Brian Motley

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Research Papers in Economics

FRBSF WEEKLY LETTER
October 19, 1990
The Landing Was Harder
than We Thought!
In July of each year, the Bureau of Economic
Analysis issues revised estimates of the gross
national product for the previous three years.
These "benchmark" revisions incorporate new
information that was not available when the ear-
lier estimates were released. Some information is
available only on an annual basis (for example,
from annual surveys of firms in various industries
and from annual tabulations of tax data), so the
quarterly estimates of GNP are based on inter-
polations and extrapolations and must be revised
when new annual data become available.
The resulting re-estimates may alter our views
of where the economy has been and where it is
heading, and may, in turn, have implications for
monetary policy. This Letter discusses the most
recent GNP revisions, which showed that real
(inflation-adjusted) growth since 1987 has been
less than previously estimated, particularly
in 1989.
Not as soft...
In recent years, the economy has been operating
at or close to its productive capacity, and the
demands on the economy's resources have been
strong. These demand pressures have tended to
feed inflationary pressures. The Federal Reserve
has been conducting monetary policy with a
view to reducing these pressures and bringing
the inflation rate gradually down toward zero.
This has entailed slowing the growth of real
output to a rate below the rate of growth of
the economy's productive capacity ("potential
growth rate") in order to reduce the pressure
of demand on resources.
At the same time, however, the Fed has been
concerned that the economy might slow so
sharply that there could be a serious risk that real
GNP actually would decline. The goal of policy
has been to guide the economy toward what
many have been caliing a "soft landing;" this
would avoid both the rapid growth that could in-
crease inflation and a recession that could cause
unemployment to rise to unacceptable levels.
Prior to the release ofthe revised GNP data, it
appeared that the economy had been following
a path close to that needed to achieve a soft
landing. The growth rate of real GNP had slowed
from 5.3 percent over the four quarters of 1987
to 3.3 percent in 1988 and to 2.5 percent in
1989. Growth in 1989 actually would have been
slower than this if it had not been for the bounce-
back in farm production associated with the end
ofthe previous year's drought. Excluding this
temporary boost, the growth rate last year was
originally estimated to be 1.8 percent.
Most estimates of the economy's potential growth
rate, which depends on the growth of the labor
force and its productivity, fall in the 2Y2 to three
percent range. With 1989's drought-adjusted rate
just below this range, it appeared that a soft-
landing was being achieved.
However, the revised GNP data show slower
real growth in each of the last three years. The
downward revision was especially large for 1989;
drought-adjusted real GNP increased only 1.1
percent last year, rather than the 1.8 percent
previously estimated. Moreover, the slow pace
of growth in 1989 persisted in the first half of this
year. Despite this sluggish pace, inflation appears
not to have been affected: almost no revisions
were made in the estimates of the average level
of prices. The combination of sluggish growth
and unchanged inflationary pressures suggests
that the landing was not as "soft" as had been
thought.
Acloser look at the revisions
To put the not-so-soft landing into perspective,
it is useful to look at the revisions to the main
components of GNP. The largest revisions for
1989 were in the output of consumer services,
especially of medical care services. The revised
data indicate that real personal spending on
medical care increased only 2Y2 percent last year
rather than the 6Y2 percent previously estimated.
Households also spent less on private education
and on state lotteries than earlier estimated. InFRBSF
addition to the revision to household spending,
small downward revisions were made to the
1989 estimates of spending on business equip-
ment, inventory accumulation, and goods
purchased by state and local governments.
These downward revisions in turn were reflected
in lower estimates of national income. The shares
of income going to different groups also were
revised. Labor income, which Comes mainly
from wages and salaries was revised downward
by more than the revision in total GNp, while
corporate profits and the incomes of noncorpo-
rate businesses were revised upward. The pre-
vious estimates had suggested that the share of
the nation's output going to employees had been
trending upward in recent years. It now appears
(see the chart)that, excluding the effects of the
sharp decline in business profits in the early
1980s, labor's share has been roughly constant
since the late 1970s.
Employee Compensation as a
Share of National Income
Percent
76
75
74
73
72
Since the revised GNP data were released,
benchmark revisions also have been made to
data on payroll employment and hours of work.
These new data show no major change in the
estimates of total hours worked in the economy.
But since both output and labor income were
revised downward, output per employee hour
(labor productivity) and hourly compensation
(real wages) also were lower. After adjusting for
the effects ofthe drought, the revised data indi-
cate that output per hour in private business
declined by 1Y2 percent over the four quarters
of 1989. Real hourly compensation decreased
by 2V2 percent. Before the data revisions,
hourlyoutput and compensation both were
estimated to have risen slightly lastyear.
Implications for policy
These data revisions point up a problem that
faces the Federal Reserve when it conducts pol-
icy on the basis of measures of current economic
activity. Revised data may suggest a different pol-
icy from that adopted on the basisof the earlier
data. For example, economic growth that turns
out to have been greater or less than previously
estimated may suggest that earlier policy deci-
sions should be reviewed. However, other factors
must be considered before deciding that a
change in policy is indicated.
For example, data revisions may not justify
a policy response ifthey do not cause policy-
makers to alter their forecasts of future activity
and especially of future inflation. Because mone-
tary policy has observable effects on the econ-
omy and the price level only after a considerable
time lag, policy actions always must be taken
with an eye to the future (see the Letter ofJuly 8,
1988). Thus, when revisions to past data do not
alter the forecast of futureeconomic activity, they
will not change the Fed's judgment ofthe appro-
priate course for policy.
The reasons for the revised estimate of past
growth generally will have an important bearing
on the Fed's response to the revisions. When data
revisions can be attributed to stronger or weaker
aggregate demand than previously thought, a
reassessment of earlier policy actions may be
needed. Data revisions that are due to a hitherto-
unrecognized change in aggregate supply ("sup-
ply shock"), on the other hand, may not justify
a change of policy.
Supply shocks arising from changes in such
factors as the population's willingness to work or
the prices of important raw materials, such as oil,
affect the economy's capacity to produce goods
and services. Monetary actions cannot do much
to offset the effects of these kinds of shocks on
real growth. Consequently, a change in policy
probably would not be justified in the case of a
supply shock, even though supply shocks gener-
ally do affect inflation, at least temporarily.
These observations suggest that to the extent
the recent downward revision in 1989's growth
can be attributed to weaker demand, the current
stance of monetary policy may be tighter thanwould be desirable. On the other hand, to the
extent the downward revision is the result of a
shock to aggregate supply, earlier actions to
tighten policy remain appropriate.
Supply or demand?
In practice, it may be difficult to determine
whether a revision in GNP is due to demand or
supply considerations. One possible interpreta-
tion of the recent data revisions is that the Fed-
eral Reserve's tightening of monetary policy in
1988 and early 1989 has had a greater impact on
aggregate demand than was estimated earlier. If
this were the case, however, the revision should
have been concentrated in areas of the economy
that generally are particularly sensitive to a tight-
ening of monetary policy. Instead, the principal
revisions were to consumer expenditures on serv-
ices which generally are considered relatively
insensitive to monetary actions.
Of course, this does not rule out the possibility
that aggregate demand was reduced by some
other shock unrelated to Federal Reserve policy.
If aggregate demand was weaker than earlier
estimated, whether or not this was due topast
policy actions, upward pressure on inflation
probably was less than previously assumed.
An alternative interpretation is that the aggre-
gate supply factors that have sustained the long
expansion of the 1980s have weakened some-
what in recent quarters. As discussed in a recent
Letter Uune 22, 1990), the expansion apparently
has been associated with an increase in workers'
willingness to work. Both labor force partici-
pation and average hours of work have risen
strongly since the early 1980s, thus boosting the
potential growth rate of the economy. Although it
is clear that the supply of labor has continued to
rise, the revised GNP data suggest that this posi-
tive supply-side effect on real output has been
partially offset in recent quarters by slower
growth of labor productivity. In addition, both
labor force participation and hours of work have
increased less strongly in recent quarters than
earlier in the expansion.
In this regard, it is notable that, in a number
of instances, the downward revisions to the
estimated output of consumer services directly
reflect lower estimates of labor productivity in
the service industries. The preliminary estimates
used employment data to calculate service sector
income, based on assumptions regarding the
growth of productivity. These assumptions turned
out to be too high. For example, the results of the
Census Bureau's annual survey of the service in-
dustries showed that the receipts of suppliers of
medical care were less than had been estimated
from payroll employment data.
It is difficult to determine whether the slowing
in the growth of labor supply and labor produc-
tivity represents a supply shock or merely a
response to reduced aggregate demand. For ex-
ample, the slower growth in output per hour may
have occurred because firms did not immediately
adjust their payrolls in response to reduced out-
put associated with reduced demand. Alterna-
tively, the slower growth in labor supply and
labor productivity may be due to changes in
the age structure of the population and other
"exogenous" changes in aggregate supply.
Inflation pressures
Given that the recent revisions to the GNP data
show that the economy's growth rate has been
less than earlier estimated, butthat inflation has
been no lower, it is likely that supply factors have
played an important role. Ifthe slowing reflected
weaker aggregate demand, one would have ex-
pected the underlying inflation rate to begin to
ease after a year and a half of below-potential
growth. In contrast, negative supply shocks do
not affect the underlying inflation rate and may
even raise inflation temporarily. The supply-side
explanation, moreover, is consistent with the
nature of many of the detailed data revisions.
In recent years, the Federal Reserve has con-
ducted monetary policy with a view to lowering
the inflation rate by reducing aggregate demand
pressures. If changes on the supply side (most
likely in the form of slower growth of both labor
supply and labor productivity) are primarily re-
sponsible for the slower real growth, the recent
revisions in the GNP data do not imply any
lessening of inflationary pressures.
Brian Motley
Senior Economist
Opinions expressed in this newsletter do not necessarily reflect the views of the management of the Federal Reserve Bank of
San Francisco, or of the Board of Governors of the Federal Reserve System.
Editorial comments may be addressed to the editor (Barbara Bennett) or to the author.... Free copies of Federal Reserve
publications can be obtained from the Public Information Department, Federal Reserve Bank of San Francisco, P.O. Box 7702,
San Francisco 94120. Phone (415) 974-2246.Research Department
Federal Reserve
Bank of
San Francisco
P.O. Box 7702
San Francisco, CA 94120

The landing was harder than we thought!

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The landing was harder than we thought!

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