Presentation to the Stanford Institute of Economic Policy Research
(Stanford University, Palo Alto, California)
By Janet L. Yellen, President and CEO of the Federal Reserve Bank of
For delivery February 11, 2005, 2:25 PM Pacific Time, 5:25 Eastern
The U.S. Economic Outlook
It’s a pleasure to join you today. I was very pleased when John
Shoven asked me to share the dais with John Lipsky to give my views on
the U.S. economic outlook and the implications for monetary policy. Let
me note that, as always, I am speaking for myself and my comments do
not necessarily reflect the opinions of other Fed policymakers.
I appreciate hearing John’s views on the real side of the economy.
In general, I’m in agreement with him. Over the past year, output
growth averaged three and three-quarters percent, modestly above trend,
which, by most estimates, is around three and a quarter to three and
a half percent. I believe that we have now seen enough positive signs
in the economy to have some confidence that it is on course for sustained
growth, being supported by accommodative financial conditions and robust
In terms of the labor market, the data have been
consistently positive for several quarters. Taking the average over
all of 2004, the economy
gained 181,000 jobs per month and in January it added another 146,000
jobs. This performance is by no means spectacular, but it is sufficient
to conclude that the labor market is gradually firming up. In January,
the unemployment rate fell to 5.2 percent, suggesting that at least
a bit of slack still remains.
As a Fed policymaker, of course, I’m
committed to the dual goals of maximum employment and price stability.
Like my colleagues on the Federal Open Market
Committee, my expectation is that inflation will remain well contained, assuming
that the economy continues to grow at a pace that is modestly above trend so
that any remaining labor market slack is gradually eliminated.
There are a number
of risks to this outlook for inflation over the next year or so, but overall,
they appear to be essentially balanced. One risk is that
there is a good deal of uncertainty about the actual extent of slack that remains
in the labor market. Another relates to the possibility of further movements
of important relative prices—especially the price of oil and the foreign
exchange value of the dollar. A third risk is that firms’ markups of
prices over unit labor costs, which are now exceptionally high, could revert
normal levels. This could result in a significant reduction in the rate of
Productivity Growth and Inflation
The final risk factor,
and the one I’d
like to focus on in my remarks today, concerns the pace of labor productivity
growth going forward. Productivity growth,
of course, matters not just to inflation but also to the long-run prospects
for the U.S. economy. I might add that issues relating to productivity
are of particular
interest to the Federal Reserve Bank of San Francisco. As some of you know,
a couple of years ago we established the Center for the Study of Innovation
Productivity at the Bank to explore these very topics.
Several recent developments
have raised concerns about a productivity slowdown that could slow economic
growth and boost inflation. For example, during the
latter half of 2004, the nation’s productivity growth came in noticeably
below the astounding rate of nearly four and a half percent in the prior two
and half years. In the third quarter, non-farm productivity growth slowed to
around one and three-quarters percent, and in the fourth quarter to only eight-tenths
of a percent. Moreover, during the last year, quality-adjusted computer prices
haven’t been falling as fast as they have for the past decade. That may
signal some slowing of technological innovation in this sector. In addition,
there is some industry opinion that the pace of software development is beginning
These developments give us ample reason to think seriously about what
the future may hold for productivity growth. But it is also important to put
them into perspective.
For one thing, productivity growth rates are extremely volatile over periods
as short a few quarters, so we shouldn’t make too much of the very recent
data. More importantly, I want to emphasize that few economists expect the economy
to continue to deliver the very fast productivity growth rates we saw in both
2002 and 2003 and in the first half of 2004. Rather, there’s some consensus
among economists that the trend growth rate of U.S. productivity, since the productivity
surge began in 1995, is around two and a half percent. That is still a very high
number—nearly double what it had been during the quarter century before
1995—with the potential to enhance living standards dramatically in this
country if it is maintained in the decades ahead. The real issue from the standpoint
of inflation is whether recent developments portend a slowdown in the trend rate
of productivity growth below a rate of roughly two and a half percent.
a slowdown below two and a half percent likely boost inflation? In theory,
there are two counteracting effects. First, a slowdown in the trend rate
of productivity growth is likely to raise business costs for a time, because
firms would face more rapid growth of unit labor costs. To offset the resulting
squeeze on their profit margins, they would need to raise prices more rapidly.
Eventually, increases in unit labor costs are likely to fall back toward previous
slower rates as workers are forced to accept lower wage growth to compensate
for their slower productivity growth. But during the adjustment period—which
can last for a considerable period of time—there is upward pressure on inflation.
Of course, by the same token, a rise in the trend growth rate of productivity
could lead to downward pressure on inflation for a time.
A slowdown in trend productivity
growth would have a second effect which might offset some of the upward pressure
on inflation. A productivity slowdown would
likely result in slower growth in aggregate demand. Growth in consumer spending
would probably weaken as lower business profits limit stock market gains, thereby
reducing household wealth. More foresighted consumers might also reduce spending,
perceiving that the prospects for growth in real wages are not as bright. Further,
lower expected rates of productivity growth should restrain business investment
by reducing the prospective return to capital.
The net impact of the two opposing
effects of productivity growth on inflation is an empirical issue. My reading
of the evidence suggests that the predominant
medium-term effect of a slowdown in productivity growth would likely be higher inflation. This would seem to be the counterpart to the reductions in inflation that occurred
over the past decade, when rapid productivity growth aided the
Fed in bringing inflation toward price stability.
So a key issue for inflation
going forward is whether the trend growth rate of productivity will remain
near its estimated rate of around 2 ½ percent.
If so, core inflation seems likely to remain stable, near its current moderate
pace. If productivity accelerates or decelerates, we could see inflation start
to fall or rise relative to the 1-1/2 to 2 percent rate that prevails today.
My own view is that the risks surrounding the outlook for productivity are roughly
Prospects for productivity
To explain why I hold this
view, let me start with a brief look at what the sources of productivity
growth have been since the
surge began in the mid-1990s. There
are three basic factors to consider. The first is capital investment—in
particular, the pace at which the quantity of capital per worker rises over time.
The second is improved labor quality, or human capital—that is, a better
educated or more skilled work force. The third factor is called “multifactor
productivity,” which I will refer to as MFP for short. As you can tell
by its eloquence, this is a term coined by economists. It essentially stands
for all the gains in productivity that are not accounted for by either increased
capital investment or improved labor quality. It is thought to capture, more
or less, the productivity gains that ultimately stem from innovation. For example,
it would include the engineering and scientific knowledge that goes into new
technology. It also would include improved management processes, such as ”just-in-time” inventory
management, as well as “creative destruction,” whereby innovative
firms expand market share at the expense of less innovative firms.
at the Federal Reserve Board analyzed U.S. labor productivity, looking at the
period from 1996 to 2001, when productivity rose to nearly two and a half
percent a year, as well as the period from 2002-2004, when labor productivity
rose at an annual rate of almost four and a quarter percent. They found that
the initial mid-1990s acceleration in labor productivity reflected in about
equal parts an increased contribution of capital investment and an increase
with little, if any, change in the contribution from worker skill improvements.
But the results for the period from 2002 to 2004 were noticeably different.
This period, of course, was the worst of the “investment bust,” when
business investment actually receded. The study’s results suggest
that, over those years, a further acceleration in MFP accounted for more than all of the acceleration
in labor productivity.
How do we explain the most recent speedup in the pace of
labor productivity and MFP growth? One possible answer is that the increase
is more apparent than real,
and that it soon will be reversed. This argument relies on a link between shaky
business confidence and weak hiring. It’s understandable that the investment
bust in the last recession, the tragedy of 9/11, the wars in Afghanistan and
Iraq, and the corporate governance scandals could have eroded business confidence.
And that may have made firms reluctant to take on the long-run commitment of
adding workers. This hesitancy could then lead to strong labor productivity growth
to the extent that firms have been pushing their existing workers particularly
hard and requiring them to put in extraordinary effort. This extraordinary, unobserved
effort would raise measured labor productivity and MFP. Presumably, if this story
were correct, then when firms regain confidence, they’ll be willing to
start hiring again, and the pace of productivity growth will decline.
I have my doubts that an unusual degree of worker effort explains much of the
strong productivity performance we’ve seen in the past few years.
First, if firms were boosting their productivity by making their existing employees
work harder, you would also expect that they were requiring them to work longer
hours. But the admittedly limited data we have—which covers only production
and non-supervisory workers—don’t show that. Rather, they show
that hours per worker have been declining since the late 1990s.
Second, there have been considerable
differences across states in labor market performance since 2001, with some
states expanding employment and others contracting.
If this story linked to unwillingness to hire were quantitatively important,
then you might expect to see less productivity growth in states where employment
grew more rapidly than in states where employment growth was weak. But an analysis
of the data by staff at the San Francisco Fed does not show that. Instead,
for the most recent period, it finds essentially no relationship across
employment (or output) growth and productivity performance.
So, what if we accept
that much of the productivity speedup is real—and
not merely a mismeasurement of labor effort? What might explain the pickup
in labor productivity growth over the past few years? Some recent studies suggest
that the answer lies in information technology, where the pace of technological
innovation is clearly quite rapid. But its role in the last few years is different
from its role in the late 1990s. In that period, studies tend to find that
gains in the production of information technology contributed substantially
to the overall pickup. In addition, firms invested heavily in new (and steadily
cheaper) information technology, boosting capital investment in industries
used IT intensively.
But for the more recent period, studies tend to find that
the MFP acceleration
is more broad-based across industries that use technology—not confined
to the IT-producing sector. For example, the results I cited earlier from Federal
Reserve Board economists suggest that the MFP acceleration since 2002 is entirely
accounted for (in fact, more than accounted for) by an acceleration in MFP
in sectors that use information technology. Sectors that produce information
especially semiconductors, have actually contributed somewhat less to MFP growth
in the 2000s relative to the late 1990s.
mechanism that may explain the continued rise in MFP in sectors that use technology
is that firms are learning new and better ways to use technology
have in place to become more productive. Indeed, some evidence suggests that
the extraordinarily high rates of investment in high-tech equipment during
the second half of the 1990s actually led to a reduction in measured productivity
growth over that period. The reason is that firms had to devote a lot of human capital and time to learning how to get the most out of it; that is, resources
were diverted from current production to installing the new capital and learning
how to use it. If firms continue to increase their proficiency in using the
they already have, this could help keep productivity growing at a robust pace.
For example, one of our contacts told us that his law firm had recently discovered
they could use computer search facilities effectively to look for incriminating
evidence in email files; that meant less labor on the project and therefore
reduced legal expenses.
Second, a fundamental way that information technology enhances
productivity is by allowing firms to reorganize work-place processes. For example,
report that, through ongoing use of technology, they have been able to support
growth in customers and services with fewer staff. A further example is the
continuing expansion of Wal-Mart and other “big-box” stores,
a trend that has had a dramatic effect on productivity growth in the
retail and wholesale sectors.
This process of using information technology to reorganize work processes,
of course, takes time. Sam Walton, for example, argued that he benefited
1980s and 1990s from knowledge he had accumulated in the 1960s and 1970s, when
he flew around the country visiting competing discount stores and attending
More formally, the growing academic literature on information technology
as a “general
purpose technology”—a technology that has broad applicability across
the economy—suggests that to reap its benefits, firms have to make substantial
investments in learning, reorganization, and the like. Hence, the payoff in
terms of measured output may be long delayed. For
example, one study finds that in
a sample of 527 large U.S. firms from 1987 to 1994, the benefits of computers
for output and productivity rise over time and are not fully realized for at
least five to seven years. The
authors interpret their results as suggesting the importance of combining computer
investments with “large and time-consuming
investments in complementary inputs, such as organizational capital.” Another
study finds that industries that had high growth rates of information and communications
technology capital in the 1980s or early 1990s tended to have faster MFP growth
rates in the late 1990s, consistent with the notion that firms were undertaking
unobserved investments in organizational capital, which then paid off in terms
of measured output and productivity with a long lag. More generally, innovations
in information technology appear to have caused ripples of co-invention and
co-investment in other sectors, such as retail trade.
In addition, the general purpose technology
literature suggests that the benefits of information technology used by one
firm often “spill over” to
other firms, which again imparts a lag to the process. For example, successful
new managerial ideas—such as those implemented in retail trade—seem
likely to diffuse to other firms. Imitation is often easier and less costly
than the initial co-invention of, say, a new organizational change, because
by watching and analyzing the experimentation, the successes and, importantly,
the mistakes of others.
What does this analysis suggest that we should expect
going forward? I’m
reasonably optimistic. It seems unlikely that the business learning and reorganization
that we’ve been hearing about and that the academic literature emphasizes
has suddenly disappeared. My sense is that businesses are still learning what
new technologies can do for them.
As I noted earlier, several leading economists
suggest that a reasonable estimate for trend productivity growth going forward
is about 2-1/2 percent per year. This is close to the rate of productivity growth that we saw from 1995 to 2001.
And although it would represent a slowing of the outsized, and unsustainable,
gains we’ve seen since then, it appears fast enough to maintain the favorable
inflation results we’ve had in recent years. Forecasting is, of course,
always uncertain and difficult. But it seems to me that the risks to this expectation
are reasonably well balanced.
I’ll conclude with just a few thoughts on monetary policy.
We know that with the federal funds rate at 2-1/2 percent—only about
1 percent or a bit
less above the inflation rate—the current policy stance remains accommodative.
Over time, the degree of accommodation will have to diminish, with policy reverting
toward so-called “neutral” for inflation to remain well contained.
It’s uncertain exactly what the neutral range is, but a common estimate
is 3-5 percent. The Committee has stated for some time that, with underlying
inflation remaining low, policy accommodation can be removed at a pace which
is likely to be measured. In fact, we have raised the rate by 25 basis points
at each of the last six meetings. However, it should be obvious that the closer
the actual rate gets to the neutral range, the more carefully we will need to
consider each successive increase. In other words, the pace of removing policy
accommodation must, in reality, depend on how economic activity and inflation
actually develop. Moreover, these developments themselves could affect the Committee’s
judgment concerning the momentum in aggregate demand or supply and thus the
real federal funds rate corresponding to a neutral policy stance.
If the pace of economic
activity accelerates and labor market slack erodes more quickly than expected—or
if some of the upside risks to inflation materialize—it
would probably be appropriate to remove accommodation more rapidly. If, alternatively,
the expansion falters or we experience some of the downside inflation risks,
there are likely to be more opportunities for the Committee to pause. Of course,
we could be confronted with more difficult choices if output growth and inflation
moved in opposite directions. In any event, risks to both growth and inflation
abound. However, I agree with the Committee’s judgment, reiterated in its
statement last week, that the upside and downside risks are currently balanced.
# # #
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