Mr. Meyer discusses the economic outlook and the challenges facing
monetary policy in the United States Remarks by Mr. Laurence H. Meyer, a member of the
Board of Governors of the US Federal Reserve System, at the Forecasters Club of New York on
24/4/97.
It is a pleasure to be here and discuss the economic outlook and monetary policy
with fellow forecasters. I am going to offer some interpretations of the outlook as a context for
the recent policy action by the Federal Reserve and explain how I view this action as part of a
prudent and systematic strategy for monetary policy. The Forecasters Club of New York is an
ideal forum for me to offer this commentary because, in my view, the recent policy action must
be understood not in terms of where the economy has been recently, but rather in terms of the
change in the forecast, a change in expectations about where the economy likely would be in six
or twelve months in the absence of a policy change.
Before proceeding, let me emphasize that the views on the economic outlook and
monetary policy strategy I present this afternoon are my own. I am not speaking for either the
FOMC or the Board of Governors or for any other individual members. If you want to know the
views of the FOMC, you will have to do your homework--for example, read the announcement
issued at the end of the last FOMC meeting, the Humphrey Hawkins testimony of the Chairman,
the speeches and other comments by the full complement of participants in the FOMC, and the
minutes of the last meeting when they become available.
First, I shall discuss some aspects of the analytical framework or model that
underlies my forecast, which in turn underpins my reasoning for the recent policy action.
Second, I'll discuss the outlook context of the policy decision. Third, I'll describe the evolution
of policy from a period of steady policy and asymmetric directives to the recent preemptive
action. Fourth, I'll offer several interpretations of the policy action in relation to what I believe
are important aspects of the strategy of monetary policy. Finally, I'll discuss some of the factors
that will influence my views of the appropriate course of policy in the months ahead.
The Analytical Framework
Let me remind you at the outset of the framework I have been using to explain the
challenge facing monetary policy in the current environment of healthy growth and high levels
of resource utilization. The risk of higher inflation in this environment has two dimensions.
First, there is the risk that current utilization rates are already so high that inflation will
gradually increase over time. Second, there is the risk that the growth in output will be above
trend going forward, implying that utilization rates will rise from their already high level,
compounding the risk of higher inflation.
Some apparently believe there are no speed limits, and no utilization rate can be
so elevated that it threatens higher inflation. The reality is that above-trend growth raises
utilization rates and, after some point, excessively high utilization rates result in higher inflation.
But it is also true that threshold utilization rates and trend growth can change, that the current
threshold levels for both utilization and growth rates are uncertain, that inflation can be affected
by factors other than excess demand, and that policy is not infallible. Such uncertainty is a fact
of life for both forecasters and policymakers. Just as forecasters do not stop forecasting because
the job is difficult, policymakers have to adjust to uncertainty and not be paralyzed by it.
The recent Federal Reserve policy action was clearly a preemptive one. This
means that it was undertaken not in response to where the economy and inflation were at the
time of the policy change, but in response to where the economy and inflation were projected to
be in the future, absent a policy change. Such policy action necessarily involves a forecast and
such a forecast typically is grounded in some model that relates growth, unemployment, wage
change and inflation, among other variables. So let me be specific about the causal structure of
the model that underpins my judgment with respect to appropriate monetary policy action.
I am a strong and unapologetic proponent of the Phillips Curve and the NAIRU
concept. Fundamentally, the NAIRU framework involves two principles. First, the proximate
source of an increase in inflation is excess demand in labor and/or product markets. In the labor
market, this excess demand gap is often expressed in this model as the difference between the
prevailing unemployment rate and NAIRU, the non-accelerating inflation rate of unemployment.
Second, once an excess demand gap opens up, inflation increases indefinitely and progressively
until the excess demand gap is closed, and then stabilizes at the higher level until cumulative
excess supply gaps reverse the process.
There is a third principle that I subscribe to, which, though not as fundamental as
the first two, also plays a role in my forecast and in my judgment about the appropriate posture
of monetary policy today. Utilization rates in the labor market play a special role in the inflation
process. That is, inflation is often initially transmitted from labor market excess demand to wage
change and then to price change. This third principle may be especially important today because,
in my view, there is an important disparity between the balance between supply and demand in
the labor and product markets, with at least a hint of excess demand in labor markets, but very
little to suggest such imbalance in product markets.
It is important to understand that the Phillips Curve is a model of inflation
dynamics, not a model that determines the equilibrium inflation rate. For this reason, the Phillips
Curve paradigm is not at all inconsistent with the view that inflation is, in the long run,
exclusively a monetary phenomenon. Perhaps the easiest way to appreciate this is to recall that
the long-run Phillips Curve is widely understood to be vertical. In other words, NAIRU is
consistent with any constant rate of inflation, including zero. The Phillips Curve therefore
cannot determine inflation in the long run because it is consistent with any constant rate of
inflation. What does determine the rate of inflation in the long run? The rate of money growth,
of course, though one needs to assume a stable money demand function to get a stable
relationship between money growth and inflation. What does the Phillips Curve explain, if not
the long-run level of inflation? The answer is that it explains the dynamics of the inflation
process, how the economy evolves from one inflation rate to another, for example, in response
to an increase in the rate of money growth. The dynamics of changes in inflation operate through
excess demand in labor and/or product markets. Thus the Phillips Curve indicates that, if the
unemployment rate is maintained at a level below NAIRU, inflation increases over time,
progressively and indefinitely.
The initial source of an increase in inflation can be anything which produces
excess demand in labor and output markets. It could also be a supply shock, but I am ignoring
this possibility so I can focus exclusively on the implications of the current strength in aggregate
demand. Under an interest rate operating procedure, an increase in aggregate demand which
increases output, utilization rates, and, ultimately, inflation will itself generate an increase in the
money supply to support the higher nominal income. Money is not pinned down in such a
regime, but passively adjusts to changes in nominal income.
Despite the sharpness and force of the Phillips Curve/NAIRU model, it can be
difficult to implement in practice. Still, this relationship was about the most stable tool in the
macroeconomists' tool kit for most of the past 20 years; those who were willing to depend on it
were likely to be very successful forecasters of inflation, and the record speaks for itself on this
score. Nevertheless, the combination of the 7-year low in the unemployment rate and 30-year
low in inflation was a surprise to those using this framework. The challenge is to understand
why we have been so fortunate. But, it should also be noted that monetary policy has responded
appropriately to this surprise. That is, monetary policy has been careful not to be tied rigidly to a
constant estimate of NAIRU. Instead, in my view, monetary policymakers have, in effect,
implicitly adjusted their estimate of NAIRU to reflect the incoming data; this might be viewed
as following a procedure like the time-varying parameter estimation technique applied by Robert
Gordon and others.
In the short run, there are many factors, in addition to aggregate demand, that
influence inflation - including changes in the minimum wage, shocks to food and oil prices
unrelated to the balance between aggregate demand and supply in the U.S., changes in the
exchange rate, and exogenous effects on health care costs, etc. Some of these can be and have
been effectively incorporated into the Phillips Curve model, but some of these factors have
generally been outside the model. One explanation for the better than expected performance of
core inflation in relation to the unemployment rate focuses, for example, on a series of favorable
supply shocks - including the slowdown in benefit costs and the decline in import prices - that
traditionally are not incorporated in estimated Phillips Curves.
In addition, even adjusting for the above factors, NAIRU is not a constant, but
can and has changed over time. For example, the evidence suggests that changes in the
demographic composition of the labor force affect NAIRU and it is also likely that government
programs, including unemployment compensation and welfare, also affect NAIRU. Further, the
evidence suggests that, even accounting for demographics, government programs, and supply
shocks, NAIRU may have edged lower over the last couple of years. The consensus in the
profession is that NAIRU may have declined from around 6 percent in the decade ending in the
early 1990s to perhaps 51⁄2 percent today, though some believe that the decline is even larger,
while others believe that any appearance of decline is due to temporary factors so that NAIRU
will ultimately settle back to close to the earlier estimate. Clearly, one of the challenges of
monetary policy is to set policy in the context of uncertainty about the precise value of NAIRU.
The second element in the analytical framework is the link from output growth to
the level of excess demand. The economy has a capacity to grow over time that is limited by the
sum of the trend rate of growth in the labor force and the trend rate of growth in labor
productivity. While both components can change over time and labor force and productivity
growth are subject to both cyclical variation as well as secular shift, the historical record
suggests that the trend rate of output growth changes very slowly over time. Currently, the trend
rate of labor force growth is near 1 percent per year (based on population growth and leaving,
for later, the interpretation of the recent rise in the participation rate) and the trend rate of
productivity growth is slightly above 1 percent per year (though there is more than the usual
uncertainty about this estimate, in part due to conflicting indications in measures of productivity
derived from the product and income sides of the national accounts), resulting in trend output
growth in the 2-21⁄2 percent range. A key relationship is that when actual growth in output equals
trend growth, utilization rates are constant; and when actual growth exceeds trend growth,
utilization rates increase.
Now we can put the causal structure of the inflation process together, connecting
up growth, unemployment rates, and inflation. Growth above trend raises utilization rates.
Rising labor force utilization rates raise wage change relative to productivity growth. An
increase in wage change relative to productivity growth raises labor costs and an increase in
labor costs results in higher price inflation.
Quiz time! Does growth cause inflation? Not exactly. Certainly, higher trend
growth does not raise inflation. Indeed, an unexpected increase in trend productivity and hence
trend growth in output would likely result in lower inflation for a while; if the rate of money
growth were held constant, a permanent increase in productivity growth would result in a
permanent decline in inflation. Although above-trend growth in output does not directly cause
inflation, to the extent it results in increases in utilization rates, after some point, sustained
above-trend growth will result in higher inflation.
There are, to be sure, a number of uncertainties in this causal structure that are
highly relevant to the current circumstances. First, we have to worry about whether there may
have been a change in trend growth, for example, due to a rise in trend productivity growth or a
change in the trend in labor force participation. If trend growth has increased, whether because
of higher labor force growth or higher productivity growth, then we would observe that rapid
growth does not raise utilization rates. Second, we have to worry about whether NAIRU may be
declining or, at least, may be lower than currently estimated. If NAIRU is lower than we expect,
then the current unemployment rate is less likely to be associated with excess demand in the
labor market and therefore poses less risk of higher inflation.
Checks and balances are essential here. For example, it is important to confirm
that utilization rates are rising before continuing very long to tighten policy to damp presumed
above-trend growth. This will prevent a persistent mistake in the face of an unexpected shift in
the economy's trend rate of growth. Monetary policy usually avoids this mistake by focusing on
utilization rates and not growth. The second check is to confirm that, following a decline in the
unemployment rate, wage change is moving higher, consistent with increased excess demand in
the labor market. In addition, we have to take into account temporary forces related to, for
example, minimum wage, health care costs, and exchange rates. Finally, we have to make
allowances for the dynamics of the process, including the tendency for inertia to result in only a
very small initial increase in inflation once excess demand has developed and the tendency of
the initial rise in wages in excess of productivity to be tempered by a decline in profit margins
before leading to higher prices.
The Outlook Context
Now let me summarize the key features of recent macroeconomic performance.
The economy advanced at a 3.1 percent rate over 1996, including a 3.8 percent rate in the fourth
quarter. Growth in the first quarter appears to have been at least as strong as the pace in the
fourth quarter, and the economy seems to have solid momentum in the current quarter. In short,
the economy appears to be growing at an unsustainable above-trend rate.
By the way, is the prevailing trend rate of growth both historically low and
disappointing? Yes. Would it be desirable, therefore, to raise the trend rate of growth? Yes. Can
monetary policy accomplish this worthy task? No. Can the Congress and the Administration,
through judicious combination of deficit reduction and saving and investment incentives, raise
trend growth (at least for a while)? Yes. Are there opportunities for monetary policy to
contribute to steady growth? Yes. First, to the extent that policy can avoid a cyclical rise in
inflation, it can avoid the subsequent monetary policy response to limit and then reverse the rise
in inflation; the result of avoiding the boom is avoiding the bust. Disciplined monetary policy
therefore encourages steady growth, with the emphasis on the steady. Second, to the extent that
price stability encourages saving and investment and a more efficient allocation of resources, as
is widely believed, a monetary policy that promotes price stability is the one that best
encourages steady growth, now with the emphasis on growth. Now back to the economic
outlook.
The unemployment rate which has fluctuated in a rather narrow band over the last
year and a half has recently been inching lower and is now equal to its cyclical and 7-year low. I
suspect that the unemployment rate is now below NAIRU, though the steady rise in wage change
over the last year suggests that the unemployment rate may have been somewhat below NAIRU
for a while.
Another aside. Don't I like wage growth? Yes, but only to the extent it is real;
that is, only to the extent that it does not yield increases in inflation that in turn prevent the
purchasing power of wages from advancing. Shouldn't workers share in the bounty of a healthy
economy? Of course. But workers will best share in the bounty when there is sustainable growth
and will pay a high price for unsustainable growth in the cyclical instability that would surely
follow such excess. Let me add one more complication. It is possible for wages to increase faster
than productivity for a while to allow a rebound in real wages, for example, if real wages had
earlier in the expansion advanced at a rate less than allowed by trend productivity. In this case, a
rebound in real wages could be unwinding a temporary increase in profit margins and could
therefore be accommodated without an increase in inflation.
Wage change, as I just noted, has been rising. The 12-month increase in average
hourly earnings is now 4.1 percent, a percentage point higher than a year ago. Compensation per
hour, as measured by the ECI, has to date accelerated more modestly, with the slowing rise in
benefit costs tempering the effect of a sharper rise in wage costs. The first quarter ECI bears
watching for signs of a further rise in wage change and possibly a bottoming out of the recent
slowing in the pace of increase in benefit costs.
Core inflation remains at a cyclical and 30-year low, with the 12-month increase
in the core CPI at 2.5 percent. Note, however, to correctly measure the change in inflation, a
comparison of core inflation over the last couple of years has to be adjusted to account for the
methodological revisions to the CPI. To date, BLS revisions have lowered inflation cumulatively
by around a quarter point over the past two years. The point of the policy action, of course, is to
try to prevent any significant increase in core inflation.
Clearly the recent performance has been extraordinary. I have noted previously
that it is not only better than virtually anyone had forecast, it is better than historical regularities
would have suggested was possible. The explanations for the continuing decline in core
inflation, despite an unemployment rate that in earlier periods would have been associated with
rising inflation, include some combination of temporary coincidences and longer-lasting
structural changes.
First, the labor force has been growing about twice as rapidly as a trend rate based
on population growth. It is as if demand is calling forth its own supply. Part of the explanation is
a rebound from a sharp decline in participation rates over 1995. Part reflects a normal cyclical
rise in participation rates, delayed in this expansion. A small part could be the early effects of
changes in welfare laws and previous state efforts to trim welfare roles. As a result, the recent
strength of output growth has not resulted in much of an increase in resource utilization rates. I
do not expect labor force growth to continue at its recent rapid rate, though the underlying trend
over the next several years may well be augmented by an upward trend in participation rates.
The net result is that output growth must slow from recent levels to prevent further increases in
utilization rates. Second, increased job insecurity appears to have moderated the pace of wage
change, relative to what we would have expected at current levels of labor force utilization. It is
important to note here that the effects on inflation of an increase in worker insecurity may be
only temporary. Even with the higher worker insecurity, wages are clearly on a rising trend.
Third, a slowing in the rise in benefit costs (primarily via slower increase in health care costs)
has moderated the rise in labor compensation associated with wage pressures. As a result, the
rise in compensation and hence labor costs has been muted, compared to the faster pace of wage
gains. Fourth, declining import prices - directly and indirectly--have restrained price inflation.
Some judgment has to be made in any forecast about the persistence of the special
forces that have contributed to restrained wage and price change over recent quarters. The least
likely to continue to act as a restraining influence, in my judgment, is health care and therefore
benefit costs, based on surveys of prospective health care insurance premiums. Given the recent
further appreciation of the dollar, import prices may decline further, though the restraining effect
on inflation may be less important going forward than it has been over the past year.
From an Asymmetric Directive to Preemptive Policy: Why Now?
During the period from July of 1996 through February of 1997, monetary policy
remained unchanged but operated with an asymmetric directive. Utilization rates were high
-high enough to suggest some risk of rising inflation, but wage gains -- while trending higher,
remained modest and core inflation remained on a downward trend, perhaps due to declining
import prices and the slowing of the rise in health care costs. The anxiety associated with high
utilization rates was clearly tempered by the excellent performance of core inflation, resulting in
a posture of "watchful waiting." The Federal Reserve remained alert during this period, but on
the sidelines. While growth was at times well above my estimate of trend, various factors made
it reasonable to expect a slowdown in growth toward trend immediately ahead, suggesting that
utilization rates would likely remain within their recent ranges.
The asymmetric directive reflected a view that the risks in this environment were
asymmetric, that there was a greater risk that inflation would rise in response to the prevailing
high utilization rate (and to still higher utilization rates if growth continued above-trend growth)
than that the economy would slow to below trend growth. The asymmetric policy posture was,
therefore, a reflection of concern that our forecast might be wrong and that if it were wrong it
was more likely to underestimate inflation going forward.
What was different in March, compared to this earlier period? Not utilization
rates. They were still within the narrow range that had prevailed during this period, though
admittedly close to the bottom of that range. Not core inflation. If anything, core inflation was
lower. No, the difference, from my perspective, was not in the data for utilization rates, wage
change, and inflation, but in my forecast of the future path of these variables. The change in the
forecast, to be sure, was prompted by incoming data suggesting persistent strength in aggregate
demand. Instead of projecting a slowing to trend immediately ahead, it now appeared to me that
we were in a period of sustained above-trend growth that would push utilization rates higher
and, in particular, would push the unemployment rate below its recent range. A tightening of
monetary policy was motivated, from my perspective, not by the prevailing data on
unemployment rates, wage change, and inflation, but rather by a forecast of where I expected
utilization rates and inflation to be six months and a year from now, if monetary policy remained
unchanged. Whereas I supported the earlier asymmetric directive based on concern that my
forecast might be wrong, the preemptive policy action was motivated for me by concern that my
(new) forecast might be correct!
The case for a preemptive approach is that it alone holds the promise of sustaining
a durable expansion with continued healthy, balanced growth. The greatest threat to expansions
does not come from a spontaneous weakening of demand, from lethargy, but rather from
over-exuberance and overheating. Once overheating unleashes an increase in inflation, the
attempt to first control and then reverse the higher inflation often results in recession. This gives
substance to the well-known worth of "an ounce of prevention."
Interpreting the Policy Action as Part of a Strategy for Monetary Policy
Let me now interpret the tightening in relation to several descriptions of monetary
policy strategy. The first three really are alternative perspectives on a single essential principle
of prudent monetary policy, the importance of leaning against the wind by enforcing
pro-cyclical movements in short-term interest rates. The fourth reflects one way in which
monetary policy might take into account the uncertainty in the outlook.
A Taylor Rule perspective
I have noted in a number of previous speeches that I view the Taylor Rule as
highlighting a couple of important requirements for prudent monetary policy. First, the Taylor
Rule links Federal Reserve policy to a long-run inflation target and thus ensures that, in the long
run, policy will force the actual inflation rate to converge to the long-run target. The Taylor Rule
thus imposes a powerful nominal anchor on monetary policy. Second, the Taylor Rule generally
imposes a pro-cyclical pattern on real short-term interest rates, so that monetary policy leans
against the cyclical winds and thereby stabilizes the economy, in much the same way that
automatic stabilizers in our fiscal institutions, via cyclical swings in government budget deficits,
damp business cycles.
Nevertheless, the traditional specification of the Taylor Rule does not provide a
justification for tightening in March, relative to the earlier decisions to hold policy unchanged.
According to the Taylor Rule, the federal funds rate should adjust over time to changes in
utilization rates (the gap between actual and potential output or between the unemployment rate
and NAIRU) and to changes in inflation. Because utilization rates had not increased (at least had
not increased outside the range of the last year) and core inflation was actually lower in March
compared with earlier, the Taylor Rule did not dictate a tightening. The Rule did suggest,
however, that monetary policy would have had to tighten over time if the forecast of rising
utilization rates and higher inflation proved correct. But it did not dictate immediate action.
There is however an alternative specification of the Taylor Rule that does
motivate an immediate tightening. I call this a forward looking version of the Taylor Rule. The
traditional specification is forward looking to a degree in relation to inflation, in that it sets the
funds rate in relation to both the utilization rate (an advance warning of future increases in
inflation) and to inflation. But the forward-looking specification I have in mind replaces actual
inflation and utilization rates in the rule with forecasts of future inflation and utilization rates.
This approach to policy reaction functions was pioneered by Steve McNees of the Federal
Reserve Bank of Boston in the mid 1980s and there has been a renewed interest in such an
approach, in the context of the Taylor Rule, during the last couple of years. Such a
forward-looking specification would rationalize and justify an increase in the funds rate in
response to the forecast of rising utilization rates in the future.
This leaves an interesting question. Does following a Taylor Rule based on an
uncertain forecast outperform a Taylor Rule based on actual data? That, of course, depends on
the quality of the forecasts. This is an interesting question, one that deserves scrutiny. But it is
really the same as the question: Should policy be preemptive or reactive? As a forecaster, I am
inclined to believe in the forward-looking approach and therefore in preemptive policy. But I
recognize that further work should be done on this subject.
An IS-LM perspective on leaning against the wind
I would interpret the recent strength in demand, from the perspective of an IS-LM
model, as a shift in the IS curve. Such an interpretation of cyclical swings is, of course, in the
Keynesian tradition: output is demand determined in the short run (reflecting price stickiness)
and swings in output are dominated by autonomous changes in aggregate demand.
How should monetary policy respond to cyclical swings in demand? Should
monetary policy hold short-term interest rates constant, in effect imposing a horizontal LM
curve? In order to do so, it would, in general, have to respond to rightward shifts in the IS curve
by adding reserves and facilitating faster money growth, so as to prevent interest rates from
rising. This might be appropriate very early in an expansion, when the unemployment rate is
high and inflation is declining, but it is not, in my judgment, prudent in the mature stage of an
expansion, and it is most surely imprudent once utilization rates have increased toward or
beyond their capacity levels. The alternative is to maintain an upward sloping LM curve. In the
static model, this is the case when the money supply is fixed; allowing for trend growth and
inflation, it would be equivalent to holding money growth constant, assuming a stable money
demand function. In this case, a shift in the IS curve would raise interest rates as the IS curve
moved along the upward sloping LM curve. This is an example of monetary policy "leaning
against the wind." The resulting pro-cyclical movement in interest rates increases the stability of
the economy in much the same way as cyclical swings in the federal budget deficit.
Some might argue, however, that even if short-term interest rates do not rise,
long-term interest rates, equity prices, and the dollar may change in ways that damp the cyclical
swing in demand and thereby lessen the necessity of a direct response of monetary policy. This
is sometimes referred to as the "gyroscope" theory (the bond market is the economy's
gyroscope) and the active part of management of the cycle is in the hands of so-called "bond
market vigilantes," some of whom are undoubtedly in the audience this afternoon.
When long-term rates rise in response to a cyclical strengthening, it reflects, in
large part, the expectation of higher short-term interest rates. Specifically, it reflects expectations
about monetary policy. While monetary policy cannot be a slave to the bond market, when the
cyclical state of the economy suggests the desirability of a pro-cyclical response in interest rates,
the Federal Reserve should pat the bond market on the back and appreciate its help, but not
expect the bond market to carry the entire burden. Monetary policy in this case needs to validate
the movement in the bond market, rather than resist it. If it does not, surely real long-term
interest rates and the dollar will decrease, eroding the market restraint, and in the future markets
will be less likely to perform this stabilizing function. Of course, there will be times when the
bond market is, in our view, misreading the strength of the economy and hence also misjudging
the future course of our policy. In this case, we should ignore the bond market and provide an
anchor for long-term interest rates to adjust back toward.
Implications of a money growth rule
As I have just noted, a pro-cyclical path for short-term interest rates would result
from following a money growth rule. For an extended period, money demand has been
insufficiently stable to allow the monetary aggregates to play a constructive role in the monetary
policy process. More recently, the relationship between M2 and its determinants has stabilized,
but the period of a more stable relationship has been relatively brief and has coincided with a
relatively stable economy. As a result, there is not yet much inclination to place increased weight
on M2 in the policy process.
What I am offering here is therefore only a thought experiment. Assume that the
money demand function for M2 has stabilized and that we could conduct policy by enforcing a
constant rate of M2 growth. Assuming policy maintained a fixed rate of money growth (perhaps
the better way to define an unchanged policy), what would be the effect of a cyclical
strengthening of the economy (an increase in nominal income growth)? The answer, of course, is
that short-term interest rates would rise. This is of course just another way of telling the IS-LM
story. What would it take to prevent i