Alan Greenspan: Challenges for monetary policymakers
Remarks by Alan Greenspan, Chairman of the Board of Governors of the US Federal Reserve System,
at the 18th Annual Monetary Conference, "Monetary Policy in the New Economy", at the Cato
Institute, in Washington DC, on 19 October 2000.
* * *
For the past two decades, central bankers have largely been successful at subduing the inflationary
pressures that threatened to upend market-oriented economic systems a generation ago. The Federal
Reserve, during this period, has squeezed out an inflationary excess of liquidity. In Europe, tolerance
for inflation has declined dramatically, and a commitment to price stability - long the hallmark of
Bundesbank policy - has gained widespread acceptance.
In the past five years or so, two new trends have greatly assisted this process in the United States. One
has been the serendipitous emergence of a once- or twice-in-a-century surge in technology. Without
the accompanying boost to productivity, our progress toward price stability might well have been
marked by the social pressures that arose in many previous episodes of disinflation both here and
abroad. The other trend was the growing political commitment to address an outsized federal budget
deficit that was absorbing an inordinate share of our national saving. That change in our political
environment - accompanied by the faster pace of technology-driven growth - has resulted in a sharp
reduction in the unified budget deficit and, more recently, the emergence of a significant surplus. This,
in turn, has helped fill the pool of saving that has fed productivity-enhancing and cost-reducing capital
formation.
A number of elements came together to make this economic configuration possible. The essential
ingredient was the public support that developed as the growth-inhibiting consequences of the
inflation of the 1970s became manifest. Without this public recognition and support, it would have
been difficult to establish the stable macroeconomic foundation upon which the private sector has built
so productively in recent years.
By now, the story of the boom in information technology is well known, and nearly everyone
perceives that the resulting more rapid growth of labor productivity is at least partly enduring. Capital
deepening has surged during the past seven years, and innovations, synergies and networking effects
have boosted significantly the growth of multifactor productivity. With output per hour having
accelerated, cost pressures have been patently contained.
For the most part, the Federal Reserve generally recognized these changing fundamentals and
calibrated American monetary policy accordingly. Although we have learned much about managing
the financial backdrop to accelerating economic activity, it is essential that we not be deluded into
believing that we have somehow discovered the Rosetta stone of monetary policy. A failure by
policymakers to sufficiently appreciate the inevitable uncertainties that they confront could result in
unfortunate consequences for the economy.
While we central bankers do not have full knowledge, we have continued to gain insight - albeit
slowly - into how market economies function. That learning process has been aided, especially in the
United States, by a vast panoply of data and information from both public and private sources.
However imprecise, these readings on the economy have helped us steer monetary policy through an
inevitably uncertain future.
In practice, it is the joining of ideas and data that drives policy in the face of uncertainty. We seek to
array the probabilities of future policy outcomes, attempt to gauge the costs of being wrong in our
decisions, and endeavor to choose the policy paths that appear to offer greater benefits and fewer risks.
Whether we choose to acknowledge it or not, all policy rests, at least implicitly, on a forecast of a
future that we can know only in probabilistic terms. Even monetary policy rules that use recent
economic outcomes or money supply growth rates presuppose that the underlying historical structure
from which the rules are derived will remain unchanged in the future. But such a forecast is as
uncertain as any.
This uncertainty is particularly acute for rules based on money growth. To be sure, inflation is at root a
monetary phenomenon. Indeed, it is, by definition, a fall in the value of money relative to the value of
goods and services. But as technology continues to revolutionize our financial system, the
identification of particular claims as money, near money, or a store of future value has become
exceedingly difficult. Although it is surely correct to conclude that an excess of money relative to
output is the fundamental source of inflation, what specifically constitutes money is a notion that has,
so far, eluded our analysis. We cope with this uncertainty by ensuring that money growth, by any
reasonable definition, does not reach outside the limits of perceived prudence. But we have difficulty
defining those limits with precision, and within any such limits there remains significant scope for
discretion in setting policy.
In history, discretionary monetary policy, of course, has not been without its shortcomings, and the
dominant force of accelerating productivity has made our current task of policy calibration especially
daunting. Policymakers, in fact all forecasters, invariably construct working hypotheses or models of
the way our economies work. Of necessity, these models are a major simplification of the many forces
that govern the functioning of our system at any point in time.
Obviously, to the extent that these constructs, formal or otherwise, fail to capture critical factors
driving economic expansion or contraction, conclusions drawn from their application will be off the
mark.
In practice, we continuously monitor a substantial quantity of incoming data to test the capability of
any specific model or hypothesis to explain actual outcomes. When we experience outcomes that do
not square with what our models have projected, we form new hypotheses and reconstruct the models
to more closely conform with our observations.
With the virtually unprecedented surge in innovation that we have experienced over the most recent
half decade, many of the economic relationships embodied in past models no longer project outcomes
that mirror the newer realities. Data series that better measure the workings of the so-called new
economy are under development. But we still have far more information on the variety of yarns and
weaves produced by textile establishments than data on output of the burgeoning software industry or
many of the other rapidly growing high-tech industries. The paucity of data for the latter inhibits our
ability to fully test our working hypotheses or models in order to detect changes in economic
relationships as quickly and confidently as we would like.
Evidence began to accumulate in the early and mid-1990s that prospective rates of return on capital
were rising. This was implicit both in the marked rise in investments in high-tech equipment and in the
updrift in estimates of the growth of long-term earnings by corporate management, which were
reflected in the projections of securities analysts. Nevertheless, we could not be certain whether what
we were observing was a short burst of productivity gains or a more sustained pickup in productivity
growth. The view that we were experiencing a sustained pickup gained plausibility when productivity
growth continued to increase as the expansion lengthened. But importantly, only after we could see
evidence in other economic behaviors and in readings from asset markets that were consistent with
accelerating productivity did we begin to develop confidence in our analysis.
When confronted with a period of structural change, our policy actions must be based, in large part, on
identifying emerging trends from surprises and anomalies in the data and then carefully drawing their
implications. It would be folly to cling to an antiquated model in the face of contradictory information.
Some who question the economic implications of the spread of innovation and the step-up in
productivity growth hypothesize that the gains are largely confined to the so-called new economy,
with little effect on efficiency in the old economy. But this notion fails to capture the dynamics of the
marketplace. To be sure, a significant segment of our economy's growth reflects output of high-tech
equipment. Moreover, the long-term prospective profit growth of those firms engaged in the computer
and telecommunications industries has been revised up during the past five years by more than double
the amount for the so-called old-economy industries. But in a meaningful sense, there is, with few
exceptions, little of a truly old economy left. Virtually every part of our economic structure is, to a
greater or lesser extent, affected by the newer innovations. No old-economy textile plant could exist in
today's environment without technologies that Edmund Cartwright could never have imagined.
There are, of course, significant differences in the degree to which the newer technologies have been
applied. However, almost all parts of our economy have shared to some extent in the benefits of this
wave of innovation.
So it is with some irony that just as we are adapting our old-economy models to the new realities, in
drifts an apparition from the past - a spike in oil prices that has potential implications for economic
stability and for monetary policy.
The reemergence of oil prices as an important macroeconomic consideration is a reminder that there is
less of a stark division between old and new economies than is often loosely suggested. Even the oil
industry, a presumed old-economy stalwart, is a surprisingly major player in the new. As a
consequence, policymakers will need to consider how changes in technologies and world markets may
have altered the response of our economies to oil-price shocks and, thus, how best to respond to them.
Any evaluation of the current oil-price spike, if indeed that is what it is, will require us to delve into
the forces of new technology and to understand how significantly the impact of oil on our economy's
workings has changed with a generation of innovation.
Largely in response to past oil price increases, the energy intensity of advanced industrial economies
has been reduced by half from the levels of the early 1970s. This, of course, does not mean that the
effect of any given oil-price increase is half that of a generation ago, because the size of the effect also
depends on the potential to reduce energy consumption as prices rise and on the degree to which other
energy sources can be substituted for oil as relative prices change.
Most of the oil displacement was accomplished by 1985, within a few years of the peak in the relative
price of energy. Progress in reducing energy intensity generally has been far more modest in the last
15 years - not surprising, given the generally lower level of real oil prices after 1985.
What has changed dramatically in recent years is the production side of oil, which is likely to be a
substantial factor in determining the extent and duration of any oil-price spike. Oil, in this regard, has
truly become at least an associate member of the new economy.
The development of seismic techniques and satellite surveillance to discover promising new oil
reservoirs has more than doubled the drilling success rate for new field wildcat wells during the past
decade. New techniques and the use of oil rigs that have more computer chips in them than most
modern office buildings facilitate far deeper drilling of promising pools, especially offshore. The
newer recovery techniques reportedly have raised the proportion of oil reserves eventually brought to
the surface from a third to nearly a half in recent decades.
One might expect that, as a consequence of what has been a dramatic change from the old hit-or-miss
wildcat oil exploration and development of the past, the cost of developing new fields and, hence, the
long-term marginal cost of new oil have declined.
And, indeed, these costs have declined, but by less than might otherwise have been the case; much of
oil development innovation outside OPEC has been directed at overcoming an increasingly
inhospitable and costly exploratory environment, the consequence of more than a century of draining
the more immediately accessible sources of crude oil.
One measure of the decline in recent years of the marginal cost of additions to oil availability is the
downdrift in the prices of the most distant contracts for future delivery of Light Sweet crude oil. Spot
prices have soared and plunged, but for the most distant futures contracts - which cover a time frame
long enough to seek, discover, drill and lift oil - prices generally moved lower over the past decade.
The most distant futures prices fell from a bit more than $20 per barrel just before the Gulf War to $17
to $18 a barrel a year ago. The current six-year futures contract has risen over the past year to about
$21 per barrel. Arguably, however, this rise is related less to technology and the structure of
underlying marginal costs and more to concerns about how quickly new practices will be exploited to
expand OPEC's productive capacity. Having increased output significantly during the past year, only a
little excess capacity remains. Moreover, going forward, there is concern that OPEC may choose not
to expand capacity adequately from their large proven reserves.
The long-term marginal cost of extraction presumably anchors the long-term equilibrium price and,
thus, is critical to an evaluation of the magnitude and persistence of any current price disturbance.
Over time, spot prices are inexorably drawn back to the long-term equilibrium price, as the balance
between underlying supply and demand is restored.
But in the short run, the price of oil, as that of all commodities, inevitably is influenced importantly by
inventory levels, especially when stocks become critically short. Over the years, innovation and
consolidation have significantly reduced the operating inventories of crude oil and products required
to service a given level of product demand. Excluding these operating stocks, the world oil industry
has historically run on a rather thin buffer, roughly a 13-day inventory of "usable stocks", according to
data from the Energy Intelligence Group.
Thus, when OPEC and its allies cut back oil liftings by more than 3 million barrels a day in 1998 and
1999, against the backdrop of expanding world demand, the buffer of more than 15 days of usable oil
that prevailed at the time rapidly shrank to a little more than 10 days. As a consequence, the price of
crude oil tripled.
OPEC has since more than restored its output, bringing world production now to record levels - levels
that exceed reported demand by nearly 11⁄2 million barrels a day, seasonally adjusted. Inventories of
usable stocks are building but have yet to regain normal levels. But the remarkable surge in shipments
of home heating oil, both here and in Europe, suggests very heavy precautionary oil accumulation by
dealers and households not covered in the usual data on inventories for the industry.
It would certainly seem that, with inventories building and the spot price of crude oil well above its
long-term equilibrium, spot prices would shortly be under significant downward pressure. However,
concerns about the potential for political difficulties to impinge on available supplies persist, as has
been so evident over the past few weeks. Even before the recent unfortunate developments in the
Middle East, demand to augment buffer stocks surged, which has helped to keep prices high. This
owed largely to the possibility of a politically driven removal of a significant part of Iraq's 21⁄2 to
3 million barrels a day from global markets at a time when there exists so little available world excess
capacity to replace it.
Even though the intensity of oil consumption is markedly below where it was thirty years ago, it still
has the potential to alter the forces governing economic growth in the United States. To date, the
spillover from the surge in oil prices has been modest. Any effect on inflation expectations, at least as
inferred from the behavior of long-term Treasury Inflation-Indexed Securities, has been virtually nil.
Moreover, despite some slowing that likely has been related in part to the bite from the so-called "oil
tax" on household incomes, the growth of consumer spending has remained firm. But policymakers
will need to be on the alert for oil-driven, indeed energy-driven, risks to our expansion.
Looking further ahead, some of those favorable factors that I discussed earlier - in particular, growing
fiscal surpluses and accelerating productivity - remain in place, but presumably will not persist
indefinitely.
The mounting fiscal surpluses have been an important source of national saving, muting upward
pressures on interest rates at a time of strong demand for private credit. By keeping the cost of capital
lower than it otherwise would have been, the surpluses have contributed to capital deepening and
faster growth of productivity. But I believe most of us harbor doubts about whether the dynamics of
the political process, some of which have been on display in the current budgetary deliberations, will
allow the surpluses to continue to grow.
Moreover, as I indicated in remarks at Jackson Hole in August, a tapering off of productivity
acceleration is inevitable at some point in the future. When that occurs, even should the growth rate of
productivity remain high, we could experience less benign readings on cost pressures if the tightness
of labor markets persists.
That said, as best we can judge, credible evidence that the rate of structural productivity growth has
stopped increasing is still lacking. It is the continuing acceleration of productivity that, by allowing
businesses to absorb rising compensation increases without incurring ever rising unit costs, has been
so essential to containing price increases.
We are observing some remarkable structural advances in our economy. Central bankers have learned
much about their implications. But, it will be essential for this learning process to continue if we are to
recognize and respond effectively to the inevitable surprises placed in our path by a constantly
evolving and highly dynamic economy.