David M. Jones

September 9, 1997

Comparison with the late 1950's and early 1960's. The late 1950's and early 1960's was a period of stable prices, high Federal Reserve credibility (due to the skillful efforts of Chairman Martin to "lean against the wind" in the last half of the 1950's and 1960), and fiscal restraint (there were budget surpluses in 1956, 1957, and 1960). Today we also have functionally stable prices, a Federal Reserve Chairman with a high degree of credibility, and budget deficits that have fallen to less than 1% of GDP.

Contrast with the late 1950's and early 1960's. Two key differences between the two periods have an important bearing on monetary policy.

The first difference is the current investment boom in high technology equipment. Since 1993, such investment has risen to $286 billion per year--a level greater than that of all of our principal competitor nations combined. Not all of this investment has added to capacity, but it has contributed to the second key difference: flexibility. Compared to the late 1950's and early 1960's, output is more flexible to demand and the economy can manage capacity better. The contribution made by the investment in technology is complemented by flexibility in the labor market, where increases in contract and temporary labor arrangements have also helped to slow increases in labor costs.

The economy's "speed limit" and why Federal Reserve action will be needed in the not too distant future. Since 1993 real GDP has grown at a 3% rate, and inflation has been stable at the 2.5% to 3.5% level. Furthermore, third quarter growth was 4.3%, unemployment is now below 5%, and real GDP will likely be growing at a 3.5% to 3.75 % rate in the fourth quarter. It doesn't get any better than this! But can the economy keep growing this fast without incurring inflation?

Probably not. Economic growth is now greater, and unemployment lower, than what most economists believe is consistent with the rate of sustainable, non-inflationary growth (the "speed limit"). In recent years the economy's speed limit has no doubt increased as a result of the new investment and labor market flexibility mentioned above. And, as Greenspan has observed, we haven't been estimating productivity well. Still, the speed limit probably lies in the range between 2.1 % (CEA estimate) and 2.6% (Federal Reserve), with labor growing at an annual pace of 1.1% and productivity in the range of 1.0% to 1.5%.

With unemployment low and the economy growing at a rate that appears to be exceeding its speed limit, the economy is in what might be viewed as a danger period. The strains in the labor market are growing despite the increased flexibility mentioned earlier, and this should produce accelerating labor costs, which account for upwards of three-quarters of the costs of production. Thus, inflation will likely go a bit higher next year, especially if Europe begins to grow faster, and at some point Federal Reserve action will be required. However, given the uncertainties involved in measuring the economy's true speed limit, this action will likely follow a theory opportunistic disinflation. This means the Federal Reserve will likely focus on maximum sustainable growth while waiting to take action until danger signals actually materialize.

What will Greenspan do to carry out this policy? In part, he will let markets take the lead and do it for him, much like in 1996 when market rates went up. However, this may not be enough.. Next year will be 8^th year of expansion, and danger signals are beginning to appear. One of those that Greenspan has talked about is the stock market, but it is not possible to predict the peak. Another possible danger signal Greenspan mentioned in a recent speech at Stanford is excessive growth in domestic demand. In part reflecting favorable financial conditions (higher stock prices, falling long term interest rates, declining credit spreads, banks competing for loans), this demand has been so strong that it has cleaned up inventories, and kept real GDP growth above the economy's sustainable pace.

In the end, though, it will come down to a matter of judgment. Aggregates don't help and the monetary base isn't a good guide. Imports (and their subsequent impact on the value of the dollar), serve as a safety valve, but there is a limit and imports and the value of the dollar just become other influences that the Fed must juggle.

In response to questions, Mr. Jones made the following additional points: (1) One reason Greenspan is likely to wait for material evidence of inflation, rather than make a preemptive move against inflation, is that the tightening done in March 1997 brought a lot of criticism from both left and right. (2) The non-accelerating inflation rate of unemployment is about 5 something--above where we are. (3) Why do we need the Fed Reserve at all? We are close to a world in which market interest rates do most of the work in a self-correcting process that influences short term economic growth, and in such a world the Fed merely confirms what markets are doing. But markets aren't infallible. We therefore need the Fed to shave peaks and valleys off the cycle. (4) The information age we are in is as important now as the agriculture and manufacturing ages where in their time. As was also the case with big inventions in the past, it takes decades for the new inventions to be reflected in new productivity gains. (5) Global competition, which is particularly important for goods industries, at the margin helps to achieve flexibility in the economy. (6) The euro will have an effect on the dollar, but he is not sure which way. If the drive for the euro slows down or dies, this will strengthen the mark vis a vis the dollar, but a soft euro then will strengthen the dollar. His guess is soft euro, although there is more talk of delay.

Rapporteur: Stephen Swaim

December 21, 1997

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