Mark W Olson: Assessing prospects for economic growth in the United States
Speech by Mr Mark W Olson, Member of the Board of Governors of the US Federal Reserve System,
before the Chambers of Commerce of Bloomington, Eden Prairie and Edina Bloomington, Minnesota,
22 May 2003.
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Thank you for the invitation to be with you today. I would like to focus my remarks largely on what I
think will, over time, lead the U.S. economy back to a path of solid economic expansion. In particular, I
want to explain to you why I believe that, although the economy still faces substantial risks and
although the timing and the extent of a pickup in activity remain uncertain, the stage has been set for
an improvement in the economic climate. To lay the groundwork for that discussion and to put the
current situation into perspective, I will briefly step back and touch on some recent economic history. I
should note that my comments today reflect my own opinions and not necessarily those of my
colleagues on the Board of Governors of the Federal Reserve or the Federal Open Market Committee.
As you know, the latter half of the 1990s was a time of remarkable economic performance. Businesses
added workers and expanded output at a rapid clip. The unemployment rate fell from over
7-1/2 percent in the middle of 1992 to just under 4 percent by the end of 2000. In Minnesota, the
unemployment rate fell from 5.2 percent to 3.4 percent over the same period. The stock market
soared, and - remarkably enough - core inflation moderated. Much of this performance was fueled by
an investment boom that also contributed importantly to rapid growth in labor productivity. To be sure,
some of the acceleration in productivity over that period was cyclical in nature; but more critical for our
longer-run economic performance is that at least a portion of the pickup now appears sustainable.
By late 2000, the boom had come to an end. The stock market began to retreat in early 2000, and by
the end of the year, analysts were revising down their expectations for future earnings. Many
businesses were cutting back sharply on capital investment - particularly in high-tech equipment - as
demand and profits weakened and many companies, such as those in the telecommunications
industry, found that they had overspent on equipment during the boom.
The downturn in the economy, which began in 2000, had two distinct characteristics. First, and
thankfully, it turned out to be one of the shallowest in our economic history. Second, it was one of the
few business-led recessions in the United States since the end of the Second World War. Most
recessions since then have been brought on by sharp cutbacks in spending by households, with
housing and consumer durables among the most sensitive sectors.
The recent experience was clearly different. Consumer spending and residential investment were both
relatively well maintained throughout 2001, even as firms cut employment and stock market losses
eroded household wealth. Despite only modest increases in nominal wages and salaries, households'
real disposable income was supported by tax cuts and lower inflation. In addition, low interest rates
helped promote spending. As you know, consumers took advantage of falling mortgage rates to buy
new homes, to refinance their existing mortgage debt, and to tap into their increasing home equity to
pay off more expensive debt or to finance spending on other things. As a result, the contraction in real
GDP during the first three quarters of 2001 turned out to be quite shallow despite the disruptive
economic fallout from the horrific events of September 11.
By early last summer, economic recovery appeared to be under way. Real GDP increased at an
annual rate of roughly 3-1/2 percent over the first three quarters of the year. Businesses seemed to
have brought their inventories into better alignment with sales, and employment began to rise again,
though the gains were too small to make a dent in the unemployment rate. A particularly encouraging
development, given the nature of the downturn, was that the contraction in business investment
appeared to be slowing while household spending, still supported by low interest rates and gains in
real disposable income, continued to trend up.
Although the government statistics were looking a bit better, signs appeared over the summer that the
economy's resilience would be tested by several new shocks. As a banker who experienced several
previous economic downturns, I know that whatever weaknesses exist in our economy become
problematic at the low point of the economic cycle. At such times, we typically see loan losses and
evidence of weak business models. What emerged in early 2002 was not what I had expected. The
Enron and WorldCom scandals raised serious concerns about the adequacy of the corporate
governance system and tended to cloud the outlook for business expansion. Abroad, mounting
tensions with Iraq were beginning to take their toll on consumer and business confidence. The stock
market moved down again, conditions eroded in corporate debt markets, and risk spreads widened.
As we moved into the fall, industrial production faltered, and business investment posted only modest
and uneven gains. By the final quarter of 2002, real GDP growth had slowed to a pace of
1-1/2 percent, and heightened caution in the business sector showed through to renewed layoffs and
a sharp cutback in inventory investment.
That brief review brings us to this year, which began with a few bright spots: Concerns about corporate
governance were apparently receding, employment and industrial production moved up solidly in
January, and the unemployment rate edged down a bit. Unfortunately, these improvements were
short-lived. In late February and early March, as the confrontation with Iraq heated up, uncertainty was
pervasive. No one knew if or when the war would start, or end. The possibilities that chemical or
biological weapons might be used, that the war might spread, or that terrorists might again attack on
U.S. soil seemed to be quite real. There was a risk that Iraq's oil fields might be damaged. The ranges
of possible outcomes and of their economic consequences were extremely wide.
The uncertainty hit consumer confidence hard. The University of Michigan's survey of consumer
attitudes reported that, by the middle of March, confidence had fallen to its lowest level since the early
1990s and was below what we would have expected given the state of the economy. The oil, equity,
and financial markets all showed signs of strain. Oil prices rose to nearly $40 per barrel in early March,
though civil strife in Venezuela undoubtedly played a role in the increase. Broad stock market indexes
moved down about 10 percent in the two months leading up to the war, and the equity risk premium
widened. Measures of implied volatility in stocks edged up. All in all, the economy's performance in the
first quarter of 2003 ended up little better than it was in the fourth quarter of 2002. Real GDP again
rose at an annual rate of about 1-1/2 percent as both households and businesses reined in spending.
Our overall economic performance would have been even weaker had housing markets not remained
vibrant.
Fortunately, the range of plausible outcomes narrowed significantly even before the official conclusion
of hostilities with Iraq. As the onset of the war became imminent, financial markets rallied. Oil prices
fell sharply during the week that ended with coalition missile attacks on Baghdad.
Two months have passed since the war began, and we do not yet have a clear understanding of how
strongly the economy is emerging from this most recent shock. The most positive signs are responses
from energy and equity markets. The price of crude oil has returned to levels that prevailed at the end
of last year, and both households and businesses should welcome the lower energy bills. Equity
values, with additional support from generally favorable earnings reports, are up substantially. Spreads
have narrowed significantly, continuing the downward trend that began last fall. Other positive signs
include further reductions in mortgage interest rates and the rebound in consumer confidence. All told,
these indicators point to a noticeable reduction in the economic tensions that built up earlier this year.
Though markets can respond instantly to positive news, business investment decisions adjust more
slowly, and that distinction is evident in current production and employment data. Businesses cut
another 80,000 jobs in April, the jobless rate moved up to 6 percent, and new claims for
unemployment insurance in recent weeks remain at levels associated with little net change in jobs. (In
Minnesota, the jobless rate moved up to 4.4 percent in March, and about 28,000 workers filed claims
for unemployment compensation in April.) Industrial production fell 1/2 percent in both March and
April, and capacity utilization is under 75 percent. Retail sales have been, on balance, lackluster in
recent months.
Turning briefly to inflation, last week's report on the consumer price index showed, as expected, that
consumer energy prices had begun to retreat noticeably last month, reversing about one-third of the
run-up over the first three months of the year. In April, prices of core goods and services - that is,
consumer prices excluding food and energy - were unchanged for a second month. As a result, the
core CPI was up just 1-1/2 percent from last April.
On balance, these indicators suggest that the economy will probably remain soft in the near future and
that inflation will remain low. Nonetheless, I continue to believe that the pieces are in place for future
robust growth.
Looking back over the past three years, I am struck by how much the U.S. economy has had to
contend with. For much of the period since mid-2001, large negative wealth effects from the falling
stock market, the shakeout in the high-tech sector, and the slowdown in economic activity abroad
have combined to restrain economic activity. Outside shocks, such as September 11, corporate
scandals, and the war with Iraq, provided additional drag to renewed expansion. The economy,
however, proved to be remarkably resilient.
Looking forward, one must ask, what will lead to economic growth? The best way to start answering
that question is to look at the fundamental forces shaping economic activity. In that regard, a first
consideration is that financial conditions should prove conducive to stronger economic growth over the
next year or so. Monetary policy is very accommodative. The nominal federal funds rate is currently
1-1/4 percent, a level that, using standard measures of core consumer price inflation, implies a real
funds rate that is at or below zero, as compared with the real rate's long-run average of about
2-3/4 percent. With corporate risk spreads having narrowed considerably, borrowing terms are now
quite favorable. Business financing needs have been very limited recently, and demand for credit has
been weak. But the financial sector is well capitalized and under little stress, and lenders should be
well positioned to fund a pickup in business demand for credit. In addition, as I noted earlier, equity
prices have moved up again.
Fiscal policy, like monetary policy, has been providing fundamental stimulus to economic growth over
the past two years, through both tax cuts and higher outlays for defense. The tax proposals currently
under consideration by the Congress could add to that stimulus, either by accelerating some of the tax
cuts enacted previously or by excluding some portion of dividends from taxable income.
A third factor underpinning longer-run prospects for growth is the sustained strong uptrend in labor
productivity. Labor productivity rose 2 percent in 2001, a remarkable showing for a recession year, and
it was up an additional 4 percent in 2002. Productivity appears to have a strong underlying trend,
which could support overall income growth even if the weakness in the labor market continues for a
while longer.
In assessing how these factors will play out over time, I find it useful to consider separately how they
translate into a pickup in demand among households and among businesses. From the perspective of
households, the combination of lower energy prices and tax cuts should help bolster real disposable
income in the near term. In addition, the drag on household spending from the earlier declines in stock
market wealth should gradually diminish, especially if the stock market holds on to its recent gains.
Low interest rates should allow consumers to continue to finance their purchases relatively cheaply,
whether through home equity loans or through more standard instruments.
The outlook for the business sector is perhaps a more critical consideration. Here, too, the
fundamentals look favorable. In the near term, lower oil prices should reduce the costs of production
for many businesses and free funds for other uses. Also, with interest rates low, the incentives for
capital expenditure in the tax code in place until late 2004, and prices for high-tech goods still falling,
the cost of capital should remain low. Over the longer run, the continuing rapid pace of technological
innovation implies that there are many potential investments that offer attractive returns. In the
uncertain business environment that has prevailed for some time, many businesses have probably
been making do with their existing equipment, stretching out their normal replacement cycles,
especially for rapidly depreciating high-tech equipment. Overall, though shifts in business attitudes are
difficult to measure, I believe that markets reward businesses that outperform their competitors and
that, as demand picks up, companies will respond to opportunities to incorporate technological
advances in production, communication, and organization. Because of the uncertainties that have
been restraining investment, predicting exactly when firms will act is difficult; but I do believe that they
will act.
As you can see, I remain generally optimistic about the longer-run prospects for the U.S. economy.
However, I want to mention some significant questions about the outlook. Perhaps the most significant
is whether the slump in capital spending will be more prolonged than expected. Such a slump could
occur if firms remain so uncertain about the outlook for a pickup in sales that they continue to shelve
plans for upgrading or expanding their businesses. Given the very low levels of capacity utilization
both in our factories and in service-providing industries such as telecom and air transportation and the
high vacancy rates in many office buildings, this risk is not trivial. For example, here in the Twin Cities
metro area, one-fifth of available office space sat empty at the end of last year.
Another question that is frequently asked is whether financial stress in the household sector might
restrain growth. Specifically, some argue that the high level of consumer debt might mean that
households will be unable to increase spending substantially for some time to come. To be sure, the
debt service burden is quite high by historical standards, and personal bankruptcies moved up in 2001
and 2002. However, households have been converting their more expensive, non-tax-deductible debt
into mortgage debt, which has helped keep the debt service burden fairly stable during the past few
years. What is more, banks are not experiencing broad weakness in their consumer loan portfolios as
most of the increase in delinquencies has been in a narrow spectrum of households. On the whole,
looking at the available evidence, I tend to give less weight to the questions concerning the financial
situation of households than I do to the risks of continued uncertainty in the business sector.
A third question bearing on the outlook for the U.S. economy regards prospects for a pickup in activity
among our major trading partners. Concerns about the strength of the global economy remain, and the
emergence of SARS poses a threat to the economic prospects of several emerging-market economies
in Asia. To date, however, we have no evidence that the new disease has affected U.S. economic
activity. Nonetheless, continued slow growth abroad could have a damping effect on our recovery
here.
To summarize, the recent news from oil and financial markets and about consumer confidence clearly
suggests that the reduction in risks associated with the situation in Iraq has had a number of favorable
effects. At the same time, the available indicators of production and employment suggest that the pace
of economic activity may remain slow for a while longer, likely restrained by lingering uncertainty about
the timing of economic recovery. Looking ahead, however, it seems likely that, at some point the
combined effects of a fundamentally solid financial sector, sustained consumer spending power, and
improving consumer confidence will demonstrate sufficient demand potential to stimulate increased
levels of capital investment.