Ben S Bernanke: The economic outlook
Speech by Mr Ben S Bernanke, Member of the Board of Governors of the US Federal Reserve
System, before the Bloomberg Panel for the Outlook on the U.S. Economy, New York,
4 September 2003.
The references for the speech can be found on the Board of Governors of the Federal Reserve System's website.
* * *
I am pleased to have this opportunity to participate in the Bloomberg Panel on the Outlook for the U.S.
Economy. When I was a boy in South Carolina, my parents always advised me never to discuss
religion or politics in public, those being subjects on which everyone has a strong opinion but on which
no one can ever be proved wrong. I have always followed their advice on those particular topics, but I
am afraid that economic forecasting may be just about as bad on both counts. Everyone has strong
views on where the economy is heading, but when the time finally comes to compare your forecast
with the data, the world has changed in eleven unpredictable ways that no one can blame you for
failing to foresee - that is, if they remember what you forecast in the first place.
Unfortunately, as helping to make monetary policy is part of my current job, I cannot avoid forming
some opinions about the outlook for the U.S. and world economies. Today I will give you a few of my
impressions about what seems likely to unfold in the next year to eighteen months, as well as what I
see as the most important risks to that forecast. I will talk first about output growth and unemployment,
and then about inflation, and I will conclude by discussing some implications for monetary policy. Both
my prepared remarks and the comments I may make in the discussion later should be clearly
understood as reflecting only my own views and not those of my colleagues on the Federal Open
Market Committee (FOMC) or the Board of Governors of the Federal Reserve System.
The forecast through 2004: Growth and unemployment
To provide some context for this talk, I consulted the prognostications (in August releases) of some
prominent private - sector forecasters and surveys of forecasters, namely Global Insight (formerly
DRI-WEFA), the Blue Chip Survey, Macroeconomic Advisers, and the Survey of Professional
Forecasters (see table 1). As you will see, I agree with several aspects of these well-regarded
forecasts but (perhaps at my peril) disagree with, or at least have reservations about, some others.
Beginning with the real side of the economy, we see in table 1 substantial agreement among the
private-sector forecasters about the prospects for real GDP growth and the unemployment rate
through the end of 2004. All the forecasters expect output growth during the second half of this year to
be strong, in the general range of 3.7 to 4.2 percent. Despite the projections of high growth rates, the
private forecasters expect the unemployment rate to remain at about the current rate of 6.2 percent
through the end of this year. The private-sector forecasters also see strong economic growth
continuing, although generally not accelerating, in 2004. Measuring growth as 2004:Q4 over 2003:Q4,
Global Insight forecasts 4.1 percent growth for real GDP in 2004, Blue Chip calls for 3.7 percent
growth, Macroeconomic Advisers sees 4.0 percent growth, and the Survey of Professional
Forecasters looks for 3.8 percent growth. Notably, according to the professionals, even this
performance is not expected to decrease the unemployment rate by very much. Only Macroeconomic
Advisers sees unemployment in the fourth quarter of 2004 falling as low as 5.4 percent; the rest
foresee the unemployment rate remaining at 5.8 or 5.9 percent during the last quarter of next year.
These projections for the paths of growth and unemployment are broadly consistent with forecasts
made by the members of the FOMC prior to our June 24-25 meeting and released shortly thereafter as
part of the Federal Reserve's semiannual Monetary Policy Report to the Congress. The FOMC
members' forecasts for real GDP for 2003 were for growth over the entire year; they were not broken
down by quarter. However, given information about the first half available at the time the Committee's
forecasts were made, the central-tendency FOMC forecast for real GDP growth for the year as a
whole almost certainly implies a noticeable pickup in the pace of expansion in the second half of 2003.
For 2004, the central-tendency FOMC projection for real GDP growth as of the end of June covered
the range of 3-3/4 percent to 4-3/4 percent, a forecast more optimistic than even current private-sector
forecasts of growth for next year and suggestive of an acceleration in real activity from the second half
of 2003 to 2004.
The central tendency of FOMC forecasts for the unemployment rate, as of the end of this past June,
called for the rate to fall to between 6 and 6-1/4 percent in the fourth quarter of this year and to decline
to between 5-1/2 and 6 percent in the fourth quarter of 2004. Again, these values are broadly
consistent with the more recent private-sector forecasts. In particular, the private-sector forecasters
and FOMC members evidently agree that strong GDP growth will only gradually erode the
accumulated slack in the job market. Simple arithmetic tells us that all the forecasters are expecting
much of the projected increase in output to be met by ongoing increases in labor productivity, rather
than by substantial new hiring. This point is a crucial one, to which I will return later when discussing
inflation projections.
I should tip my hand at this point and say that I personally find the real growth and unemployment
forecasts just described to be broadly reasonable, though there are important risks. In particular, I
have been of the view for quite a while that acceleration of growth to 4 percent or better in 2004 is
plausible; and I agree also that the decline in the unemployment rate, though steady, is likely to be
slow.
Why do I believe that there are grounds for optimism about economic growth, even as more caution is
warranted regarding unemployment? The consumer plays a central role as always, and recent news
on retail sales (including automobile sales) and housing starts and sales, among other data, suggests
that household spending continues to hold up well, as it has throughout the past three years. Tax cuts,
signs of stabilization in the job market, and rising stock prices are among the factors that should keep
the consumer in the game as the recovery proceeds. What makes the situation today feel particularly
encouraging, however, is that we may finally be seeing some signs of a revival in business investment.
Because I see the strength and sustainability of that revival as the key to the forecast, I would like to
discuss it in a bit more detail.
In a speech I gave to the Forecasters' Club last April (Bernanke, 2003a), entitled "Will Business
Investment Bounce Back?," I pointed out that the recession that began in March 2001 is distinctive in
being one of the few business-led-as opposed to household-led-recessions of the post-World War II
period. In particular, a sharp decline in business investment spending that began in the second half of
2000 was the proximate cause of the recession. By the same token, I argued in my earlier speech -
making a point that many others have made as well - that a balanced recovery would be impossible
without a sustained revival in capital expenditures. My earlier speech surveyed the prospects for
various types of investment spending but emphasized the importance for the strength of the
investment recovery of CEOs' views on prospective returns to capital expenditure and the future of the
economy - their animal spirits, if you will.
With a little more than four additional months' worth of data, what can we say today about the recovery
of investment spending? As I noted in April, the best prospects for an investment rebound in the
corporate sector lie in the equipment and software sector, particularly in high-tech equipment. Over the
summer we have seen indications of at least a moderate pickup in this sector. Notably, according to
the preliminary GDP estimates, real investment in equipment and software rose at an annual rate of 8
percent in the second quarter. Real expenditures for high-tech equipment advanced 34 percent (at an
annual rate) in the second quarter, a significant step up from the first quarter, and real spending on
software rose at a 9 percent rate. Perhaps managers have finally decided that they can't put off that IT
upgrade any longer. Even spending on communications equipment was strong in the second quarter.
Investment in non-high-tech equipment, including both transportation and general machinery, has also
improved. In recent months, indicators such as orders data and indexes based on surveys of
managers' plans for capital expenditures have strengthened, on balance, suggesting that investment
in equipment and software is likely to continue to rise in the near term.
By contrast, as I noted in my earlier speech and others have observed, investment in nonresidential
structures is not a promising source of growth. The strength in this category in the second quarter was
due importantly to an increase in spending in the drilling and mining sector, tied primarily to high
natural gas prices. The outlook for buildings, particularly office and industrial buildings, remains weak,
as high vacancy rates and low utilization rates persist. However, for better or worse, investment in
nonresidential structures has become such a small part of aggregate spending on average that
recovery in this sector is not a make-or-break factor for the overall economy.
Looking beyond the very near term, I see some grounds for optimism that the revival in business
investment will persist, laying the foundation for continuing rapid expansion in 2004. First, the strong
growth in demand already in train should provide incentives to corporate managers to expand
productive capacity, particularly given the efforts that they have already made to reduce costs and
increase the efficiency of production within existing plants. In that regard, I think it is worth pointing out
that firms have been meeting demand recently not only by getting greater productivity out of their
existing capital and labor resources but also by running down inventory stocks relative to sales. If the
past is a guide, we may soon see a quarter or two of inventory building that provides a powerful boost
to the growth rate of output.
Second, financial conditions remain favorable to business investment. Profits are rising smartly, and
corporations have considerably improved their balance sheets. Although corporate bond rates have
risen in the past few months, they remain low by historical standards, and spreads have continued to
come down. Banks are well capitalized, profitable, and eager to lend to business borrowers. In short,
both internal funding and external finance for investment are available. Third, tax provisions passed in
2001 and 2003 lower the effective cost of investing in new equipment. Finally, as best as we can tell,
expectations and attitudes in the business community - as reflected in surveys, information from
business contacts, analysts' expectations of long-term earnings growth, and the like - have brightened
somewhat. When all these factors are taken together, it seems a reasonable bet that the revival in
capital expenditures will continue and will strengthen sufficiently to support the optimistic growth
forecasts that I discussed earlier.
As the prospective investment revival is central to the optimistic growth forecast, however, it is also the
locus of the most critical risks to the forecast. For some time now, CEOs have displayed a greater
reluctance to invest and hire than standard econometric models predict. Commentators have given
this negative residual many names: the workout of post-bubble excesses, geopolitical uncertainty, the
reaction to the accounting scandals of 2002, and self-fulfilling pessimism. Personally, I admit that I
don't fully understand the sources of this conservative behavior on the part of company management,
and for that reason, I cannot be entirely confident that caution will not continue to predominate in the
executive suite. A weaker investment trajectory reflecting continued CEO caution would probably not
derail the current recovery, but it would certainly put the more-optimistic growth projections for 2004
out of reach and would substantially slow the absorption of unemployed resources.
I have not mentioned the trade sector. Net exports have been a drag on U.S. growth; indeed, in the
second quarter, net exports deducted (in an arithmetic sense) a hefty 1-1/2 percentage points from
U.S. real GDP growth. My sense is that the optimistic growth forecasts for the United States for the
next year do not rely on anything more than a modest increase in growth in the rest of the world. Of
course, to the extent that unanticipated strength abroad materializes and raises demand for U.S.
exports, the outlook here will improve further.
Finally, a word on long-term interest rates, which as you know have been rising. At current levels,
bond yields do not pose a major risk to continuing strength in housing or the recovery in corporate
investment, in my view, though they may well end the boom in mortgage refinancing activity. Since
those consumers who had the most to gain from refinancing have mostly already done so, a slowdown
in refinancing is unlikely to have a significant effect on household spending.
The forecast through 2004: Inflation
I turn now from the forecast for real activity to the outlook for inflation. As before, I will both compare
the various published projections and talk about some risks to the forecast.
Inflation has been quite low, of course, and the private-sector forecasters expect inflation to remain
low for the rest of this year and next. As table 1 shows, forecasts for CPI inflation for the second half of
2003 (the average of third- and fourth-quarter inflation forecasts, at an annual rate) by Global Insight,
Blue Chip, Macroeconomic Advisers, and the Survey of Professional Forecasters are tightly clustered
in a range of approximately 1-1/4 percent to 1-1/2 percent. (I will not comment here on forecasts for
inflation as measured by the GDP price index, also shown in table 1, other than to say, as you can see
for yourselves, that they are also quite low.) The same four sources report CPI inflation forecasts for
2004, fourth quarter over fourth quarter, of between 1-1/4 and 2 percent.
For monetary policy purposes, one is often interested in measures of underlying inflation. One such
measure is so-called core CPI inflation, defined as the rate of change of the consumer price index
excluding food and energy prices, which tend to be relatively volatile. I was able to find a core CPI
inflation forecast only for Macroeconomic Advisers. Macroeconomic Advisers expects core CPI
inflation for 2004 to be 1.5 percent, compared with an expectation of 1.3 percent for overall CPI
inflation. If Macroeconomic Advisers is representative, then the distinction between core and overall
CPI inflation is not of first-order importance for next year's inflation forecast. As best as I can tell, the
same should be roughly true for inflation forecasts for the second half of 2003, though not for 2003 as
a whole (the third column of the table) because of the sharp increases in energy prices in the first
quarter of this year.
For comparison with the private-sector forecasts, the FOMC's central-tendency forecast at the end of
June was that inflation in 2004 will range between 1 and 1-1/2 percent, as measured by the personal
consumption expenditures (PCE) chain-type price index. Because of differences in the construction of
this index and the CPI, an upward adjustment of 0.2 to 0.4 percentage point is probably necessary to
make PCE inflation comparable to CPI inflation. Hence the FOMC central-tendency forecast for
inflation for 2004 is also broadly consistent with the private-sector estimates.
One can try to assess the validity of these forecasts in two ways. For the short run, a couple of
quarters, looking in some detail at the components of price indexes, to try to isolate trends and special
factors, is useful. For the longer run, there is no substitute for thinking hard about the underlying
economic factors influencing inflation.
Consideration of the details of the price indexes suggests that the rather marked deceleration we
recently saw in core inflation measures has come to a halt for now, and indeed, that core inflation may
tick up a few tenths during the remainder of 2003. The reasons are largely technical. Probably the
most important factor, quantitatively speaking, has to do with the way that the Bureau of Labor
Statistics (BLS) calculates owners' equivalent rent (OER), an estimate of the cost of living in one's own
home. Data on market rental rates for homes and apartments are important inputs into the calculation
of OER. Because rental leases often include landlord-provided utilities, the BLS subtracts estimates of
the costs of utilities from market quotes of gross rents to obtain estimates of rents net of utilities.
However, to the extent that, in the short run, landlords do not fully pass on changes in utility costs to
renters, the BLS adjustment is an over-correction. In particular, in periods when energy prices and
hence utility costs are rising, as in the first half of 2003, the BLS procedure may overstate the
deceleration in rents net of utilities and hence in owners' equivalent rent. As a result, on this particular
count, the slowdown in CPI inflation may have been slightly overstated in the first half of 2003. If so,
the stabilization in residential energy costs in the second half of 2003 should unwind this effect and
likely add a bit to measured inflation going forward.
Another example of a special factor affecting measured inflation arises from the fiscal problems of
state and local governments: To cover rising budget deficits, a number of public university systems
have announced large tuition price hikes for the upcoming academic year. These tuition hikes will
naturally affect the measured cost of living. As one-time events that are more fiscal than monetary in
nature, however, I do not consider them particularly important from a monetary policy point of view. A
similar effect was seen in the increase in the July CPI number, which was partly attributable to a rise in
tobacco excise taxes imposed by a number of states. Other examples arise because of lags in data
collection: For example, telephone rates are incorporated into the CPI only with some lag, so that rate
increases that occurred earlier this year will not be reflected in the index for a few months yet. I alert
you to some of these special cases only to illustrate why the Federal Reserve does not react to
monthto-month changes in inflation data, or any other series for that matter.
For assessing the inflation forecast for the longer run, in this case the year 2004, one has to turn to the
underlying economics. I do not disagree with the general tenor of the private-sector forecasts and the
FOMC projections. It seems plausible that the combination of a strengthening recovery, well-anchored
inflation expectations, and a monetary authority strongly committed to stabilizing inflation will serve to
keep inflation in the projected range. However, in my view, the most likely outcomes are in the lower
part of that range, and I believe that the risks remain to the downside. The reason is that ongoing
productivity growth, together with stepped-up capital investment, may enable producers to meet
expanding demand without substantially increased hiring in the near term, with the result that labor
markets remain soft. Indeed, as I have noted, several of the private-sector forecasters project
unemployment rates still near 6 percent in the fourth quarter of 2004, despite real growth approaching
4 percent for the second half of 2003 and all of 2004. By a standard textbook calculation (Bernanke,
2003b), this amount of slack should lead to additional disinflation of a few tenths of a percentage point
or so by the end of 2004. So by my reckoning, inflation in 2004 might well be a bit lower than in the
second half of 2003, not higher as the majority of private-sector forecasters have projected. Of course,
if real growth were to disappoint - for example, because the investment rebound in 2004 was less
strong than is hoped for and expected - the disinflationary pressures would be all the stronger.
Caveats abound, of course. As I have already noted, for various reasons including some special
technical factors, core CPI inflation is likely to tick up during the remainder of 2003. It is always
possible that employment may rebound more quickly than we now expect. And, as history tells us,
inflation forecasts only two to five quarters out have large standard errors, so that a wide range of
inflation outcomes are possible for 2004. Nevertheless, for now it seems to me that, with inflation
already low, disinflation risk will remain a concern for some time.
Implications for monetary policy
Let me turn then to the implications for monetary policy. Given these forecasts, how should the
Federal Reserve be expected to respond?
Since May 6, the Federal Open Market Committee has assessed the risks separately for the two main
components of its mandate, economic growth and inflation. According to the statement that followed
our August meeting, the FOMC views the risks to sustainable growth as being roughly balanced.
However the risks to inflation, according to the statement, are tilted downward, with the probability of
an unwelcome fall in inflation outweighing the probability of an increase in inflation. As I see it, the
persistence of economic slack even as growth picks up makes it likely that inflation will remain low and
in some scenarios may fall still further.
As the statement concluded, "the Committee believes that policy accommodation can be maintained
for a considerable period." How long is "a considerable period"? The right answer, I think, is that "a
considerable period" is not a fixed stretch of time but depends on the evolution of the economy. In
particular, in my view, the Federal Open Market Committee has little reason to undertake significant
tightening so long as inflation remains low and promises to remain subdued, as it does today.
Let me elaborate. In the past, significantly tighter monetary policy often came shortly after the
beginning of a cyclical pickup in economic growth. When Fed policymakers responded that way, they
did so as the consequence of living in a regime in which inflation was already above the desired
range, and the rapid acceleration of activity threatened to press against capacity and raise inflation still
higher. Then the risk to satisfactory economic performance was that inflation would rise too high, and
policy was forced to preempt that risk. Today inflation is at the lower end of the range consistent with
optimum economic performance, and soft labor markets and excess capacity create a further
downward risk to inflation. As a result, I believe that increased economic growth may not elicit the
same response from the Fed that it has sometimes elicited in the past.
Besides the fact that inflation is currently at the low end of the desirable range, there is a second
reason why the Fed may not respond as it has in the past to a pickup in economic growth. As you
know, we have seen in the past few years a truly remarkable increase in labor productivity, sufficient to
permit growth in output even as employment has fallen. Output growth arising from higher productivity
is not typically accompanied by increased inflationary pressures. Indeed, I would argue that, in
situations of considerable slack, growth that is generated solely by increased productivity, and that is
unaccompanied by substantial employment growth, may possibly require monetary ease, rather than
monetary tightening, in the short run.
I should emphasize that, though current circumstances should permit the Federal Reserve to
accommodate a considerable period of above-trend growth, this does not in my view imply an
increased tolerance for inflation. The FOMC has made clear in its new statement, as introduced after
the May 6 meeting, that it has an acceptable range for inflation, consistent with its mandate for
maintaining price stability. The current policy of ease results from concerns that inflation will fall below
that acceptable range. But at some point in the future, disinflationary forces will abate, and the risks to
inflation may turn upwards. At that point I expect that the FOMC will act forcefully to ensure that
inflation remains low and stable.
Let me close by restating and summarizing the three main conclusions of these forecasts for monetary
policy. First, a "considerable period of time" is not a fixed period of time but depends on the evolution
of the economy. In my view, the Fed has no reason to undertake a significant tightening of policy so
long as inflation is low and inflation pressures remain subdued. Second, productivity-led growth that
does not raise the underlying rate of resource utilization does not increase inflationary pressures and
thus, in my view, should not prompt a policy tightening. Finally, the Fed's current policy of resisting a
fall of inflation below its implicit zone for price stability does not, in my opinion, signal a new
dovishness with respect to inflation in general. I expect the Fed to be just as tough in resisting
unwanted upward movements in inflation as it currently is in resisting undesired declines.
References
Bernanke, Ben (2003a). "Will Business Investment Bounce Back?" Speech delivered at the
Forecasters' Club, New York, New York, April 24, www.federalreserve.gov.
Bernanke, Ben (2003b). "An Unwelcome Fall in Inflation?" Speech delivered at the Economics
Roundtable, University of California, San Diego, La Jolla, California, July 23, www.federalreserve.gov.
Table 1: Comparison of Private-Sector Forecasts
2003:Q3 2003:Q4 2003:Q4/ 2004:Q4/
2002:Q4 2003:Q4
GDP (percent change)
Global Insight1 (8/11/03) 3.6 3.7 2.8 4.1
Blue Chip (8/10/03) 3.7 3.8 2.8 3.7
Macroeconomic Advisers (8/21/03) 4.2 4.2 3.1 4.0
Survey of Professional Forecasters (8/22/03) 3.5 3.9 2.8 3.8
Unemployment Rate (level)2
Global Insight1 6.2 6.2 6.2 5.9
Blue Chip 6.2 6.2 6.2 5.8
Macroeconomic Advisers 6.2 6.1 6.1 5.4
Survey of Professional Forecasters 6.2 6.1 6.1 5.8
CPI (percent change)
Global Insight1 1.5 1.0 1.7 1.5
Blue Chip 1.5 1.6 1.9 1.9
Macroeconomic Advisers 1.8 1.0 1.8 1.3
Survey of Professional Forecasters 1.5 1.4 1.8 2.0
GDP Price Index (percent change)
Global Insight1 1.3 1.1 1.4 1.7
Blue Chip 1.3 1.3 1.5 1.6
Macroeconomic Advisers 0.6 0.6 1.1 0.9
Survey of Professional Forecasters 1.4 1.5 1.5 1.8
1. Formerly DRI-WEFA Return to table
2. Figures in the annual columns are Q4 levels. Return to table