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Testimony by

Jerry L. Jordan

President
Federal Reserve Bank of Cleveland

before the
Committee on Banking, Housing, and Urban Affairs
United States Senate

March 10, 1993

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Mr. Chairman and members of the Committee, I appreciate the opportunity to
appear before you this morning to discuss economic developments within the Fourth
District of the Federal Reserve System and to offer m y views on monetary policy. I find
that approaching the issue of monetary policy from the perspective of economic conditions
within our region is particularly informative. I make this statement for two reasons. First,
the extensive restructuring within the four states that comprise the Fourth District-Ohio,
and parts of Kentucky, Pennsylvania, and West Virginia-provides important insights into
the expenence of the national economy during the last several years. Second, the gains
that this region achieved because of these adjustments were aided to a large extent by the
stable-price policies of the Federal Reserve System during that period. As I will discuss in
m y testimony, these issues are important for understanding the current and future course
of the national economy.
In m a n y ways, the Fourth District's performance during the last decade
foreshadowed that of the national economy during the last several years. While the
national economy saw extraordinary growth since 1980, the Midwest's expansion was
much more subdued. Employment within the Fourth District states grew 9 percent from
1980 through 1992. During the same period, employment in the national economy, driven
by the bicoastal boom, expanded 21 percent. The nationwide increase was sufficient to
absorb both an enormous number of baby boomers reaching working age and the steady
rise in women's participation in the work force.
While much of the rest of the nation expanded, the Midwest was forced to focus
on restructuring— process that had been under way for some time. Although
a
restructuring was a painful experience for many people, businesses, and banks in the
District, i was necessary to restore the competitiveness of its industries. O n the negative
t
side, in 1980-82, w e saw the devastating results of the worst recession to hit this region
since the 1930s: basic industries scaling back or shutting down, whole communities cut

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off from their economic mainstay, workers displaced and discouraged. O n the positive
side and more recendy, the beneficial results of this ongoing process have become more
evident in the phoenix-like rise by some industries to become m u c h more vibrant and
competitive forces in the local, national, and international economy. Newspapers and
magazine articles have heralded this recent resurgence as the renaissance of
manufacturing. The Rust Belt has indeed begun to regain some of its old luster.
Through improvements in productivity and a more balanced industrial mix, our
region is n o w poised for future growth. The growth will be uneven, as some parts of the
District are m u c h stronger than others. Clearly, restructuring will continue, both within
the Fourth District and across the United States. But I have no doubts that a strong
foundation is in place for a healthy and sustainable expansion for the foreseeable future.
Our relatively buoyant regional economy during the past two years and our increased
presence in foreign markets attest to the gains that w e have made. The central questions
will be about the pace and durability of the expansion, not about contraction.
During the 1980s. the Midwest faced a host of market imbalances, not unlike the
problems that confront other parts of the country today. The region was able to work
through these problems, not because of government action, but because market forces led
inefficient industries to invest in new technologies or simply to close down, workers to
invest in n ew skills, employees and management to seek more flexible and innovative
relationships, and entrepreneurs to find and develop promising n e w opportunities.
Government does have an important role, however. It is to establish an
environment of competition and long-run stability so that markets can allocate resources
to their most valued uses. The restructuring that took place in the Fourth District was
aided immensely by the reduction in inflation and by the acceptance that this vigilance
would continue in the future. Maintaining this commitment will facilitate the restructuring
that this and other regions of the country are currently experiencing.

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A s I have stated on m a n y occasions, monetary policy can best promote sustainable
long-run economic growth and rising standards of living by stabilizing the aggregate price
level, by creating a climate of confidence about the outlook for price stability, and by
avoiding being a source of economic disturbances through unexpected changes in
monetary policy. The extent to which this current recovery is at risk depends importantly
on monetary policy. Deviating from a steady and determined pursuit of our longer-run
objectives in response to short-term events could jeopardize our progress.
M y prepared comments discuss in some detail the restructuring and current
conditions of the Fourth District and m y views on the most effective monetary policy for
maximizing long-run output and raising the standard of living of all of us.

Fourth D istrict Restructuring

The byword for this region over the last decade has been resTructuring—
replacement of old technologies with new ones, innovation in business practices, scalinc
back of less efficient industries and expansion of more competitive ones, and absorption of
excess commercial real estate. The restructuring, although difficult and painful, was
necessary to improve efficiency and restore competitiveness. The success of these
adjustments can be illustrated by comparing the employment pattern during the last
recession with that of previous ones. In the six downturns prior to this most recent
contraction, the Fourth District states experienced employment declines two to four times
as large as that of the nation. In the past recession, the drop was less than half as large as
the national decline. Furthermore, during the 1990s, the region's unemployment rate
generally has been lower than the national rate.
The restructuring led to four basic changes, which have strengthened this
economy. First, companies, particularly in the manufacturing sector, have improved

4

productivity. For example, manufacturing output in Ohio has doubled since 1982, while
the number of factory jobs has remained roughly the same. With each worker producing
considerably more output, w e n o w have a leaner, more competitive manufacturing sector,
but one that does not generate as m a n y jobs as it once did. If this trend continues, as I
expect, employment will m o v e up as productivity levels increase, but in all probability,
more slowly than past experience would suggest
Second, the industrial mix of the economy is more balanced, relying less on the
cyclically sensitive durable-goods-producing sectors. Third, the region has increased its
participation in export markets. Through greater competitiveness, improved product
quality, and a deliberate effort by businesses to meet foreign specifications and to cater to
foreign tastes, local businesses have gained an increasing share of m a n y export markets.
This is one reason w h y the region was more resilient in the early 1990s downturn.
Finally, the region has a strong banking sector. Sound and efficient banks are
better able to provide financing to creditworthy borrowers, which bolsters regional
growth. Our banks are among the strongest in the country. B y implementing prudent
management strategies and avoiding the construction boom-and-bust cycle of the past
decade, Fourth District banks have outperformed their national counterpans. In the first
nine months of 1992, return on assets of District banks was higher than the national
average (1.37 percent versus 0.95 percent) and net loan losses as a share of total loans
was lower (0.95 percent versus 1.15 percent). In addition, as of September 30, 1992,
noncun-ent loans as a share of total loans of District banks was lower (1.87 percent versus
3.34 percent), and the ratio of book equity to total assets was somewhat higher (7.77
percent versus 7.39 percent).
A s a result of these developments, our region is n o w in much better shape than
previously. I a m encouraged by m y conversations with businesspeople and bankers
around the District, w h o tell m e of significant improvements in some of our key industries.

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The view and the attitude expressed are overwhelmingly forward looking, and this gives
m e reason to believe that the trend will continue. Capital goods producers generally
anticipate continued and broadening strength in orders and production this quarter from
last Auto manufacturers tell us that they anticipate a healthy improvement in U.S. motor
vehicle sales in early 1993. With dealer inventories generally under control, increased
vehicle demand has led to rising factory orders. Steel producers in the District report that
the surge in n ew orders since late last year, from auto and appliance producers, continued
m February and has led to rising backlogs of unfilled orders and stretching out of
deliveries. S o m e flat-rolled-steel producers report that their order books for the first half
of 1993 are virtually at capacity.
Despite production gains, most of the people w e have talked to are very cautious
about near-term hiring plans. Employment gains simply have not matched output growth
in most industries. For example, while manufacturers of industrial controls, truck
components, and steel note a high level of operations in recent months, they are resorting
primarily to outsourcing, extra shifts, and overtime to accommodate output growth
instead of adding workers. In the auto industry, however, most employees on temporary
layoff have been recalled, and some facilities are hiring additional workers, as many
assembly plants have increased their production schedules. But w e must not forget that
the U.S. auto industry' is still adapting to change and working through large excess
capacity.
Service-sector employment growth also has been relatively anemic. For instance,
retailers report that they, like manufacturers, are experiencing intense competitive
pressures to cut costs and have relied upon labor-saving technology and management
techniques, such as tighter inventory control, to accomplish that goal. Employment
growth has been steady in the health care industry, which has emerged as one of the
largest sectors in both Cleveland and Pittsburgh—
two of the largest cities in our District.

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Sluggish jobs growth in the Fourth District is pan of a national phenomenon. The
interesting question is whether employment will pick up enough to offset the slow growth
of the last few years or whether it will remain moderate, growing along a permanently
lower trend. Certainly, last month's payroll employment figures are encouraging.
In m y mind, there are several reasons w h y employment has not been increasing
faster in this expansion. A large amount of sectoral reallocation of labor is taking place,
not just in m y district, but across the country. For example, displaced defense workers are
having to retrain for employment in other sectors. This process is neither painless nor
instantaneous, but as workers become absorbed in new jobs, w e expect employment to
return to previous trends. Productivity is on the rise, some of which is due to new
technologies. A s workers are reabsorbed into more competitive industries and these
industries expand in domestic and world markets, w e might expect a return to normal
growth along a higher trend.
There m a y be some additional factors that discourage firms from hiring workers.
One factor is the steady rise in the cost of medical coverage for employees. Firms often
find i cheaper to pay overtime to existing workers than to take on more workers.
t
Another factor is the mounting regulation facing businesses. Even legislation designed to
achieve useful purposes can sometimes create unintended side effects. For instance,
businesspeople have viewed several pieces of legislation enacted during the past several
years as adding significantly to payroll costs. While businesses m a y not yet fully
understand the actual costs of such regulations, they m a y very well be reluctant to do any
significant hiring until these costs become more clear. To the extent that recent slow
employment growth is due to permanendy higher labor costs, w e m a y not recover all
those jobs lost in the last few years.

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While signs of a faster-paced and sustainable expansion are improving, I still have
some concerns. Unless monetary policy is conducted in a manner consistent with price
stability, the overall expansion could remain anemic.

Monetary Policy
Monetary policy has played an important role in the restructuring that is still goins
on in the nation and, to a lesser-but still important-degree, in the Fourth District N o
doubt the need for some of this restructuring has its roots in mistakes that were made in
the 1970s. O ne of the problems with inflation is that i obscures price signals and causes
t
both businesses and households to make mistakes that can take years, even decades, to
remedy. Price level uncertainty distorts the economic information contained in market­
generated prices. It can induce people to save too much or too little, to invest in the
wrong assets, and to be cynical about their government. And, when inflation surprises are
curtailed, as the public inevitably demands, the resource allocation mistakes become
painfully apparent
Unfortunately, the role of monetary policy in affecting output is often
misunderstood. It is important to remember what policy can and cannot do. It cannot
create capital stock, train workers, or improve technology. Nor can i produce real goods
t
and services, create employment, permanently lower the unemployment rate, or peg or
permanently lower the real interest rate. This is not to say that there is no role for
monetary policy. But instead of manipulating aggregate demand in a futile attempt to
achieve an unattainable employment objective, monetary policy should focus on providing
the conditions that lead to m a x i m u m sustainable growth.
In the not-too-distant past, prices were destabilized by policymakers w ho believed
in a tradeoff between price stability and full employment That dichotomy was false.

8

Monetary policy affects only the efficiency with which real productive resources are used.
In the past, monetary policy often kept the economy from reaching its potential because
the policy was not made consistently from one year to the next. W h e n short-run attempts
to stimulate the economy through monetary policy have led to inflation, the economy
operated less efficiently and people ended up working just as hard but producing less.
What monetary policy can do to promote long-run economic efficiency is to
stabilize the aggregate price level and to create a climate of confidence about the oudook
for price stability. Confidence in price level stability would raise living standards because
i would enable businesspeople, investors, workers, and consumers to make wiser plans
t
for consuming, saving, and investing. Plans made on the basis of inaccurate assumptions
about future prices are often inefficient
Pnce level stability would eliminate the incentives people have to employ resources
to hedge against inflation. A firm commitment to price stability would free these
resources for more productive uses. Moreover, i would foster the stability of banks and
t
the financial system. W h e n investments are made on the basis of price projections that
prove to be wrong, the lenders that provided the funds for those projects are often hurt
along with the investors.
H o w can price stability best be achieved? There has been some discussion about
the need to go beyond monetary targets in the Humphrey-Hawkins process. I could not
agree more. W e need a commitment to an explicit long-run price objective so that the
Federal Reserve can use annual monetary targets more effectively. The question is
whether monetary targeting can achieve price stability in the absence of an explicit
commitment to a price objective. Perhaps so, but not as easily in m y view, and at a
considerably greater cost A n explicit commitment to price stability is an essential
operational element that is missing from today's policy process. Given the apparent
inability of policymakers to agree on an explicit price objective, the next best thing the Fed

9

can do is to keep money supply growth within specified target ranges that are consistent,
over longer periods of time, with price stability.
But w hich money supply: M2, or a naiTow measure like M l ? Ml, which
includes currency and transactions balances, grew very rapidly last year. Households and
businesses added considerably to such balances relative to their income and as a share of
total assets. In economists jargon, the velocity—
rate of tumover--of such balances
declined. At the same time, the small time deposits included in the broad measure of
m o n e y ,M 2 (which includes M 1 as well as small time deposits and savings balances) fell
sharply and are continuing to decline. Households have reduced their holdings of these
instruments in absolute terms, as well as relative to their income and as a share of their
total assets. As a result, the velocity of this M 2 component rose substantially and by a
surprisingly large amount relative to past experience.
For a policymaker, the challenge is to analyze these conflicting signals and attempt
to anticipate future trends in order to conduct reserve supplying operations that, over
time, are consistent with achieving m a x i m u m sustainable growth in a stable price
environment. W e have spent considerable time and resources trying to understand the
monetary data, and still w e are uncertain. While this is discouraging, i is not unusual. W e
t
should not forget that all economic data represent attempts to match aspects of the real
world with theoretical concepts. Just as there is a wide gap between the theoretical
concept of output and the real-world measure of output, there is also a gap between a
theoretical concept of money and the tarseted aggregates.
Nevertheless, in the real world, w e must make prudent judgments about h o w much
weight to give to various measures of money. In m y opinion, the best w e can do today is
to choose monetary targets that w e think are consistent with long-term price stability and
try to maintain them. W h e n these targets need to be adjusted in order to achieve and
maintain price stability, w e should adjust them. Such a strategy automatically avoids

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aggravating the fluctuations in economic activity. Should the economy go into recession,
the money supply would tend to fall below target, unless the Fed supplied additional
reserves. Conversely, should the economy expand very rapidly, the money supply would
tend to go above target unless the growth of reserves is restrained. If the long-run
inflation objective is known, and credibility is maintained, then the adjustments necessary
to achieve price stability can be made much more effectively.
Of course, other factors affect the monetary aggregates, including interest-rate
differentials, the resolution of the S&L crisis, and the evolution of liquid mutual funds.
Although these factors have been exerting an unusually large effect on money supply
growth, the announced target ranges for the broad aggregate (M2) are wide enough to
accommodate even this extreme behavior.
What is the alternative? Some have argued that policy judgments would be better
made if the Fed ignored monetary aggregates and instead looked at the real economy. I
cannot agree. In view of the dramatic economic restructuring taking place todaytechnological developments, defense cuts, commercial real estate problems, to name just a
few— cannot have any more confidence in our estimates of potential output than we
we
have in our estimates of demand for a specific monetary aggregate.
Furthermore, we have no direct linkage between monetary policy actions and
either actual or potential output. Let me say once again that although we may be
uncertain about how to interpret the disparate behavior of the monetary aggregates today,
this uncertainty is no greater than the uncertainty that always exists about potential output.
What does all this mean for monetary policy? One of the biggest obstacles to
sustained economic growth during the year or so has been the lack of credibility of the
long-run commitment to price stability. While inflation has moved down, the public has
persisted in its belief that future inflation will be higher. Long-term interest rates have

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declined, but are still substantially above the levels that would be consistent with price
stability. This belief is reflected in consumer surveys and is manifested in the extraordinary
steepness of the yield curve and in such behavior as the record number of homeowners
who have refinanced mortgages. The extensive business balance-sheet restructuring,
which is still going on, also suggests expectations that future borrowing costs will be
higher as inflation accelerates.
The credibility of the Fed's goal to achieve price stability has been undermined to
some extent by the belief of analysts and policymakers that the Federal Reserve, through
aggressive monetary policy, could move the economy to a sustainable, faster long-run
growth trend. As Chairman Greenspan indicated to you last month in his HumphreyHawkins testimony, these mistaken beliefs have left us with an economy in which private
markets quickly embed even the expectation of stimulative monetary policy into higher
inflation expectations and nominal bond yields.
To lock in the hard-won gains made against inflation in the 1980s and extend them
well into the 1990s, the challenge is to find a way for the Federal Reserve to make a
gedible lon§-ter™ commitment to an explicit goal for price stability. Only by doing this
can we combat the 1970s legacy of heightened market sensitivity to short-run monetary
policy actions, reduce long-term nominal interest rates by another 2 or 3 percentage
points, and create an environment in which inflation fears no longer retard the efficient
functioning of the economy.