Fed Policy in a New Economy
This is a crucial moment in the evolution of the New Economy. On the one hand, the technological, policy, and management changes that helped create the conditions for faster growth with less inflation in recent years are still present. At the same time, worries grow that the economy is in danger of overheating and causing inflation. Indeed, core consumer inflation over the last six months has been running at 2.5%, the highest level since mid-1998.
Both structural and cyclical forces can be operating at the same time. The advent of the New Economy has never implied that the U.S. will enjoy an eternal boom. As BUSINESS WEEK has emphasized time and again over the last four years, the New Economy does not eliminate the normal constraints of the business cycle. Inflation and recession are real and present concerns, not things of the past.
We support the Fed's fight to bring down the excess growth rate of the economy by raising interest rates. It's only prudent: The above-6% growth rate recorded over the last two quarters is clearly higher than the economy can sustain over the long term. The GDP speed limit, we believe, is about 3.5%. And with unemployment at 3.9%, allowing the labor markets to tighten even further would lead to higher inflation in the future.
But even with the need to raise rates now, it's important to remember that the forces that propelled the boom are still at work. Going into the second half of 2000, all the pieces of the New Economy--an investment-led, high-productivity expansion with less propensity for inflation--are still in place:-- Moderate inflation pressures. There are signs of rising inflation, but there are other signs that it is under control. For example, core producer prices over the last six months are rising at only a 0.8% rate.-- Strong investment. Despite talk of a consumer-led boom, business investment is outrunning consumption, just as it has for the last four years. In the first quarter of this year, consumer spending, in current dollars, rose at a 12% annual rate. By contrast, business investment in equipment, software, and structures rose at a 21% rate. In inflation-adjusted dollars, business investment is up by 10% over the last year, compared with 6% for consumption.-- Strong productivity growth. Nonfarm-productivity growth is still accelerating, at 3.7% over the last year, compared with the 2.7% rate of a year earlier.-- Rising demand for technology. Orders for information-technology equipment are rising at a 17% annual rate in the first quarter.
Given this strength in investment and productivity, it is critical not to go too far too fast in raising rates. Some inflation hawks, such as the economists at J.P. Morgan & Co., have started saying that a soft landing may not be enough to keep inflation under control. They would propose boosting interest rates enough to bring growth in gross domestic product below the sustainable rate--say 2% or so--to bring up the unemployment rate.
But that sort of aggressive policy is potentially dangerous, and completely misreads the lessons of the 1990s. Attempts to fine-tune the economy can often miss their marks by a wide margin, since it's hard to know at the time just what the true speed limit of the economy is. Equally bad, raising rates too high can smother the incentives for business investment that are helping sustain the New Economy. Letting inflation start is not a good thing, but neither is unnecessarily dampening growth.