Mark W Olson: Update on the U.S. economy and fiscal outlook
Remarks by Mark W Olson, Member of the Board of Governors of the US Federal Reserve System, at
the Albers School of Business and Economics, Executive Speakers Series, Seattle University, Seattle,
13 October 2005.
Governor presented identical remarks at the Fraser Institute Roundtable Luncheon, Vancouver, Canada, on 12 October 2005.
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Thank you for inviting me to speak to you today. My remarks will focus on the near-term economic
outlook of the United States in the immediate post-hurricane aftermath. Then I will address the fiscal
challenges that the country confronts. As always, and perhaps even more so this time, I will be
speaking for myself and not necessarily for my colleagues at the Federal Reserve.
In July, when I accepted your invitation to speak, I chose as my title "Update on the U.S. Economy."
On the basis of how the U.S. economy was performing around midsummer, I anticipated that an
October presentation on the economy would be quite positive. At that time, the first-quarter increase in
real GDP had been revised up to almost 4 percent, and after a slightly softer second quarter, most
estimates pointed to another increase in the 4 percent range or higher for the third quarter. The
economy was generating, on average, 175,000 private nonfarm jobs per month, and the
unemployment rate was down to 5 percent. Core consumer price inflation was running at about
2 percent. In short, at midyear, the U.S. economy appeared to be on firm footing, and inflation
appeared to be well contained. Canada's economy appeared to be in a roughly similar position, as
inflation was running at about 2 percent--approximately the midpoint of the Bank of Canada's
inflationtarget band--and the unemployment rate at about 6-3/4 percent.
As always, the positive picture in the United States was not without potential risks, and the Chairman
noted them in his midyear report to the Congress: Rising prices of energy and other commodities had
put upward pressure on costs. Labor costs had also picked up. Already lofty housing prices that
allowed homeowners to convert equity appreciation into consumption continued to rise and in some
markets had reached levels that our Chairman had described as "frothy."
On balance, the FOMC continued to believe that policy accommodation could be removed at a
measured pace. However, the Committee noted that it would need to be alert to inflationary pressures
and would respond to changes in economic prospects as required to fulfill its obligation to maintain
price stability.
An additional benefit of the solid economic performance of the U.S. economy was that federal tax
revenues were coming in faster than expected, an indication that the budget deficit for the fiscal year
would be at its lowest level in the past three years. However, despite the near-term positive fiscal
news, no progress had been evidenced on addressing the longer-term fiscal issues involving the
significant projected rise in spending for federal health and retirement programs.
In any event, I had expected that I would be going into the September FOMC meeting, and then
speaking to you, with the U.S. economy on an upward trajectory. But that expectation changed
dramatically when Hurricanes Katrina and Rita came along. Although the combined effect of the
hurricanes was contained within a geographic area that accounted for just under 2 percent of the
nation's population and roughly the same amount of the nation's production and income, the potential
for spillover effects on the economy more broadly was difficult to assess. The disruptive effect on oil
refining, natural gas distribution, and chemical production; the damage to major ports and
transportation infrastructure; and the significant devastation of a major city raised the risks of an effect
on the economy that exceeded the direct effects on the areas battered by the storms. To be sure,
these disruptions also had adverse implications for costs and prices. Further clouding the picture, the
fiscal policy implications of funding the rebuilding and restoration had not yet been fully defined.
As our September FOMC meeting followed Hurricane Katrina by approximately three weeks and was
held concurrently with the formation of Hurricane Rita, I felt that there was insufficient information as
well as great uncertainty about how these forces would play out in the near term. As a result, I voted to
pause in the removal of policy accommodation until more was known.
What was clear then, and has become even more evident in the time since, is that the Gulf Coast of
the United Sates suffered extraordinary human and economic losses. The news reports have
graphically displayed the tragic dislocations of millions of people, loss of life, and destruction of
property. As well, we have seen moving examples of the efforts directed toward the rescue of and
care for the victims of the storms. More recently, the massive cleanup operations have gained
momentum, and it has been awesome to witness the determination of people beginning to rebuild their
lives. These forces--the destruction wrought by the hurricane and the reconstruction efforts--will be two
of the key factors shaping economic activity in coming months.
A frustrating aspect of the situation is that even now, some six weeks after the first of the hurricanes
made landfall, the incoming data are only beginning to shed some light on the economic ramifications
of the storms. Clearly, however, the destructive power of these hurricanes reduced economic activity
by forcing the evacuation of millions of people from their places of work, destroying factories and
offices, shuttering businesses, and closing schools and government offices. The overall magnitude of
many of these effects will be difficult for economic statisticians to measure. In the industrial sector,
however, a number of real-time indicators are available, and they show the effect in that sector to have
been significant. The Federal Reserve estimates that Hurricane Katrina reduced industrial production
by 0.3 percent in August, even though it struck near the end of the month. Oil and gas production and
refining were particularly hard hit. Hurricane Rita further damaged the Gulf Coast infrastructure and set
back the pace of recovery. In normal times, the Gulf produces 1-1/2 million barrels of crude oil per
day--about 30 percent of the national total--and 10 billion cubic feet of natural gas per day--about
20 percent of the national total. After Hurricane Rita struck, 100 percent of the oil production in the
Gulf region was shut in for a time, as was 80 percent of the natural gas production. Petroleum refining,
chemical plants, and electricity distribution were also relatively hard hit by the hurricanes. All told,
industrial production was held down significantly in September as a result of lower output in these
sectors.
That said, various daily and weekly data sources indicate that the industrial sector is beginning to
recover in October as oil and gas production come back on line and repairs to factories and
distribution advance. The resilience and resourcefulness of the U.S. economy is illustrated by the
reactions of firms and industries to the disruptions. For example, the reduction in refining capacity in
the Gulf has been partly replaced by higher operating rates in other areas, shifts in the composition of
refined products, and an increased reliance on imports. As a result, stock-outs and supply disruptions
in the energy sector have not been widespread, at least thus far. Industry sources suggest that much
of the repair and recovery effort will likely be undertaken over the course of the next several months,
and as that occurs, production rates should gradually return to normal.
Beyond the industrial sector, one indicator of economic activity more broadly is the behavior of
employment. Last week's employment report for September indicated that private nonfarm
employment fell 66,000, compared with increases averaging around 175,000 per month over the
preceding twelve months. The shortfall of roughly 240,000 jobs from the earlier trend is a crude
measure of the direct disruption effects of the hurricane. More important, the apparent absence of
significant indirect effects in other areas of the United States is an indication that the underlying gains
in employment and income were well maintained outside the Gulf region.
An important question for policymakers is how inflation and economic activity will respond in coming
months. One concern is that the rise in energy prices, as well as the downshift in consumer
confidence seen in recent readings, may hold back aggregate demand at least for a time. However,
the rebuilding itself should provide some impetus to demand in coming quarters. At the same time, of
course, higher prices for energy items, including gasoline, heating oil, and natural gas, will be adding
to top-line inflation in the near term. As well, these price increases will put upward pressure on the
costs of the producers of other items, thereby posing the risk of some impetus to core inflation.
Whether these pressures are, in fact, passed through to core inflation will depend on a host of
considerations, including the willingness of producers to absorb those cost increases and experience,
at least for a time, lower profit margins. Needless to say, developments in this area will be the subject
of intense scrutiny on my part in coming months.
A vital contributor to the rebuilding and recovery effort will be the various actions of the federal
government. The magnitude of the devastation called for a significant response from the federal
government, and the Congress and the President acted quickly to provide emergency spending and
tax breaks to aid the areas affected by the hurricanes. Whether these emergency fiscal measures will
ultimately be financed by increased federal borrowing, or by finding offsetting spending decreases or
revenue increases, is still an unsettled issue in the Congress. To a certain extent, temporary
emergency federal borrowing may be viewed as appropriate, as the costs would ultimately be spread
out across all U.S. taxpayers over time. Nonetheless, given the current size of the federal deficit,
additional federal borrowing raises issues because of the potential negative effects that higher deficits
can have on the economy.
Although expected outlays and tax breaks for hurricane disaster relief raise concerns about future
deficits, budget developments over the past year had turned positive before the hurricanes for the first
time in a while. For the 2005 fiscal year that just closed at the end of last month, the U.S. federal
government's budget deficit shrank, as federal tax revenues came in at a greater-than-expected pace.
Although the final accounting for the fiscal year is yet to be tallied, Treasury data indicate that the
federal budget deficit was probably equal to about 2-1/2 percent of GDP--below its level of about
3-1/2 percent of GDP in the preceding two years.
That said, the budget figures for the fiscal year just ended were little affected by the fiscal policy
response to the recent hurricanes. Only a small portion of the emergency federal outlays budgeted for
hurricane relief were actually spent in September, the last month of the fiscal year. The bulk of the
hurricane-related spending and tax relief will show up in the budget accounts in the current and next
fiscal years. Moreover, the total magnitude of the federal response is still unknown, adding to the
uncertainty associated with the fiscal outlook.
Viewed from a longer-term perspective, the financial position of the U.S. federal budget has oscillated
dramatically over the past ten years. Ten years ago, the federal budget had a deficit that amounted to
about 2-1/2 percent of GDP, roughly similar to the current percentage, and forecasts at that time
pointed to some widening in this budget gap in future years. Budget agreements in earlier years--1990
and 1993--had both raised taxes and reduced spending, and the combination of these actions had
helped lower the federal budget deficits from the levels of previous years. These budget agreements
demonstrated the desire of policymakers to undertake some hard steps necessary to reduce the
deficit. They had also put in place caps on so-called discretionary federal spending--that is, the portion
of federal spending that is allocated annually--and had required that legislative changes to taxes or
entitlement spending be deficit neutral, a requirement called the PAYGO rule. The PAYGO rule
mandated that changes in taxes or entitlement spending be offset by other changes in taxes or
entitlement spending so that the deficit was not increased. Despite the enactment of deficit-reducing
legislation and the existence of these budget rules, the best estimates ten years ago had the federal
budget still running deficits far into the future. However, as it turned out, a number of positive
developments pushed the budget into surplus in 1998 through 2001.
Importantly, bipartisan support in the Congress for establishing and maintaining some measure of
budget discipline was demonstrated by adherence to the guidelines set by the PAYGO rule and the
discretionary spending caps. In the 1990s, the discretionary spending caps appeared to be effective in
limiting the rise in annual spending appropriations. Defense spending declined by more than 2 percent
of GDP, as the federal budget was able to claim a "peace dividend" after the breakup of the Soviet
Union. Furthermore, nondefense discretionary spending was held about constant as a share of GDP.
Discretionary spending was eventually allowed to exceed the spending caps but only after budget
surpluses appeared in the late 1990s. The PAYGO rule was also effective in the later half of the 1990s
when legislative changes to taxes and entitlement spending were relatively small and were essentially
neutral in their estimated effects on future budget balance.
The federal budget also benefited significantly from economic developments that occurred outside of
policy actions. In particular, federal tax revenues increased substantially more rapidly than expected
and at a rate greater than the robust pace of economic growth seen in the late 1990s. Also, the rate of
growth of medical care costs slowed somewhat from its high previous rate, in part because of
legislative changes. Remarkable as it now seems, progress on the deficit was sufficiently dramatic that
only five years ago serious policy discussions were undertaken concerning the possibility of effectively
retiring all outstanding U.S. federal government debt. Obviously, the federal budget did not continue to
unfold in the manner projected at that time.
The rapid pace of ascent from deficit to surplus in the late 1990s was exceeded by the pace of
descent back to deficits beginning in 2002. This development was the result of a number of factors. In
2001, tax cuts approximately the size of projected on-budget surpluses were passed. Defense and
homeland security spending increased in the wake of the attacks on September 11, 2001, and other
nondefense domestic spending also increased at a substantially faster rate. The budget rules put in
place back in 1990 and extended several times thereafter--both the caps on discretionary spending
and the PAYGO rule--were allowed to expire after 2002, though the commitment to these rules had
waned considerably over the preceding years. Besides these policy actions, spending for federal
health programs also increased at faster rates as a result of a reacceleration in medical costs. During
this time, the economy experienced a mild recession, and the stock market declined for several years
after its peak in 2000.
A review of federal government outlays--both on and off budget--and revenues since the early 1990s
helps put the issue in perspective. In the early 1990s, total federal outlays averaged about 22 percent
of GDP, while revenues during that period were about 18 percent of GDP. Annual deficits were the
result. By the late 1990s, outlays declined to under 19 percent of GDP, primarily as a result of
significant reductions in defense spending relative to GDP, while revenues, boosted especially by a
strong economy and a strong stock market, rose to a high of nearly 21 percent of GDP, thus yielding
surpluses. Canada experienced an even larger consolidation of its government budget during the
1990s. More recently in the United States, total outlays have climbed back up to almost 20 percent of
GDP, while revenue has dropped to about 17 percent of GDP and deficits have reemerged. In contrast
to the U.S. fiscal situation, Canada has maintained its budget surpluses in recent years.
Worrisome as these short-term fiscal issues are for the United States, they pale in comparison with the
fiscal issues that are projected to begin emerging by the end of this decade. In a few years, the U.S.
baby-boom generation will start to retire. Thus, the ratio of retirees to workers in the United States is
expected to increase rapidly. Indeed, this demographic phenomenon is confronting Canada and other
major developed countries to an even greater degree than that expected in the United States.
Population aging will put substantial pressure on the U.S. federal government budget, as spending for
federal government retirement and health programs will rise rapidly. A more slowly growing workforce
could also tend to damp economic growth and, thus, federal tax revenues.
So far, solutions to these long-term challenges have eluded policymakers. It is imperative, however,
that solutions be identified and implemented. The sooner such changes are made, the less painful and
disruptive they will be. Of course, I do not want to minimize how difficult these problems will be to
solve. The Congressional Budget Office's long-run estimates for the United States indicate that
demographic trends would boost federal spending by 5 percentage points of GDP by 2030, and even
more thereafter, in the absence of changes to old-age programs.
The most important factor in ultimately achieving a federal government budget that balances over the
business cycle and maintains that fiscal discipline over time is the will of the political system to make
the necessary hard choices on government spending and taxes. One possible means of expressing
that will, would be for the Congress to reinstitute a set of budget rules, possibly along the lines of the
discretionary spending caps and the PAYGO rule originally included in the 1990 budget act; these
rules may assist in the process of making the difficult choices among competing budget priorities.
However, although the PAYGO budget rule, for example, appeared to help keep legislation from
increasing federal deficits for a number of years, PAYGO did not provide a mechanism to deal with the
long-term budget imbalances already in place. Thus, it is worth considering whether future budget
rules should go beyond the scope of PAYGO and require more fundamental adjustments to spending
and taxes. Clearly, there are numerous ways in which budget policy could be adjusted to bring the
budget back into balance in the short run and to maintain it over the long run. In any event, these
difficult choices must ultimately be made. If left unchecked, persistent and widening federal
government deficits will have an increasingly corrosive effect on the U.S. economy because, all else
being equal, federal government borrowing takes up some of the funds that would otherwise go to
finance capital accumulation or to purchase capital assets from abroad. A good deal of controversy
has swirled around the question of whether increased federal borrowing reduces domestic investment,
and presumably increases interest rates, or whether it increases U.S. borrowing from abroad. Viewed
from a broader perspective, however, that distinction is probably not very consequential because
future national income is lower in either case. For the federal government to run a deficit in the short
run as a temporary response to an emergency event, such as the recent devastating hurricanes, or a
recession or a war is not the type of fiscal policy imbalance that tends to have a negative long-run
effect on an economy. To the contrary, appropriate discretionary fiscal responses to these types of
situations can have beneficial economic effects, as I suggested earlier in my remarks. However, it is
imperative that the nation come to grips with the fiscal implications of the retirement of the baby-boom
generation. Creating a budget strategy and implementing policy changes to balance the federal
government's budget over the long term will require hard choices, which will become more difficult the
longer they are delayed. Moreover, changes made to federal government spending programs and
taxes to bring the budget toward balance should also be evaluated with regard to the economic effects
on work and retirement behavior, private saving, and the distribution of income likely to result from
particular policy choices. The benefits of taking timely and appropriate federal budget actions are
important for the long-run health of the U.S. economy.