Commentary: Handling The Hot Rod Economy
In some ways,the Federal Reserve's June 30 quarter-point rate hike seems like a retreat from the New Economy view of the world. It looks perhaps as if the big, bad Fed is back on the job again--fighting inflation and holding down growth.
But despite this light tap on the economy's brakes, Fed Chairman Alan Greenspan still believes in the New Economy--and so do a growing number of other Washington policymakers. After years of dispute, there is a new consensus forming around the proposition that the economy's rate of sustainable growth is 3% or greater, much higher than most economists had considered possible without igniting inflation.
For monetary policy, the new consensus means that the Fed is less likely to raise rates again, despite tight labor markets and strong growth. Following the hike, the Fed's policy-making committee issued a statement saying that there was no longer an upward bias on future rate changes, noting that "strengthening productivity growth has contained inflationary pressures."
Without direct signs of inflation, the June 30 hike was mainly an attempt to bring the rate of economic growth back into the safety zone of around 3%--after hitting 6% in the last quarter of 1998 and 4% in this year's first quarter. Many forecasters already expect the second quarter to be under 4%. So, if the gross domestic product slows to between 3% and 3.5%, then the Fed will not have to move again.
NEW CONSENSUS. The notion that the economy is capable of a new level of noninflationary growth is permeating the budget debate as well. President Bill Clinton's latest budget proposals are based on the belief, in his own words, that technology "has given us enormous increases in productivity." Policies which were formerly unthinkable--such as paying down the national debt, fully funding Social Security, or making sizable tax cuts--now seem well within reach.
Leading the new consensus is Greenspan. In his congressional testimony on June 17--the same speech in which he signaled the rate hike--Greenspan also indicated his belief that the U.S. economy could sustain roughly a 2% growth rate in productivity and a 3% growth rate in GDP. These numbers represent a remarkable upward shift from the sluggishness of the 1970s and 1980s, when 1% growth for productivity and 2% for GDP were the norms.
The record of the past couple of years has even impressed some of the biggest New Economy doubters. Until recently, for example, economist Alan S. Blinder had argued that there was no evidence that long-term sustainable growth had risen above 2.3%. Now, like Greenspan, the Princeton University professor, who is a former Fed vice-chairman, sees the sustainable growth rate at 3%--and possibly even higher. "I can't rule out that we could be at a 3.5% or 4% GDP growth rate," says Blinder.
Even budget forecasters--who were burned in the early 1980s by excessively optimistic projections of growth--are finally upping their estimates. For example, in its latest set of budget projections, the Office of Management and Budget (OMB) raised its estimate of potential GDP growth over the next three years from 2.5% to 2.8%. That's a major reason why the budget surplus is now projected to be a trillion dollars larger than predicted just five months ago.
"CRYING SHAME." Admittedly, this is still below what the new consensus suggests. What's more, the revision has not taken place across the board: The OMB is projecting that annual productivity growth will fall back to 1.4% beginning in 2003. If policymakers really believe such conservative forecasts, then any actions based on them could prevent the economy from fulfilling its real potential. "It's a crying shame if we could grow at a 3.5% rate and we only let ourselves grow 2.5%," says Blinder. "Underperforming growth is just as bad as too much inflation."
Still, there are some wild cards that could cause the Fed to change direction. One of the most serious potential problems would be a pronounced slowdown in the high-tech sector. That would, in fact, cut off the fuel for the New Economy growth-and-productivity machine. The rapid growth of information technology has contributed one-third of growth, cut half a point or more off inflation, and provided the bulk of the productivity gains.
Then, there are the mixed signals from the labor market. Despite an unemployment rate of 4.2%, wage growth seems to have decelerated in the last year. Worker compensation, as measured by the employment cost index, has risen by 2.9% over the past year, down from 3.3% a year earlier, for example.
Nevertheless, the pool of available labor has been dramatically shrinking and now is as small as it was in the mid 1970s. And some forecasters, including St. Louis-based Macroeconomic Advisers, still argue that the natural rate of unemployment is closer to 5.5% than to the 4.5% that some economists now use. If they are right, and wage growth accelerates again, the economy would have to be slowed to somewhere below the sustainable rate in order to keep inflation under control.
Finally, the real imponderable is whether the Fed feels it necessary to raise rates in order to rein in a galloping equities market. Over the past year, surging prices for stocks have helped fuel much of the consumer spending that has kept the expansion alive. If Greenspan was aiming at this equity bubble on June 30, he missed: The Dow Jones industrial average jumped 155.45 points, the S&P 500 rose 21.21, and the NASDAQ advanced by 41.04. Without some pullback, Greenspan and the Federal Reserve could be tempted to raise rates to prick what seems to be an asset bubble.
The Fed would be wise to resist that temptation. Some of the greatest central bank policy failures--including the Great Depression of the 1930s and the deep Japanese recession of the 1990s--followed attempts by a central bank to bring down asset prices. What's more, to the degree that the rising equities markets have made it easier for innovative new companies to raise money, an attempt to bring down a perceived stock market bubble could have the unintended side-effect of crimping innovation--or cutting off the high-tech boom.
Certainly, managing economic policy through a period of rapid structural change isn't easy. "When there's a swing, people don't recognize it for a while," says Blinder. But Washington finally seems to be getting its mind into the New Economy.