U.S.: Why The Fed Has Time On Its Side

The global economy gives Greenspan & Co. room to keep rates unchanged

When policymakers meet at the end of this month, the Federal Reserve will have gone a year without moving interest rates. The longest the Fed under Chairman Alan Greenspan has gone without a shift in rates, either up or down, is 18 months. And after the extremely disappointing jobs report, along with no signs of inflation, economists are wondering if the Fed will break its record. Indeed, a strong case can be made that the Fed might not raise rates until 2005.

Such thinking was unconventional wisdom a few months ago. The economy was roaring, with real gross domestic product surging at an annual rate of 8.2% in the third quarter, and job growth seemed on track to add about 100,000 per month in the fourth quarter. Plus, many Fed officials began to make the case that "accommodative" policy doesn't mean the federal funds rate has to stay at 1%.

Now, though, it looks as if the Fed has even more room to wait. That's because, to gauge future inflation, most Fed officials try to keep an eye on "the output gap." The problem is, it's not something you can see and measure. It's the difference between the actual level of real GDP and the level that would exist if all the economy's resources were fully employed. That potential level is determined by how much labor may be available and how productive it can be.

But the analysis is clear. If the level of actual GDP is above its potential level, then labor and product shortages will begin to trigger wage and price pressures. But if the actual GDP level is below its potential, then inflation can't get a foothold, even if the economy is growing strongly. That's what has been happening so far in this recovery: For example, producer prices of finished goods, excluding food and energy, increased just 1% for all of 2003, after falling 0.5% in 2002.

ALTHOUGH THE OUTPUT GAP can be measured only in theory, some central banks, like the Bank of Canada, do attempt to estimate it. But at the Fed, policymakers look for indirect evidence that the U.S. economy is using up its available resources too quickly. In the past, the two central measures of slack have been industrial capacity utilization and the rate of unemployment.

What's different in setting policy today, however, is that these numbers are far less relevant than they used to be and no longer serve as accurate gauges of economic slack. In the globalized economy, capacity and labor can be found almost as easily in Mexico as in Michigan. And in the U.S., people available for work aren't necessarily counted among the official tally of the unemployed. As a result, the American economy has more resources it can tap before production constraints appear. That's why the Fed will relax about inflation for far longer in this recovery than it ever could in the past. Equally important, the Fed can no longer operate U.S. monetary policy in the vacuum of the U.S. economy.

Imports Satisfy Much of U.S. Demand
Foreign producers are clearly key players in the U.S. economy. Imports' share of U.S. spending on goods other than oil reached as high as 31% before the last recession, and in 2003 was a still hefty 28% (chart).

Imports are now so massive that even the ongoing turnaround in exports is being overwhelmed by the inflow of foreign goods. Exports have grown by nearly 3% in each of the three months ended in November. But imports have done almost as well because much of U.S. spending, especially for holiday gifts, was satisfied by offshore production.

True, the November trade deficit of goods and services narrowed to $38 billion from October's $41.6 billion, thanks in large part to a drop in oil imports. But the trade deficit deteriorated in the preceding two months. For the fourth quarter as a whole, the price-adjusted trade gap likely subtracted a bit from real GDP growth.

MOREOVER, THE DROP of the U.S. dollar has done more to help exports than stem the inflow of imports by making them more expensive. Foreign producers will not easily give up their share of U.S. markets even if it means swallowing the cost of the weaker U.S. dollar and higher commodity prices. The trade-weighted dollar has fallen 8.5% in the past year, but nonoil import prices have risen only 1%. In volume terms, merchandise imports have grown 12% since February, 2002, when the dollar peaked.

For the Fed and its concern over the output gap, foreign producers are now a crucial safety valve when it comes to production bottlenecks. U.S. manufacturers are using 75% of their capacity. Operating rates typically have to approach 85% before an overextended factory sector starts to generate inflation pressures.

But in today's global economy, the Fed can't rely just on U.S. operating rates to measure the output gap. It must also track the capacity being added in China and the operating rates of the euro zone when it determines how much slack exists among goods producers.

LIKEWISE, THE TOP-LINE JOB DATA may not be giving a true view of the amount of slack in the labor markets. The Labor Dept. said that job growth in December was much weaker than anticipated. Only 1,000 new jobs were created, far short of the 150,000 forecast by economists, although the government's own employment data tell two different stories. Job growth averaged only 48,000 a month in the fourth quarter. And the December drop in the unemployment rate, to 5.7% from 5.9% in November, was the result of people leaving the labor force, perhaps after giving up hope of finding a job.

As a result, a lower percentage of people remain in the labor markets. From 1997 to 2000, about 67% of the adult population were either employed or actively seeking work. By December, participation had slipped to 66%. While the difference may seem small, if the participation rate stood at 67%, more than 2 million additional people would be working or looking for work.

The Labor Dept. itself measures how much labor is being underutilized by adding up unemployed, part-time workers, and other marginally attached workers. That rate of underemployment in December stood at 9.9%.

Still A Lot of Slack to Be Taken Up
Policymakers are well aware of the vagaries of employment data. Chairman Greenspan has long tracked the pool of available workers, defined as the number of unemployed plus the number of people who have dropped out of the labor force but still want a job. In December, this pool totaled 13.1 million workers. That's down from 13.9 million in June, but not much different from the hefty level so far in this recovery (chart). No wonder wages in December were up only 2% from a year ago, the smallest annual pay gain since 1987. Even if productivity gains slow this year, as expected, the rate will still be high enough to offset such meager pay raises and keep unit labor costs on the downswing.

Favorable trends like declining unit labor costs are why inflation won't be on anyone's radar this year. That, plus the excess capacity among global goods producers and the slack still hidden in the U.S. labor markets, makes a strong argument that policymakers might be able to sit out the entire year.

Corrections and Clarifications "Why the Fed has time on its side" (Business Outlook, Jan. 26) said that the Federal Reserve has gone a year without moving interest rates. Actually, the Fed last moved rates in June, 2003, not January.

By James C. Cooper & Kathleen Madigan

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