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The Federal Reserve's Contribution to Sustained Growth

June 4, 1997
Milwaukee Investment Analysts Society | Milwaukee, Wisconsin 

The Federal Reserve's Contribution to Sustained Growth

Good afternoon. It's a pleasure to be back in my home town, although I'll try not to get irrationally exuberant about it. And it's similarly a pleasure to have this opportunity to share some thoughts with you regarding the state of and prospects for the U.S. economy, and also to discuss some broader public policy issues related to these topics. By way of introduction, I think it fair to say that we find ourselves in favorable business and financial circumstances, circumstances which show every promise of continuing. Nevertheless, concern has been voiced in recent years about the outlook for economic growth, which many see as unsatisfactorily slow. This concern leads naturally to a search for the sources of economic growth and for policies that can enhance growth. In this regard, recent scholarship indicates that growth largely stems from private sector creation and implementation of new and improved technologies, and that growth can be promoted by providing the private sector with a stable environment in which technological progress can thrive.

Let me begin to get more specific about several of these issues by first taking a few minutes to discuss the substance of the generally positive situation in which we find ourselves. The current expansion of the U.S. economy began in the spring of 1991, so it has already achieved its sixth birthday. It has been a long and remarkably well-balanced expansion, accompanied by modest inflation, moderate interest rates and advancing equity prices, In general over this period, employment has increased significantly, the unemployment rate has fallen, and business activity in most sectors of the economy and most regions of the country has improved demonstrably. Moreover, this period of growth has followed on the heels of the expansion of 1982-1990, so our economy has in fact churned out an enviable record for an extended period.

Furthermore, prospects seem excellent for this positive performance to continue, with economic growth sustained through the balance of this year and into the next. Evidence that the economy might somehow “run out of steam” is lacking; indeed, there are few, if any, hints of serious trouble spots at the moment.

Among other things, one has to guard against complacency in this setting, and we should bear in mind the difficulty of accurately forecasting turning points in economic activity. Most downturns come as a surprise to most forecasters and to most policymakers. Still, the economy appears well positioned for another year of balanced growth.

After the macroeconomic turbulence of the 1970s and early 1980s, our more recent experience is both welcome and reassuring. Further, I suspect that this experience has been no accident, because as a nation we generally have in place incentives favorable to improved productivity and growth. Moreover, through much of the expansion of the 1980s and in this decade as well, inflation has been contained to moderate rates, a characteristic shared by the long expansion of the economy during the 1960s. Causality is exceedingly difficult to prove in economics, but we seem to be building a considerable body of evidence which suggests that, at least in the United States, modest inflation and prolonged periods of growth go hand in hand.

As it turns out, such a relation between modest inflation and sound economic performance is found in the data for many countries around the world, which is one reason why more and more central banks are emphasizing attainment of low inflation as the objective of monetary policy. So it is with the Federal Reserve, and I take some satisfaction in our progress on this front. But let me emphasize that our commitment to low inflation, significant as it is, is not the ultimate goal of policy. Our ultimate goal is sustained growth and rising standards of living over time. We have concluded that the most important contribution the Federal Reserve can make to growth and improvement in living standards is the achievement and maintenance of low inflation, and we are committed to this policy.

Let me expand on this point a bit. The reason the Federal Reserve and other central banks have committed to low inflation objectives is an accumulation of evidence indicating that economies perform better, in terms of growth, employment and improving living standards, in low-inflation environments that they do when inflation is persistently high. This evidence is principally a comparison—across countries and over long periods—of the association between economic performance, measured, say, by the growth of output or growth of productivity, and inflation. The association indicates a negative relation; that is, the higher the rate of inflation, the lower the rate of growth of the economy. Environments of absolutely high inflation appear to be particular devastating to economic performance.

To examine this further, let's explore the subject of economic growth. A good way to start to think about growth is that it is the result of the expansion of total hours worked by employees together with the productivity of that labor; that is, it is a question of labor input and productivity of that input. You might think that the quantity and quality of a nation's capital stock would also affect growth significantly, and it does, but these effects are captured by the labor productivity term. The negative relation observed between inflation and growth is, in essence, then, largely the result of inflation's deleterious effects on productivity, a subject I will get to momentarily.

The evidence of the relation between inflation and growth, based as it is on association, does not demonstrate causality, so we should ask ourselves if in fact it seems reasonable that low inflation would be relatively favorable for growth and, conversely, that high inflation would be unfavorable? I believe that there are two broad reasons why the answer to the question is “yes,” it is reasonable.

First, low inflation is favorable to optimum allocation of “real” resources, that is, labor and physical capital. This is significant, because the closer to optimum is resource allocation, the more output an economy produces for the same inputs. Thus, optimal allocation of resources is obviously positive over time for living standards. This positive effect on resource allocation results because price signals are more easily and accurately interpreted in a low-inflation environment. Let me explain.

Relative price changes provide an important guide to resource allocation in an economy. For example, a change in relative prices resulting from a change in demand patterns should shift resources and production from the activity whose price has fallen relatively to that whose price has risen, while a general rise in prices—inflation—should not alter resource allocation in this way.

But in an inflationary environment, it may be difficult for individual decision makers to distinguish between inflation on the one hand and a change in relative prices on the other. Such confusion is especially likely if high inflation is correlated with variable inflation—inflation rates which fluctuate substantially from period to period—as it appears to be. In short, because of the confounding of price signals, resources may be seriously misallocated during inflationary periods, to the detriment of output and living standards.

Institutional arrangements add to the problems stemming from high and variable inflation. Since the tax system is not fully indexed, inflation may adversely affect incentives to work and to invest. In the extreme, considerable resources may be wasted in efforts to avoid or to offset the ravages of inflation. And, without widespread indexation, inflation may well result in capricious transfers of wealth.

All of these effects diminish when inflation is persistently low. Overall, there is little question that low inflation implies less uncertainty about the future. Indeed, in the Federal Reserve, our working objective is to reduce inflation to the point where it is no longer a factor in economic decision making. As we succeed, resource allocation moves closer to optimal, with attendant benefits for growth and living standards.

The second broad reason why low inflation favors growth is that it contributes to financial stability. A low inflation economy is less likely to engender the sharp swings in asset prices and in expectations about such prices that have been so devastating to the financial system from time to time.

In a sense, problems associated with the misjudgment of asset prices and their prospects are no different than the confusion about relative vs. general price changes I just described. Investors and creditors misjudge price signals and draw erroneous conclusions, financial resources are then misallocated, and disruptions occur.

Financial stability is vital to a prosperous economy in several ways. Credit decisions, which determine the allocation of financial resources, are likely to be closer to optimal in a low inflation economy. And financial stability enhances an economy's ability to withstand “shocks”—run-ups in energy prices, significant technological changes, unforeseen developments in the economies of major trading partners, and so forth. Certainly, such events will cause dislocations, but a financial system which can absorb them without significant feedback to business activity helps to limit the extent and duration of the disruption. In these circumstances, growth will be affected less than it would be under conditions in which the financial sector magnifies and spreads the effects of the shock. Further, it is likely to be easier to identify the effects of shocks and the proper responses to them in a low-inflation environment.

To be sure, all this talk about the benefits of low inflation would not matter much if the Federal Reserve, through monetary policy, cannot achieve and maintain low inflation. Fortunately, on this subject there is considerable agreement among business economists, academics and practitioners. Most agree that inflation is first and foremost a monetary phenomenon; it results from a long-term pattern of money creation which is excessive relative to the economy's ability to produce goods and services. Further, there is agreement that the supply of money is determined by the central bank in the long run. Thus, with appropriate policy, the Federal Reserve can achieve and maintain low inflation—it should be expected to do so and should be held accountable for doing so. The operational responsibility of the Federal Reserve, then, is to provide for long-run, expansion of the money supply consistent with low inflation.

It should be noted that, even with our economy's favorable track record and positive short-term prospects, considerable concern has been expressed over the past year or two about the outlook for growth. Economists, both inside and outside the government, have predicted expansion in real gross domestic product per capita of only about 1 to 1 1/2 percent per year, and this pace is considered unsatisfactory by many. An important question, then, is how can this performance be improved?

Based on my earlier comments, a key ingredient in growth is labor productivity, and two economists at the Minneapolis Fed have been looking carefully at factors which influence productivity significantly. We have just published their analysis, so let me share some of it with you.

The productivity of labor—essentially output produced per hour worked—depends on physical capital, as noted earlier, and on human capital, the education level of the labor force, for example. But labor productivity also depends on the available state of technology, which refers to the efficiency with which a given set of productive inputs is employed. It has long been recognized that improvement in the state of technology—technological progress—is an important factor in the growth of labor productivity.

One implication of this chain of reasoning is relatively clear: to improve economic growth, we need to promote technological progress. How might this be done?

The study I am describing takes the view that the state of technology in a country depends, in part, on the pool of world knowledge at a given time and, perhaps more importantly, on internal institutional arrangements that promote or retard the use of this knowledge. Technological progress, therefore, depends on the rate at which world knowledge grows and on the extent to which a country's institutions provide enhanced incentives for employing the expanding world knowledge. Government policy, then, can have an appreciable impact by ensuring that institutions are provided with incentives to use and to adapt world knowledge and with a stable environment in which to do so.

More specifically, recent evidence shows that the state of technology of a country is related positively to such policies as, for example, deregulation and openness to foreign trade. Conversely, countries which erect barriers to the use of world knowledge—barriers which limit international trade, tightly constrain business practices or reduce competition—tend to have relatively poor states of technology.

One has to be cautious in applying this evidence to the United States, because we are already relatively open to new ideas and products. But recent policy changes—notably deregulation of many industries—and commitment to certain existing policies—a preference for open trade and a strong reluctance to protect particular industries—have led to gains in the use of world knowledge and in labor productivity. Such policies should be continued and extended, where appropriate, in order to encourage technological progress and, ultimately, real economic growth per capita. And I would add, as implied earlier, that a noninflationary, stable business and financial environment is critical to sustained gains in productivity. This is where monetary policy—the Federal Reserve's commitment to low inflation and attendant benefits in terms of resource allocation and financial stability—contributes positively to long-term growth.

Let me close by summarizing the points I have tried to emphasize this afternoon. First, the business outlook is favorable, and the economic expansion should continue, in my judgment. Further, it is not accidental that in the United States extended periods of growth are associated with modest inflation, and the Federal Reserve's commitment to low inflation is unwavering. In and of itself, this augurs well for economic performance. Finally, though, long-term economic growth in our economy depends importantly on the path of labor productivity which, in turn, is intimately tied to technological progress. Policies which promote such progress and provide an environment in which it can thrive are critical to our economic well being.

Thank you.