Alan Greenspan: The US Economy
Speech by Mr Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve
System, at the Bay Area Council Conference, San Francisco, 11 January 2002.
* * *
In the period immediately prior to September 11, there were tentative signs that some sectors of the
U.S. economy had begun to stabilize, contributing to a hope that the worst of the previous cumulative
weakness in world economic activity was nearing an end. That hope was decisively dashed by the
tragic events of early September. Adding to the intense forces weighing on asset prices and economic
activity before September 11 were new sources of uncertainty and risk that began to press down on
global demand for goods and services.
In almost all areas of the world, economies weakened further, a cause for increasing uneasiness. The
synchronous slowing in activity raised concerns that a self-reinforcing cycle of contraction, fed by
perceptions of greater economic risk, could develop. Such an event, though rare, would not be
unprecedented in business-cycle history.
We had already observed a coincident deceleration in activity among the world economies over the
past year, owing apparently, at least in part, to the retrenchment in the high-technology sector. The
global nature of most technology industries and the global reach of the capital markets in which the
firms in these industries are valued and funded appears to have fostered a greater synchronousness
in world activity in this cycle, seemingly broader than has generally been the case. However, before
the terrorist attacks, it was far from obvious that this concurrent weakness was becoming
self-reinforcing.
But, if ever a situation existed in which the fabric of business and consumer confidence, both here and
abroad, was vulnerable to being breached, the shock of September 11 was surely it. Indeed, for a
short period, in response to that shock, U.S. economic activity did drop dramatically.
But, arguably, our economy has not been weakening cumulatively in recent weeks. In fact, indications
of stabilization, similar in many respects to those observed in the period immediately preceding
September 11, have been appearing with greater frequency. A possible significant contributor to this
emergence of stability--if that is what it is--may be the very technologies that have fostered coincident
global weakness: those that have substantially improved access of business decisionmakers to
real-time information.
Thirty years ago, the timeliness of available information varied across companies and industries, often
resulting in differences in the speed and magnitude of their responses to changing business
conditions. In contrast to the situation that prevails today, businesses did not have real-time data
systems that enabled decisionmakers in different enterprises to work from essentially the same set of
information. In those earlier years, imbalances were inadvertently allowed to build to such an extent
that their inevitable correction engendered significant economic stress. That process of correction and
the accompanying economic and financial disruptions too often led to deep and prolonged recessions.
Today, businesses have large quantities of data available virtually in real time. As a consequence,
they address and resolve economic imbalances more rapidly than in the past. At the same time, firms
are largely operating with the same information set, and thus resolution of imbalances induces parallel
movements in activity. Contractions initially may be steeper, but because imbalances are more readily
contained, cyclical episodes overall should be less severe than would be the case otherwise.
In the current situation, inventories, especially among producers and purchasers of high-tech products,
did run to excess over the past year, as sales forecasts went badly astray; alas, technology has not
allowed us to see into the future any more clearly than we could previously. But, technology did
facilitate the quick recognition of the weakening in sales and backup of inventories. This enabled
producers to respond forcefully, as evidenced by output adjustments that have resulted in the
extraordinary rate of inventory liquidation currently under way.
Inventories in many industries have been drawn down to levels at which firms will soon need to taper
off their rate of liquidation, if they have not already done so. Indeed, in recent months, there have been
fewer reports from industrial purchasing managers that their customers' inventories are too high.
Moreover, the relative stability of industrial commodity prices in recent weeks, and especially the
recent firmness in the prices of semiconductors, could be hinting at less intense stock drawdowns.
A slowing in the rate of inventory liquidation will induce a rise in industrial production if demand for
those products is stable or is falling only moderately. That rise in production will, other things being
equal, increase household income and spending. The runoff of inventories, even apart from the large
reduction in motor vehicle stocks, remained sizable in the fourth quarter. Hence, with production
running well below sales, the potential positive effect of the inevitable cessation of inventory liquidation
on income and spending could be significant.
But that impetus to activity will be short lived unless the demand for goods and services itself starts to
rise. On that score, despite a number of encouraging signs of stabilization, it is still premature to
conclude that the forces restraining economic activity here and abroad have abated enough to allow a
steady recovery to take hold. For that to happen, sustained growth of final demand must kick in before
the positive effects of the swing from inventory liquidation to accumulation dissipate.
For the household sector, which had been a major stabilizing force through most of last year's
slowdown, the outlook for demand is mixed. Low mortgage interest rates and favorable weather have
provided considerable support to homebuilding in recent months. Moreover, attractive mortgage rates
have bolstered both the sales of existing homes and the realized capital gains that those sales
engender. They have also spurred refinancing of existing homes and the associated liquification of
increases in house values. These gains have been important to the ongoing extraction of home equity
for consumption and home modernization.
The recent rise in home mortgage rates, however, is likely to damp housing activity and equity
extraction. It is already having an effect on cash-outs from refinancing. Cash-outs rose from an
estimated annual rate of about $20 billion in early 2000 to a rate of roughly $75 billion in the third
quarter of last year. But the pace of cash-outs has likely dropped noticeably in response to the recent
decline in refinancing activity that has followed the backup in mortgage rates since early November.
Consumer spending received a considerable spur from the sales of new motor vehicles, which were
remarkably strong in October and November owing to major financing incentives. Sales dropped last
month when the incentives were scaled back, but have remained surprisingly resilient. Other
consumer spending appears to have advanced in recent months, though at a subdued pace.
The substantial declines in the prices of natural gas, fuel oil, and gasoline have clearly provided some
support to real disposable income and spending. These price declines added more than $50 billion at
an annual rate to household purchasing power in the second half of last year. However, a decline in
energy prices provides, in effect, only a one-shot boost to consumption, albeit one that is likely to take
place over time. To have a more persistent effect on the ongoing growth of total personal consumption
expenditures, energy prices would need to continue to decline. Futures prices do not suggest that
such a decline is in the immediate offing, but the forecast record of these markets is less than sterling.
Although the quantitative magnitude and precise timing of the wealth effect remain uncertain, the
steep decline in stock prices since March 2000 has, no doubt, curbed the growth of household
spending. Although stock prices recently have retraced a portion of their earlier losses, the restraining
effects from the net decline in equity values presumably have not, as yet, fully played out. Future
wealth effects will depend importantly on whether corporate earnings improve to the extent currently
embedded in share prices.
Perhaps most central to the outlook for consumer spending will be developments in the labor market.
The pace of layoffs quickened last fall, especially after September 11, and the unemployment rate
rose sharply. Over the past month or so, however, initial claims for unemployment insurance have
declined markedly, on balance, suggesting some abatement in the rate of job loss.
Although this development would be welcome, the unemployment rate may well continue to rise for a
time, and job losses can be expected to put something of a damper on consumer spending. However,
the extent of that restraint will depend on how much of any rise in unemployment is the result of
weakened demand and how much reflects strengthened productivity. In the latter case, average real
incomes could rise, at least partially offsetting losses of purchasing power that stem from diminished
levels of employment.
Finally, economic policies will have an important influence on household spending in the period ahead.
No doubt, we will continue to benefit from the tendency of our tax and entitlement systems to buffer
cyclical swings in income. Moreover, despite the failure of Congress to enact further tax cuts and
spending increases, the continued phase-in of earlier reductions in taxes and the significant expansion
of discretionary spending already enacted should provide noticeable short-term stimulus to demand.
Some of this stimulus has likely been offset by increases in long-term market interest rates, including
those on home mortgages. The recent rise in these rates largely reflects the perception of improved
prospects for the U.S. economy. But over the past year, some of the firmness of long-term interest
rates probably is the consequence of the fall of projected budget surpluses and the implied less-rapid
paydowns of Treasury debt.
In our conduct of monetary policy, the Federal Reserve responded to the weakening economy over
the past year by markedly lowering our target for the federal funds rate. We accelerated the pace of
rate reductions during this period in response to the accelerated pace of economic adjustment.
Moreover, the magnitude of policy adjustment and the resulting low level of the federal funds rate
responded both to the strength of the forces restraining demand and to the continued subdued pace of
underlying inflation. Liquidity, as a consequence, has expanded significantly, and the accompanying
lower interest rates have supported spending and held down the cost to households of servicing
debts.
The dynamics of inventory investment and the balance of factors influencing consumer demand will
have important consequences for the economic outlook in coming months. But, the broad contours of
the present cycle have been, and will continue to be, driven by the evolution of corporate profits and
capital investment.
The retrenchment in capital spending over the past year was central to the sharp slowing we
experienced in overall activity. The steep rise in high-tech spending that occurred in the early
post-Y2K months was clearly not sustainable. The demand for many of the newer technologies was
growing rapidly, but capacity was expanding even faster, exerting severe pressure on prices and
profits. New orders for equipment and software hesitated in the middle of 2000, and then fell sharply
as firms re-evaluated their capital investment programs. Uncertainty about economic prospects
boosted risk premiums significantly, and this rise, in turn, propelled required, or hurdle, rates of return
to markedly elevated levels. In most cases, businesses required that new investments pay off much
more rapidly than they had previously. For much of last year, the resulting decline in investment
outlays was fierce and unrelenting. Although the weakness was most pronounced in the technology
area, the reductions in capital outlays were broad-based.
These cutbacks in capital spending interacted with, and were reinforced by, falling profits and equity
prices. Indeed, a striking feature of the current cyclical episode relative to many earlier ones has been
the virtual absence of pricing power across much of American business, as increasing globalization
and deregulation enhanced competition. In this low-inflation environment, firms have perceived very
little capability to pass cost increases on to customers. Growth in hourly labor compensation has
slowed in response to deteriorating economic conditions, but even those smaller increases have
continued to outstrip gains in output per hour for the corporate sector on a consolidated basis. The
result has been that profit margins are still under pressure.
Business managers, with little opportunity to raise prices, have moved aggressively to stabilize cash
flows by trimming workforces. These efforts have limited the rise in unit costs, attenuated the pressure
on profit margins, and ultimately helped to preserve the vast majority of private sector jobs. To the
extent that businesses are successful in stabilizing and eventually boosting profits and cash flow,
capital spending should begin to recover more noticeably.
Such success would likely be accompanied by a decline in elevated risk premiums back to more
normal levels and, with real rates of return on high-tech equipment still attractive, should provide an
additional spur to new investment. When capital spending eventually recovers, its growth is likely to be
less frenetic than that which characterized 1999 and early 2000, when outlays were boosted by the
dislocations of Y2K and the extraordinarily low cost of capital faced by many firms.
Still, the evidence strongly suggests that new technologies will present ample opportunities to earn
enhanced rates of return. Indeed, anecdotal reports from businesses around the country suggest that
the exploitation of available networking and other information technologies was only partially
completed when the cyclical retrenchment of the past year began. Many business managers are still of
the view, according to a recent survey of purchasing managers, that less than half of currently
available new, and presumably profitable, supply chain technologies have been put into use.
While these opportunities remain abundant, they will now play out against the backdrop of a major
uncertainty that we all must deal with these days--the specter of further terrorist incidents on American
soil. It simply is not possible to predict whether there will be any such incidents or to forecast their
possible consequences for the economy. But we can have little doubt that the tragic events of
September 11 have left obvious marks on the economy that will not soon fade even though some of
the initial impact of the shock has receded. Importantly, as I suggested shortly after the event,
adjustments to new levels of perceived risk will cause a one-time downward shift in the level of
productivity.
Clearly, businesses will be less comfortable now than they were before September 11 in allowing
inventories to shrink to minimal levels in a just-in-time supply chain. Moreover, in some industries,
resources will need to be diverted from efficiency-enhancing capital investment to providing security
and contingency backup. Fragmentary data for the months following September 11, however, indicate
output per hour is holding up well. Temporary labor-shedding may have overwhelmed the effects of
added security and redundancy. It is not yet clear whether the negative shock to output per hour from
the heightened risks is small, or just delayed. In any event, once these adjustments are completed, the
full benefits of more rapid technological advance should show through to the growth of productivity.
The central role that is being played by technological advance poses special challenges to
forecasters. Few technologies that influence our economic future are truly anticipated much in
advance. And even when they are anticipated, their effect on economic growth is difficult to predict, in
part because their pace of diffusion and application is so uncertain. The latter consideration is
particularly significant to the longer-term rate of growth of productivity.
The events of the past decade clearly illustrate those difficulties. Few observers foresaw how
microprocessors, integrated circuits, and the mating of laser technology with fiber optics, even well into
their development and application, would rejuvenate the American economy.
For example, as recently as a decade ago, the outlook was for a continuation of meager gains in
output per hour, with the rate of growth barely exceeding one percent per year, if that. Instead, during
the last half of the 1990s, we experienced a surge in productivity growth well above the rate of
increase experienced in the previous quarter-century.
Even as our economy slipped into recession, the growth of output per hour remained positive and, as I
indicated earlier, has held up well even in the wake of September 11. Until last year, the hypothesis of
an accelerated productivity trend had not been tested in the contracting phase of a business cycle.
Recent developments have provided that test, and the early returns certainly look favorable to the
hypothesis.
In retrospect, our economic structure changed in the mid-1990s. The crucial agent of this remarkable
change was the quantum leap in information availability.
If the tentative indications that the contraction phase of this business cycle is drawing to a close are
ultimately confirmed, we will have experienced a relatively mild downturn. To be sure, a great deal of
real economic pain has been felt over the past year and a half. But imbalances have not been allowed
to fester. They could have progressively undermined endeavors at stability and prolonged this difficult
period.
The American economy has had to absorb some extraordinary shocks over the past year and a half.
For the economy to have weathered as well as it has a severe deflation of equity asset values followed
by an unprecedented blow from terrorists to the foundations of our market systems is impressive. In
my judgment, this performance is a testament to the exceptional degree of resilience and flexibility that
our economy has gained in recent years, much of which owes to advances not only in information
technology, but to the globalization and deregulation of our markets, as well. The adaptability and
resourcefulness of our businesses and workers have been especially important in this trying period.
There are sound reasons for concluding that the long-run picture remains bright, and even recent
signals about the current course of the economy have turned from unremittingly negative through the
late fall of last year to a far more mixed set of signals recently. But I would emphasize that we continue
to face significant risks in the near term. Profits and investment remain weak and, as I noted,
household spending is subject to restraint from the backup in interest rates, possible increases in
unemployment, and from the effects of widespread equity asset price deflation over the past two
years.
But if the recent more favorable developments continue and gather momentum, uncertainties will
diminish, risk premiums will fall, and the pace of capital investment increase. Should those gains in
investment materialize, they would, doubtless, embody the newest technologies. As we have
witnessed so clearly in recent years, advances in technology have enhanced the growth of
productivity, which, in turn, has been essential to lifting our standards of living.