Presentation before the AAIM Management Association, St. Louis - Jan. 11, 2002Monetary policy ; Economic conditions

William Poole

English

Research Papers in Economics

1
What Is Happening in the U.S. Economy?
AAIM Management Association
St. Louis, Missouri
January 11, 2002
slowdown did materialize, but it also persisted,
as had not been anticipated. The bottom of the
projected “V” came to look more like a “U” as
forecasters adjusted their projections of a recovery
further into the future. As late as August, fore-
casters continued to project near-term recovery
without a recession. The Blue Chip consensus
forecast released on September 10 projected 2.9
percent real growth for 2001:Q3 and 3.6 percent
real growth for 2001:Q4.
All bets were off as of September 11. The
tragic events of that day were unprecedented and
created an environment where forecasters had
no relevant history on which to base projections
of the future course of the economy. Forecasters
quickly concluded that the losses of lives, property
and jobs in New York City and the disruption to
transportation networks, particularly air travel,
would trip the economy into a recession. Con-
siderable uncertainty prevailed about the depth
and duration of such a recession. The dispersion
of forecasts for 2001:Q4 and 2002:Q1 was much
wider than typically occurs.
In a press release dated November 26, 2001,
the Business Cycle Dating Committee of the
National Bureau of Economic Research announced
that it had determined that a recession was in
progress and called the cycle peak at March 2001.
It is impossible to know whether we would have
had an official recession without the terrorist
attacks; clearly, the economy was not performing
well. We might still have had a recession, or per-
haps just a pronounced flat spot in a continuing
expansion. In the event, the terrorist attacks did
occur and tipped the economy over rather deci-
sively into a recession.
E
veryone wants to know what is happen-
ing to the economy. So do I. I’m pre-
sumed to know, which is why I am here
this morning. But the fact is that I am
as curious as you to find out the answer to the
question. Although I do not have a working
crystal ball, I can offer a perspective on where
we are right now and on how we got here. I can
also offer a perspective on why economic fore-
casts are as hazy as they are.
Before proceeding, I want to emphasize that
the views I express here are mine and do not
necessarily reflect official positions of the Federal
Reserve System. I thank my colleagues at the
Federal Reserve Bank of St. Louis for their com-
ments, and especially Bob Rasche, director of
Research, for his extensive assistance, but I retain
full responsibility for errors.
I’ll begin this morning by reviewing how the
U.S. economy got to its current state. Then, I’ll
discuss the range of possible outcomes for the
economy over the next year or so. Finally, I’ll
make a few general comments on forecast uncer-
tainty and its relevance for monetary policy.
HISTORY
As the year 2000 came to a close, the consen-
sus outlook was that the economy would slow in
the first few months of the new year, but that the
slowdown would be a brief “V” shaped event
that would not end a decade of economic expan-
sion. The Blue Chip consensus forecast released
on January 10, 2001, projected 1.9 percent real
growth for 2001:Q1, increasing to 3.1 percent by
2001:Q3. As the year progressed, the anticipatedThe current recession has some fairly standard
features and some that are decidedly atypical. It
is not unusual for special events to tip a soft econ-
omy into recession. Iraq’s invasion of Kuwait in
August 1990 is an example. In that case, the cycle
peak is dated July 1990. Another example is the
General Motors strike that ran from September
1970 to January 1971; without the strike, we might
not have had a recession that is today dated as
having a cycle peak in December 1969 and cycle
trough in November 1970.
Failure to predict a turning point in the
economy, or even realize for several months that
a peak has occurred, is typical. Missing the onset
of a recession is sometimes due to unforecastable
events, such as the terrorist attacks, but more
generally to incomplete scientific knowledge of
how the economy works. Consider the minutes
of the August 21, 2001, FOMC meetings, which
stated in part that
The staff forecast prepared for this meeting
suggested that, after a period of very slow
growth associated in large part with very weak
business fixed investment and to some extent
with an inventory correction, the economic
expansion would gradually regain strength
over the forecast horizon and move to a rate
around the staff’s estimate of the growth of
the economy’s potential output...
In the Committee’s discussion of current
and prospective economic developments,
many of the members commented that the
anticipated strengthening in economic expan-
sion had not yet occurred and, indeed, that the
economy and near-term economic prospects
appeared to have deteriorated marginally fur-
ther in the period since the previous meeting.
Another dimension of the 2001 recession,
typical of past cyclical behavior, is that substantial
inventory accumulation occurred as the economy’s
growth rate slowed in 2000. Because inventories
had accumulated beyond the levels firms wanted,
they began to reduce production. In the first
quarter of 2001, this process had reached the
point that firms cut production below the level
of final sales, so that inventories were actually
reduced. In the second and third quarters, firms
continued to liquidate inventories, and by increas-
ingly large amounts. Although we do not have
official data yet, forecasters believe that the rate
of inventory liquidation was larger yet in the
fourth quarter.
The importance of the inventory cycle can be
shown with a few numbers. Using quarterly data,
the peak quarter was 2001:Q1. A reasonable guess
for 2001:Q4 puts the decline in real GDP from the
first quarter at only 0.7 percent. However, that
decline was more than accounted for by inventory
liquidation. Over this period, final sales likely
rose slightly, by 0.2 percent. Expressed at an
annual rate over these three quarters, inventory
liquidation knocked about 1.2 percentage points
off the economy’s growth rate.
The inventory cycle is a standard feature of
almost all recessions. At some point, firms get
inventories down to desired levels, and produc-
tion then catches up with final sales. Assuming
that final sales growth occurs this year at a modest
pace, as most forecasters expect, the recession
will come to a natural end when inventory liqui-
dation is complete.
In many ways though, the current recession
is atypical of U.S. economic history. First, indus-
trial production peaked in September 2000, well
in advance of the cycle peak date. Second, housing
investment, which historically has been a leading
indicator of a cycle peak, has remained on a high
plateau throughout 2001. By way of contrast,
consider the 1990-91 recession; housing starts
peaked in January 1989, well before the cycle
peak, and by January 1991 had dropped by 51
percent.
Third, consumer expenditures on light vehi-
cles have continued at near record levels, albeit
with considerable support through price reduc-
tions in the form of zero-interest-rate financing
and/or substantial rebates. Data released last week
indicated that sales of light vehicles during 2001
were second only to the record sales in 2000.
More generally, durable goods consumption
expenditures, which typically decline substan-
tially during a recession, have held up pretty
well this time.
ECONOMIC OUTLOOK
2Fourth, productivity growth has remained
strong despite the slowdown in real growth. There
has been debate in recent years about how much
ofthestrongproductivitygrowthhasbeencyclical.
The typical cyclical pattern is that productivity
growth falls, or even becomes negative, as the
economy enters a recession and then recovers as
an expansion takes hold. Productivity growth
slowed in the middle of 2001, but continued at
an annual rate of 1.5 percent for the nonfarm
business sector and 2.5 for manufacturing in
2001:Q3. These are healthy rates of productivity
growth for a period of recession.
Fifth, in contrast to the typical cyclical pattern,
but in common with the 1990-91 recession, market
rates of interest reached a peak in advance of the
cycle peak. Historically, market rates of interest
turn within a month or two of NBER reference
peaks. Ahead of the most recent cycle peak in
March of last year, the 3-month Treasury bill rate
reached its peak in early November 2000 and the
10-year government bond rate actually reached
its peak in January 2000, or 14 months before the
cycle peak. Using monthly average data, by March
2001 both these rates were down by about 175
basis points from their peaks.
Sixth, the FOMC acted aggressively in advance
of the cycle peak to reduce the intended federal
funds rate. At the December 2000 FOMC meeting,
at which time two months of data indicating
negative growth of industrial production were
available, the FOMC altered its “balance of risks”
statement from one with equal weight on the risk
of inflation and the risk of slower growth to one
indicating that the risk was weighted toward
slower economic growth. At that time, the most
recently released data on the unemployment rate
(for November 2000) had increased only 0.1 per-
cent from the cycle low level of 3.9 percent. On
January 3, 2001, the FOMC lowered the intended
federal funds rate by 50 basis points to 6.00 per-
cent.BytheAugust2001FOMCmeeting,250basis
points of additional reductions in the intended
federal funds rate were implemented. Over the
course of these eight months, the intended rate
was reduced from 6.50 percent to 3.50 percent.
Let me now link the decline in market inter-
est rates well in advance of the cycle peak to Fed
policy actions last year. I believe that the market
understands quite well the Fed’s mode of setting
a target for the federal funds rate. That is, the
market understands the policy within which
individual policy actions fit in a consistent and
coherent way. Given this understanding, the mar-
ket brought down interest rates in advance of
Fed policy actions, because the market sensed the
economy’s slowing and was confident that the
Fed would take appropriate steps. Of course, no
one—Fed or market—accurately anticipated the
economy’s evolution over the course of the year.
The effect of Fed policy actions was to supply
the economy with significant amounts of liquidity.
From December 2000 through August 2001 the
M2 measure of the money stock grew at an annu-
alized rate of 9.5 percent. During the same period,
a narrow measure of the money stock known as
MZM, which incorporates all cash and assets
that can be converted to cash quickly at no cost,
grew at an annualized rate of 17.8 percent. Thus,
monetary policy was already quite expansionary
when prospects for the economy changed with
the attacks of September 11.
As news of the attacks arrived, the attention
of the Federal Reserve became totally focused on
sustaining the smooth functioning of the payments
mechanism and preventing a liquidity crisis. The
“lender-of-last-resort” function rose to the fore-
front. Lessons learned from previous financial
crises, including the Penn Central default, the
stock market crash of 1987, and the Asian crisis
and Russian default in 1998, provided valuable
insights. On the morning of September 11, even
before the extent of the terrorist attacks was fully
certain, Vice Chairman Ferguson announced that
“theFederalReserveSystemisopenandoperating.
The discount window is available to meet liquid-
ity needs.” Over the next several days, about
$100 billion of short-term liquidity was injected
through discount window lending, open market
repos, float, and “swap” agreements with four
major foreign central banks.
What Is Happening in the U.S. Economy?
3These actions were sufficient for the financial
system to weather the first days of the crisis and
continue to function smoothly. Within a week,
most of the short-term liquidity injections had
matured and trading in the securities markets
had resumed.
Immediately before trading resumed in the
stock market on Monday, September 17, the
FOMC met by conference call and implemented
an additional 50 basis point reduction in the
intended federal funds rate. At the regularly
scheduled FOMC meetings in October, November,
and December, additional reductions in the
intended funds rate were implemented, bringing
the total policy actions since September 11 to
175 basis points. Ample liquidity has been pro-
vided to the economy as measured by the high
growth rates of monetary aggregates from August
through the end of last year.
THE LONGER-RUN ECONOMIC
OUTLOOK
Where do we go from here? I’m not going to
offer a specific forecast, but instead will empha-
size my conviction that the U.S. economy contains
very powerful forces promoting growth and full
employment. Our strengths include a resilient
people, efficient markets, and low inflation. The
Federal Reserve has made clear for many years
its commitment to maintaining low inflation.
Our culture and institutions reward entre-
preneurial activity. They are intact, completely
undiminished by the tragedy of September 11.
People are motivated by the intellectual and
financial rewards of building companies and
serving markets. They will be looking forward
for opportunities to move the U.S. economy for-
ward. Government policies and the structure of
our labor and capital markets enable entrepre-
neurs to be successful. Those conditions are in
place, undepreciated. For these reasons, all of us
have every reason to be optimistic about the course
of the U.S. economy in the years ahead.
RECENT ECONOMIC “NEWS”
In recent weeks, as usual, the short-run out-
look is pushed first one way and then the other
way by the arrival of economic news. I will take
just a few minutes to review some of this news,
but want to emphasize that, just as economists
are not particularly good at forecasting cyclical
peaks, they are also not particularly good at fore-
casting the cyclical troughs that mark the end of
recessions.
Consensus forecasts at the present time are
quite optimistic. The Blue Chip consensus fore-
cast released yesterday projects real growth to be
slightly positive in 2002:Q1, at an annual rate of
0.7 percent, and then for the economy to reach a
growth path of about 3.5 percent in the second
half of 2002 and continuing in 2003.
Data that have become available in the last
several weeks give mixed signals. On the positive
side, industrial production for November fell 0.3
percent, a considerably smaller decline than had
been experienced in September and October and
smaller than had been anticipated just the day
before the data were released. Both the Michigan
Consumer Sentiment Index and the Conference
Board Consumer Confidence Index increased in
December, the latter quite sharply. Personally, I
don’t place much weight on these measures
because I believe that at best their contribution
as an indicator of future consumption demand is
marginal. Recall that late in 2000 the Michigan
Consumer Sentiment Index dropped sharply and
was the source of considerable commentary that
consumption demand would weaken substan-
tially. The weakness in consumption demand
never was realized.
The December reading on the Manufacturing
Report published by the Institute for Supply
Management (formerly, the Purchasing Managers
Index) also came in much stronger than expected
and close to the level consistent with the end of
contraction in output of the manufacturing sector.
Hours worked per week during December in the
manufacturing sector jumped to 40.7 from 40.3
in November.
ECONOMIC OUTLOOK
4In recent weeks, prices of computer chips
have stabilized and even risen somewhat. At
that same time, orders for chips have increased.
This may signal that the sharp contraction in the
computer segment of the “high-tech” sector is
coming to an end. There are even some signs of
stabilization in the beleaguered telecom industry.
Earlier this week Corning announced that it will
resume production at four plants that were idled
for three months because of excess inventories of
fiber.
On the other hand, incoming information
continues to signal weakness in labor markets.
In December, according to the data released at
the end of last week, the unemployment rate
increased to 5.8 percent. Nonfarm payroll employ-
ment decreased by 124,000 workers, with employ-
ment in the manufacturing sector decreasing by
133,000 workers. These signals from labor mar-
kets are not necessarily in conflict with the other
income and production data, since historically
the unemployment rate has been a lagging indi-
cator that continues to rise after the economy has
started to recover.
I could go on in this vein for the rest of the
morning—indeed, for long after all of you had
walked away. In summary, it is too early to pick
a precise date for the recession trough, but there
is a bottoming out feel to the data.
FORECASTS AND FED POLICY
I’m going to finish with a few comments on
the relevance of the economic forecast for Fed
policy. Consider this analogy: You are traveling
to Seattle the day after tomorrow for meetings on
Monday and Tuesday. You have gone to several
web sites and discovered that weather forecast-
ers are predicting rain for the two days of about
half an inch. You ask me for my expert opinion
and I tell you that I expect 0.1 inch of rain—just
a little drizzle for a short time. Do you leave your
umbrella home? I don’t think so.
The fact is that weather forecasts and eco-
nomic forecasts have a considerable range of
error. If it makes no sense to base my behavior in
carrying an umbrella to Seattle on the details of
the weather forecast, why should I spend much
time trying to guess whether the rainfall will be
0.1 or 0.5 inches?
The right way to look at monetary policy, in
my view, is that the primary responsibility of the
central bank is to maintain the purchasing power
of the currency—to be successful in a policy of
maintaining low and stable inflation. While
achieving that primary responsibility, the Fed
has a great deal of room to make policy adjust-
ments to help stabilize employment and output.
As short-run conditions change, often in unpre-
dictable ways, we do our best to adjust the target
federal funds rate in the direction conducive to
maintaining economic equilibrium. All we need
is a general sense of where the economy is going
and a willingness to act decisively when some-
thing happens that calls for such a response. We
did not predict the terrorist attacks, but we did
act decisively when confronted by them. The
markets understand that we will act decisively
when required, and that understanding yields
better market results.
Let me reiterate: What is important about the
strategy of monetary policy is not that the Fed has
a superb crystal ball, which it doesn’t, but that
its long-run goals are clear and that it is ready to
act when required. The Fed is also ready to do
nothing, when required. My detailed parsing of
the data—and I’ve done a little of that this morn-
ing—is not for the purpose of coming up with a
better forecast but rather to make sure that there
is not something important going on that fore-
casters in general are missing.
Given all the data I’ve studied, I don’t think
there is any mystery to the current situation. The
patient is recovering from recession in the normal
way. We have a pretty good idea what is going
on; our diagnostic tests are coming up negative.
You can walk out of the economic doctor’s office
this morning still knowing that you don’t feel
just right, but that nothing serious is wrong with
you looking out to the years ahead. I know that I
am reassured when I walk out of a physician’s
office with that message; I hope you are reassured
this morning with regard to the economy.
What Is Happening in the U.S. Economy?
5

What is happening in the U.S. economy?

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What is happening in the U.S. economy?

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