Roger W Ferguson, Jr: A review of economic developments in 2001 and the
economic outlook
Remarks by Mr Roger W Ferguson, Jr, Vice-Chairman of the Board of Governors of the US Federal
Reserve System, at the Canton Forum Speaker Series, Canton, Ohio, 27 February 2002.
* * *
I am pleased to address the Canton Forum today. As always, the views I will be expressing are my
own and are not necessarily shared by other members of the Board of Governors or of the Federal
Open Market Committee.
Review of 2001
A confluence of factors shaped economic developments last year, and I would first like to review these
factors, to provide a backdrop for assessing our economic prospects in 2002.
A year ago, signs of the recession that eventually unfolded were just beginning to materialize. After
several years of booming growth, economic indicators started sending mixed signals. Although
consumer sentiment had dropped around the end of 2000, consumers were still spending at a healthy
clip. Though consumption growth had decelerated somewhat over the previous year, the modest
slowing was consistent with the deceleration of aggregate demand necessary to better align supply
and demand.
Businesses, however, appeared to be struggling. As data for the end of 2000 became available, it
became clear that businesses--amid disappointing sales and earnings--had abruptly curtailed the
record-setting expansion of investment spending. Of course, some reduction of investment usually
accompanies the recognition of a downshift in the economy, as firms bring their capital stocks in line
with a revised outlook for sales. But the severity of the adjustment last year appeared to reflect more
than the usual reaction. Businesses seemed to be reassessing the profitability of additional fixed
capital in a more fundamental way. New capital, especially capital that embodies new technologies,
continues to promise efficiency gains, but expectations seemed to have gotten ahead of even the
more favorable reality, resulting in an unsustainable buildup of capital and run-up of equity market
values. Capital expenditures on high-tech equipment were especially hard hit. Moreover, the sudden
drop-off in business demand, coupled with some slowing in the consumer sector, apparently caught
producers off guard. And despite rapid cuts in production, inventories were uncomfortably high relative
to sales. Early last year, manufacturers took steps to address the unwanted stocks and began
liquidating inventories in earnest by slashing production of all types of goods.
Against this backdrop, the Federal Open Market Committee reduced the target for the federal funds
rate sharply last January to contain the weakness and head off a more serious slackening. This was to
be just the first installment of a series of policy easings to counter the weakness in the economy that
emerged over the first half of last year.
In the business sector, a serious retrenchment in spending and production was under way. In addition
to the initial causes of the pullback, the abruptness of the slowing seemed to jar business confidence,
leading firms to postpone spending while they reassessed their situations. In this way, the investment
downturn became self-reinforcing. At the same time, financial developments, including a stronger
dollar, sharply lower equity prices, and tighter lending standards at banks and in security markets,
tended to offset some of the influence of the lower federal funds rate. By midyear, investment--and
high-tech investment in particular--was posting some of the largest decline in decades. The weaker job
market and lower stock prices also began to weigh on consumers, though to a much lesser extent.
With overall sales sagging, inventories remained excessive in many sectors.
As the weakness in the economy intensified, policymakers responded. In June, President Bush signed
the Economic Growth and Tax Relief Reconciliation Act of 2001 into law. The first installment of the
reduction in personal income tax rates went into effect in July. In addition, the act provided tax rebates
of $300 to $600 per household that were paid directly to taxpayers.
As for monetary policy, between March and June, the FOMC voted to ease monetary policy four more
times, bringing the cumulative reduction in the federal funds rate to 275 basis points in the first six
months of the year--the most rapid reduction in the funds rate since the early 1980s. Despite both
fiscal and monetary efforts to bolster sagging aggregate activity, by late summer only a few hard signs
had surfaced that recovery was at hand.
The terrorist attacks on September 11--whose worst effects were felt by those people and their
families directly touched by the tragedies--were a blow to our already weakened economy. In the
weeks immediately following those events, most forecasters expected the damage to the economy to
be extensive. The initial effects on the airlines and the travel industry were severe. Also, a rapid
deterioration of business and consumer confidence seemed highly probable. In addition to immediate
crisis-related injections of liquidity, the Federal Reserve moved to address the perceived shock to the
macroeconomy by lowering the federal funds rate 50 basis points on September 17 and an additional
75 basis points by the end of the year.
Over the past few months, we have all been watching closely to see how aggregate activity would
unfold in the aftermath of the terrorist attacks. No doubt a great deal of pain has been inflicted on the
economy. But, given the magnitude of the shock, the economy has proved more resilient than initially
anticipated. Though several industries have been hit very hard, the worst-case scenarios spun in late
September have not materialized. In particular, households' views of the economy have remained
relatively stable, all things considered. In fact, in one of the most recent readings, consumer
confidence was not much lower than it had been in August. While spending has surely been
buttressed by some temporary factors such as aggressive discounting on motor vehicles and other
retail goods, the effect of terrorism on consumer spending has not been as severe as most had feared
in late September.
To be sure, 2001 was a rough year for the economy--one of the roughest we have faced in a long
time. The weak economic outcome despite sizable reductions in the federal funds rate has led some to
question the effectiveness of monetary policy. But I believe that monetary policy substantially
cushioned the negative forces weighing on the economy. Residential construction has been visibly
buoyed by policy easing. Housing activity remained at a high level all year, as lower mortgage rates
apparently offset the restraint from declines in employment, smaller gains in income, and lower levels
of wealth. Also, although delinquency rates have risen, few restrictions have emerged on the
availability of credit to consumers. Indeed, low interest rates have made it attractive to refinance
mortgages to reduce mortgage payments, extract some home equity buildup, and pay down more
expensive forms of consumer credit. Even businesses, which have been feeling the pinch of lower
corporate profits, have benefited from lower interest rates; aggregate interest expense has remained
fairly low relative to cash flow, and businesses have moved aggressively to bolster their financial
stability by locking in more-certain, longer-term sources of funds. Automakers in particular have been
able to offer inexpensive financing to customers because their own funding costs have fallen.
In many ways, the mechanism that propagated the weakness last year was quite traditional: A
negative demand shock led to unwanted inventories and to an adjustment of production. That, in turn,
idled workers and fed back into even weaker demand. But even before the shock of the terrorist
attacks, two aspects of last year's slowdown were atypical. First, the main source of the negative hit to
demand was a large shock to capital expenditures. In the past fifty years, investment spending has
nearly always begun its decline one to four quarters after the peak of the economic cycle, not before it.
What started out as a very gradual cooling of an overheated economy became much more serious
because of the severe shakeout that hit the high-tech sector. Second, consumer spending on goods
and services--which represents about two-thirds of the gross domestic product--held up remarkably
well last year. In the past, consumption spending has almost always declined as a recession started.
But last year, despite a sharp drop in consumer confidence and a decline in wealth from lower equity
values, households kept buying.
At this point, it is still too early to classify this recession as mild or severe. In general, economic
fluctuations in the past fifteen to twenty years have been tamer than their counterparts in earlier eras.
Economists have conjectured that this is so because improved technologies allow businesses to
monitor their demand more closely and manage their inventories better. Recent developments ought
to give us more evidence on this subject. One thing is certain: Because of the unusual, investment-led
nature of this recession, we cannot put too much weight on the shape and profile of past recoveries in
trying to predict this one.
Current situation and near-term outlook
That said, the data we have received in recent weeks have been encouraging and suggest that
economic activity is in the process of turning up. Although payroll employment continued to fall in
January, the pace of that decline was slower than in the fourth quarter of last year. Initial claims for
unemployment insurance have moved lower over the past two months--another hopeful sign of
recovery. Industrial production fell in January, but here, too, the rate of decline was well below the
pace in preceding months.
As we obtain more information on spending patterns since September, the behavior of households is
increasingly proving to be the key stabilizing force on economic activity. Sales of cars and light
trucks-though down from the extraordinary rates of the fourth quarter--have continued at quite healthy rates.
In addition, retail sales outside motor vehicles were very strong in both December and January.
Housing construction, too, has been robust, bolstered in part by favorable weather and low mortgage
rates.
In the business sector, the very rapid pace at which companies liquidated inventories in the fourth
quarter contributed to the weakness in manufacturing output. However, the downward adjustment of
stocks to more desired levels now seems well along in most industries, and this drag on production
may be diminishing.
Business fixed investment has not as yet shown consistent and sustained evidence of a turnaround,
although there have been some positive indicators. After a year of dealing with an overhang of capital
goods, many firms are being cautious in their capital spending. With corporate profits under pressure
and capacity utilization rates near past cyclical lows, many businesses report that their expansion
plans remain on hold. However, capital investments that allow businesses to reduce cost might be
more attractive. Spending indicators have been more positive in the past few months, particularly with
respect to computer equipment. Developments in this sector will importantly influence the strength of
our economy in the months ahead, and will therefore warrant careful monitoring.
As you know, Chairman Alan Greenspan presented the Board's semiannual Monetary Policy Report to
the Congress this morning. As he indicated, the central tendency of the forecasts of the members of
the Board of Governors and the Federal Reserve Bank Presidents for real GDP growth this year was
between 2-1/2 and 3 percent. I am comfortable with that range of forecasts. As I just noted, recent
data indicate that household spending has been reasonably well maintained. In addition, there are
some signs that capital spending may be improving, but the strength and durability of that
improvement are still uncertain. Until there is a clearer perspective with regard to business investment,
I believe that there is still reason for some reservations regarding the contours of the recovery.
The longer-run outlook
One of the main forces that will lead to the recovery from this temporary slowdown is the confidence of
businesses and households that, in the long run, the outlook for the U.S. economy is still bright.
Despite our current problems, the fundamentals of this economy are strong. Our workforce is well
educated and adaptable. Our banking system is healthy, and our capital markets, which are flexible
and multifaceted, are well equipped to handle shocks.
Perhaps the most notable feature of our economy in recent years, however, has been the acceleration
in productivity. In the second half of the 1990s, output per hour in the nonfarm business sector
increased at an annual rate of almost 3 percent per year, well above the pace earlier in the decade.
These efficiency gains allowed real GDP to rise 4 percent a year, on average, over the period. With
these rapid increases in productivity, business costs were well contained, and the rate of price inflation
was stable, despite a fall in the unemployment rate to below 4 percent.
Productivity growth continued over the four quarters of 2001. That it increased is impressive, given the
historical tendency of productivity growth to turn negative when the economy enters recession. This
performance provides additional evidence that the improvements in productivity growth that we have
witnessed since the mid-1990s have been largely structural and will persist for a time.
But the fundamental factor leading me to be cautiously optimistic that much of the improvement is
likely to be sustained is my outlook for the state of technological advancement in the United States. As
Fed economists Dan Sichel and Steve Oliner have shown, one major source of the gains in output per
hour were the high and rising levels of business investment, which increased the amount of capital per
worker, thereby boosting productivity. Booming investment in the 1990s was due importantly to steep
declines in prices of high-tech equipment, which largely reflected rapid technical progress. About
1⁄2 percentage point of the increase in productivity growth in the 1995-99 period can be attributed to
this so-called capital deepening. Although the extraordinary pace of investment spending in those
boom years was not sustainable, I believe that technological progress will continue to drive down the
cost of information technology in the coming years, inducing still robust growth of the capital stock.
Moreover, businesses have reaffirmed their intentions to improve productivity by substituting
cost-saving high-tech capital for labor.
Though there are certainly risks to the view that improvements in productivity growth will persist, I do
not believe the terrorism of last fall is going to permanently harm increases in output per hour (and
thus the health of the economy). Most assuredly, in the aftermath of these attacks, many businesses
have been forced to redirect resources from efficiency-enhancing investment to meet greater demands
for security. Businesses may also have been compelled to increase redundancy to cope with the
greater potential for supply disruption. However, these effects will be mainly a one-time hit to the level
of productivity. They are not likely to change the trend growth rate of output per hour. Moreover, their
effects will be ameliorated as businesses use new technologies and find creative ways to hold down
the cost of enhancing security and providing for contingencies.
Conclusion
Obviously, 2001 was a challenging year. But the American people once again proved to be up to the
challenge, and signs of economic recovery are increasing. At the Federal Reserve, we stand ready to
do what is necessary to maintain financial stability, as we did on September 11, and to maintain a
monetary policy stance that will foster price stability and promote maximum sustainable growth in
output.