The 11th Annual Business Expo Luncheon
Rocky Mount, N.C.
Ladies and gentlemen, it is a pleasure to be with you today for your 11th Annual Business Expo. I always enjoy visiting the great state of North Carolina, and it is a special privilege to be here in Rocky Mount--a city that is obviously contributing significantly to both our Fifth Federal Reserve District and the national economy through its thriving businesses and industries.
But I was also pleased to receive your invitation to speak today for another reason. One of your prominent citizens, Lindy Dunn, the chairman and CEO of Guardian Corporation, served on our Richmond Board of Directors from January 1981 to December 1983, and I have greatly enjoyed seeing him again here on his home turf. Lindy was also a charter member of our Small Business and Agriculture Council and served as chairman of the Council from 1985 to 1988. We are grateful for his guidance and his many contributions to our Bank.
I'm here today to talk about the economy--its current condition and its future prospects. I have addressed this subject many times during my career, not because I am a great economist or a particularly insightful analyst, but because I have been blessed with the opportunity to follow economic events quite closely for an extended period of time--most recently as a direct participant in the deliberations of the Federal Open Market Committee, the senior policymaking body in the Fed. I've given talks about the economy in good times and bad, and some of those experiences have been better than others. On one especially memorable occasion, I spoke to an association of homebuilders during the early 1980s, when the prime rate was over 20 percent and mortgage rates were well above 15 percent. The members of that audience had little two-by-fours and they were sort of shaking them at me as I made my remarks. I got the message very quickly that they were not pleased with my remarks or with my forecasts.
The contrast between the economic conditions when I made that earlier speech and the backdrop for my comments today could hardly be sharper. To be sure, conditions today are not perfect. There are many people without jobs who want them. There are people who need to acquire basic skills to get even unskilled entry-level jobs. And there is growing inequality of income and wealth levels across American families.
But, by and large, macroeconomic conditions in the United States are about as favorable now as they have been at any time in the entire post-World War II period. Labor market conditions are particularly robust. The unemployment rate is at a 20-year low and below 5 percent. And a significant portion of those who are unemployed left their last job voluntarily because they feel confident they can find a better position somewhere else. I hear numerous reports of businesses that cannot find qualified workers even for entry-level jobs. Indeed, someone told me recently that a fast food chain that used to advertise their monthly specials on little cards on each table now uses that space to notify customers of available jobs.
This job market strength reflects strong growth in total economic activity across the country. Real gross domestic product grew rather sluggishly in the initial phase of the current expansion due to the credit crunch and other restraining forces, but it has been steaming ahead recently. Real GDP rose 3 1/4 percent last year, well above most estimates of our maximum potential trend growth rate. And it accelerated to a 4 1/4 percent annual rate in the first half of this year. By sector, consumer spending on goods and services and housing activity have been quite solid in recent quarters, and business investment--especially in new productive technology--has accounted for an unusually large share of total spending in the current expansion. This new investment is particularly welcome news since it holds out the possibility of increased productivity and sustained higher real economic growth and higher living standards in the years ahead. Meanwhile, exports have been a major source of support for the economy despite the recent strength of the dollar, accounting for nearly one-third of the total growth of our economy over the last decade.
Yet, despite these bullish general economic conditions--and this represents an especially favorable part of the current overall economic picture--inflation has remained remarkably well contained. If we remove the volatile food and energy components from the CPI to get a better indication of the underlying inflation trend, we find that the 'core' CPI has decelerated steadily in recent years. You may remember that inflation peaked at around 13 percent in the late 1970s and early 80s. In contrast, prices rose only about 2 ½ percent last year, and to date this year are rising at only about a 2 1/4 percent rate. The persistence of this lower inflation has bolstered confidence in financial markets dramatically. In the days of high inflation, nobody wanted to hold financial assets; investors didn't know what their dollars would be worth in the future, so they opted for real assets like gold, real estate, collectibles and so forth. Those days are gone, and this country has enjoyed an historic bull market in financial assets for the last 15 years. As a result, long-term interest rates are currently at their lowest levels since the early 1960s, and the stock market, while currently a few points below its most recent highs, is up nearly 300 percent since the expansion began in 1991. Given the broader ownership of stocks--partially because of the easy availability of low cost and convenient stock mutual funds--many ordinary American households feel wealthier now than at anytime in recent memory.
In sum, the broad economic landscape is quite sunny currently, and everyone feels pretty optimistic. Indeed, the picture is so nice that some people wonder if the economy and the way it works has changed in some fundamental and permanent way for the better. Some also wonder why inflation has been so well behaved when the unemployment rate is so low and the economy has been growing for an extended period at a considerably more rapid pace than most of us thought sustainable without rising price pressures. Economists have generally believed that the economy's maximum sustainable growth rate was somewhere in the neighborhood of 2 1/4 percent annually, given the underlying growth rate of our labor force and our capital stock. But the actual growth over the last four quarters has been closer to 4 percent, and the economy is operating at a very high level. Similarly, people have thought that when the unemployment rate declines much below 6 percent, inflation pressures begin to rise and become visible. The unemployment rate was 4.9 percent in September, but current inflation pressures are still not apparent.
What's going on here? The short answer, quite frankly, is that we don't know for sure. Some believe there has been a permanent change in the way the economy functions: that we're in a 'new economy' or a new 'paradigm.' Many of those who hold this view think the long-term trend growth of the nation's productivity--what the average worker produces in an hour--has increased from its current rate of around 1 percent annually to something greater, perhaps in part because of our heavy recent investment in computers, new communication facilities and other high-tech capital. This view would imply that the economy's sustainable long-term potential growth rate has risen from the 2 1/4 percent rate I mentioned earlier, since the sustainable rate is entirely dependent on two underlying rates: (1) the growth rate of the labor force, which is mainly determined by demographic trends that we know pretty much in advance; and (2) the rate at which each worker's productivity is growing. Faster growth of productivity would obviously tend to reduce labor costs and price pressures at any particular level of GDP and any particular overall economic growth rate, and would help account for our excellent recent economic performance. The 'new economy' adherents also emphasize intensified competition in world markets in the context of the increasing importance of foreign trade to the American economy and American business: both greater competition for our exports in foreign markets, and more competition for home-grown goods and services in domestic markets from imports. This, too, would tend to restrain inflation at any given rate of overall growth. Finally, 'new paradigmers'--if I can use that term--believe that the heavy recent investment in conventional capacity as well as in high-tech equipment in many industries is allowing the economy to absorb a greater proportion of the labor force before price pressures begin to develop. New paradigmers are optimistic about both the near-term and the longer-term outlooks for the economy. Moreover, they think we may well be able to grow even faster without kicking off another round of high inflation, both in the near term and over the longer haul.
The opposite and more conservative view--call it the 'old paradigm'-- holds that the economy still works pretty much the way it has been working and that the sustainable growth rate has not really increased appreciably. These folks believe that some more or less adventitious developments have been restraining and even reducing inflation temporarily and that these temporary developments are masking the regular relationships among growth, employment and inflation, which are still lurking beneath the surface. The specific temporary developments they cite include the widespread anxiety among workers about the security of their jobs due to downsizings and restructurings, the recent reductions in health care costs due to the trend toward managed care, and, perhaps most importantly in recent months, the strength of the U.S. dollar in financial markets, which directly reduces the dollar price of imports and restrains the prices of domestically produced products that compete with imports. Old paradigmers have a less sanguine view of the outlook than the folks who buy into the new economy idea. They think we are skating on thin ice, as my father used to say. The old paradigmers predict that with growth over 3 percent and unemployment below 5 percent, any waning of the influence of the temporary factors I just mentioned will cause inflation to rise, which would lead in turn to rising long-term interest rates, greater risk, less investment and less growth.
Who's right? Again, we don't know for sure. I have described the positions at each end of the spectrum of views in the public discussion of this issue. There obviously is considerable middle ground in the debate, and that's where I find myself personally. I must admit, however, that I stand closer to those who are skeptical about the new economy idea. At the risk of your brandishing your own two-by-fours, I must tell you that I'm not quite as optimistic as the new paradigmers. It is certainly possible, of course, that all the recent innovation and investment in new technology has permanently increased both our productivity and our sustainable noninflationary growth rate. But I haven't seen much hard evidence that they have increased dramatically over the last two or three years. And while there have been some abrupt shifts in the behavior of the U.S. economy in the past, such events have been the exception rather than the rule. Changes in the economy's performance and its basic internal relationships tend to be evolutionary rather than revolutionary. So I am skeptical of the new economy view, at least in its most categorical form. The trade-offs we face have probably improved in recent years. But my guess, given what we know now, is that the improvement has been modest.
What does all this imply for the outlook for the economy for the next year or so--for overall growth in jobs, income, business profits and prices--the things that people like you and me really care about? Let me give you my personal opinion. I think the near-term outlook remains bright. The economy's performance over the last year or so--the extraordinary combination of above-trend growth, exceptionally tight labor markets, but continued low inflation--has been much more favorable than I and many others expected. And this outstanding performance may well continue a while longer. But speaking strictly for myself, I am doubtful it can continue indefinitely. We are pushing the limits of our historical economic experience, and unless we are willing to buy the story that there has been an abrupt and wholesale change in the economy's long-term capabilities, I think we need to be cautious going forward. Policymakers especially need to be cautious. What we want is sustained growth in production and sustained growth in jobs, and it is reasonable and appropriate for policymakers and others to ask whether the current level of economic activity and its recent growth rate is sustainable or not.
Let me close with some brief remarks about what I believe are minimal economy policy requirements to ensure the economy's continuing good health. I'll touch on trade policy, fiscal policy and monetary policy.
Trade policy has always been a contentious subject for Americans: it is currently and probably always will be. But we need to keep our perspective and our eye on our long-term economic goals. Our country, by and large, has pushed forcefully and consistently throughout the post-World War II period for a more liberal, global trade regime and a free flow of capital internationally. NAFTA and the completion of the Uruguay Round of worldwide trade agreements are just the latest accomplishments in this long history. We need to continue this progress, and I hope we will take whatever legislative and other initiatives we need to ensure this result. The U.S. economy is currently as competitive in world markets as perhaps it has ever been, so we are especially well positioned to reap the benefits of expanding trade.
With respect to fiscal policy, we can be encouraged by the recent unexpectedly sharp decline in the federal budget deficit. The deficit peaked at $290 billion in fiscal year 1992, inspiring the suggestion to rename the Secretary of the Treasury the Secretary of the Deficit. In contrast, the deficit in fiscal 1997, which ended on September 30th, is estimated to be in the neighborhood of $30 billion, and may even be a little below that level. This reduction represents a lot of progress and we should be grateful for it. But we also need to be clear on what is driving this progress. Most of it has resulted from higher-than-expected tax revenues, due to higher-than-expected economic activity and income. Whether the recently passed budget deal will be sufficient to keep the deficit from reversing course, should the economy decelerate for whatever reason, is far from clear in my opinion. Additionally, in the absence of bolder long-term initiatives, the fiscal fallout from the demographic changes we all know will occur early in the next century could be exceedingly damaging to our economic welfare. Last, but not least, because you and I and other citizens in our country spend innumerable hours annually preparing income and other tax returns--when we could put that time and talent and effort to more productive uses--we need to get off our collective duff and do something meaningful and permanent to simplify the tax code.
Finally, what are the requirements for monetary policy? Monetary policy, as the phrase implies, should be about money and the money supply. When most Americans think of Fed monetary policy, however, they usually think of interest rates and what we may or may not do to change them, and I have to acknowledge that the way we conduct monetary policy in the short run undoubtedly contributes to this focus on interest rates. Throughout most of its history the Fed has manipulated certain key short-term interest rates--currently the so-called federal funds rate--to influence the growth of the money supply and achieve our other long-term policy objectives. And, largely for technical reasons, I think we are stuck with this procedure for the time being.
Because this monetary policy implementation procedure is less than ideal, it is important to look beyond all the day-to-day discussion and debate about interest rates to the Fed's longer-term monetary strategy. Not too many years ago a lot of people, including some prominent economists, believed the Fed could fine-tune the economy with monetary policy. The high inflation, high interest rates and general economic turbulence of the late-1970s and early-1980s taught us differently. Since then we have focused on reducing inflation gradually but steadily over time, and we have succeeded in bringing it down to its current rate below 3 percent.
I believe this steady progress against inflation has played an important role in the economy's strong performance in recent years. If they gave out Oscars for best supporting economy policy in the current expansion, I think our success in helping reduce inflation would be a strong contender. There is a widespread notion that when the Fed resists inflation to stabilize the purchasing power of our hard-earned dollars we are also resisting growth in jobs and income. Nothing could be further from the truth in my opinion. On the contrary, low inflation promotes strong long-term growth by reducing risk and encouraging investment in new plants, new equipment, new technology and new ideas, and by clarifying the signals individual prices are sending to producers, consumers and investors. These things make our free market economy work more efficiently. So the monetary policy requirement for continued strong economic performance in my view is that the Fed continue to focus squarely on price level stability as its principal longer-term strategic objective. We have made substantial progress towards achieving this objective and we need now to solidify these gains and make them permanent, and I hope you will support us in this effort.