as the effect on the economy of a given percentage
decline in equity prices, probably tell more about the econometric model used than about prospects for
the economy.
The challenge for monetary policy
The most important of the perceived imbalances I have discussed today is, in my view, the possibility
of an overheated economy. In three of the four combinations of aggregate demand/supply and
market/sector imbalances, it seems to me that the best approach would be to focus directly on the
aggregate demand/supply imbalance and allow the indirect effects of such a policy to mitigate any
other imbalances. In addition, any other imbalances are more likely to grow to worrisome proportions
during an unsustainable boom and are more likely to unwind in a disruptive manner if confronted by
rising inflation, sharply higher interest rates in response to higher inflation, and a subsequent
recession. As a result, my guess is that if we avoid the boom-bust scenario, we shall have avoided the
most serious of the other imbalances or at least will be in a better position to absorb and respond to the
unwinding of other possible imbalances.
That leaves the possibility that there might be cases when we face market/sector imbalances in the
absence of any aggregate demand/supply imbalance. In such a case, the level and growth of output are
sustainable in the sense that they are not putting pressure on inflation; but this aggregate balance might
be threatened subsequently by a spontaneous unwinding of a market/sector imbalance. Alternatively,
the depth and duration of a downturn in response to some future adverse shock might be aggravated by
the unwinding market/sector imbalances. What role can and should monetary policy play in such a
case? Policymakers will, I expect, be reluctant to undermine macroeconomic performance in the short
run in an attempt to unwind a perceived market/sector imbalance that might not be serious or might
unwind in a gradual and nondisruptive fashion on its own. Furthermore, it is not obvious how to
unwind an excessive debt burden, to raise the personal saving rate, or to narrow the current account
deficit in a sustainable way through monetary policy.
As a result, monetary policy, in my view, needs to focus on achieving balance between aggregate
supply and aggregate demand. In pursuing this course, monetary policy is confronted by two
competing challenges. The first is to allow the economy to realize the benefits of any decline in the
NAIRU and any increase in trend growth. Supporting maximum sustainable growth is very much the
business of monetary policy. But achieving maximum sustainable growth also is about ensuring the
sustainability of an expansion and hence avoiding overheating. This is the second challenge today. I
view the efforts of the FOMC as precisely focused on balancing these considerations.