The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
For Release on Delivery 2:00 p.m., E.D.T. Wednesday, May 22, 1985 Issues for Longer-term Monetary Policy: Growth and International Capital Flews Presentation by Preston Martin Vice Chairman Board of Governors of the Federal Reserve System Presented at the Congress of American Industry National Association of Manufacturers Washington, D.C. May 22, 1985 Issues for Longer-term Monetary Policy: Growth and International Capital Flews Preston Martin Vice Chairnan Board of Governors of the Federal Reserve System National Association of Manufacturers Washington, D.C. May 22, 1985 Today's in our economy: sector as less exuberant expansion has highlighted imbalances lewer capacity utilization, cutbacks in our industrial it continues to be buffeted by foreign competition, and the high foreign exchange value of the dollar. are negative: business Of course, not all sectors capital formation is continuing, albeit at a slcwer rate, and the consumer may still be willing to go into debt spend. But, on and balance, economists are lowering their forecasts for real growth this year. The slowdown in our economy redirects our long-run potential growth, which domestically and around the world. pared to last, but is so attention to its vital to. material progress Growth is sluggish this year com are we actually progressing below our potential? Just what is the long-run trend of economic growth that this economy is capable of sustaining? ion on this question. sustainable Seldom have we had such a wide variety of opin Those with an historical bent suggest that growth potential is only 2 to 3 percent per year. If that is true, then the last three quarters have been around the trend There are others who line. project figures as high as 4 to 5 percent. they are correct, then our present mix.of fiscal may be missing an opportunity for growth. and monetary our If policy 2 Seme have argued that rapid growth would be a solution to the danestic-fiscal and international imbalances U.S. economy. They currently besetting the assert that the Federal Reserve could do a great deal to solve the problems of imbalances. Their prescription is a sub stantially easier monetary policy, which they assert would reduce real, or inflation-adjusted, interest rates and the dollar, and increase growth in the economy. they occur, would help balance the federal deficit, abroad. 1985 and permit a reversal exchange with budget, reduce over economic the trade growth in the startling size of the domestic budget deficit the longer terra. monetary-policy VJhat is the relationship between monetary policy, the budget deficit, and international To the to begin in the capital inflow from and foreign capital inflows raise some questions about objectives of These developments, should In short, then, the deceleration of real together value capital flows? what extent should monetary policy aim at correcting these interna tional and domestic imbalances? Economic Growth and Potential GNP The appropriate answers to these questions depend importantly on the interpretation placed on the unusual configuration of the cur rent economic recovery. historically high Economic growth has occurred in real interest rates. Treasuries ranged from 4 to of of interest rate on 7-plus percent in the current recovery, compared to a range of 1-1/2 to 2 percent strength face On the basis of sample inter view data, survey responses as to the expected real 10-year the in 1978-80. The the dollar is another development that has surprised most 3 analysts, with its trade-weighted foreign exchange creased The strong dollar is a major by over 70 percent since 1980. factor behind the deficit, which unprecedented grew in of the U.S. having current in account to over $100 billion in 1984, and the associated inflew of foreign capital. billion size value The federal budget deficit exploded to $200 fiscal 1984, the largest in history. Finally, Federal Re serve monetary policy has been aimed at contributing to the solution of the inflation problem that developed in the 1970s: has fallen sharply frcm 9 percent in 1981 to 3-1/2 the inflation rate percent last year (measured by the GNP deflator). Sane analysts argue that, although such disinflation should be a major goal of monetary policy, the Federal Reserve has been doing a good thing in the past two years or so. over According to this school of interpretation, which focuses on the potential growth rate of GNP, the configuration of events in this economic recovery is explained by a cartoination of the tax cuts in 1981 and other incentive-enhancing policies such as deregulation. Has raising the incentives for saving and investment in creased the so-called "potential," or long-run trend rate of growth real GNP? There is no question that venture capital is back. 1983-1984 investment boom, in part, reflects marginal tions. Potential tax-rate in The reduc GNP essentially is the supply of goods and services that the economy is capable of producing on a long-term basis. Those who believe that potential Off* growth is faster than before argue that, as a consequence, rapid actual GNP growth now is feasible on a 4 sustained basis without reigniting inflation. monetary policy has not permitted exchange rates) to real interest In this view, today's rates (and dollar- fall to their natural, or equilibrium levels, and thereby has restricted GNP to unnecessarily slew rates of growth. Even the high budget deficit, it is argued, has by backward-looking monetary policy. caused Much lower interest rates would reduce the deficit via lower debt servicing, and much growth would enhance tax revenues. been faster economic Thus, in this view of the world, a significantly easier monetary policy could contribute to a solution to the problems of the budget and trade deficits, and of high interest and exchange rates. This policy prescription could have merit if the of underlying events could be supported. Unfortunately, the available evidence raises serious doubts about the applicability requiring markedly explanation easier monetary policy. of any theory But, as I indicated, this particular theory focuses on the growth rate of potential GNP. Let us then examine the four components this growth, which are the trend growth rates in: that contribute (1) population; (2) the percentage of the population that participates in the (the participation rate); (3) these labor force the average number of hours the labor force works in a week (the workweek); and (4) productivity. in to The trends four factors define how rapidly the U.S. economy can produce goods and services on a sustained basis. First, with respect to population growth, the Census projects a 1 percent growth rate in the working-age population in the years 5 immediately ahead. somewhat be lew As to participation they will likely the 3/4 percent annual increment of the 1970s. all of the upward movement in the higher rates, participation by women. last 20 years has be Almost resulted fran It is unlikely that this participation will continue to climb as in the past, since the demographic trends behind it, such as falling birth rates, have slowed. The trend rate of decline in the average workweek has been stable past 3 decades. relatively over the A reasonable guess is that the workweek will continue to fall at its historical average rate of about 1/4 percent per year. Of course, the incentive effects of changes in rates may cause increases in tax participation rates and the workweek. Lower tax rates, not to ignore "tax reform and induce marginal sinplification," could these effects, but this does not seem to have happened yet. In 1985, both the participation rate and the workweek are displaying typi cal cyclical behavior. The strongest case for a higher growth in potential GNP today ccroes from productivity developments. dotal evidence that companies There is a great mass of anec are streamlining their management and staff structures, rationalizing work rules, introducing new, high-tech products into the production process, and generally becoming more effi cient in the new environment of deregulation and international competi tion. Moreover, productivity has grown fairly rapidly over the p>ast few years, especially when compared with the tivity in the 1970s. sluggishness of produc Over the past 2 years, nonfarm productivity has grown at rates of 3-3/4 and 2-1/2 percent, respectively, compared to trend of about 1/2 to 1 percent in 1973-79. a 6 Analytically, a good deal of the increase in productivity growth in recent years represents a normal economic recovery. cyclical response to the At present, private nonfarm productivity has grown by just about the average in five previous postwar cyclical upturns. However, more sophisticated econometric analysis of the trend and cycle components of productivity yield more premising results. suggests This analysis that the trend is around 1 to 2 percent in 1979-84. But this is considerably better than the subpar trend noted in 1973-79. VJhat does this mean for growth in potential GNP? late the estimated growth If we re rates of its four components, and include reasonable ranges for error, we cane up with an estimate of 3 percent, plus or minus 1 percent. This result is consistent with the divergent views of the experts on this subject, and with my personal projection of a range of 3 to 4 percent real growth. Of course, none of this analysis of (historical) data denies the possibility that the anecdotal evidence on productivity-enhancing measures by business will begin to show stronger results in the future. I will be surprised, in fact, if this does not occur. But this happy circumstance does not seem to have occurred yet, at least not in a dra matic fashion. Until it does, it would be a mistake for the Federal Reserve to assume that very rapid GNP growth could occur on a sustained basis without threatening progress on inflation. parable to the debate. This is an error com the "grcwtli-means-inflation" syndrome on the other side of A more balanced view leads to better policy. 7 Fiscal/Monetary Mix In ray view, the most likely explanation for the configuration of developments in the current recovery centers on a ocntoination of a highly expansionary fiscal policy and a disinflationary monetary policy. Increases in government spending and tax reductions in recent years have raised demands for goods and services. With Federal Reserve policy designed to prevent the economy from "overheating," real inter est rates have had to rise, threatening to crowd out seme spending in interest-sensitive sectors of the economy. Expressed in terms of the credit markets, government has increased its demands for credit. This has raised real interest rates enough to crowd out the credit demands of seme private sector spending; at the same time there have been increases in the pool of savings available to United States borrowers. Because of safe-haven character istics, high real interest rates, and projections of robust future rates of economic growth, the foreign exchange value of the dollar has risen sharply and a record volume of foreign capital has poured in. Could the Federal Reserve safely attempt to bring down short term rates and stimulate much stronger economic growth in order to reduce budget deficits, absent fiscal policy leadership and support? Would massive money growth avail in foreign exchange markets without economic policy changes here and abroad? is no. The answer to both questions Such policies by the central bank would involve substantially reducing real interest rates in the U.S. below their natural, or equi librium rates, which, in large part, are historically high because of 8 the stimulus of fiscal policy. way would set the stage for higher inflation in the future. excessively expansionary policies might have sane transitory they obviously would not be a solution disruptive the Although benefits, taught us about influence of high and variable inflation in the United States on the domestic and world economies. onstrated this to present problems. The experience in the late 1970s and the early 1980s has the ix \ To reduce real interest rates high This experience also dem costs for the economy of getting rid of inflation once it gains mcmentum. Foreign perceptions that monetary policy will cated to disinflation are future real rates of return. response to high of the Cbviously, a decline inflation therefore in the dollar in would involve higher real interest rates spending. Given the budget deficit, sustaining reasonable levels of domestic spending depends importantly on the availability and dedi essential to investors as a protection of domestically, and more crowding out of domestic size remain on the of foreign capital, continued attractiveness of dollar-denaninated assets to foreign investors. Nor is there is any real trade off between domestic and world economic considerations that can be exploited by monetary policy. Highly expansionary monetary policy could tenporarily bring down short term interest rates and exchange rates, but it could raise the long term interest rates attractive to foreign investors. aspect of This is another the general conclusion that while monetary policy goals for the long-run have to be framed with due consideration of foreign 9 capital flews, the strength of the dollar, and international trade imbalances, Federal Reserve policy should not focus so much problems that it runs the risk of reigniting inflation. on these Of course, it should be recognized that, even with a favorable inflation outlook, cannot indefinitely we count on such large amounts of foreign capital to sustain domestic spending. Eventually, foreign investment portfolios will become saturated with dollar-dencminated assets, and the inflow of capital from abroad will wane. These considerations demonstrate hew progress essential it is that be made in correcting domestic imbalances, and their interna tional counterparts. But major progress will have to await action policies the authority of the Federal Reserve. Efforts in not under this regard cure proceeding. gress Congress currently is making notable on pro in putting together a deficit reduction package; the prospect of high-level trade liberalization talks was raised at the recent economic sunmit in Bonn; and the central banks of several industrialized coun tries showed an increased willingness earlier this year to intervene in the foreign exchange markets in an attempt to head off strengthening of the dollar. I am personally not optimistic about our ability to use ket mar intervention to move exchange rates materially below levels deter mined by fundamental economic factors. months may Although intervention in recent have had a marginal impact on the dollar by braking a cer tain degree of speculative psychology, the decline in the dollar February probably since was related mainly to more fundamental factors— for 10 example, prospects for lower real interest rates in response to economic growth and weaker improved chances of reducing the budget deficit. Similarly, although there are potential benefits from opening up for eign markets to U.S. products and financial services, fundamentally the trade deficit is likely to persist as long value It is with special interest that of the dollar remains so high. I follow the drama unfolding in the since progress at reducing as Congress the over foreign the budget by bill, the deficit offers the premise of a real solution to current domestic and international imbalances. actions exchange The recent the Senate and the House Budget Ccnmittee are encouraging, but the Congress still has a long way to go before a final budget is passed. What Can the Fed Do? During the interim, while other solutions are being worked out, what contribution can the Fed make to correcting imbalances? The optimum abjective for the Federal Reserve is to foster a so-called soft landing for the economy— with real upper range GNP growing or at least not rise. rate can also the decline However, the Federal Reserve can con tribute to dealing with the imbalances by guarding against bility toward of its potential rate, so that the excessive unemployment rate can decline gradually, and the inflation gradually somewhat the possi that the economy might slip into an extended period of sluggish growth, as it has over the past nine months. The factors that contribute to the underlying rate of tion look reasonably favorable. infla Trends in wages and productivity seem 11 to fit that description, as do measures of slack in the labor and capi tal markets— the unemployment and capacity utilization rates, including those measures related to our trading partners. prices Similarly, caimodity have been declining for seme time new, and producer prices have been relatively flat. decline Apparently it would take to cause major U.S. inflation problems. a precipitous dollar Foreign suppliers are likely to absorb declines in the dollar in the short-run to hold market share. The main point is that although the inflation picture is imper fect, it has improved enough to afford latitude in the conduct of mone tary policy. Historically, given the uncertainties about the lags in monetary policy, it has not been possible to tell for sure if nomic slowdown is simply a an eco pause before the stimulating effects of lower interest rates and faster money growth take effect, or whether it indicates an attenuated period of inadequate expansion. Over the long run, flexible monetary policy implementation, in turn, is desirable from the standpoint of against unemployment. Slow further growth the budget deficit and international raises the deficit, and indirectly increases the pressure for foreign capital to be made available in the for the progress And more to the point, the approach also avoids exacerbating the problem with imbalance. making associated trade deficit. U.S. and Although, as I said, it would be a mistake for the Fed to aim at trying to achieve a major contribution to balancing the budget through excessively high real economic growth, it also obviously would be a mistake to exacerbate these problems by mitting sluggish GNP growth to persist. per 12 At the same time, the Federal Reserve today must be particu larly watchful for changes in the long-run potential growth of the U.S. economy. The longer-term grcwth of the monetary aggregates should be adjusted to facilitate a rate of economic growth which in the long-run without inflationary pressures. is sustainable Today's evidence does point to rates of economic growth above those of the 1970s, but not yet in line with the most optimistic projections. Nevertheless, progress to date at reducing marginal tax rates, the spread of the deregulation in economy, and technological progress may already have set in motion forces that will enhance the potential growth of future. our in the Continued progress in the Congress toward expenditure control and toward tax reform that should further increase vest, economy incentives to in save, and work is vital to achieving significantly higher growth rates. Monetary policy should play a complementary policy in this respect, once it is evident that the economy is capable of sustaining a more rapid pace of expansion. role to fiscal
@FedFRASER