Speech by J Alfred Broaddus, Richmond Fed, 5 Jun

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Remarks by J. Alfred Broaddus, Jr, President, Federal Reserve Bank of Richmond, Washington Association of Money Managers, Embassy Row Hotel, Washington, DC, 5 June 2002.

An Update on the Economy and Monetary Policy

It's a pleasure to be with you once again. I remember well meeting with you exactly a year ago today, when you honored me with the inaugural WAMM Hall of Fame award. What I especially remember about that happy event in my life is that you presented the award to me before I made my speech. I remember thinking to myself that the pressure was really on and I needed to make a good speech. With that in mind, I was both relieved and pleased when you invited me back again this year. Seriously, I'm honored by these repeat invitations - you are a great audience, and I always enjoy being with you. And my Hall of Fame certificate is hanging proudly on my office wall. Actually, I had wanted to hang it prominently in our living room with a little spotlight on it, but my wife, Margaret, thought that might be a little over the top.

I'll follow my usual format tonight if I may: first, a few comments on where the economy stands currently; second, a few remarks about where it may be headed over the remainder of the year; and, finally, some thoughts about monetary policy. Regarding the latter, as usual I will shy away from any specific comments about what the Federal Open Market Committee may do or not do with the federal funds rate target in the weeks immediately ahead. Any remarks I offer along those lines might well be confusing rather than constructive, and, as you know, there is now an active market in federal funds futures that summarizes the funds rate predictions of a lot of people who are willing to bet real money on their predictions. So my comments on policy will focus more on our longer-term strategy, where I think I can add more value.

The Current Picture

With respect to the current economic picture, let me first offer a couple of background remarks. You may remember that when I was here last June, my bottom line was that while the economy - which by then had been decelerating for more than a year - could reaccelerate fairly soon, it was not clear that it had bottomed out yet, and there were still considerable downside risks in the outlook.

That conclusion turned out to be remarkably prescient compared to my usual fairly dismal forecasting performance, although that was due as much to the extraordinary events that unfolded over the next several months as to any analytical prowess on my part. After remaining flat in the second quarter of last year, real GDP declined at about a 1 percent annual rate in the third quarter. The terrorist attacks, of course, occurred close to the end of that quarter. As you know, the immediate economic impact of those awful events was negative. Consumer confidence and spending, in particular, dropped sharply in the wake of the attacks, and as we entered the fourth quarter, just about everybody expected the economy to decline in the quarter.

Some key indicators of economic activity did decline in the fourth quarter. Most notably, nonfarm payroll employment declined by close to a million jobs between the third quarter and the fourth quarter, and the average monthly unemployment rate rose from 4.8 percent to 5.6 percent. Moreover, business investment in equipment, software and new structures continued the decline that had begun in the spring. But consumer spending accelerated sharply to a 6.1 percent annual rate of increase, spurred by extraordinarily aggressive sales incentive programs offered by U.S. automakers. On net, real GDP rose at a 1.7 percent rate in the fourth quarter, again, an outcome totally unexpected at the beginning of the quarter just 19 days after September 11. The rise in GDP in the face of a significant decline in employment, of course, implied a substantial rise in productivity. Indeed, productivity increased at a very healthy 5 ½ percent annual rate in the quarter.

From the standpoint of future economic prospects, though, probably the most important development in the fourth quarter was the liquidation of almost $120 million in business inventories - a record - which set the stage for the much earlier than anticipated recovery of business activity we are now enjoying. The public's strongly positive reaction to the new car incentives obviously facilitated this liquidation enormously, and the exploitation of new IT capabilities for managing inventories also probably played a role. In any case, by year-end, inventories were in much closer alignment with sales than a few months earlier, and while liquidation continued in the first quarter of 2002, it did so at a much reduced rate. As a result, even though final sales grew more slowly in the first quarter than the fourth quarter, a smaller portion of these sales were supplied from inventories of previously produced goods and a larger portion from current production, which enabled the remarkably robust 5.6 percent rate of growth of GDP in the first quarter. Factory output, which had declined steadily for many months, turned up in the first quarter. Moreover, while employment continued to decline, it declined at a significantly diminished pace from the fourth quarter drop, and the unemployment rate held steady at about 5 ½ percent.

To sum up: it now appears that the economy bottomed out either late in the fourth quarter or early in the first quarter. If so, although some industries - especially manufacturing industries - suffered full-blown downturns, the overall recession that began last spring was relatively brief and mild by post-World War II standards. In part this may reflect the innovations in inventory management I mentioned earlier. But it likely resulted also from the Fed's persistent and substantial easing of monetary policy throughout 2001. As you know, we reduced our funds rate target from 6 ½ percent in January last year to 1 percent in December. This reduction and its cumulative effect on other interest rates made those inviting car financing incentives feasible, and also helped hold mortgage rates down, which in turn supported remarkably strong housing activity throughout the recession.

My purpose here is not to brag about Fed policy but to make a point I try to drive home whenever I make a talk like this: namely, that we were able to ease policy as aggressively as we did last year precisely because we had succeeded over the previous several years in at least approximately achieving the longer-term price stability goal I've been preaching about to this audience for so many years. Not only has measured, current inflation been persistently low in recent years, but available inflation indicators suggest that fears of future inflation for now at least are no longer a pervasive consideration in financial and business decisions. Consequently, the Fed was able to shift to a strongly accommodative posture last year with much less risk of reawakening inflation worries than in other recent downturns.

The Outlook

Let me turn now to the outlook for the next several quarters. In a word, it's murky. The recovery at this point seems firmly in place. But how strongly and rapidly it will proceed from here is an open question in my view. The boost to production from diminished inventory liquidation has pretty much run its course. Hence prospects going forward will depend on the strength of final demand, both domestic and foreign, for U.S. goods and services.

There are certainly indications of healthy demand in some sectors and industries. In the residential real estate arena, sustained low mortgage rates have helped drive existing home sales to record levels, and while new home construction and sales have moderated recently, they are still robust by historical standards. Sales of new cars and other durable goods were strong in April, and consumer confidence is rising according to both the Michigan and Conference Board indexes. Elsewhere, industrial production has increased for four consecutive months after declining steadily since mid-2000, and both new factory orders and shipments overall, and new orders and shipments of nondefense capital goods were stronger than expected in April. Moreover, an improving corporate profits performance and the recent introduction of new tax incentives aimed at stimulating business investment may accelerate outlays for new capital equipment going forward. Finally on the positive side of the ledger, there are for the first time in a while signs of life in our export markets in Japan and Europe.

All well and good. At the same time, though, some of the recent data suggest that while the recovery will continue, it may continue at a subdued pace in the months immediately ahead. Although durable goods sales have been hefty of late, there is some initial evidence that car sales softened in May, and the growth of overall household spending, including spending on nondurable items and services, appears to be throttling down in the current quarter. The stock market's recent lackluster performance may be reinforcing this trend. With respect to business spending, I noted a minute ago that new orders and shipments for nondefense capital goods rose sharply in April. This was encouraging because most observers believe that business investment in new capital equipment and software must accelerate for the recovery to gain real momentum, and orders and shipments of nondefense capital goods are a leading indicator of equipment and software outlays. (Weakness in business investment, as you know, was a principal factor pulling the economy down into recession in the first place.) But these monthly reports on capital goods orders are volatile. The April increase had been preceded by a sizable drop in March. And capacity utilization is still relatively low despite the recent increases in industrial production I cited earlier.

Perhaps the most important soft spot in the recovery presently, however, is the labor market. For several months earlier this year, the initial employment reports showed an increase in jobs for the month, but subsequent revisions turned the increases into declines. For the moment the data show a modest increase in jobs overall in April - the first increase since last July. The unemployment rate, which dropped briefly below 4 percent in early 2000 has now risen to 6 percent. The job report for May will be released Friday morning and will undoubtedly be scrutinized for any hints it may offer regarding the direction of labor market conditions.

My personal view, for what it's worth, is that the strength of final demand and hence the strength of the recovery over the remainder of 2002 will depend to a large extent on the interplay between the labor market and productivity growth. (Productivity growth, of course, is just the growth of output per hour for an average worker.) To put this point in perspective, there is now a fairly broad consensus among economists that the underlying trend growth of productivity - what some people call structural productivity growth - increased from about 1 ½ percent annually on average between the mid-1970s and the mid-1990s to a range of 2 to 3 percent in the late '90s.

An interesting feature of the recent recession was that measured productivity growth remained relatively high throughout the downturn rather than dropping sharply as it frequently had in previous recessions. This has led many analysts to project that trend productivity growth will remain relatively high in the recovery, a conjecture reinforced by the nearly 5 ½ percent annual rate increase in measured productivity in the final quarter of 2001 I mentioned earlier and the 8 percent plus growth rate in the first quarter of 2002. These quarterly growth rates are not unprecedented, but they are very high by historical standards.

Let me be very clear here. Higher productivity growth is unambiguously better than lower productivity growth. If the Godfather is the source of all wisdom, then productivity growth is the source of all economic progress. In the very near term, though, rising productivity growth could have disparate effects on the pace of the recovery. On the positive side, perceptions of strong productivity growth in the corporate sector would tend to increase expected future returns to investment and therefore stimulate investment. Again, weak business investment contributed importantly to the recession, and its continued sluggishness is one of the principal drags on the economy currently. On the other hand, strong productivity growth in the near-term would enable firms to economize on labor input, which would tend to extend the current softness in the job market. Firms typically rehire workers cautiously in the early stages of a recovery, which gives measured productivity its strongly procyclical pattern, and this pattern may be even more than normally evident in the current recovery. Over time, of course, sluggish growth in jobs could negatively impact consumer confidence and retard the growth of consumer spending - and as you know, consumer spending accounts for about two-thirds of total domestic final demand.

In short, I think the relative strength of these two opposing, potential results of higher productivity growth in the near-term will largely determine how robust the recovery is in the remaining weeks of the current quarter and over the next several quarters.

The Challenge for Monetary Policy

These remarks provide a convenient segue to the comments I want to make about monetary policy. Up to this point I've focused almost exclusively on real economic activity: production, employment and so forth. I haven't said very much yet about the behavior of prices or inflation, which I've always emphasized in earlier visits. I don't want to disappoint you, so let me turn to these topics now, although you may find the tone of some of my comments about price behavior a little different than in years past, at least superficially. Over the years I've acquired a reputation as an anti-inflation hawk. Last year, though, I strongly supported our aggressive policy easing, and that's led some of my friends to tell me I've turned into a dove. One of our Bank's former directors went so far as to send me a dove kite, which my wife has been trying to fly in our front yard to the considerable amusement of our neighbors.

The hawk-dove dichotomy may have its uses, but it also can be misleading and confusing. The Fed's principal objective now, as I see it, should be to maintain the price stability we appear to have achieved - no acceleration of inflation, but no unexpected move in the other direction either - because doing so will permit the economy to grow at its maximum potential, sustainable growth rate over the long run. Indeed, a strong case can be made that, over time, price stability and maximum sustainable growth in production and jobs are really two sides of the same coin. If you have one, you're likely to have the other. I obviously can't speak for my FOMC colleagues, but my own view is that a longer-term annual increase in the core personal consumption expenditures index in a range of ½ percent to 1 ½ percent is a good working definition of price stability in practice. We are in that range now, and I would like to see us stay there.

It's helpful to keep this framework in mind in thinking about the role of monetary policy in the current recovery. Operationally, the Fed's task now is to foster continued price stability as best we can by helping keep the growth of actual aggregate demand in the economy in line with the economy's longer-term potential growth rate as defined by the sum of trend productivity growth and labor force growth. Achieving and maintaining balanced growth in this way as the recovery proceeds won't be easy, but this is what needs to occur. Sustained demand growth above potential will lead eventually to inflation. By the same token, sustained demand growth below potential could yield further disinflation, which could restrain the recovery. Many Americans are not accustomed to thinking of disinflation as a problem. Indeed, disinflation was the objective of monetary policy when inflation was unacceptably high. But with the underlying inflation rate now in the neighborhood of 1 percent by some measures, further disinflation, if unchecked, could lead eventually to deflation. Japan's experience in recent years amply demonstrates how difficult it can be to revive an economy once it dips into deflation, particularly when nominal interest rates are close to zero and hence can't be lowered significantly further to stimulate the economy.

The key point here is that a departure from price stability in the direction of either rising inflation or significant further disinflation would destabilize the economy and complicate the recovery. What's different about this recovery from other recent recoveries is that the respective risks of these two outcomes are more evenly balanced in the present recovery. To be sure, the risk of excessive demand growth and rising inflation is always present, and you can rest assured that if we appear to be moving back in this direction as the recovery proceeds, I will be back with my anti-inflation sermon if you honor me with another invitation next year.

At the same time, we need to give adequate weight to the risk of excessive disinflation. In this regard, it's worth noting that the core PCE inflation rate has declined from a 1.6 percent annual rate in the 12 months that ended last November to only 1.2 percent since then. I don't want to overstate the downside risk in the outlook. Disinflation has appeared frequently in the initial stages of other recent recoveries only to be replaced relatively promptly by accelerating inflation. But things could turn out differently this time. For one thing, the absence of significant inflationary expectations presently - a result of the Fed's currently high credibility for low inflation - will induce many firms to hold the line on price increases for fear of losing customers. Most of our business contacts at the Richmond Fed tell us that they still have "no pricing power." Beyond this, the potentially restraining short-term impact of higher productivity growth on job growth and consumer demand I mentioned earlier may also work to balance the inflation-disinflation risks more evenly in this recovery.

At this point, some of you may be thinking: "Gee, this guy has been lecturing to us for years about the need to achieve price stability, which he defines as core PCE growth between ½ percent and 1 ½ percent. The current rate is well within this range. Why isn't he happy?"

A fair question. Actually, I am pleased with the recent behavior of the price level, and I should emphasize that I don't see either a near-term acceleration of inflation or a drop into deflation as a clear and present danger to the economy. But monetary policymakers aren't paid to be complacent. The risks to price stability are still out there - they're just more symmetrical than in earlier periods, and in some ways that makes our job tougher. We will need to monitor the actual performance of the economy against its potential especially closely in the weeks and months to come in order to adjust our policy settings in a manner that maintains price stability and fosters sustained growth. As I said earlier, this won't be easy. But I believe we are up to the challenge, and I can assure you that we will give it our very best shot.