Labor Markets, Energy Prices, and the Outlook for 2005*

I've been taking part in this event for several years now. I'd like to think that I keep getting invited back because of my jokes, but I suspect it is because the economy has been such a compelling story during this time.

In 2001, the economy endured its first recession in a decade. Then it was hit with a series of shocks, the start of the war on terrorism, revelations of corporate malfeasance, and the buildup to the war in Iraq, which restrained the pace of recovery.

However, since early last year, the expansion has accelerated. Firms began creating jobs again and increasing their capital spending. Consumers increased their spending at a faster pace. All told, real GDP growth averaged an annual rate of 4-1/2 percent over the past year and a half.

This solid growth suggests that many of the economy's headwinds have receded. Still, as you read the newspapers, you find two topics that remain areas of uncertainty for the near-term outlook: labor markets and energy prices. As we move into 2005, the stimulus from monetary and fiscal policy will diminish. So, any weakness in the labor market and any drag on spending, like rising energy prices, could become more critical for the strength of the expansion. Today, I want to discuss these issues in a broader context. And, since I know you won't let me get away without doing so, I'll also say a few words about monetary policy.

Labor markets have improved recently, but for most of the recovery, job growth was the missing link. Payroll employment has yet to surpass its level at the start of the recession, even though the recession officially ended 36 months ago. In contrast, averaging over the previous 6 recoveries, payrolls returned to their pre-recession levels after 10 months.

Analysts have proposed many explanations as to why job growth has been slow to recover. One common explanation is that there has been a greater-than-normal need for workers to move between industries, in part because of a large decline in manufacturing employment, and in part because it has been easier to outsource both manufacturing and service jobs to other countries.

Certainly these developments are noteworthy, but they are not enough to explain the slow employment growth. With regard to manufacturing, its share of total employment has been declining for decades, and factory jobs are usually hit harder by recessions and periods of weak growth. Our research at the Chicago Fed has found that recent changes in industry employment shares, including that for manufacturing, have not been that unusual considering the long-run trends and the usual fluctuations over the business cycle.

With regard to outsourcing, estimates of the number of affected jobs are not large—especially in relation to the regular churning that takes place in the job market—although accurately measuring the impact of outsourcing is quite difficult. But more important, 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. At the same time, technological advances have created new jobs that replaced the jobs lost to foreign competition. That is why, even while there has been a decline in manufacturing's share of employment and an increase in international competition, the U.S. economy has generated over 80 million net new jobs over the past 50 years.

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 are significant and compelling. Factories or offices may close and workers lose their jobs. We must always strive to ease the transition for affected workers and their families, whether it is through financial assistance, retraining programs, or other efforts. But if we are to continue to increase overall incomes and our standard of living, we must continue to open our markets and allow dynamic changes in the economy to take place.

Later this week the Chicago Fed will host a conference on the causes and consequences of job losses.

If the decline in manufacturing and the increase in outsourcing are not to blame, what else might have caused weak employment growth?

One possibility is that, in the face of increased geopolitical and corporate governance concerns, firms held back on hiring longer than they usually would at the beginning of a recovery. New employment practices, which some call just-in-time hiring, may have made such caution a more viable strategy. In the past, firms would hire in anticipation of a pickup in demand so they would not be caught short of workers when a rush of new orders started to come in. But, the burgeoning temporary help industry and the spread of business service providers now give firms the option of quickly bringing in temps or contractors when demand increases. As a result, they can wait until orders are in place before hiring.

These explanations suggest there has been a structural change in how labor markets work. However, we should not forget an old and pretty fundamental explanation—employment growth will be slow if aggregate demand is weak relative to gains in the productive capacity of the economy. Demand languished in 2002 and early in 2003. But, at the same time, firms dramatically increased their productivity. They reorganized their production and distribution networks, exploited advances in technology, and took advantage of the significant capital investments they had made in the late 1990s. As a result, the potential productive capacity of the economy likely advanced much more than demand.

Since the middle of last year, however, demand has been catching up to potential output and has supported an increase of 2.2 million new jobs over the last 14 months. These job gains have been uneven at times, particularly as the economy moved through a soft patch in late spring, but firms created an average of 225,000 jobs per month during the past three months. These data suggest there will be continued improvement in the labor market.

Let me now turn to energy prices. Energy prices weigh heavily on views of the economy. Consumers only have to go past a gas station to see their effects.

This is especially true when energy prices rise sharply, as they have over the past year and half. From 2000 to 2002, the price of West Texas Intermediate crude oil—the bellwether of oil prices—had averaged just under $30 per barrel; in late October, it topped $55 per barrel. Oil prices have retreated more recently but they certainly remain high.

What is most remarkable, though, is how long these higher oil prices are expected to persist. The pickup in world demand—boosted in part by the strong economic growth in China and India—and geopolitical uncertainties have created expectations for oil prices to remain high. For many years, the price of oil for future delivery five years ahead averaged in the low $20 per barrel range. Now, it is nearly $40 per barrel.

Higher energy prices primarily can affect the economy in two ways. First, they can be a drag on output and spending. Because we import so much oil, an increase in energy prices acts like a tax on U.S. consumers and businesses—they have to spend more of their income on energy expenses.

This effect is now smaller than in the past. First, adjusted for inflation, oil prices are well below those following the oil shocks of the 1970s. Second, the U.S. economy increased its energy efficiency in response to those oil shocks. Homes have been built to be more energy efficient, and factories have invested in energy-saving machines and processes. And, the U.S. has continued its evolution away from energy-intensive activities like manufacturing toward more service activities. As a result, the economy needs much less energy per unit of output than it did in the past. Twenty-five years ago, it took more than 15,000 BTUs of energy to produce one real dollar of GDP; in 2003, it took just under 9,500 BTUs.

The recent run-up in energy prices has had a noticeable effect on spending, but, as of yet, it certainly has not derailed the recovery. According to our estimates, higher energy prices have reduced real GDP growth this year by 1/2 to 3/4 percent.

Energy prices can also matter for the overall price level. In addition to the direct impact on the cost of energy-related items, rising energy prices increase the cost of producing other goods and services. These cost increases can be passed through to the consumer. However, lingering slack in the economy has limited this passthrough thus far. In fact, overall inflation remains low and has even moderated during the recent surge in oil prices.

But will these higher oil prices eventually lead to persistently higher inflation? Not necessarily. Suppose oil prices stop rising and stay at their current high levels. Once the cost adjustments in the economy are complete, there will be no reason for prices to rise further, and inflation should return to what it was before.

There is a concern, however, that when people see prices rise, they may come to expect them to continue to rise. If so, such expectations can actually become self-fulfilling. We saw this in the 1970s when higher expected inflation became built into business and household plans. So the Federal Reserve must be vigilant in monitoring inflationary expectations and be prepared to act if they threaten price stability. Thus far, though, we have seen little evidence that long-run inflationary expectations have risen.

What do low inflation and low inflationary expectations mean? In effect, they mean that we are in the neighborhood of price stability–which is to say that inflation does not figure prominently in the spending and investment decisions of consumers and businesses. The challenge for the Federal Open Market Committee is to adjust monetary policy so the economy can maintain price stability at the same time it moves toward a sustainable growth path.

By any measure, monetary policy remains accommodative. Accommodative policy has been necessary to support economic growth, but as the economy continues to strengthen and employment picks up, interest rates will need to return to a neutral level.

We started this process in June, and, since then, we have raised the federal funds rate from its forty-year low of 1 percent to 2 percent. There is certainly more ground to cover. But given the low level of inflation, well contained inflationary expectations, and the remaining slack in the economy, we believe we can remove the remaining policy accommodation at a pace that is likely to be measured.

In closing...I'd just like to note that in the late 1990s, when the Fed tightened policy, many analysts used the phrase "soft landing" to describe the process of the economy cooling off from its red-hot pace to a sustainable growth path. Today, rather than heading toward a soft landing, the economy is approaching its cruising altitude along its sustainable growth path.

And this growth path looks good–the fundamentals of our economy are strong. With our market-based principles, our entrepreneurial culture, and our continuing technological advances, our economy has the foundation to enjoy solid growth and price stability in the years ahead.

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