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ECONOMIC CLUB OF GREATER LANSING KELLOGG HOTEL AND CONFERENCE CENTER MICHIGAN STATE UNIVERSITY East Lansing, Michigan November 21, 2002 ..................................................................... Economic Outlook Before I address the economic outlook, I’d like to give a little background on the Federal Reser ve and its role in the economy. The Federal Reser ve System is made up of 12 regional reser ve banks, plus the Board of Gover nors in Washington, D.C., that together ser ve as the nation’s central bank. The Chicago District covers a fivestate area that includes most of Michigan, Illinois, Indiana, Iowa and Wisconsin. We also have a branch in Detroit. As president of the Federal Reser ve Bank of Chicago, I ser ve on the Fed’s key policymaking group, the Federal Open Market Committee, or FOMC. This is the group chaired by Alan Greenspan that is responsible for deter mining monetar y policy. At each meeting, we report on regional economic conditions and share our outlook and policy recommendation for the national economy. After our discussion of the outlook, the FOMC makes a decision on where to set its target for the federal funds rate. Our goal is to foster the monetar y conditions that are most conducive to the economy achiev ing maximum sustainable growth and price stability. Fed perspective on economy Clearly, this is a tough job. Let me take a few minutes now to share my perspective on the economy, both nationally and regionally, and the challenges that were faced by monetar y policymakers this year. 102 Michael Moskow Speeches 2002 Just two weeks ago, the FOMC reduced its federal funds rate target by 50 basis points, to 1 1⁄4 percent. This was our first action to change interest rates since last year, when the funds rate target was reduced 11 times - from a high of 6 1⁄2 percent to 1 3⁄4 percent in December 2001. While acknowledging the current softness in the economy, the FOMC on November 6 said that with the action to reduce the funds rate target, the risks to the outlook were balanced between economic weakness and inflation. As you know, the economy slipped into recession in March 2001, with real GDP falling during the first three quarters of 2001. Now the National Bureau of Economic Research — the nonprofit organization that is the arbiter of when recessions begin and end — has not yet deter mined an official end to the recession. But most economists think it ended sometime in late 2001 or early 2002. Indeed, real GDP growth tur ned positive in last year’s fourth quarter, and continued to rise through the first three quarters of 2002, although growth has been uneven. The recession, which was mild compared with other recessions, was led by sharp cutbacks in capital spending by businesses. At the same time, consumer spending and housing held up quite well. But that meant there was little pent-up household demand. So most forecasts made early this year were expecting the recover y to be relatively modest compared with the robust growth typically seen in the first year of prev ious economic recoveries. The economic data for the first half of this year generally were consistent with these expectations. Industrial production rose moderately each month from Januar y through July. Payroll employment increased each month from April though August. And as I noted, real GDP increased — with growth averaging about a 3 percent pace so far this year. However, some of the earlier signs of strength started to fade as we moved through the summer and into the fall. • Industrial production fell in each of the last three months. • Payroll employment fell slightly in both September and October. • Light vehicle sales moved down from their lofty levels of July and August. • In addition, most of the anecdotal infor mation we’ve been hearing in recent weeks suggests slower activ ity. It appears that spending by consumers and businesses alike has been restrained recently by a high degree of uncertainty. Outlook for regional economy Before I touch on these uncertainties, though, I’d like to take a look at conditions here in our region, and how the Midwest economy has been impacted by the slowdown. Michael Moskow Speeches 2002 103 First, a little perspective. For much of the 1990s, the economy in the region outperfor med the nation by some measures. For example, the unemployment rate in the region was below the national rate. Indeed, it is interesting to note that over the latter half of the 1990s, the rate of net job creation in the Midwest was only about half that of the nation. But this was not due to a lack of economic v itality. R ather, we were running short of qualified workers to fill job openings. More recently, however, economic activ ity in the region began to slow before it did in the rest of the nation. Employment growth began to fall off in the region in late 2000, about six months before the nation as a whole. And when job growth here did begin to slow, there was little doubt that it was due to a softening economy. The Midwest’s unemployment rate rose quickly, and for much of last year it stood above the national average. But as the slowdown spread throughout the economy, trends in our unemployment rates have more or less mirrored the nation’s since late 2001. Indeed, here in Michigan, October marks the first month in nearly two years when the unemployment rate was below the national average. Much of the recent softness in our labor markets can be traced back to our concentration in manufacturing industries. Manufacturing was one of the first segments of the economy to feel the effects of the slowdown, as the imbalances that developed toward the end of the expansion reduced business demand for capital equipment and inventories. Household spending, on the other hand, has held up relatively well in the District, much as it has in the rest of the nation. Although sales recently have softened somewhat, consumers continue to spend on automobiles and appliances - two industries that are vital to the region and to Michigan in particular. Buoyed by some of the lowest interest rates in a more than a generation, sales of both new and existing homes have remained remarkably resilient. Realtors and builders here in Michigan tell us that residential real estate sales remain at ver y high levels. In addition, home price appreciation has been ver y healthy during this run, helping to keep the market active. At the same time, commercial real estate activ ity has tur ned sluggish. Still, we are seeing some major building projects mov ing for ward in our District. Importantly, we have not experienced as large of a rise in vacancy rates as some other markets have, such as those where commercial building took off during the boom in the high-tech sector. Of course, the Midwest did not benefit as much from the “new economy” euphoria that some other regions did. But, when the tech bubble burst, we did not feel the pain that those regions felt either. To be sure, the Midwest did not come away completely unscathed. We do have some significant concentrations of high-tech industries in the region - for example, Michigan’s infor mation technology sector. But our high tech industries are integrated and complementar y to our diverse economy, not just to other dot.coms. Still, the Midwest economy, like the rest of the nation, has hit somewhat of a soft spot in recent months. And the factors contributing to that softness are the same as those affecting the nation as a whole. So let’s now tur n to the national situation. 104 Michael Moskow Speeches 2002 Challenges facing economy At the national level we face a number of uncertainties. For one thing, we are liv ing in a different world than we did before 9-11. In addition to the uncertainty generated by concer ns about terrorism, the cost of doing business is now higher, both through increased insurance premiums and the added costs of prov iding security and back-up contingencies. And the economy is now dealing with accounting improprieties and failures in corporate gover nance. These scandals have added to an already uncertain business climate. They also have raised the cost of financing new investment. This is ev ident from further increases in risk spreads on corporate borrowing — particularly for lower-grade issues — and lower prices for new equity issues. To be sure, to the extent that markets had been mis-evaluating risks and retur ns, then investors should be demanding higher premiums. The concer n, however, is that they may go overboard. Capitalism cannot thrive without entrepreneurial risk taking. If we are too risk-averse, we will stifle innovation and, with it, our ability to generate continual increases in our standard of liv ing. That said, capitalism also requires a transparent system of laws and regulations that are enforced in a fair manner. So if we find ev idence of criminal behav ior or fraud in the executive suite, we must root it out and prosecute. Those found guilty must be punished…which in some cases should include jail time. Another source of concer n is the fact that we are operating in a world of increased geopolitical risk, with heightened concer ns about developments in the Middle East, particularly Iraq. No one knows how these events will play out. All this uncertainty can inhibit activ ity. Fir ms may become hesitant to take on capital spending projects or hire per manent workers when the downside risks are more apparent — or if the consequences of such risks appear to have become more serious. Fir ms may simply decide to hold off doing anything until they feel more certain that the projects will soon start showing positive cash flow. Also, to the extent that uncertainty depresses the stock market, the dent in household wealth can be a negative factor for spending. This high level of uncertainty has been one of the reasons for the slowing in the economy this quarter. In fact, in a recent sur vey, private-sector forecasters are expecting real GDP to rise at an annual rate of only 1.6 percent in the fourth quarter. So, we’re in a soft patch. Factors supporting economic recovery Nevertheless, not all the indications are negative. Consumer spending beyond autos, while softer, is still mov ing for ward. Consumer confidence, buoyed by recent gains in the stock market, tur ned up a bit in early November. And the housing market has remained robust. Further more, certain fundamentals are still positive for the economy. Michael Moskow Speeches 2002 105 First, aggressive inventor y control means that stock levels are now ver y lean. Thus, some further lift from inventor y investment can be expected. This would give a temporar y boost to growth. But to solidify the expansion, final demand needs to gain a fir mer footing. Important to this will be the degree to which business fixed investment tur ns around and household spending keeps mov ing for ward. Second, inflation remains low and well contained. This has allowed monetar y policy to maintain an accommodative stance for an extended period of time. This accommodative stance bolsters demand throughout the economy. Further more, fiscal policy moves, including last year’s tax legislation and bills signed into law after 9-11 and early this year, also have been stimulative. Third, household incomes continue to rise at a solid pace. Despite the recession and the modest pace of activ ity early in the recover y, real disposable personal income currently stands about 5 1⁄2 percent higher than it was at the time the recession began. In contrast, if we look back over the past 30 years, real disposable incomes a year and half after the onset of a recession were up only modestly, at best. Finally, real income also has been supported by strong gains in productiv ity, or output per unit of input. Since the mid-1990s, the rate of productiv ity growth has been nearly double the pace of the prev ious 25 years. Further more, productiv ity was unusually well maintained during last year’s downtur n, and, on average, it has increased at a remarkably robust pace in recent quarters. We know that there often is a boost to productiv ity growth in the early stages of recover y, as businesses demand more from their employees and trim fat from their organizations. But the continued high levels of productiv ity growth that we have experienced recently support the v iew that took hold in the late 1990s — that a more fundamental positive structural change has occurred. To the extent this is true, it is an extremely positive sign for the U.S. economy. R apid gains in productiv ity growth support the growth in incomes and profits needed to maintain the economy’s for ward momentum. The role of productivity growth The high rates of productiv ity growth in the U.S. are particularly remarkable when we compare them with growth rates abroad. In the 1980s, Japan and many European countries achieved larger increases in productiv ity than the U.S. But since the mid-1990s, productiv ity growth in the U.S. has surpassed that in Japan and Europe. Recent research estimates that the pickup in U.S. productiv ity growth is in large part due to the increased use of Infor mation Technology — or IT- capital (that is, computer hardware, software, and communication equipment, etc.). But the increase in productiv ity growth we’ve seen since the mid1990s is not simply a matter of increasing our IT resources — it’s also how we apply those resources to the challenges in the workplace. Over the past decade or so, we have lear ned to run our businesses smarter through improved management practices and significant advances in the overall logistics of producing and distributing goods and ser v ices. And, the U.S. labor market is functioning more efficiently than it used to. All of these factors allow us to organize and allocate our productive resources much more efficiently, which boosts overall output in the economy. 106 Michael Moskow Speeches 2002 In the long run, productiv ity is key to the prospects for both the household and business sectors. Ultimately, it is productiv ity growth that deter mines our standard of liv ing. Conclusion Let me conclude with some final thoughts. The economy’s road to recover y has tur ned out to be bumpier than expected, and we’re currently in a soft spot. But the low-inflation env ironment has allowed us to maintain an accomodative monetar y policy for some time, and also gave us room to take out some extra “insurance” with the easing action we took earlier this month. While there is a lot of uncertainty about the outlook, we believe that the monetar y policy we have put in place will support aggregate demand. Further more, the underlying trends in productiv ity are strong. As a result, we see the economic expansion regaining momentum next year, with growth reaching its potential during 2003. Moreover, the long-ter m prospects are bright. The U.S. economy has proven itself resilient and dynamic, driven by an entrepreneurial culture, market-based principles and continuing technological advances. These factors have enhanced the economy’s ability to handle challenges and have laid the foundation for solid non-inflationar y growth in the years ahead. Michael Moskow Speeches 2002 107