Speeches

Remarks by Charles L. Evans
President and Chief Executive Officer
Federal Reserve Bank of Chicago

Association for Manufacturing Technology
Lost Pines, Texas

October 6, 2008

"Productivity Growth in Manufacturing"*

Introduction

It's a pleasure to speak to you today. Let me start by thanking the Association for Manufacturing Technology and John Byrd for inviting me, and Pat McGibbon who helped arrange my visit here today.

I'd like to spend much of my time with you today talking about productivity growth in manufacturing—a topic that I know is of critical importance to this group. But I will also share some thoughts on the extraordinary events that have occurred in the financial markets over the past several weeks. Before we begin, though, let me note that the views I express today are my own and are not necessarily shared by my colleagues on the Federal Open Market Committee.

Extraordinarily Turbulent Times

Over the past year, we have witnessed the deteriorating performance of mortgages and mortgage-backed securities spill over to other segments of financial markets. Market participants have reassessed the risk profiles of other similarly structured assets, and prices of these securities have declined as well. This cascading re-pricing process has had a significant impact on liquidity and capital positions in a wide range of financial institutions and markets in the United States and around the world. As we have observed over the last few of weeks, we are indeed in the midst of extraordinarily turbulent times. We are seeing large-scale disruptions in the financial services industry, and financial institutions, nonfinancial borrowers and lenders, and policymakers all confronting how to best respond to them.

The disruptions in financial markets have spilled over making credit more costly and more difficult to obtain for many households and businesses. For example, the reluctance of banks to lend to one another because of concerns over counterparty risk and the desire to preserve liquidity has resulted in large increases in the London interbank offered rate, or LIBOR—the common benchmark for the interest rate charged on short-term interbank lending. Many banks set their interest charges on loans to households and businesses as a markup over their cost of funds, as measured by LIBOR. So the increases in LIBOR have translated into higher bank borrowing rates for many of you in this room. As another example, heightened concerns over some financial services firms' ability to roll over their commercial paper (CP) have strained the markets for other types of commercial paper. This has affected the availability and cost to some nonfinancial firms of funding activity through the CP market. And I could list many other examples of such spillovers from the financial turmoil to the nonfinancial economy.

In addition to developments in the financial markets, the protracted weakness in housing markets continues to be a drag on the economy. And the elevated prices for energy and other commodities have reduced the spending capacity of households and businesses.

As a result of all these factors, job creation, consumer spending, and industrial production have all weakened. Payroll employment declined again in September, bringing the cumulative year-to-date job losses to 760,000. There also has been a sharp rise in the unemployment rate this year—in September it was 6.1 percent, a full percentage point above the level many view as being consistent with "full employment." The weak labor markets and high consumer prices have held back growth in real incomes, contributing to marked weakness in consumer spending: the average level of real personal consumption expenditures for goods and services in July and August was down more than 2 percent at an annual rate from the second quarter. With regard to industrial production, overall output has fallen nearly 2 percent since last December. And after changing very little for about a year, the ISM manufacturing purchasing managers' index was down sharply last month.

In addition to the challenges to financial markets and economic activity, we also are dealing with concerns about inflation. Of course, one reason for the increased risk to inflation is the surge in commodity prices, particularly energy. Another has been high food prices. However, even excluding food and energy, so-called core inflation for personal consumption expenditures was up to 2.6 percent (year-over-year) in August. This rate is too high. Also, the dollar is regaining ground from its previous lows, which should lower pressures from import prices. Furthermore, the increased slack in the economy will likely reduce more general cost and inflationary pressures. This channel seems stronger today than I expected earlier this summer. Nevertheless, the inflation outlook remains a risk. Energy and commodity prices are notoriously volatile, and could rise again. More importantly, there is the risk that persistently high rates of overall inflation will boost the long-run inflation expectations of businesses and households, and thus become embedded in their actual price and wage setting behavior.

Turning to the outlook, because of the economic headwinds we face, real economic activity is likely to be quite sluggish in the second half of this year and into 2009. I expect that growth will pick up as financial markets make headway in working through these problems, and credit flows improve somewhat. Still, the level of uncertainty surrounding this time path is very high.

In these circumstances, the U.S. economy faces difficult challenges. Last month I attended our regular policy meeting in Washington, where, after considering all of the issues, the Federal Open Market Committee decided to leave the federal funds rate unchanged at 2 percent. Of course, we policymakers must continuously reevaluate our policies in light of current and forecasted conditions to ensure that our assessments of risks are aligned to meet our long-term policy objectives of maximum sustainable growth and price stability. Currently, these risk evaluations must factor in substantial uncertainty in the outlook for both growth and inflation. In particular, there is a great deal of uncertainty over how the intensified stress in financial markets we have seen over the past few weeks—and the policy responses to them—will play out over time and in turn how this path will affect the economy.

With regard to those policy responses, as you are aware, the Federal Reserve has enacted a number of policies aimed at supporting the flow of liquidity through the financial system. We have faced many difficult decisions; and in making them we have been guided by our mandate to help foster a sound and stable financial system. And last week Congress enacted a plan of unprecedented scope to address the difficulties we face as a nation. I will be happy to address questions on this topic after my remarks, but let me now turn away from "breaking news" and spend a little time on the longer-term prospects of productivity growth in manufacturing.

Manufacturing's Performance in the U.S.

Last month I attended the International Manufacturing Technology (IMT) show in Chicago with John Byrd. It was the largest manufacturing show I'd ever attended—and I suspect one of the largest shows of its type anywhere in the world. I understand this year's show was one of the most successful—with over 92,000 attendees. Congratulations to the Association for Manufacturing Technology (AMT).

Although I only had time for a quick tour, I was fascinated by the uses of software, robotics, and other technologies that were part of virtually every manufacturing application on display at the show. I already have the dates marked for the 2010 show—September 13–18—and I'm looking forward to seeing you in Chicago.

The manufacturing sector is of great importance to us in the Seventh Federal Reserve District. Our District includes Iowa and the larger parts of Illinois, Indiana, Michigan, and Wisconsin. This region makes up 13 percent of both the U.S. population and our gross domestic product. It produces nearly 30 percent of America's vehicles; more than a third of America's steel; more than half of its farm machinery; and almost half of our corn, soybeans, and pork. As measured by the manufacturing share of nonfarm payroll jobs, Indiana ranked first among the 50 states in 2007; Wisconsin, second; Iowa, fourth; Michigan, seventh; and Illinois, 19th. So, of course, we at the Federal Reserve Bank of Chicago closely watch and monitor the manufacturing sector.

We do so in many ways, ranging from research studies to face-to-face roundtables with company analysts to monthly phone calls with industry leaders. For many years we have published the Chicago Fed Midwest Manufacturing Index (CFMMI), which measures manufacturing output in the Seventh District on a monthly basis. It is the regional analog to the manufacturing component of the Industrial Production Index for the U.S. as a whole that is produced by the Federal Reserve Board of Governors. Since 2000, Midwest manufacturing output growth has lagged that of the nation. However, our CFMMI, along with our national measures of the manufacturing sector, show—at least to date—there has been a milder rate of slowdown in manufacturing activity than in other recent episodes of economic stress. However, this steady ground may be beginning to slip. Our August CFMMI indicates a sizable decline in output over the July reading.

Of course, industry performance varies sharply from sector to sector. Currently, you will not be surprised to hear that transportation equipment—which in the Midwest is largely concentrated in the automotive industry—shows steep declines. In contrast, our machinery sector—which includes a host of capital goods—is holding up much better. This deviation, too, is somewhat unusual. It reflects strong economic growth by our international trading partners who demand items such as tractors, generators, and mining equipment, as well as the strength in the mining and farm sectors here in North America.

Differences in the concentration in specific industrial sectors have influenced the economic performance among the states in the District. Since 2000, the automotive-intensive states of Indiana and Michigan have experienced deteriorating labor markets relative to the national average. In contrast, several metropolitan areas in Illinois, Wisconsin, and Iowa with machinery-intensive manufacturing operations have held up better than in the past. We have a "Tale of Two Industries" within the District, with significant stress in many of our automotive-dominated metropolitan areas, but also continued prosperity in many of our machinery-concentrated areas.

While manufacturing fortunes are mercurial and ever changing, over the past 50 years the overall sector has experienced strong productivity growth in excess of the remainder of the U.S. economy. Productivity measures how much output can be produced for each hour of labor input. It is the fundamental determinant of our ability to generate economic well-being.

Globalization has sharpened competition in recent years so that survival requires ever more dedication to staying one step ahead and at the forefront of innovation. We observed an acceleration of productivity during the mid-1990s that was concentrated in the production of durable goods. Today, workers and businesses have kept productivity on a solid uptrend by continually improving process technologies in the plant and by developing new products to meet the needs of customers at home—and, increasingly, abroad. One way to boost productivity is through research and development. Manufacturing companies are investing more in R&D as a way to develop new products and improve productivity. In 2003, manufacturing companies accounted for an outsized 44 percent of the nation's R&D spending. In fact, in the Midwest, manufacturing company R&D is even more dominant.

While such technological innovations are critical, we should not overlook the profound and continual organizational changes in our economy that also contribute to manufacturing productivity. These include recombination of business activities and finer specialization along individual business and product lines. Such recombination includes mergers and acquisitions of firms as well as the outsourcing of business services and products to highly specialized suppliers. As Peter Drucker exhorted in 1989, "sell the mailroom." In the U.S., manufacturing firms have done exactly that. On average, in the late 1950s the sector purchased 15 cents in services for every dollar of its own output. This figure has approximately doubled since then. Manufacturing firms are focusing on their core competencies while outsourcing business services such as accounting, transportation and logistics, legal, and H.R. to both U.S. and foreign-domiciled service companies.

Such moves toward finer specialization and the search for the "core competency" also take place along product lines. In the U.S., we often find that manufacturers shift from mature products, whose competitive advantage tends to depend on factor costs alone, to innovative and customized products. Such products may have high research and development content, require advanced tools and machinery, or include intensive product design and marketing. The process, however, of such product shifting often results in less-skill-intensive products being offshored to other regions of the world. For example, in my home District, office furniture manufacturers have survived and prospered by ceding production of many low-end and routine products to low-cost overseas producers, while they then specialize in high-end custom-designed office systems and related services.

In the process of focusing on innovative high-end products, it is not surprising to find that the skill requirements for the manufacturing work force have been increasing. This phenomenon is not confined to manufacturing by any means, but is widespread throughout our economy. For example, across the entire U.S. work force, the average wage premium for college-educated workers over workers with just a high school diploma climbed from 40 percent in 1980 to 60 percent in 2005.¹ As the tools of production in both manufacturing and in services have become more sophisticated—for example, CAD/CAM and personal computers—the educational requirements and analytical skills of those who work with these tools have also increased. In turn, rising demand for such workers and skills has raised their relative wages.

This is true on the factory floor as well as in the office tower. In examining payroll job trends since 1979, for example, one research study divided manufacturing sector jobs into low-, medium-, and high-skill categories. According to the authors' definition, between 1979 and 2002, high-skill manufacturing jobs rose by 37 percent, or 1.2 million jobs. In contrast, low-skill jobs fell by 25 percent, and mid-skill jobs dropped by almost 18 percent.²

From you and your manufacturing colleagues, we at the Fed often hear it lamented that young people have abandoned the pursuit of careers in manufacturing, even though jobs go begging and generations of older workers are set to retire. To some extent, this aversion to training for manufacturing careers has come about because the images of the "dirty factory" and the dark mill are enduring. But it may also reflect lack of information on the emerging opportunities in manufacturing. That is, young people have learned that education and training increasingly "pays" in today’s labor market. But they have not learned that this applies not only to financial and business services but also to some jobs in manufacturing as well.

Now let me turn to the international nature of the markets for manufactured goods. The story for exports in manufacturing has been good. The U.S. produces more than 20 percent of the world's manufactured goods—the largest output in the world—with less than 5 percent of the global population. In 2007, manufactured exports made up 6.6 percent of the nation's output, and an estimated 8 percent of the output of the Seventh Federal Reserve District.

Exports have become a larger part of our domestic production. For example, even amid the current environment of sagging domestic automotive sales, exports of new automobiles from the U.S. have increased by 21 percent since 2002. And service exports, such as media, entertainment, financial services, and computer software, are up nearly 10 percent over the past year.

We can attribute the rising role of U.S. exports to many things, especially to the greater integration of world markets that has taken place as a result of falling communication and transportation costs as well as to lower tariff and regulatory barriers to trade that have been put in place over the last half century. But for firms to succeed and participate in the new environment, they have needed to adapt and innovate along many fronts.

At a minimum, manufacturing prowess in today's highly competitive markets increasingly requires mastery of the global supply chain. This means timely and low-cost acquisition of parts and components from around the world to meet domestic demand, and the shipment of product abroad.

Mastery of such processes has allowed some companies to globalize their production operations. By both sourcing and producing worldwide, and by integrating their operations worldwide, firms can more effectively meet product demands originating from various regions of the world.

One such company is Caterpillar, headquartered in Peoria in my District. By leveraging lean manufacturing, overhauling organizational processes, and being at the forefront of product technology, Caterpillar is now meeting the needs of a world market. Today Caterpillar operates factories in over 60 locations in 23 countries. At the same time they also produce at 50 facilities in the U.S.

Deere, headquartered in Moline, Illinois, is another company that has positioned itself globally. To meet today's growing market for agricultural production. Deere recently announced investment in a large tractor plant in Waterloo, Iowa, while also expanding in Brazil.

However, it's not just large manufacturing companies that are going global. North American Tool is a cutting tool manufacturer with about 100 employees in South Beloit, Illinois, which has a population of about 5,500. When the industry began shifting, North American Tool decided to enter the global marketplace. Today, it is a $10 million company in the U.S. that exports to 54 countries.

Conclusion

The real story in manufacturing is phenomenal productivity growth. Through innovation along many channels, U.S. manufacturers have demonstrated that they can compete in the global economy—manufacturing exports are at the highest percentage of GDP since World War II. Prior to 1970, manufacturing was defined by craftsmen operating machines, whereas today the focus is on advancing the integration of computer-controlled machinery. The impact of technology on manufacturing was evident in almost every manufacturing application on display at the International Manufacturing Technology Show. As everyone here appreciates, U.S. manufacturing must lead the global industry in producing innovative and high-quality products if it is to be successful. It looks as though you are well on the road to accomplishing this.

*The views presented here are my own, and not necessarily those of the Federal Open Market Committee or the Federal Reserve System.

¹Claudia Goldin and Lawrence Katz, 2007, "The race between education and technology: The evolution of U.S. educational wage differentials, 1890 to 2005," National Bureau of Economic Research, paper, March.

² Richard Dietz and James Orr, 2006 "A leaner, more skilled U.S. manufacturing workforce," Current Issues in Economics and Finance, Federal Reserve Bank of New York, Vol. 12, No. 2, Feb/March, pp. 1-7.