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CHICAGOLAND CHAMBER OF COMMERCE Chicago, Illinois September 13, 1995 ..................................................................... Charting the National Economy — Where to From Here? Today, I’d like to discuss my view of what’s happening with the national economy—where we are now, and where I think we’re headed. Our goal at the Federal Reserve is sustainable economic growth with price stability. The question now seems to be, “Are we on the final approach to achieving that elusive soft landing?” Right now, I’d say it looks like a soft landing, it sounds like a soft landing, but it hasn’t necessarily felt like a soft landing. We’ve experienced some turbulence along the way. In general, though, I’m feeling positive about the economic outlook. Before going into detail about the outlook, let me touch briefly on the Fed and how we develop national monetary policy. The Fed is a fairly complex and diverse organization. In addition to studying the economy and formulating national monetary policy, we also supervise and regulate banks and provide them with financial services, like check processing. We strive for an efficient, stable financial system and the highest rate of economic growth we can achieve without igniting inflation. Our decentralized, regional structure helps us accomplish that goal. The Chicago Fed is one of 12 regional Reserve Banks that—along with the Board of Governors in Washington, D.C.—make up the Federal Reserve System. Our decentralized structure is reflected in how we determine monetary policy. All the governors of the Federal Reserve Board in Washington and all the presidents of the Reserve Banks take part in policy-making. The Fed’s main policy-making body is the Federal Open Market Committee, the FOMC, which is chaired by Alan Greenspan. It consists of the seven members of the Federal Reserve Board and five of the 12 Reserve Bank presidents, who vote on a rotating basis. This year, I’m a voting member. The presidents report on their regional economies at the FOMC, and that plays a part in the policy-making process. One of the ways I get a feel for what’s happening in Chicago and throughout the Midwest is through meetings with groups like the Chicagoland Chamber. Not just to give my point of view, but to get your point of view as well. It’s very helpful to know what’s going on at the local level—in the bank’s branch office, on the production line, in the cashier’s aisle—where the nation’s business takes place. What’s happening out there right now, today. And what your expectations are for the future. The various economic data series compiled and published by the Fed and other government agencies are extremely useful, but they’re often dated and likely to be revised. They capture what's happened in the past. As a result, depending only on statistics is like driving a car using only a rear-view mirror. Supplementing statistics with more current, anecdotal information helps us get a clearer view of an economic landscape that’s constantly changing. 54 Michael Moskow Speeches 1995 Considering all the information available, I think we’re at an interesting juncture right now concerning the economy. Three weeks ago I was in Washington for a meeting of the Federal Open Market Committee. As you may recall, we didn’t take any new policy actions at that August meeting. At our July meeting, we did decide that inflationary pressures had receded enough to accommodate a modest easing in monetary conditions. More specifically, we allowed the federal funds rate to decline by 25 basis points, from 6 percent to 5 3⁄4 percent. It was the first policy action to lower short-term interest rates since September 1992. And it came after seven moves between February of last year and February of this year geared toward raising rates. I’d like to bring you up-to-date on how we reached the point we’re at today, and let you know how things look for the future. First, let’s look back to the start of 1994. The economy had picked up steam after the doldrums of the early ’90s. It was expanding rapidly. We were concerned about an unsustainable pace of expansion and mounting inflationary pressures. The goal at the start of 1994 was to eliminate inflationary pressures before they had a chance to build. As it turned out, we had unusually strong real GDP growth of 4.1 percent during 1994, despite the policy actions to raise short-term interest rates. You might ask why we didn’t let the economy keep rolling along at that pace. The answer is that 4 percent real growth is not sustainable. The economy’s real potential is closer to 2 1⁄2% percent. Let me compare it to a sailboat. A 2 1⁄2% percent rate is that point when the boat is cutting through the water at peak efficiency, with just the right amount of wind in its sails, not tipping to one side or the other. If the wind picks up too much, the boat’s in danger of tipping over. For the economy, real output growth much above the 2 1⁄2% percent level really can’t be sustained without inflation accelerating. And keeping inflation in check is absolutely crucial. Central bankers are paid to make statements like that, but it’s really true. Once inflation is allowed to rise uncontrollably, the impact on the economy can be devastating. To put it another way, once inflation gets out of hand, it’s like trying to tape grav y to the wall. It just oozes out all over. That’s what we learned in the ’70s. Remember price controls? I worked in government in Washington at the time, and I directed efforts to monitor wages and prices after the controls were lifted. The controls, of course, were a futile effort. Our 1994 monetary policy actions to foster sustainable, non-inflationary growth began to have a significant impact on the economy in 1995. We’ve seen a definite slowdown in output growth, especially in the second quarter. Real GDP grew at a very robust 5.1 percent in the fourth quarter of last year. It slowed to a 2.7 percent pace in the first quarter of 1995, and to only 1.1 percent in the second quarter. The slowdown in output growth was most noticeable in areas sensitive to interest rates, like autos and housing, where sales growth softened. It eventually spread to other areas such as appliances and other durable goods. As growth in sales moderated, some stores and factories were caught with excessive inventories, particularly in the auto industry. As a result, we began to see an inventory correction taking place in many industries. In its simplest form, an inventory correction becomes necessary when too many goods and services are produced relative to demand. There were too many products on the shelves, too many vehicles on car lots, all waiting to be sold. It appears that a significant portion of the inventory correction took place in the second quarter. Michael Moskow Speeches 1995 55 Factories have been trimming production to bring inventories back in line with sales. Just-in-time inventory management techniques have helped firms respond when production levels moved out of alignment with demand. The major area where production may still be exceeding demand is autos, which I’ll come back to later. The good news is that inflationary pressures appear to be subsiding. It’s true that the core Consumer Price Index (CPI) increased at an annual rate of 3.5 percent in the first seven months of 1995, higher than last year’s 2.6 percent rate. But there has been a gradual reduction so far this year from month-to-month. Some of the underlying cost structure that was generated last year carried through into early 1995, but it appears that our monetary policy actions have had an impact. We’re not seeing as many signs of an overheated economy, which could spark inflation. For example, capacity utilization rates have declined. At the same time, there’s been a speed-up in the delivery of materials to factories, indicating a slowing in demand and possibly less upward pressure on prices. Fewer purchasing managers are reporting increases in what they pay for materials used in production. We’re also hearing anecdotal evidence here in the Seventh Federal Reserve District that price pressures are fading. In addition, the unemployment rate recently has fluctuated within a range close to what many economists estimate to be the so-called natural rate of unemployment, where typically you see no upward or downward pressure on wages or prices. The actual unemployment rate has been between 5.4 percent and 5.8 percent so far this year. The most recent figure was 5.6 percent. Speaking of labor markets, here in the Midwest our state unemployment rates generally have been below the national average all year. Illinois’ rate did jump to 6 percent in August from 5.1 percent in July, but these monthly rates tend to be quite volatile. Let’s take a look now at what’s ahead. You may have heard the line, “Economists have forecasted nine out of the last five recessions.” That pretty much sums up the difficulty of forecasting economic turning points. Right now is no exception. There’s still some uncertainty, but in general I’m optimistic about the prospects for stronger growth through the end of the year. And I’m certainly not forecasting a recession. Let’s look at four key areas: the consumer sector, the business sector, government and the international arena. • Number one—the consumer sector. We expect consumer spending to rise at a moderate pace in the second half of the year. Early indicators of consumer spending in the third quarter have been mixed. However, consumer confidence measures remain at high levels, and recent income gains have been solid. In terms of the housing sector, we expect a modest rebound during the second half of 1995. That’s a result of lower mortgage rates. In fact, we’ve recently seen a pick-up in housing starts. As for autos, we keep close tabs on that industry because it has such a spill-over impact on the rest of the economy, especially here in the Seventh Federal Reserve District. Sales of autos and light trucks this year have been quite volatile on a month-to-month basis. For example, August numbers show an annual sales rate of 15.7 million units, but July’s rate was just 13.7 million units. 56 Michael Moskow Speeches 1995 Last December, the Chicago Fed sponsored an economic outlook symposium. The consensus forecast at that time was for 1995 light vehicle sales in the area of about 15.4 million units. But sales so far this year have been well below those expectations. In fact, the participants at our Auto Outlook Symposium in June scaled back their 1995 sales forecast to 14.9 million units. It now looks like sales for the year will end up at about 14.7 or 14.8 million. That’s about the average of the July and August numbers. The big question right now is whether we’re going to see the August rebound sustained for the rest of the year. Why have sales run so far below what seemed like a pretty reasonable forecast last December? There were a number of one- time occurrences that may have had an impact: Higher tax payments, delayed tax refunds, and reduced fleet sales. But some more fundamental explanations have also surfaced. One is higher rates for auto loans, which have had a significant impact on how much people can afford to pay. Used car sales are also up. Better-built cars are simply lasting longer, and high-quality leased vehicles are also entering the used-car market. Needless to say, that affects new-car sales. The auto industry’s response has been rebates and discount financing. Over the long run, the industry is going to have to deal with the increasing durability of cars and with more and more people buying used cars and autos that were formerly leased. It’s a situation we are watching closely. • So much for the consumer sector, which we see as positive even with some uncertainty about autos. The second key area of the economy is the business sector. Capital spending should continue to be strong, although the pace of growth should slow from the double-digit rates we had last year and during the first half of 1995. Competitive pressures are encouraging firms to continue spending for equipment that enhances productivity— even in the face of moderating demand for their products. With no large buildup in debt and lower long-term interest rates, firms are in a good financial position to undertake additional capital spending. • Number three—government. Fiscal restraint is a common theme across all levels of government. At the national level, there appears to be growing momentum for deficit reduction. It’s clear that the President and Congress are moving toward reducing the federal deficit, and I find those efforts encouraging. In the short term, reducing the deficit would result in less stimulus from the government sector. But that shouldn’t deter us. Meaningful deficit reduction would have a positive impact on the economy overall. Long term, a smaller deficit will be a major plus because the government will be borrowing less. That will tend to lower long-term interest rates and stimulate private investment. And that sets the stage for higher productivity and a better standard of living in the future. Over Labor Day, we discussed this very important topic thoroughly at a large gathering of economists and central bankers in Jackson Hole, Wyoming. A key point that came out of the discussions was that deficit reduction would have to be sustained over a number of years for it to be truly effective. Commitment is crucial. Commitment by Congress and the executive branch over a long period of time is key to the success of any deficit-reduction plan. And we’re going to have to come to grips with more than just deficit reduction. The impact of an aging America is also a major concern. Americans are growing older at a startling pace. That’s great from a social perspective—we all want to live longer. But we have to keep in mind that when Baby Boomers start Michael Moskow Speeches 1995 57 retiring, they’ll be paying less in taxes and receiving more in retirement benefits for a longer time than was true for previous generations. At the same time, relatively fewer younger workers will be contributing to the Social Security fund. If the current levels of spending stay the same—if the formulas used to distribute benefits stay the same—the revenue needed to pay for Social Security and health care for Baby Boomers in their retirement is going to be enormous. Clearly, the impact of this situation must be addressed over the long term when considering the question of deficit reduction. This is a problem we’ll face after the turn of the century—in another 20 or 25 years. And it will be a problem of worldwide dimensions. Other developed countries such as Japan, Germany and Canada face even more severe problems in this area. • Number four—the international arena. At the start of 1995, we were expecting solid growth abroad. The Mexican crisis took some of the wind out of our sails, but that situation has stabilized. However, Japan’s economy has stalled, prompting the Bank of Japan on Friday to lower its discount rate to a record low 0.5 percent. That should help promote recovery in the Japanese economy. Economic growth in Canada, another significant trading partner, has also slowed more than expected. In fact it actually declined in the second quarter. In addition, growth in many European countries has been slower than we expected earlier this year. So, in general our forecasts for growth abroad have been scaled back. That means our country’s economy will get less of a boost from exports. In summary, while we’ve experienced slowing in U.S. economic growth, we’re not seeing many of the imbalances that occurred in the late 1980s. In addition, the recent data we’re seeing is consistent with a pick-up in economic activity. Consumers are confident. Housing activity appears to be rebounding. And some businesses seem to have nearly completed the process of adjusting their inventory levels to the desired slower pace of the economy. For 1995, we anticipate growth in real GDP to trend higher for the third and fourth quarters. For 1996, we expect real GDP growth of approximately 2 1⁄2%. We see the CPI rising about 3 percent this year and next, and at the end of 1995 and 1996 we expect the unemployment rate to be slightly above its current level. I’m guardedly optimistic about the economic outlook. Although it may not feel like it, I think it’s fair to say that we’re headed toward the soft landing I mentioned before. We’ve certainly experienced some turbulence, but I think we’re well- positioned to make continued progress toward our objective of sustainable growth with price stability. As always, the Federal Reserve will continue to promote price stability over time. High inflation distorts incentives to save and invest. Low inflation allows for efficient savings and investment decisions, and that ultimately means a better standard of living for all. Price stability is a goal we should all share. Working together toward this objective is the best way that we can help ensure a healthy, vibrant economy. Thank you very much. 58 Michael Moskow Speeches 1995