Gary H. Stern
Federal Reserve Bank of Minneapolis
R.I.S.E VII Forum
University of Dayton
March 29, 2007
Good afternoon. It is a distinct pleasure to join you in Dayton and to have the opportunity to speak at this forum. I have titled these remarks "Perspectives on the Economy" but a better description might actually be how to think about the U.S. economy. Since I gather that all of you share a keen interest in investments, the ability to accurately understand the economy, and its prospects, could be a significant asset in your human capital portfolio.
The U.S. economy is large, diverse, and complex with lots of moving parts, so it is not necessarily easy to gauge what is going on. Still, I think there are lessons from recent history, as well as implications from economic theory, that can aid our understanding and keep us grounded in an environment of exceedingly rapid transmission of data and almost instantaneous analysis, only some of which is of value. Accordingly, my plan today is to interweave a description of the current state of business activity with the performance of the economy over the past 2 ½ decades or so to elucidate some principles appropriate to understanding the economy and assessing its future course. Specifics will be forthcoming momentarily; first, though, let me remind you that I am speaking only for myself and not for others in the Federal Reserve.
The current economic expansion began in the fourth quarter of 2001, so it has now proceeded for about 5 ½ years. In itself, this duration is unremarkable; the expansions of the 1980s and 1990s (about which I'll have more to say shortly) lasted about 8 ½ and nearly 10 years, respectively. The latest extended period of growth may appear more impressive, however, when we recall all the concern expressed about its fragility just a few years ago. So, one question relevant to thinking about the economy and, by implication, its likely performance: is the U.S. economy fragile?
I think the evidence of the past 25 years addresses this issue convincingly. The economy grew uninterruptedly from late 1982 until the middle of 1990, with a substantial net increase in employment economy-wide, diminishing inflation, and strong financial markets. Growth resumed in the spring of 1991, following a mild recession, and persisted, again uninterruptedly, through 2000. Again, the expansion of 1990s was accompanied by sizable job creation, healthy financial markets, and generally low inflation.
On the surface, these episodes don't depict a particularly fragile economy, and, if we look a little deeper, concerns about fragility seem even less compelling. Remember that during the 1980s and the 1990s there were on occasion material economic problems at some of our largest trading partners, including Mexico and Japan, and there was the stock market crash of 1987, the Asian financial and Russian debt problems of 1997-98, the demise of many domestic savings and loan institutions and major problems in commercial banking in the late 1980s-early 1990s. Note also that employment in the manufacturing sector peaked in 1979 and has been declining persistently if unevenly since. I'm sure I've excluded some of the shocks to which the economy responded, but the point is that the expansions proceeded largely unimpeded. Rather than fragile, the economy appears resilient and flexible, and these are the characteristics I would emphasize in thinking about the future.
But, you might object, didn't monetary or other policies play an important role in stabilizing the economy during these decades and, therefore, doesn't policy deserve credit for the record just described? There are two responses. First, I do think that policy played a constructive role over much of the period but, having said that, I do not think it deserves the lion's share of the credit, much as we policymakers might like to claim it. Rather, the relevant history is largely a testament to the fundamental soundness of our market-based system. Second, and in any event, if in thinking about the future you choose to assign a significant role to monetary policy rest assured that policy, too, will remain sound.
So, we have before us a flexible, resilient economy demonstrably capable of sustained economic growth even in the face of disruptions, characterized at the moment by persistent gains in employment and consumer spending, generally liquid financial conditions, and improving activity abroad. In these circumstances, the outlook would seem to be positive as, indeed, I think it is. To be sure, the housing sector has been a drag on activity and is of concern but I suspect that the bulk, although not all, of the adjustment in residential construction is behind us.
All of this is not to say that the business cycle has become an historical curiosity. Downturns in business activity will no doubt occur but, as I have learned from hard experience, their timing is exceedingly difficult to forecast accurately. And there may be comfort in recognizing that, overall, the economy appears to have become more stable since the mid-1980's, when the low inflation regime was established.
As you no doubt know, there is a virtually continuous flow of statistics on the economy over the course of a month and this "high frequency data," as economists like to say, may assist in identifying changes in conditions. While paying attention to the weekly and monthly reports, I would caution against putting considerable weight on any one of them. Most of the data are notoriously noisy and subject to revision; moreover, they frequently provide inconsistent, if not contradictory, signals. It is valuable, I think, in assessing incoming high frequency reports, to ask whether they are basically in line with your fundamental long-run outlook for the economy or if, alternatively, they represent a significant departure from expectations? To the extent that Federal Reserve communications leave the impression that high frequency observations are of great value, then this is something which I think we need to address. In my experience, a considerable accumulation of evidence usually is required before it is wise to change your view.
This warning might provide a convenient place to conclude these remarks, but there is another issue I want to call to your attention because it has important implications for thinking about the economy of the future. Broadly speaking, the issue is demographics and, in particular, the implications of the aging of the population for the labor market and for economic growth. To be sure, demographics also have significant implications for entitlement programs and the Federal budget, but those are matters for another day.
In this country, we have become accustomed to (net) increases in employment of at least 150,000-160,000 workers per month on average, roughly equal to the average monthly addition to the labor force. But labor force growth is projected to slow appreciably over the next ten years as the baby boom generation retires; depending on which reputable set of projections you select, we should probably expect monthly increments to the labor force of 110,000 on the low end to 150,000 on the high side. Increases in employment will adjust down similarly, other things equal, since people who are not available cannot be hired. Moreover, to the extent that labor force participation rates level off or decline—and this is widely anticipated in part because of the end of the run-up of participation rates of women—increases in the labor force will be even smaller than the estimates I just cited, probably by several tens of thousands per month.
Diminution of growth of the labor force could have pronounced implications for economic performance, since the volume of labor input is a major determinant of the aggregate supply of goods and services. Other things equal, slow expansion of the labor force would imply slow growth of the overall economy, at least relative to the experience of the past several decades. But other things may not be equal.
An acceleration in productivity, for example, could offset (or conceivably more than offset) the moderation in the increase in the labor force and sustain economic growth. Is such a development likely? It is difficult, to put it mildly, to answer this question definitively, but there are reasons to think that productivity may fill at least some of the gap. The fact that people on average live longer than formerly provides an additional incentive to investment in human capital, suggesting that skills, and therefore productivity, should benefit. Returns to education have been substantial for some time and this incentive works in the same direction. Business may also adopt more capital-intensive production processes over time.
Moreover, it is probably worth taking the labor force projections with a grain of salt. To the extent that the demographics make labor relatively scarce, we would expect compensation to rise more rapidly than otherwise, thereby inducing some to stay in the labor force longer than they otherwise would have, some to enter the labor force earlier than they would have, and some to work longer hours. Employers may also become increasingly flexible about work schedules and locations, for example, in order to improve the attractiveness of participation. Note, also, that I would not expect inflation to accelerate even if compensation does, as long as the Federal Reserve remains committed to a stable, low inflation policy.
It seems doubtful that these labor market adjustments will offset fully the effects of changing demographics; nevertheless, they serve to illustrate the inherent flexibility of a market economy in responding to such factors. And, of course, the U.S. participates in a dynamic global economy, suggesting other avenues for flexible adjustment.
Let me, in wrapping up, briefly summarize the theme of these remarks. Taking a step back, I have essentially been advocating the adoption of a long-run view of the U.S. economy—one that does not put inordinate emphasis on weekly or monthly developments. This longer-run perspective is appropriate to investors and reveals, I think, an economy anything but fragile; instead, a resilient and flexible economy is observed. And, even though demographic trends associated with the labor force might suggest slower growth in prospect over, say, the next ten years, the flexibility inherent in a market economy like ours suggests the likely emergence of changes which will work to moderate, and possibly eliminate, this prospect.