Are recent Fed actions and monetary targets appropriate for our technology- and information-based economy?
Technology is everywhere and clearly plays a much more important role in today's economy than it did just a decade ago. The changing roles of technology, investment, and productivity in the economy and their effects on monetary policy pose important questions for Federal Reserve policymakers. As several of the articles cited below indicate, changes in the economy are being evaluated and prompting new ways to monitor both the economy and monetary policy.
First, let's look at just how much of the "new economy" is real and how much is financial. One place to start is looking at changes over the past decade in high-tech's share of the economy. FRBSF Economic Letter 2000-15, titled "Three Questions about 'New Economy' Stocks," by Simon Kwan, asks just how dominant high technology companies are in the year 2000 economy. His findings show that high technology firms' dominance is much greater in terms of stock market valuation than it is in terms of other standard measures of the economy; total tangible balance sheet assets, total employment, and total sales by all publicly traded nonfinancial companies.
Kwan notes that as the new economy has expanded, tech firms' market valuation has soared, from about 7 percent of total stock market capitalization in 1990, to over one-third in 2000. In contrast, the changes in asset size, employment, and annual sales of the high tech sector are much smaller. In 2000, all high tech accounts for less than 10 percent of U.S. assets, employment, and sales. These three measures show that while high tech has expanded--its products are being used throughout the economy--high tech firms have not dominated corporate assets, employment, or sales in the same way that they dominate equity market valuation. These other measures indicate that a large "old economy" continues to play an important role in the U.S. economy.
An even more interesting part of your question, "Is monetary policy appropriate for the new economy?" also was addressed in Kwan's research. His findings suggest that monetary policy may affect the new and old economies in different ways, which is important for policymakers to consider. Kwan concludes:
Technology stocks are not sensitive to interest rate changes after controlling for systematic stock market movements. With tech stocks accounting for a large share of the stock market, at sky-high valuations, any wealth effects stemming from the stock market can be largely attributable to technology companies. However, can monetary policy be used to bring down these high fliers? The answer appears to be "no"--not without bringing down the entire market. This suggests that targeting stock prices may not be an effective policy approach. Rather, targeting inflation with an eye on the wealth effect seems to be the better policy to pursue.
Kwan's work is not the only research on the potential relationships between the new economy and monetary policy. For several years now, Federal Reserve policymakers have been evaluating how the changing economy and rising productivity might affect monetary policy. For example, in FRBSF Economic Letter 99-33, Federal Reserve Bank of San Francisco President and CEO Robert T. Parry wrote:
The uncertainty about recent productivity growth appears to be the major uncertainty in the outlook for the U.S. economy, and also for the conduct of monetary policy.
Soaring investment in high-tech hardware and software in the late 1990s is considered a key factor in the recent surge in measured productivity. Accelerating productivity growth has allowed the economy to expand at a rapid pace without a surge in inflation. FRBSF Economic Letter 2000-05 by Glenn Rudebusch asks the question, "How Fast Can the New Economy Grow?" Faster productivity growth already has increased many economists' estimates of potential supply and of the ability of the economy to expand at a faster rate without causing inflationary pressures. This key question was discussed at the Federal Open Market Committee's (FOMC) February 2000 meeting. The press release for that FOMC meeting reflected the committee's concerns about the relationship between productivity, growth, and inflation:
The Committee remains concerned that over time increases in demand will continue to exceed the growth in potential supply, even after taking account of the pronounced rise in productivity growth. Such trends could foster inflationary imbalances that would undermine the economy's record economic expansion.
Another potential issue concerning how high technology relates to monetary policy was addressed by Bharat Trehan in FRBSF Economic Letter 99-21 titled, "Supply Shocks and the Conduct of Monetary Policy." His research suggested use of an alternate economic indicator to evaluate economic conditions and monetary policy:
The existence of a supply shock makes it hard to judge inflationary risk by looking at real output growth, since such shocks tend to change the output-inflation mix in the economy. One response that is robust to the resulting uncertainty is to pay more attention to the growth in nominal GDP (or spending). As supply shocks change output and inflation growth in opposite directions, they will obviously have a smaller impact on nominal GDP.
Keeping an eye on spending would allow policymakers to keep inflation within reasonable bounds, even if they were unsure about the economy's potential growth rate. Using nominal GDP in this way--as an indicator--is similar to the way that monetary aggregates were employed in the past, before velocity shifts made them hard to interpret.
Much research has already been done on how the new economy might affect monetary policy, but further research is needed as the economy and the financial system adapt to a changing economy.
Board of Governors of the Federal Reserve System. 2000. Press Release (February 2).
Kwan, Simon. 2000. "Three Questions about 'New Economy' Stocks." FRBSF Economic Letter 2000-15 (May 12).
Parry, Robert T. 1999. "Risks in the Economic Outlook." FRBSF Economic Letter 99-33 (October 29).
"Performing miracles." The Economist. June 17, 2000. http://www.economist.com
"Productivity on stilts." The Economist. June 10, 2000. http://www.economist.com
Rudebusch, Glenn D. 2000. "How Fast Can the New Economy Grow?" FRBSF Economic Letter 2000-05 (February 25).
Trehan, Bharat. 2000. "Supply Shocks and the Conduct of Monetary Policy." FRBSF Economic Letter 99-21 (July 2).