'U.S. Economic Outlook' *
Remarks by Michael H. Moskow
President and CEO
Federal Reserve Bank of Chicago
Green Bay Chamber of Commerce
Green Bay, WI
Challenges for monetary policymakers
As president of the Chicago Fed, I participate with the 11 other District bank presidents and the seven members of the Board of Governors in meetings of the Federal Open Market Committee (FOMC). This, of course, is the group chaired by Alan Greenspan that is responsible for setting monetary policy. At each meeting, Committee members discuss the outlook and debate policy options for the national economy. Based on its discussion, the FOMC decides where to set its target for the federal funds rate-the overnight lending rate banks charge each other to borrow reserves. This short-term interest rate influences the amount of liquidity or funds available for spending and investing.
We have two goals in setting monetary policy: maximum sustainable economic growth and price stability. These two goals are not entirely independent; there is a relationship between economic activity and inflation.
While analysts and the business media commonly talk about activity in terms of growth rates-for example the 4.2 percent growth of real GDP in the first quarter of the year-it is important remember that there is a level of output behind its growth rate.
Along with this level of actual output, the economy also has a level of potential output-the amount of goods and services that it can produce on a sustained basis, given its technology, labor, and capital and how productively it uses them. The level of potential output expands over time. Currently, many economists believe that it grows between 3 and 3-1/2 percent each year. These estimates are significantly higher than they were when I joined the Fed nine and a half years ago, largely because of the recent trend of higher productivity growth.
Now, the level of actual economic output fluctuates above and below its potential. The difference between the two is what economists call an output gap. When the economy operates above its potential for an extended period of time, labor and capital resources tend to become scarcer, generating inflationary pressures. When the economy is below its potential, excess resources tend to reduce inflation.
Today, it appears that the level of actual output is still somewhat below potential. But, with the impressive growth of economic output in the past nine months, the output gap has narrowed.
Looking forward, part of the Fed's policy challenge is to help accommodate economic activity so it can further close this output gap, without-sometime down the road-overshooting the level of potential output and generating inflationary pressures. To be sure, as the aggregate economy moves into balance, individual sectors or industries may develop imbalances. Policymakers must consider whether the imbalances in particular sectors pose a risk to the economy at large. But monetary policy is a blunt tool that is wholly incapable of addressing the concerns of individual sectors of the economy-it can only be used to try to influence the balance of resources at a macro level, taking into account the aggregate impact of the individual sectors.
Recent economic conditions
Our current output gap can be traced back to the recent recession, which began in March 2001. During this period, real GDP declined as businesses significantly cutback on their capital investments and inventory spending. By historical standards, the recession itself was mild: it ended just eight months after it began, and real GDP contracted only 1/2 percent between its peak and trough-about one-quarter the average decline during the other recessions since 1960.
The subsequent recovery began at a moderate pace, in part, because of the mild nature of the recession and, in part, because of a series of shocks-the start of the war on terrorism, revelations of corporate malfeasance, and the buildup to the war in Iraq-that hit the economy.
As a result, while we experienced a few short spurts of strong demand growth early in the recovery, the economy failed to sustain a vigorous pace of expansion. During 2002 and the first half of 2003, real GDP growth averaged about 2-3/4 percent-which is below the 3 to 3-1/2 percent that we estimate as the potential output growth rate. So, even though the economy stopped shrinking at the end of 2001, the output gap did not close.
As we moved through 2003, we saw signs of improvement in several key sectors of the economy. Household spending, which had held up quite well throughout the recovery, posted solid gains. But, more importantly, business confidence improved and spending on capital equipment rose strongly in the second half of 2003. Inventory investment also increased.
The economy's momentum has continued, and real GDP growth has averaged about a 5-1/2 percent annual rate over the past three quarters. This is a good deal stronger than even the most optimistic estimates of the rate of growth in potential output, and implies that we have made significant progress in narrowing the output gap.
The strength in output growth, and the confidence it has generated, have finally led to some significant gains in employment-288,000 new jobs in April and an average of 217,000 new jobs per month so far this year.
But until this year, job growth was the missing link in the recovery. Payrolls are still more than 1-1/2 million jobs below their peak, even though the recession has been over for 30 months now. Typically, employment has surpassed its previous peak 11 months after a recession ends. Even after the 1990-91 recession, which was the original jobless recovery, employment surpassed its previous peak in 23 months.
Analysts have proposed many explanations as to why we haven't seen the kind of job growth we typically do early in an expansion. One we have heard frequently is something economists describe as unusually high sectoral reallocation. Proponents of this explanation claim that extensive changes in the economy have resulted in a greater-than-normal need for workers to move among industries and occupations. As evidence, they point to the sharp declines in manufacturing employment and to firms' increased ability to outsource both manufacturing and service jobs to other countries. Certainly these developments are noteworthy. But do they imply that sectoral reallocation is unusually high?
After all, our economy is very dynamic-it is constantly changing due to a variety of factors. Consumers shift their demand for products and services. International markets open up new opportunities for trade. And new technologies emerge that create entire new industries. As a result, jobs disappear from industries that are shrinking and many new ones are created in industries that are expanding.
The monthly job numbers don't fully reflect the huge amount of churning that actually takes place in labor markets. The 288,000 new jobs in April was only the net change in employment. In fact, more than 2-1/2 million jobs are created on average each month, and approximately the same number are destroyed.
As one would expect, the gross rate of job destruction spiked during the recession but has fallen back to the low level that prevailed before then. In contrast, the gross rate of job creation fell during the recent recession and, unfortunately, has been slow to recover. But the fact that both rates have been relatively low suggests that the pace of job reallocation is not especially high.
Furthermore, despite all of the discussion about the decline of manufacturing and the increase in international outsourcing, neither factor seems to be unusual enough to make this a period of heightened reallocation.
With regard to manufacturing, factory jobs are usually hit harder by business cycle downturns and periods of weak growth. And manufacturing's share of total employment has been trending down for decades. This long-run trend is largely due to higher productivity growth in the manufacturing sector compared to the overall economy.
At the Chicago Fed, we've hosted a series of workshops devoted to understanding the causes behind the recent decline in manufacturing jobs. Most of the evidence attributed the decline to the combined effects of ongoing long-term trends and the business cycle. In relation to the rest of the economy, manufacturing employment does not appear to have been behaving much differently than it has in the past.
The workshops also highlighted a number of ongoing developments in the manufacturing sector. For example, traditional manufacturing firms have branched out beyond production and assembly into a broader range of activities that includes customer service, financing, logistics, research and development.
Manufacturing companies are also purchasing more and more services from other firms, such as accounting, computer programming, and transportation and logistics services.
Some of these changes can confound the data on manufacturing employment. For example, manufacturing firms have increased their use of temporary workers, who are counted-not in manufacturing-but in the service sector. This means that as manufacturing activity rebounds, some of the employment growth will show up as temporary help service jobs rather than manufacturing jobs.
Finally, we were reminded that the manufacturing sector is extremely diverse, and one should be cautious when making generalizations about the sector at large. Textiles, steel, pharmaceuticals, computers, and many others are all part of the manufacturing sector. But the competitive conditions in each of these industries vary enormously, especially with respect to the ever-changing global market place.
This brings us to the question of outsourcing to other countries. Accurately measuring the impact of outsourcing is quite difficult, and we do not have good information on the number of jobs that have moved overseas. But, according to one estimate from Goldman Sachs, only 300,000 to 500,000 jobs have been lost to outsourcing since 2000. For an economy the size of ours, these are not large numbers-especially in relation to the 2-1/2 million jobs created and lost each month in the U.S.
Also, outsourcing and other forms of international competition are not new. Over the past 50 years, we have been challenged by growing competition from Japan, the Asian Tigers, Mexico, and, now, China and India. Yes, certain jobs are lost forever, but our economy is remarkably flexible. Technological advances often give rise to entire new industries, new products, new services, and, ultimately, new jobs that replace the jobs lost to foreign competition. That's why over the past 50 years, even while the manufacturing sector's share of employment has declined and international competition has increased, the U.S. economy has generated over 80 million net new jobs, lifted real wages, and created a higher standard of living.
Because these new jobs are often the result of unforeseeable innovations in technology, it is impossible to say now what kind of jobs will be created in the future. When I was in Milwaukee recently, I learned that GE Healthcare had announced plans to expand their Information Technology and Ultrasound operations in Wauwatosa, Wisconsin. As many as 2500 employees at the new facility will engineer and manufacture innovative medical equipment, including computed tomography, or CT systems. These products allow doctors to readily diagnose health problems like cancer or aneurysms without exploratory surgery, and the machines are now widely available. It would have been virtually impossible to anticipate these jobs five years ago, because no one could have predicted how the use of CT technology would evolve.
Now, I do not want to minimize the impact of the job losses associated with changes in the economy, no matter what their source. The human costs of this process are significant and compelling. Factories or offices may close and workers lose their jobs. We must always strive to ease the transition for these workers and their families, whether it is through financial assistance, retraining programs, or other efforts. But the dynamic changes in the economy are important if we are to continue to increase overall incomes and our standard of living.
If there isn't an unusual amount of reallocation taking place, what else might have caused weak employment growth? A number of other factors could be in play. For example, new employment practices, such as the widening use temporary help and business services, increase firms' flexibility in hiring and allow them to delay hiring until they are certain demand is picking up. Thus, these practices, which some call just-in-time hiring, likely played some role in restraining employment growth.
However, we shouldn't forget an old and pretty fundamental explanation-job growth will be slow if aggregate demand is weak relative to gains in the productive capacity of the economy. Even though aggregate demand languished in 2002 and early in 2003, firms continued to be successful in developing innovative ways to reorganize their production and distribution networks, especially by exploiting advances in technology. In addition, they were able to take advantage of the significant capital investments of the late 1990s. As a result, productivity increased rapidly and the potential productive capacity of the economy likely advanced much more sharply than demand. Since the middle of last year, however, aggregate demand has outpaced even the highest estimates of potential output growth, and led to meaningful increases in employment.
Going forward, I believe that economic growth will remain solid, so I am optimistic that employment will continue to be strong for the rest of this year. Why?
2. Last year's round of tax cuts should support business and consumer spending.
3. The Federal Reserve's highly accommodative monetary policy stance continues to be stimulative.
4. The pickup in capital spending should continue.
5. Improving conditions abroad should provide some additional support for the expansion.
All told, these conditions lay the foundation for solid economic growth. In the Fed's Monetary Policy Report to Congress in February, the central tendency forecast was for real GDP to rise 4-1/2 to 5 percent this year. Given the data we've seen since then, I believe this forecast is still a good one.
On the price front, the most recent readings on inflation at the consumer level are up from the extremely low rates we saw late last year. This has not just been a pick up in the volatile food and energy components-core inflation is up as well. And we are all reading more stories in the press and hearing more concerns from various contacts about rising inflation.
There are a number of factors that could be in play, most of which are likely to be temporary: the fall in the dollar has raised some import prices; higher commodity prices have increased producers' costs; and unused resources may not be moving quickly enough to the sectors where demand is growing fastest. Still, we must remember that no one can measure the output gap very precisely, and one inflation risk looking ahead is that the gap may be narrower then many believe.
These are all factors to watch. But even with the recent increases, the level of consumer price inflation is still low. And, at the macro level, we have yet to see the kinds of pressure on labor and capital resources that would foreshadow a worrisome increase in inflation. Thanks to strong sustained productivity growth, unit labor costs-that is, compensation per unit of output produced in the economy-have been falling on average for the past two years. Outright declines are unlikely to continue as labor markets tighten. In fact, unit labor costs edged up in the first quarter. But I think strong productivity trends should help keep overall cost pressures in check.
Furthermore, in the aggregate, the current markup of prices over unit labor costs is relatively high. While this markup varies over time, it usually does not stray from its historical trend for more than a few years at a stretch. So, going forward, the markup should fall back toward its long-run average-it always has in the past. This decline will tend to dampen the passthrough of increases in unit labor costs to price inflation.
Nonetheless, we must remain vigilant. As I discussed earlier, the output gap is narrowing, and part of the Fed's current policy challenge is to avoid overshooting the level of potential output and generating inflationary pressures. Currently, the federal funds rate is very low. Indeed, if recent developments show through to an increase in inflationary expectations, then the real funds rate will come down-even though we did not change the nominal funds target. Regardless, we cannot maintain this degree of policy accommodation indefinitely. As the output gap narrows further, the real funds rate will have to rise to a level more compatible with long-run sustainable economic growth.
So, in conclusion, I'd say that the outlook for growth in 2004 is encouraging. A year ago, we were worried about unwelcome disinflation; that concern has now subsided. But I do not see broad-based pressures developing that would lead to a significant increase in inflation. Moreover, our economy has begun to meet the challenge of the jobless recovery.
But this is not surprising. Time and time again our economy has proven itself resilient in the face of challenges. In spite of the jobless recovery of the early nineties, the expansion lasted a decade and created 24 million new jobs, at the same time that inflation generally continued to drift down. With its entrepreneurial culture, market-based principles, and continuing technological advances, I am confident that our economy has the ability to handle its current challenges, and the foundation to enjoy solid growth and price stability in the years ahead.
*The views presented here are my own, and not necessarily those of the Federal Open Market Committee or the Federal Reserve System.