FRBSF Economic Letter
1998-06 | February 27, 1998
This Economic Letter is adapted from speeches given recently by Robert T. Parry, President and Chief Executive Officer of the Federal Reserve Bank of San Francisco, at the Bay Area Council 1998 Outlook Conference and at Town Hall Los Angeles.
As the year begins, the overall economic picture looks pretty good. Both the national and state economies are in the midst of strong, sustained expansions, and inflation remains remarkably well-behaved. But there are some areas of uncertainty to consider as we look ahead – not the least of which is the financial crisis in East Asia.
We are now in the seventh year of an expansion and still going strong in almost all sectors and regions of the economy. This strength has helped bring the federal deficit very close to balance and create jobs for American workers. In fact, the unemployment rate in January was 4.7 percent, close to the lowest levels in 25 years.
Often this combination – fast growth and low unemployment rates – means that inflation will start to heat up. But we have had good news on that front, too. The increase in the core CPI in 1997 was 2.2 percent – the lowest yearly increase since 1965. The Fed always pays close attention to inflation, since keeping it under control is our primary responsibility. So let me spend a few minutes on three reasons for its good behavior.
First – productivity. Last year, the numbers showed productivity growing at a faster rate, and that is holding down business costs. Some of the improvement is probably coming from the high level of investment in computers and other high-tech developments – especially in the last five years. The impact on productivity growth seems to be borne out by the very strong business profits we have seen, which have been reflected in the booming equity markets of recent years.
Second, people seem to have changed their expectations about inflation. For example, surveys showed that people’s expectations about inflation ten years out have fallen from around 3 percent to just over 2-1/2 percent. Similar evidence comes from analyses of the Treasury’s new inflation-indexed bonds. Lower expectations affect inflation because they lead businesses to keep a lid on the prices of their products, and they lead workers to bargain for smaller wage increases. At the Fed, we would like to think this change in expectations is due at least partly to our success at controlling inflation over the past 15 years. In other words, our past performance may be convincing more people that we will keep inflation under control in the future.
Third, the strengthening dollar over the past year has led to lower prices for imported goods. Of course, a good deal of the dollar’s more recent rise has been due to the currency crisis in East Asia. And I will return to this point in a moment.
These three factors – productivity, expectations, and the dollar – will most likely continue to work to offset any upward pressure on inflation from tight labor markets this year. So I expect inflation to come in at about 1997 levels. But beyond this year the picture is less clear. For one thing, the dollar has to keep appreciating in order to hold down inflation in the longer run, and that is just not likely to be a permanent feature of the economy. For another, we cannot say whether the enhanced productivity growth will persist – it may be mainly a temporary cyclical increase instead.
One factor that could help ensure that inflation does not become a problem in the future is some slowing in the growth of aggregate demand to a more sustainable rate. As it turns out, several factors suggest that it just might happen this year. These include a relatively restrictive fiscal policy, somewhat restrictive real short-term interest rates, and the higher dollar, which could restrain exports and stimulate imports. Finally – and this is related to the dollar – we expect the fallout from the East Asian turmoil to dampen U.S. growth this year.
To understand the East Asia story, it is instructive to start with a little background. Beginning in July, first Thailand, then the Philippines, Indonesia, Malaysia, Hong Kong, Taiwan, and Korea – one after another – suffered attacks on their currencies. After raising their interest rates to fight off these pressures, all but Hong Kong were forced to let their currencies depreciate. At the same time, they all saw their stock markets plummet.
What is going on? Two important factors – both related to the dollar – are worth highlighting. First, these countries were linking their currencies to the dollar, and that made their exports less competitive with the much bigger economies of Japan and China. Since the dollar has been appreciating relative to many currencies because of our strong economic performance, the linked currencies moved up with it. In particular, the dollar appreciated relative to the Japanese yen, reflecting Japan’s economic slowdown relative to the U.S.’s strength, and relative to China’s yuan. With the baht and the rupiah and other linked currencies rising relative to the yen and the yuan, the products of Thailand, Indonesia, and so on grew more expensive relative to Japan’s and China’s products. That hurt their competitiveness and put pressure on their currencies to depreciate.
The second factor is the banking system in these countries. Many banks financed part of their operations with short-term debt denominated in dollars and other foreign currencies. With their currencies depreciating, these countries’ banks face much higher debt burdens, which means severe financial hardship for them. Moreover, these banks are saddled with a lot of bad loans.
There is no question – these countries face some difficult times ahead. But how will that affect the U.S. economy? Much of the impact is likely to be through trade with East Asia. The combination of a higher dollar relative to those countries’ currencies plus the weakness in their economies will mean a drop in U.S. exports to that region, as well as some pickup in imports from there.
But our exposure is less than some people might think – estimates suggest that our exports and imports with East Asia amount to only about 3 and 5 percent of our GDP. On this basis, most estimates suggest that the Asian turmoil is likely to reduce real GDP growth this year by between ½ and 1 percentage point.
Another source of concern is the possibility that our financial system may take a hit, to the extent that loans were made to companies in East Asia. But it is worth noting that our exposure in this area is much less than it was during the Latin American debt crisis of the early 1980s.
This national perspective does not dwell on the sectors and regions that will feel the effects more keenly – and I will turn to them in a moment. But it does reinforce the idea that the problems in Asia are not likely to derail the U.S. expansion. The main point, I think, is to remember that this is happening when our economy is in very good shape.
Just as the U.S. is in very good shape, so is California. The state’s economy accelerated substantially from 1994 through 1996, and in 1997 it settled onto a strong growth path that affected almost all sectors of the economy. Since late 1995, California has been adding jobs at a faster rate than the nation – and that has driven the state unemployment rate down by about a point and a half.
The Bay Area led the state’s recovery several years ago, and the signs of continued strong growth are widespread – including an overall unemployment rate below 4% and sharp increases in housing prices in many areas. A key reason for this performance, of course, is the remarkable success of the Bay Area’s high-tech industries. Although this sector is subject to ups and downs, Silicon Valley’s innovators continue to discover and develop new technologies at a rapid pace. As the high-tech markets matured somewhat last year, employment growth in the Bay Area has settled slightly, but remains strong.
Employment growth also accelerated in Southern California last year – which implies healthier, more balanced economic growth for the state as a whole. In fact, last year the pace of employment growth in Southern California was almost as fast as Northern California’s.
Of course, problems remain in Los Angeles County. For example, although the unemployment rate continues to decline, it is still above 6 percent. And there will continue to be some slack in local labor markets – at least in the near term – as federal reforms move families off of welfare. Still, Los Angeles largely has regained its old economic vitality and diversity. The aerospace industry finally is growing again, and that has helped promote solid growth in related industrial sectors, such as metal products. Business and professional services also are doing very well here, and – as always – the movie industry is creating new jobs at a rapid clip.
How will the slowdown in East Asia affect California? Certainly, it will be felt here, because California’s trade with East Asia is so important. According to some estimates, California ships about twice as much of its gross state product to East Asia as the nation as a whole does. But let me stress that it is not a simple matter to translate this information into an estimate of California’s exposure relative to the U.S. Estimating this effect depends on a lot of complex issues, including, for example, how similar the industry mix is in the state and the nation. These issues will be discussed in more detail in a forthcoming Economic Letter.
The bulk of the state’s exports to East Asia consists of merchandise, primarily electrical components and computer and transportation equipment. A smaller but still significant share of exports is services, such as movie distribution rights, computer software, and professional activities, such as engineering, management, and legal services. So far, none of these sectors has felt much effect. An area where California already has begun to feel the slowdown is exports of agricultural and processed food products; however, this sector is a relatively small share of the state’s reports to East Asia compared to high-tech and services.
Let me conclude this outlook by emphasizing the main point I think we should remember about both the U.S. and the regional economies. Although we can expect some slowing as many East Asian economies work through their problems, I do not expect it to knock our expansion off track. Both the state and the national economies are in remarkably good shape right now, with strong growth, low unemployment, and very well-behaved inflation.
Certainly no one welcomes the kind of situation that has developed in East Asia – but if it had to happen, it could not have come at a better time for both the national and regional economies.
Robert T. Parry
President and Chief Executive Officer
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