FRBSF Economic Letter
2000-17 | May 26, 2000
This Economic Letter is adapted from a keynote address delivered by Robert T. Parry, President and CEO of the Federal Reserve Bank of San Francisco, to the 28th Annual Northern California Financial Planning Conference in San Francisco on May 9, 2000.
The U.S. economy’s performance has been remarkable for a number of reasons. The current expansion has lasted longer than any other in U.S. history. And in the last four years especially, it has shown remarkable strength, averaging 4-1/2% growth annually. Furthermore, unemployment continues to hover around 4%, the lowest level in 30 years. Although inflation flared up a bit in March, it has remained pretty tame overall, with the core consumer price index (CPI) (that is, excluding food and energy) rising 2-1/4% over the past twelve months.
With all this good news, it’s natural to ask why the Fed has been raising interest rates since last summer. May 16 was the sixth time we raised the short-term rate, for a total increase of one and three-quarters percentage points. In this Economic Letter, I give my views on this question and try to explain why I see risks of potential inflation in the economy. But before I get into the national picture, let me take a moment to discuss the economy here in the West, especially California.
The San Francisco Fed is headquarters for the Twelfth Federal Reserve District, which comprises the nine westernmost states. And both the District economy and the California state economy have been enjoying strong performances for the last several years.
A key source of the District’s strength has been California’s economy, especially the state’s high-tech sector. Job growth was notably strong in businesses like biotech, communications, and software and Internet services development. And it was financed by record-breaking venture capital investment, and surging proceeds from initial public offerings.
This scenario has played out even more intensely here in the Bay Area. The jobs and investment returns created by local high-tech companies during the year generated tremendous gains in income and wealth, which powered robust consumer spending and helped maintain strong economic conditions in the area—all this despite weak export demand and job losses in durable manufacturing.
Looking forward, we find that there are some factors that could restrain growth in this area. For example, tight labor markets and rising real estate prices could have an effect. And uncertainty about market valuation—especially for high-tech stocks—could damp the gains in income and wealth that have driven consumer demand and financed business expansion.
But overall, the Bay Area’s prospects look very good. Job creation remains solid overall, With high-value sectors—such as software and Internet applications—continuing to create substantial wealth. The area’s unemployment rate has fallen to just 2.5%. And exports of many Bay Area products have begun to increase. In terms of the conditions in real estate markets, construction employment continues to grow rapidly, and Bay Area home prices are increasing at double-digit rates.
One of the key reasons that the U.S. economy has been able to grow so vigorously with relatively low inflation for the last few years is the remarkable surge in productivity that’s related to the advances in technology. Not so long ago, most estimates suggested that the U.S. economy probably couldn’t sustain productivity growth faster than 1-1/2%. That had been the average from the 1970s to about the mid-1990s. But the numbers we’ve seen over the last few years have led us to revise our estimates substantially. Between 1996.Q1 and 1997.Q1, productivity grew at 1.4%, which seemed in keeping with the preceding couple of decades. But between 1997.Q1 and 1998.Q1 it came in at an astounding 3.0%! And though the number dropped slightly between 1998.Q1 and 1999.Q1, it soared back to 3.7% for the period 1999.Q1 to 2000.Q1.
These increases in productivity have wonderful effects on the economy. One effect is that a faster growth rate for productivity means that living standards rise faster. Another effect is that when productivity accelerates, it tends to hold down inflation. This is true mainly because increases in labor compensation tend to lag behind increases in productivity growth. So, for a while, more goods are being produced at the old, lower wages. But I want to emphasize that there’s an important distinction between fast productivity growth and accelerating productivity. As I said, faster productivity growth raises our standards of living more quickly. And that’s great. And we get an initial inflation benefit when productivity accelerates. But thereafter, if productivity growth levels off at the faster rate, monetary policy must respond to keep inflation at the new lower level.
The near term question is: Can productivity keep accelerating fast enough to push inflation down further? Yes, that’s possible. But it’s not something we can count on. So, even though it’s clear that technological advances are expanding the supply side of the economy, we still have to watch for conditions that raise inflationary risks. And there are several of them. These are the risks that have led the Fed to follow a course of gradually raising short-term interest rates.
One potential area of inflation risk involves the relationship between faster productivity growth and the levels of “equilibrium” real interest rates—that is, the rates that bring supply and demand in the economy into balance, so that output equals its potential level. Here’s what happens—higher trend productivity growth actually raises the level of equilibrium real interest rates in the long run.
How does this work? Faster productivity growth increases the profitability of various investment projects that firms might undertake. This means they’ll bid more aggressively for financing. And that will raise equilibrium real interest rates. Simple models suggest that the increase in the equilibrium rate is about equal to the increase in the growth rate of trend productivity. In reality, this response will depend on a number of factors, including how fiscal policy and foreign economies respond when U.S. productivity growth rises. For example, if government spending is fixed, so that it does not increase in response to a productivity shock, the budget surplus will rise and the equilibrium rate will increase by less than it would otherwise. Even though it may be difficult to determine how much the equilibrium rate has risen in response to any particular productivity shock, it is pretty certain that the equilibrium rate will rise to some extent. If the Fed tried to hold real rates at their old levels, we’d be contributing to an inflationary monetary policy.
Another area of risk is the growth in demand. We’ve seen a real pickup in demand for U.S. products from abroad—real GDP growth in the rest of the world rose to around 4-1/4% last year from less than 1% in 1998. And it’s projected to be almost as strong this year.
Here in the U.S., businesses and consumers have been spending at a phenomenal pace. In 1999, business fixed investment jumped 7% in real terms (adjusted for inflation), while real personal consumption expenditures soared 5-1/2%. And this spending actually accelerated in the first quarter; on the business side, real fixed investment rose by more than 21%, and on the consumer side, real expenditures jumped by more than 8%!
Consumer spending especially appears to have been fueled by the very large increases in equity values in recent years. Now, that doesn’t mean that the Fed has set its sights on some kind of goal for the stock market. We’re not so concerned about why consumer demand is so strong. What we are concerned about is that demand—for whatever reason—may be outstripping supply.
This brings me to another inflationary risk. One consequence of the fast pace of growth since 1996 is that labor markets in the U.S. have now become very tight. With the unemployment rate currently at just under 4%, it’s no wonder we hear stories about how hard it is for some firms to find people to fill jobs. Labor markets as tight as this eventually can lead to faster increases in labor costs and therefore to higher price inflation than we’ve seen so far. In fact, we saw a noticeable jump in the first quarter employment cost index, a broad measure of labor compensation that includes wages, salaries, and benefits.
The final risk I want to mention is one that’s made front-page news lately. And that’s the run-up in energy prices. At the end of 1998, OPEC cut back on its production, and that drove oil prices to the highest levels we’ve seen since the Gulf War. But the good news is that OPEC did agree recently to increase production somewhat. Overall, then, we expect only a modest effect, because oil prices appear to have fallen back from their highs in March.
Now, with these inflationary threats, what’s a reasonable course for the Fed to follow?
Well, it’s risky just to sit back and wait for an upward trend in inflation to show up before we do something, because monetary policy affects inflation with a long lag. To my mind, the March pickup in core inflation is worrisome, but it’s by no means conclusive. It is too soon to tell if this is the beginning of a more sustained upward movement, especially since the April core CPI data came in at a moderate rate. But it does seem pretty clear that we’ve reached a stage where inflation is no longer falling. And we certainly don’t want to abandon our goal of achieving price stability.
At the same time, we need to proceed with some caution, because there’s a fair bit of uncertainty about the economy’s behavior right now. Most forecasts—including my own—have predicted a sustained rise in core inflation for a couple of years. But we haven’t seen it yet. And that makes me less confident about the old relationships between the growth of the economy and the level of the unemployment rate and the effect on inflation. Given these considerations, I think the cautious approach of gradually increasing short-term interest rates since last summer has been appropriate. And I would characterize the most recent increase, which was 50 basis points, as in keeping with that approach. Going forward, we will continue to aim policy at keeping this remarkable expansion on track without risking our ultimate goal of price stability.
Robert T. Parry
President and Chief Executive Officer
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