Mr Ferguson reviews last year's economic performance in the
United States and raises some topics related to the underpinnings of
macroeconomics and monetary policy
Remarks by Mr Roger W Ferguson Jr, Vice-Chairman of the Board of Governors of the US Federal
Reserve System, before the Downtown Economists Club, New York, on 17 February 2000.
* * *
Thank you very much for giving me the opportunity to join this illustrious group of economists in this
historic setting. The end of one year and start of another is a natural time to focus on accomplishments
and also to list the things to do or to understand better. In this spirit, I would like to review last year's
economic performance and then raise some topics related to the underpinnings of macroeconomics and
monetary policy.
Of course, the views that I am about to express are my own and do not necessarily reflect those of
other members of the FOMC or the Board of Governors.
Economic performance in 1999
Last year presented various challenges for monetary policymakers. Domestic demand was particularly
strong, led by consumption expenditures, which grew 51⁄2% last year. However, consumption was only
one engine driving the spectacular performance of 1999. Business fixed investment, paced by
spending on producers' durable equipment, also rose strongly - by 7%. One investment sector, the
housing sector, which had been a source of considerable strength in 1998, grew less rapidly last year.
Although single-family starts rose further in 1999, starts of multifamily units were off from their 1998
pace.
Long-term interest rates trended downward in early 1999 but more than retraced those declines by the
end of the year. Equity prices rose over much of 1999, raising the value of household assets and
improving the general sense of financial well-being of our citizens as well as lowering the cost of
capital faced by businesses.
Recovery in Asia, with perhaps the apparent exception of Japan, and a pick-up in growth in Europe
accompanied this good news in the United States. During the first half of 1998, net exports subtracted
almost 13⁄4 percentage points from GDP growth. With conditions improving overseas, the external
sector subtracted less than 3⁄4 percentage point from growth in the second half of 1999.
Throughout 1999, the Federal Open Market Committee took action to maintain balance in the
economy. The sense of the FOMC was that the tightening of labor markets that accompanied a growth
of demand exceeding even the stepped-up pace of supply growth would likely create upward pressures
on labor costs and eventually on the rate of price inflation. Accordingly, we moved preemptively,
raising rates 75 basis points in three increments. This tightening reversed the easings that had been put
in place during the second half of 1998 in response to the market turmoil, including in the US markets,
triggered by the unexpected events in Russia. As you well know, rates were raised another 25 basis
points at our meeting earlier this month.
At the February meeting, the FOMC also abandoned the approach of discussing "biases" regarding
interest rate movements, which seemed to engender overly strong reactions or a misreading of our
intentions from markets. Instead, the FOMC adopted the approach of discussing our views on
economic developments and potential risks to good economic performance. Using this new approach,
the FOMC earlier this month indicated a concern that risks were weighted mainly toward conditions
that might lead to increased inflation.
Sources of performance
Four major forces provide the underpinning for the vigorous domestic growth we are currently
experiencing. The first is the creation of, and massive investment in, information and communications
technology. This capital spending, along with the apparent technological improvements, is thought to
have been important in the increase in productivity - the output of goods and services per hour of
work - that is currently providing such momentum for the economy of the United States. The second
major force is business deregulation. The removal of unnecessary government regulation started more
than 20 years ago, during the administration of President Gerald Ford, and gathered momentum during
the Carter years. It has altered the business landscape. Deregulation allowed, indeed forced, businesses
to focus more clearly on a market place that has become more competitive, with fewer constraints and
increased flexibility. The third major force is a more prudent fiscal policy. The 1990s were
characterized by a movement of federal government balances toward and then into surplus, which,
many believe, has freed up resources for private-sector investment.
The final major force is the reduction of both actual and expected inflation. Relatively stable prices
have allowed businesses and households to plan their economic affairs with an expectation that the
value of investments will not be eroded through a pernicious and uncertain increase in the general
price level. Indeed, relative price level stability has reinforced the impetus provided by deregulation
for businesses to manage their affairs with a priority on efficiency.
Observations and open issues: resource utilization
Against this backdrop, I want to raise some issues where further progress is needed if we are to
understand recent macroeconomic events better. Some of these issues have been of concern for some
time, and a few are new.
The first issue I wish to raise involves the supply side of the economy and grows out of the recent,
unusual conjuncture of rapid growth and high resource utilization with low and stable inflation. What
is the proper measurement of resource tightness? The two most prominent measures of resource
tightness, capacity utilization in manufacturing and the rate of unemployment, have historically moved
fairly closely together over the cycle. However, they have diverged in the past several years, in part as
the surge in investment has provided considerable capacity to the manufacturing sector while labor
markets have become tighter and tighter. We need a better understanding of the implications of this
divergence and, in particular, a clearer sense of which measure, or combination of measures, of
resource utilization best foreshadows the emergence of price pressures.
A second, and related, issue is whether the nature of "capacity" has changed. In the 1940s and 1950s,
large-scale units of fixed machinery - such as blast furnaces and assembly lines - more normally
characterized manufacturing capacity. Many observers have argued that, because this capacity
required long lead times to manufacture, test and install, available capacity was easier to measure and
slower to change. In such circumstances, high levels of capacity utilization were good predictors of
resource tightness, which was likely to translate into pricing pressure. Now, we hear, capacity in
manufacturing is more technology intensive and can be adjusted more easily to reflect supply and
demand conditions. If true, this relatively "elastic" supply of manufacturing capacity would imply that
capacity utilization may not become "tight" by historical standards and our measure of capacity
utilization would therefore be a less-certain early warning signal of potential pricing pressure. I have
seen no proof of the assertion that the nature of manufacturing capacity has changed, although the
experience of the last several years suggests that it has.
A third related issue has to do with the average workweek and labor force participation. During this
episode of strong growth, the average workweek has not increased significantly. In 1994, the average
workweek was about 341⁄2 hours, and today it is about 341⁄2 hours. This steadiness is in part due to mix
shifts, as the economy moves away from manufacturing sector jobs, in which the 40-hour workweek is
the norm, to service sector jobs, in which shorter workweeks are more common. Moreover, the labor
force participation rate, while fluctuating, has remained around 67% during this period. Given the
various other elements of evidence regarding labor market tightness, including survey data on job
market conditions and the measured unemployment rate, I find it puzzling that both the workweek and
the labor force participation rate have not increased more strongly. One theory, of course, is that
household wealth, to which I turn next, might limit the felt need by some potential workers,
presumably young people dependent on parents and perhaps older citizens, to participate in the labor
market.
Observations and open issues: equity markets
Also of interest are valuations in equity markets, the role they should play in policymaking, and
whether old relationships have changed. Many observers have asked if I think that the Federal Reserve
can or should have a fixed view on the proper level of equity markets. Every time I consider this
question, I come up with the same answer: the Fed cannot target specific levels in equity markets.
Equity prices are set by the give-and-take of supply and demand, with participants buying and selling
based on their own information that shapes their long-term expectations. Investors can and should be
influenced by several factors, including expectations of corporate earnings, attractiveness of
alternative investments (both domestic and international), and differing appetites for "ownership" risk
as opposed to "creditor" risk. I believe that the Federal Reserve's tools - primarily short-term interest
rates - are too blunt to attempt to achieve specific levels of stock market valuations. I also believe that
policymakers should not necessarily attempt to put their judgments of correct values above those of
the market. Simply put, equity prices should properly be thought of as a relative price-the value of the
existing capital stock relative to that of goods. Central banks are not good at fine-tuning relative
prices. Rather, leave us the responsibility for determining the policy that anchors the general price
level in the long run.
However, equity markets do have important spillover effects on the real economy. As you know,
economists often speak of the "wealth effect", and econometric modeling indicates that consumers
ultimately tend to spend about three to four cents for every dollar increment to wealth. In addition,
consumer sentiment is tied to feelings of financial well-being. Through both of these channels, the
so-called wealth effect and the more general influence on consumer sentiment, equity valuations can
and do affect consumption and macroeconomic performance. Equity markets are also a significant
source of investment capital, and valuations in the stock market are one determinant of the cost of
capital for businesses. Therefore, equity prices affect business fixed investment, a major driver of our
economy. Given the economic importance of equity prices, it is reasonable for policymakers to
monitor developments in this market even if we do not "target" specific values. We have seen in other
economies that the bursting of bubbles in financial markets can create unsettled conditions that affect
real economic activity. Therefore, the maintenance of sound equity market conditions is of concern to
policymakers, though how that can be accomplished is often far from clear.
My questions about equity markets center on the issue of valuation and the wealth effect. Economists
propose numerous approaches to determining the "correct" level of equity prices. One such approach
compares equity market valuations (namely earnings-price ratios) to the return on fixed-income
securities, generally the 10-year US Treasury bond. But many observers have suggested that this
measure of the "correct" stock market valuation may no longer be accurate. Some suggest that the
nature of equity markets has changed with the introduction of new instruments that allow for the better
management or sharing of risks. Therefore, these observers assert that lower premiums over risk-free
returns are appropriate and that old relationships between earnings-price ratios and the return on
Treasury instruments no longer hold. Others argue that, in this world of knowledge-intensive
industries, accounting treatments do not accurately measure true economic earnings, and therefore
measures of "correct" stock valuations do not capture economic reality that market participants see.
These assertions are interesting, but they need further investigation.
In addition, with respect to proper valuations, we know that many businesses are using options as a
form of compensation to employees and that the value of these options is not being recorded as
compensation at the time they are granted. We roughly estimate that accounting for the value of
options granted would have reduced reported income for S&P 1,500 firms nearly 10% in 1998. The
same adjustment would have reduced the growth rate of reported income for S&P 1,500 firms almost
21⁄2 percentage points per year, on average, during the 1996-98 period. When looked at with these
refinements, the current earnings-price ratios appear even more out of alignment with historical
experience.
When one considers the performance of the stock market during the recent past, it is clear that the
gains are not evenly distributed, even among stock market investors. Some of the greatest beneficiaries
of the unprecedented generation of stock market wealth have been those with the skills and the work
style to work in high-tech companies, who are rewarded with stock, and those with the courage to
invest in high-tech sectors. This observation leads to several questions. First, how skewed is the
distribution of gains from the stock market? If gains are indeed skewed, what then is the actual
dynamic of the wealth effect? When does an unequal participation in equities become sufficiently
broad-based to influence the path of our economy? I think of these questions as providing the
microeconomic underpinnings to our macroeconomic performance.
Finally, we have seen a run-up in margin debt, particularly during the last two months of 1999 and the
first month of 2000. I believe that the Federal Reserve should not foster the impression that we are
targeting the equity market by adjusting our one tool in the margin area, namely initial margin
requirements. However, given our obvious interest in macro-stability, it is useful to understand more
fully what has motivated this recent run-up in margin. Some argue that it reflects a desire on the part
of investors to capture some capital gains, while others are quick to point out that, as a percentage of
market valuation, margin has not increased dramatically. According to another theory, margin
borrowing is the realm of the small investor whereas large investors finance equity purchases through
other means. In any event, prudent margin procedures are an important part of sound business practice.
I expect that those extending margin credit, especially the major clearing firms, as well as investors,
and the public at large, would continue to recognize that conservative margin practices are in their own
interest.
Observations and open issues: international markets
Let me turn now to the role of international developments in policy. Our mandate gives priority to
price stability and maximum sustainable employment, which I think are the right elements for us to
consider in policy deliberations. Therefore, I believe that international economic considerations, like
stock market valuations, should receive only the focus merited because of their implications for the
US economy. Certainly, developments in the international sector, in particular a large and growing
current account deficit, might indicate that there are imbalances in the economy of the United States.
Similarly, movements in the exchange value of the US dollar might transmit pressures on inflation, but
they also are an important transmission mechanism for monetary policy. However, managing the
external balance and the exchange value of the US dollar is obviously not the goal of monetary policy.
One important contribution to the ongoing deterioration of our current account balance is the tendency
for US residents, for reasons not fully understood by economists, to have a higher propensity to import
out of every dollar of income than do residents in the countries that are our major trading partners.
This, of course, means that even sustaining trend growth both in the United States and in our trading
partners will not necessarily close the trade gap. To do so would require a period of sustained
stronger-than-trend growth overseas.
Many professional economists and market observers now question the sustainability of our current
account deficit. I suggest that the combination of a large current account deficit and a strong US dollar
is, in part, a reflection of the relative attractiveness of the US economy as a destination for foreign
capital. We are attracting savings from abroad because we currently have a higher rate of return on
investment than many other countries do. This state of affairs, of course, is a reflection of the factors
that have given rise to this long period of domestic prosperity. How much longer prosperity can
continue is obviously the key question. The answer depends on the ability of businesses and workers
in the United States to continue to generate growing productivity increases. Because few of us forecast
the current period of investment-driven productivity increases, it is difficult to predict when it will
end. We know only that, at some point, productivity will stop accelerating. But the potential for
change is not the exclusive domain of the United States. The ability of other countries to adjust their
systems of production to take advantage of new technologies will be an important determinant of
when other markets will offer returns that are comparable to those available in the United States. I
imagine that, seeing the gains that we have experienced from our capital deepening, investors would
look for the earliest signs of a similar phenomenon in other countries. The one lesson we can offer is
that the configuration of competitive and flexible markets, management focused on shareholder value,
and supportive macroeconomic conditions is not achieved without costs in terms of some societal
dislocations and that configuration requires good fortune, sacrifice and discipline.
Conclusion
As you can see, these are interesting times in which to be a central banker. This complex set of forces
requires continued vigilance on our part. Additionally, the last 24 months have raised an important set
of questions regarding measures of real economic performance, the behavior of inflation, financial
market indicators, and the growing globalization of today's economy. I highlighted some of these
questions with you today. I have enjoyed immensely having to grapple with these issues but recognize
that we at the central bank may have all of the right questions but do not have all the answers.