FRBSF Economic Letter
2001-19 | July 6, 2001
This Economic Letter is adapted from several recent presentations by Robert T. Parry, President and Chief Executive Officer of the Federal Reserve Bank of San Francisco, to civic and professional organizations in California.
During this economic slowdown, my colleagues on the Federal Open Market Committee and I have paid especially close attention to developments in the technology sector. And, as President of the Federal Reserve Bank of San Francisco, I have had a front-row seat to see how those developments are playing out in the Twelfth District, and especially in California, where technology is such an important part of the economy.
In these remarks, I’ll give my views on the national economic slowdown and the Fed’s response to it, and I’ll also discuss economic conditions and prospects for California.
From mid-1995 to mid-2000, the U.S. economy had a phenomenal run. Annual growth averaged a very high 4-1/2 % rate during those years, the unemployment rate fell to 30-year lows of just below 4%, and the inflation rate actually edged down to under 2% (as measured by the core personal consumption expenditures price index).
This combination of high growth and low inflation doesn’t come along all that often, and it’s usually associated with what economists call a “positive supply shock.” That is, for some reason, the supply of goods and services in the economy has expanded more rapidly. The most likely source of this shock, of course, is the surge in technological advances—information technologies, biotechnology, communications technology, and the like.
They helped boost productivity growth to an average rate of almost 3% a year during mid-1995 to mid-2000. This upward shift in productivity growth means the economy’s potential growth rate is higher. That is, the economy has been able to expand at a faster rate for a number of years without generating inflationary pressures. In fact, you have to go back to the 1960s—another period known for its rapid productivity growth—to find a time with such rapid, sustained growth along with stable, low inflation.
Since the middle of last year, of course, the economy has slowed quite a bit. In fact, this slowdown may feel almost like a recession—for a couple of reasons. For one thing, with the economy’s potential growing faster, today’s sluggish growth rate is likely to push up unemployment rates in much the same way that small recessions have done in past business cycles. For another, the manufacturing sector actually is in recession. And within manufacturing, high-tech has really been hard-hit. The story of what has happened in high-tech is quite striking. High-tech industrial production is now registering negative numbers after about five years of growing at an astounding average rate of about 40% a year! I’ll return to the high-tech story later, because it plays such an important role in both the national and California economic stories.
What factors contributed to the slowing in the economy over the last year or so? There are several, actually. One factor was monetary policy. By the middle of 1999, real GDP was growing well in excess of our estimates of its sustainable rate—even with optimistic assumptions about sustainable productivity growth—and labor and product markets appeared to be tight. This indicated that inflation could become a concern. In the financial markets, real corporate interest rates were rising significantly, which signaled some imbalances in the economy’s ability to continue to fund all the demand for investment. So the Fed raised short-term interest rates gradually from mid-1999 though mid-2000 to rein in demand. The Fed’s moves were felt directly in credit markets, as many people and firms faced higher borrowing costs.
At the same time, some other factors also kicked in and slowed demand dramatically in terms of business investment—especially investment in high-tech equipment and software. First, stock prices dropped, and that also put upward pressure on firms’ cost of capital. Why did stock prices drop? Part of the reason may be related to the Fed’s earlier tightening. But part of it also may be related to a re-evaluation of the long-run profitability of many high-tech firms. But don’t get me wrong. I still think we’re not near the end of the surge in technological innovation that has propelled the economy since the mid-1990s. It’s just that—even with this surge—markets may have gotten somewhat carried away.
The second factor to hit businesses was the energy crunch, as increases in the prices of oil, natural gas, and electricity cut into firms’ budgets.
The third factor slowing business demand is what I’ll call “the overhang problem.” For years, there was extraordinarily strong growth in business investment in high-tech—averaging more than 20% a year from 1996 to 2000. After all that investment, many firms seem to have large stocks of capital equipment already. So they’re not in the market to buy more. This suggests that there may be an “overhang” of business equipment and software that spells weakness in business spending going forward.
I think it’s interesting to point out that high-tech plays a dual role in this story. As I just suggested, the shrinking in that sector is intensifying the slowdown. But high-tech advances themselves also may actually help the economy adjust somewhat more quickly. In the past, it usually took quite a while for producers to cut back on their output when demand slowed. That often meant a significant buildup of unwanted inventories. And firms dealt with that by scaling back sharply, which often led to a recession. But today—with new technologies improving the quality and the timeliness of information—firms seem to be able to manage their inventories better, and that may tend to mitigate the extent of the slowdown. In addition, high-tech equipment and software may be different from other kinds of capital equipment, in the sense that they become obsolete more quickly and need to be replaced. In that case, the “overhang” may be eliminated relatively rapidly.
Finally, let me say a word about the consumer side of the demand slowdown. Typically, the three items I mentioned that have been slowing business demand—the energy surprise, the drop in stock prices, and the “overhang”—also tend to slow consumer demand. But, so far, at least, while consumer spending has slowed some, it has held up reasonably well.
Looking forward, I’d say the U.S. economy still has a lot going for it, and that we’re likely to see an acceleration in growth by the end of the year. As you know, the Fed has responded to economic weakness by cutting short-term interest rates six times since January. These cuts have brought the federal funds rate down from 6-1/2% in January to 3-3/4% today. This easing will help stimulate the economy. In addition, the recently passed tax cuts will probably add some strength to the economy before the year’s end—and they may provide more of a boost in 2002.
Finally, as I mentioned before, the continuing advances in technology suggest that the economy’s potential for growth is a good deal higher than before. So—even though we’re in a cyclical slowdown—in economists’ terms, we’re probably “cycling around a higher potential growth rate.” In other words, continuing advances in technology should afford many new opportunities for business to expand, once the “overhang” problem is resolved.
No doubt, the road ahead may be rocky, since there are some downside risks. For example, continuing sizable declines in the stock market or consumer confidence could further temper spending by households. Another risk is the global nature of the slowdown. When the U.S. economy slows, it tends to have a dampening effect on many other economies, and that feeds back to us through a smaller demand for our exports. And, some of the slowing in Asia and Europe appears to be related to economic issues specific to those countries.
While these risks are important to keep in mind, it’s also important to recognize that the 275-basis-point reduction in the funds rate overall represents a significant easing of policy. This easing affects the economy with fairly long lags, so it may be some time before the effects are fully felt—perhaps through the end of this year and into next year. As this stimulus unfolds, the Fed will need to keep its eye on its longer-term goal of price stability.
The vulnerabilities I mentioned for the nation—the adjustments in the technology sector and rising energy prices—are even more significant for many states in the Twelfth District, especially California. Indeed, we’ve already seen pronounced slowing in our high-tech sector. On top of the ongoing shakeout among dot-coms, more established software firms have scaled back. And high-tech manufacturers of goods such as semiconductors and telecommunications gear have cut production, curbed investment plans, and reduced payrolls.
Because of the prominent role that high-tech firms play in many District states, slowing in the technology sector has begun to damp expansion in other sectors of the economy. For example, vacancies are up and lease rates are falling in some commercial office markets. In fact, in the Bay Area, vacancy rates doubled between the last quarter of 2000 and the first quarter of 2001. And growth in personal income has slowed from its frenzied pace of the last several years while stock values have declined.
Energy is another distinct area of vulnerability. California has had the largest increases in natural gas and electricity prices in the nation. It’s hard to predict the precise impact from the energy crisis, but here’s a rough guess. The electricity rate hikes this year, combined with the higher cost of natural gas, will equal about 1-1/4% of output in the state. (For a more detailed discussion, see Daly and Furlong 2001.) The increase in utility rates will wipe out our advantage as a state with a temperate climate and therefore low per capita energy consumption. The summer blackouts are a wildcard, but based on projected supplies and usage of electricity, the disruptions from outages easily could be frequent enough to affect economic growth. Although conservation and lower prices for natural gas have eased the pressure on California’s electricity market in recent weeks, the fundamental problems of growing demand and inadequate supply remain. So we’re not out of the woods yet on energy.
Despite these vulnerabilities, the California economy’s long-term prospects remain sound. Like the rest of the U.S., the state is coming off a very strong run. California’s job growth last year was almost 4%. And the state’s economy also still has a lot going for it. Its highly educated population and vibrant research community, anchored by many distinguished universities and other research facilities, provide an excellent base to help keep it competitive in our rapidly changing national economy.
Robert T. Parry
President and Chief Executive Officer
Daly, Mary, and Fred Furlong. 2001. “Rising Price of Energy.” FRBSF Economic Letter 2001-11 (April 20).
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