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
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 comparisonacross countries and over long periodsof 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 pricesinflationshould 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 inflationinflation
rates which fluctuate substantially from period to periodas 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 shocksrun-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 inflationit 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 laboressentially output produced per hour
workeddepends 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
technologytechnological progressis 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 knowledgebarriers which limit international
trade, tightly constrain business practices or reduce competitiontend
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 changesnotably deregulation of many industriesand
commitment to certain existing policiesa preference for open trade
and a strong reluctance to protect particular industrieshave 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 policythe Federal Reserve's
commitment to low inflation and attendant benefits in terms of resource
allocation and financial stabilitycontributes positively to long-term
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