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
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
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.