EconSouth (Fourth Quarter 1999)


Recognizing Economic Shifts
Is Key to Effective Policy

he current U.S. economic expansion, now in its ninth year, represents the longest peacetime expansion in the nation's history. For much of this period, professional forecasts as well as those of the Federal Reserve have tended to underestimate the strength of the economy, overestimate the propensity for it to overheat and exaggerate its vulnerability to unwanted inflation.

Because of uncertainties about the reliability of these forecasts, however, the Federal Open Market Committee (FOMC) has pursued a cautious path — being mindful of the inflation warnings being sent by the economic models but not overreacting and thereby potentially choking off the expansion. The result has been low inflation with uninterrupted prosperity. Unemployment is lower than it has been in decades, and more Americans are participating in the labor force than ever before.

A number of reasons, besides good monetary policy, have been cited for this extraordinary performance, including sound fiscal discipline and favorable external shocks. These factors have put downward pressure on both aggregate demand and prices and have temporarily enabled the United States to finance a growing trade deficit with short-term capital inflows at declining interest rates and an appreciating exchange rate.

Robert A. Eisenbeis

Questions for policymakers
Today, policymakers face new potential challenges to sustaining the expansion while keeping inflation tightly controlled. Three questions are at the heart of the policy issues facing the FOMC as it contemplates the economic outlook entering the 21st century. Is the current rate of growth sustainable and consistent with a noninflationary environment? When and under what conditions will observed increases in prices constitute simply relative price changes that should be left to natural market forces to work their way through the economy? Finally, what is the current state of monetary policy, and is it consistent with a low-inflation environment?

The clues to answering these questions will surely lie in issues the Fed has grappled with for some time. These answers center on the prospects for a continuation of strength in consumer spending, business investment, potential inventory accumulation and productivity growth.

Nationally, indications are that real gross domestic product (GDP) growth in the third quarter of 1999 rebounded from its 1.9 percent level in the second quarter to more than 5.5 percent. This pace is clearly above the 3.3 percent average real GDP growth that has been experienced over the current expansion. The driving factors behind this growth include strength in consumer demand, a somewhat more expansionary fiscal situation, the continued high level of housing activity, strength in business investment spending and apparent growth in productivity.

Considering inventory levels
It is widely expected — based upon past norms for the economy — that the rundown in inventories and the decline in inventory-to-sales ratios to very low levels will lead to a round of inventory accumulation and a consequent boost to real GDP growth. The Federal Reserve has tried to determine the extent to which business people feel that this inventory rundown is temporary or permanent. Interestingly, the overwhelming consensus is that the rundown is likely permanent.

The chief reasons given for this belief are based on the spread of technology, advances in communications and the use of more sophisticated analytic approaches to inventory management. Equally interesting is the fact that most business people feel the process is not yet nearly complete and, moreover, not driven in the short term by concerns about Y2K. Thus, the short-term offset may be less aggressive inventory accumulation but with the benefit of lower inventory overhang following any future downturn.

Productivity gains
On the productivity side, it is becoming increasingly clear — especially given the recent upward revisions of GDP statistics by the Bureau of Economic Analysis — that real economic growth during this expansion has been greater than thought, the personal savings rate has not been as low as feared, inflation has been even lower than the statistics suggested, and increases in productivity have surely been undermeasured. These GDP revisions help to reconcile the anecdotal reports of increased productivity, tight labor markets and the inability to raise prices that seem inconsistent with the predictions of formal analytical models. In particular, the increased estimates of real GDP growth reverse what had been thought to be nearly zero productivity increases in financial services and other segments of the service industry.

The revisions that change the treatment of government employee retirement funds to parallel treatment of private funds have boosted personal income and converted what had appeared to be a negative personal savings rate to a positive number in the 2 percent range, albeit still a low number. The increase in personal income, combined with a recent flattening of consumer debt burdens and improvements in consumer credit quality, now helps to resolve a puzzle about where the strength in consumer demand may be coming from — if not from a drawdown in personal wealth, including homeowners' equity and stock market profits. What does all this mean?

All of these factors tend to suggest that the economy is probably not subject, at least for now, to the same old speed limits that have historically applied before an outbreak of inflation appears. Detecting incipient inflation is made even more difficult in a low-inflation environment. Research has shown that low inflation does not mean that some prices won't increase. Indeed, with low inflation some prices will increase while others will decrease, thus making it critical for the Fed to disentangle movements in current inflation measures that result solely from changes in relative prices from broader underlying forces.

These issues with inflation represent a critical challenge for the forecaster and economic analyst. For example, it is clear that the favorable declines in commodity and energy prices in 1998 are being reversed, and this development will drive up measures of inflation in the short term because of the way that price indexes are constructed. But these relative movements in commodity and energy prices will be translated into an across-the-board increase in prices only if the movements can somehow be passed on to producers and consumers and then sustained without triggering subsequent moves to economize and shift to cheaper energy sources. Such an overall price level increase can happen only if monetary policy is somehow too accommodating.

Determining whether or not policy is too accommodating can be done only in the context of projections about the economy and the course for inflation. Waiting for actual signs that inflation is evident before a policy change is made is not an option. Because of the length of policy lags, once inflation is visible it will be, almost by definition, too late to effectively control it easily, and the required responses will be stronger and will surely cause lower growth and tighter market conditions than many would like or would have been necessary if policy had been more proactive.

Being a policy adviser at this point in our economic history is without question exciting and challenging. We all want the unprecedented economic expansion to continue indefinitely, and experience has shown that the best way the Federal Reserve can help to do that is by remaining vigilant in looking for signs of inflation and striving to sustain growth. All this must be done while charting a course through a different-looking economic landscape than we have experienced in the past.

By Robert A. Eisenbeis, senior vice president and director of research of the
Federal Reserve Bank of Atlanta

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