For the past several years, monetary policy at the Federal Reserve has been anything but business as usual. Through boom and bust, the Fed has consistently replaced the medicines of previous decades with new prescriptions. That's still true. In the coming year, Fed policy may be more stimulative for a longer period than was typical in earlier post-World War II upturns.
Welcome to the low-inflation, high-productivity recovery. It's a combination that is once again radically altering the Fed's thinking about how policy intersects with growth and inflation. For the first time in 40 years, the Fed effectively has captured its Holy Grail of price stability -- the level of inflation that does not influence the economic behavior of businesses or households. Price stability is generally accepted to be inflation in the 1%-2% range, right where the Fed's favorite measure has been for the past four years (chart).
But that feat brings with it an entirely new policy mind-set: The Fed must now guard against both inflation and deflation with equal vigilance because of deflation's potentially corrosive effects on wages, profits, and business investment. As Fed Chairman Alan Greenspan told Congress on Apr. 30: "With price inflation already at a low level, substantial further disinflation would be an unwelcome development."
Moreover, the higher trend of productivity growth means the economy began this upturn with a sizable gap between what it is actually producing and what it is capable of producing without inflation heating up. Closing that output gap will require a period of rapid growth, well faster than the economy's long-run trend of about 3%, in order to employ all the workers and productive capital that the recession idled.
ALL THIS MEANS that the Fed has exceptional latitude to keep short-term interest rates low, even as the economy picks up steam. It may even keep rates on hold well into 2004. The benefits: With inflation expectations low, long-term rates will be slow to rise, a plus for housing and corporate borrowing. Generous liquidity will fuel gains in the stock market, helping to support business investment and innovation. And the dollar can decline further, lifting U.S. multinationals' profits and manufacturers' competitiveness.
The Fed's May 6 policy decision to hold the overnight federal funds rate at 1.25%, where it has been since November (chart), reflected the influences of price stability and greater productivity, as well as more immediate factors. Although measures of demand, production, and employment remained "disappointing" through April, the Fed said it was encouraged by signs that growth is poised to pick up now that war uncertainties are fading, especially given the Fed's very accommodative policy stance and ongoing growth in productivity.
However, the Fed made an unusual split in its official assessment of the risks in the outlook. While it believes the risk of unduly weak economic growth is about the same as the chance of overly strong growth, it said the risk of deflation was greater than that for inflation. Taken together, the Fed concluded "the balance of risks to achieving its goals is weighted toward weakness," suggesting it is ready to cut rates if deflationary forces intensify. For now, policymakers believe the risks of either rising inflation or deflation are both very small.
This novel twist in the Fed's statement highlights the new role of price stability in monetary policy. Making policy at price stability is like balancing on a knife edge. Prior to recent years, policy only needed to be anti-inflationary. Now, it also must be anti-deflationary.
PRODUCTIVITY WILL ALSO SWAY monetary policy, especially in the way it affects the politically sensitive labor markets. Absent a surprising surge in economic growth, the job markets will be slow to recover in the coming year, because productivity gains account for the lion's share of the growth in real gross domestic product. In the past year, the economy grew 2.1%. Productivity accounted for all of that growth, rising 2.4%, while payrolls shrunk by 330,000 workers.
In April alone, payrolls fell 48,000, the third monthly decline, and the jobless rate rose to 6%. Keep in mind that employment has to grow by at least 150,000 jobs per month just to hold the unemployment rate steady. So even with 3%-3.5% growth in the second half, the jobless rate is not likely to come down much. Slack labor markets give the Fed more time before it must start to lift interest rates (chart).
MORE IMPORTANT, to get back to full employment, where everyone who wants a job can find one, economic growth will have to pick up substantially. Why? The recession opened up a big gap between actual and potential GDP. Potential GDP is determined by the long-term growth trends of productivity and the labor force. It represents the level of output the economy can generate without putting undue inflationary pressure on the job markets and production capacity. Given the strong pace of productivity, actual GDP has fallen below its potential level.
For example, suppose the level of actual GDP is now 2% below its long-term trend -- a conservative assumption, given the economy's ability to grow about 3% to 3.5% without pushing up inflation. Then real GDP would have to grow at a 5% pace over the next year just to get back to where the economy is fully utilizing all available workers and equipment. That's a lot of leeway before the Fed has to start thinking about hiking rates.
Key precursors to stronger growth are falling into place, including rising confidence, cheaper energy, improving profits, stronger stock prices, narrowing risk spreads, and a more competitive dollar. This favorable mix of positive fundamentals has not been present in three years, although the Fed admits that the timing of the economy's improvement is "uncertain."
Nevertheless, among the host of emerging pluses for the economy, the biggest asset is monetary policy itself. The real federal funds rate, which adjusts for inflation, has been negative for almost a year. That's an exceptionally stimulative stance for Fed policy. When you add in the past and expected fiscal thrust from the White House's tax policy, the chances of a surprisingly strong rebound in the economy in the coming year look a lot higher than the odds of stagnation.
Unlike in past recoveries, the Fed would most likely welcome a strong rebound with open arms -- and not take it as a sign to start hiking rates to ward off future inflation. That would be good news for the Bush Administration. Remember, it was back in 1992 that Greenspan took political flak for "losing" the election for George Bush, the father. Heading into 2004, the Fed may be in a position to sit back and watch the economy gather steam. If so, Fed inaction could make for a very happy Presidential campaign for Bush, the son.
By James C. Cooper & Kathleen Madigan