Gary H. Stern - President, 1985-2009
Published September 1, 1996 | September 1996 issue
Several months ago, the annual report edition of this publication contained our essay "Formulating a Consistent Approach to Monetary Policy." In that essay, we addressed several policy issues, including the Federal Reserve's commitment to the objective of low inflation, reasons why low inflation is favorable for growth and prosperity, and the Federal Reserve's ability to achieve low inflation. We also discussed means to assure that policy responses to business cycle fluctuations are consistent with the long-run low inflation objective.
Among the reactions to the essay, as well as to recent monetary policy, has been a concern that the Federal Reserve is unnecessarily restraining growth. Critics maintain that the economy would grow more rapidly than the 2.5 percent average of the past four years, if only monetary policy would permit it. Presumably, critics believe that the Federal Reserve's emphasis on low inflation has inhibited economic performance.
We need a framework to examine these contentions and, fortunately, economic principles supply one. Long-term growth of an economy is simply the increase in labor input plus the productivity of that input. That is, overall economic growth is essentially composed of the growth in employment and the growth in labor productivity. What do we know about these two factorsemployment and productivity?
We know, first, that in the long run employment increases are limited by growth of the labor force; gains in employment cannot persistently outpace the expansion in the supply of labor. This observation is particularly relevant to the current situation because by almost any measure the economy is operating at or very close to full employment, and labor markets in general are tight. An implication of this situation is that on average future employment increases will be constrained by increases in the labor force, which are determined largely by long-run demographic factors. Given the demographics, the labor force is projected to expand by perhaps 1 percent per annum over the next several years, which suggests sustainable monthly increases in employment of 110,000 to 120,000.
Critics might disagree with this description of the labor market. To them, an aggregate unemployment rate of about 5.5 percent of the labor force represents a large pool of unutilized or underutilized workers. In reality, the situation is far more complicated. For one thing, because of demographic shifts in the composition of the labor force, the unemployment rate prevailing today (about 5.5 percent) is comparable to the 4 percent rate widely regarded as full employment in the 1960s. Further, roughly 99 percent of the work force currently is employed or has held a job in the last six months. Every week on average over the last four years, approximately 350,000 workers have been separated from jobs and 400,000 have found employment. In short, the labor market is highly dynamic, and the measured unemployment rate captures these flows into and out of work at a moment in time. As best we can judge, and certainly consistent with pervasive anecdotal evidence of labor scarcity, the static pool of the unemployed is small and, therefore, little is to be gained from monetary stimulus, especially considering the risks of an acceleration of inflation.
As to labor productivity, its long-run trend rate of improvement has been a bit over 1 percent per year since the late 1970s. There has been much discussion recently that productivity has been mismeasured and that this figure significantly understates productivity growth, but there is a dearth of evidence in support of this contention. To be sure, productivity has risen relatively rapidly in the manufacturing sector of the economy, but economywide statistics display no such improvement.
The sum of the demographic-based increase in employmenta little over 1 percent per yearand the measured gain in productivityalso a little over 1 percent per yearyields about 2.25 percent as trend growth of the economy, the conventional estimate. Measurement problems that may have contributed to underestimates of output and productivity in the past imply that the economy can expand more rapidly than 2.25 percent on a sustainable basis and, importantly, also imply that the economy has been growing above this pace for some time. They say nothing about the contention that Federal Reserve policy has restrained growth. Indeed, an increasing body of empirical evidence suggests that the most significant contribution monetary policy can make to productivity improvement is to achieve and maintain a low inflation environment, precisely the objective of the Federal Reserve.
The real constraint on economic growth is expansion of the labor force. Because of demographics, our economy will expand in the long run at the rate of productivity improvement plus about 1 percent (the annual increase in labor supply). To the extent that growth exceeds the number derived from this calculation because the increase in employment exceeds demographic fundamentals, such growth will prove unsustainable when the fundamentals ultimately assert themselves. In fact, it is critical to note that, even if productivity has been underestimated recently, it is nevertheless true that employment increases have exceeded trend expansion of the supply of labor.
Were productivity improvement to accelerate, so that the economy could grow at, say, a 4 percent rate over the long run, monetary policy would certainly welcome it. Policies to increase productivitypolicies which enhance the quality of the labor force or the quantity and quality of the capital stock with which labor worksare highly desirable from the point of view of growth and sustainable prosperity, but are largely beyond the scope of the Federal Reserve.