Gary H. Stern - President, 1985-2009
Published June 1, 2004 | June 2004 issue
Editor's note: These remarks were delivered to the Industry Relations Symposium of the National Automobile Dealers Association, in New York City, April 8, 2004.
Good morning. My "assignment" at this symposium is to provide an economic overview, obviously a sufficiently broad topic to permit me to discuss just about anything. So the first challenge is to decide what issues or aspects of the economy to emphasize and which to downplay, if not to ignore altogether. One of the things I want to avoid is overemphasis of monthly or other high-frequency data, as economists refer to it, which often can be misleading. Indeed, in my experience, it is far more productive to focus on longer-term trends in the economy, and I will highlight several of them today. To be specific, it seems to me that key to understanding the performance of the U.S. economy over the past decade (or more) are concepts like resilience, flexibility and productivity. I will elaborate on these themes this morning and, in the process, hope to provide a sense of both the current state of the economy and its prospects. Let me also note at the outset that I am as usual speaking only for myself and not for others in the Federal Reserve.
In that spirit, perhaps the first observation I would offer with regard to the national economy is that it has performed reasonably well over the past two years and thus has entered 2004 with the benefit of both momentum and balance. 2001 was of course a year of recession, but the economy rebounded thereafter, growing 2 1/4 percent in 2002 and expanding 4 3/4 percent last year. In fact, it took only two quarters for the economy to surpass its 2000 pre-recession peak. Many components of aggregate demand—that is, consumer spending on durable and nondurable goods and services, household demand for residential structures and business expenditures on equipment and software—have been expanding nicely, but in a sense the real action has been on the supply side of the economy. This is because there was, beginning in the mid-1990s, a distinct improvement in the pace of gain of labor productivity which has persisted to this day. This pickup in productivity is an extraordinarily significant development, and I will have more to say about it shortly.
The advance of the economy over the past two years or so has not been accidental. Both monetary policy, determined and conducted by the Federal Reserve, and fiscal policy—that is, federal government tax and expenditure policy—have been stimulative. Inflation and interest rates have been quite low by historical standards. A highly flexible financial system has served to underpin the expansion as well, for as inflation and interest rates declined, households were able to refinance existing mortgages in order to reduce monthly payments and/or to take cash out to finance other expenditures or to reallocate asset holdings. By now, we tend to take this process of mortgage refinancing for a variety of purposes for granted, but that shouldn't lead to the conclusion that it is unimportant. And, of course, low interest rates have directly supported residential construction and related activities, as well as other interest rate-sensitive sectors of the economy.
I have already commented, albeit briefly, on productivity and flexibility, so let me introduce the third theme I noted in the introduction, namely, resilience. There should be little doubt about resilience in view of the performance of the U.S. economy over the past 20-plus years. Resilience is illustrated by the fact that the economy continued to advance throughout most of the past two decades despite severe financial pressures and other dislocations at some of our major trading partners, including Mexico and Japan; the stock market crash of October 1987 and a significant bear market in equities earlier this decade; major problems in the savings and loan industry and to some extent in commercial banking as well in the late 1980s and early 1990s; a pronounced downsizing in our defense industry for a time followed by a renewed buildup; and finally the terrible events of 9/11.
Despite these shocks, and others that I have not listed, the domestic economy expanded over most of the 1980s and 1990s and over the past two years as well. Further, in both the expansion of the 1980s and that of the 1990s, net increases in employment were substantial, approaching or exceeding 20 million employees in each case. This record, in the face of the travails I earlier identified, is testimony to the resilience of the system. To be sure, appropriate policy responses helped the economy weather some of these shocks, but I think it would be a stretch to attribute the bulk of the economy's success to macroeconomic policy.
Having mentioned employment a moment ago, I should of course acknowledge that perhaps the principal concern with the current expansion has been job creation. The situation looks better today [April 8] than it did just a week ago because last Friday's employment report was stronger than generally expected and data for January and February were revised up. But I cautioned at the beginning of these remarks that we shouldn't overemphasize monthly statistics, and this admonition applies whether incoming data are surprisingly positive or negative. One important observation, it seems to me, is that typically over the long run lots of jobs are added in the U.S. economy. In fact, as others have observed as well, employment appears to grow along with population in the United States.
A second important observation pertaining to the labor market in the United States is that it is quite flexible. For example, in the mid-1950s, employment in the manufacturing sector of the economy accounted for fully one-third of total nonagricultural employment; today it accounts for about 11 percent. In absolute terms, employment in manufacturing peaked in 1979 at about 19.5 million workers, roughly 5 million above today's level. Nevertheless, output in manufacturing has increased over the decades as productivity has gone up, workers that have left manufacturing for the most part have been absorbed elsewhere in the economy, and living standards have improved measurably.
I have spent some time this morning describing the current state of the economy and its history over the past two decades in part because I think both help to set the stage for a "dispassionate" consideration of the outlook. It is important to recognize in this regard, however, that no one to my knowledge has particularly distinguished themselves as a short-term economic forecaster. Brushing this caveat aside, and considering the current health of the economy as well as its track record, it seems to me likely that the economy will grow 4 percent to 5 percent in real terms this year and that inflation will remain benign. I realize I am not going out on a limb in making this forecast, but then, one has to call them as one sees them.
Many of the major factors likely to propel economic activity have already been identified: The economy has begun the year with momentum and a notable lack of imbalances; monetary policy is accommodative; fiscal policy is stimulative; productivity is on a favorable trend; and the economy is fundamentally flexible and resilient. These factors augur well for economic performance, and it is important that we adhere to policies that support these fundamentals. In particular, policies which have promoted competition and thereby enhanced flexibility and resilience—policies which have led to deregulation of domestic industries, for example, and which have stimulated international trade—are central to our future economic success.
It is, moreover, my suspicion that pro-competitive policies have been an element in the improvement in productivity that we have experienced. Businesses, largely unable to raise prices because of the competitive environment, have had to focus on the cost side of their activities in order to achieve gains in profitability. I suspect that this pressure to contain and to reduce costs has helped to accelerate the adoption and application of new technology to the "on the ground" production of goods and services in the United States, which in turn has translated into rapid productivity advance.
Labor productivity is undoubtedly one of the keys to the long-run performance of the economy. Its definition, output per hour worked, implies this, for the more output produced for an hour of labor of input, the higher the aggregate level of economic activity and of living standards. The United States will thus be fortunate should the favorable trend in productivity persist.
While the performance of our domestic economy over the past decade or two has generally surpassed that of other large industrial countries, in some cases by considerable margins, there are other major economies, notably China and India, which have recently been expanding rapidly. These two economies, like the United States, have experienced rapid improvement in productivity, as would be expected as resource allocation improves in nations with such large populations. It seems that the emerging success of China and India has added to the competitive environment globally and that the additional capacity these economies bring has served to further restrain price pressures in a range of specific markets.
In a sense, China and India represent significant, positive aggregate supply shocks and, together with productivity gains in the United States, the global economy has seen an appreciable increase in productive capacity. As a consequence, it is possible to get more output with the same inputs, and so we would expect rising living standards over time. Moreover, China and India present tremendous opportunities for other economies around the world, including our own, for as standards of living rise in those two economies demand for an expanding array of relatively sophisticated products will rise as well. And, again, given their populations, the increase in demand could well be substantial since scale clearly matters.
While I have been emphasizing positive aspects of the domestic and international economic situation, there are, to be sure, areas of concern. Let me touch on three at this point, starting with employment.
As I noted several minutes ago, the employment situation looks better today [April 8] than it did a week ago. Nevertheless, one of the unusual features of the current expansion has been the delay of, and then only grudging increases in, employment. Many have attributed this pattern to the rapid gains in productivity experienced in recent years and, as a matter of arithmetic, this is undoubtedly correct. Still, as we saw in the late 1990s, sizable employment gains can go hand in hand with large advances in productivity, demonstrating that we need not assume that increases in productivity preclude a sustained pickup in job creation.
In fact, a second concern is almost the opposite of the first. Some analysts have identified prospective labor shortages as a potential constraint on future economic growth in the United States. The basis for this observation is demographic trends which indicate that the working-age population in the United States will increase only modestly in the years ahead. To an economist, and I admit to membership in the profession, labor shortages are unlikely to persist, if they materialize at all. Rather, I would expect labor compensation to rise sufficiently over time to clear the market, both by inducing current and prospective employees to enter the labor force earlier and to remain in it longer than they otherwise would and by inducing business firms to substitute other inputs for increasingly expensive labor. Increased immigration is another potential response as well. In any event, there is nothing novel about these processes; this is the way market economies work.
A third concern, more prominent a year ago than it appears to be today, is deflation. It was not too long ago that forecasters, analysts, policymakers and others were voicing concern about its possible emergence in the United States. Such concern may have been well founded, although the consequences of modest deflation are far from clear to me. The historical record on the performance of economies during periods of deflation—that is, periods of sustained decline in broad measures of prices—is decidedly mixed. And on the theoretical level, it seems to matter a lot if deflation is or is not widely anticipated and if it stems from a positive supply (say, productivity) shock or from a negative shock to aggregate demand for goods and services. In this vein, perhaps deflation is best viewed as an indicator which in turn encourages policymakers and others to look carefully into its origins before determining an appropriate remedy.
In trying to summarize these somewhat scattershot remarks, I find there are three points I want to stress.