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Page 1 Western District Securities Industry Association Wigwam Resort, Phoenix, AZ For delivery March 8, 1996, 8AM MST Economic Trends in the West and the Nation Good morning. It's a pleasure to be here, especially as part of your Silver Anniversary celebration. I’d like to begin by looking at economic trends in the West. Then I want to broaden the focus to discuss an issue that’s gained national prominence. That issue is the so-called “potential” growth rate of the national economy— —that is, the rate the economy can sustain in the long run. It’s the subject of broad public debate. And the reason it matters so much is that our potential growth is a key determinant in our standard of living and an important benchmark for monetary policy. Let me begin with the West. Overall, growth in the western states has been stronger than in the nation. In Nevada, Utah, and Oregon, job gains ranged from 4Z A percent to 8 percent from January 1995 to January 1996. With those rates of employment growth, the states ranked First, Second, and Third, respectively. Coming down a bit from the stratosphere, Arizona ranks Number Five, with a job growth rate of 4% percent. 2. And all four states appear to have the momentum to continue to perform well into this year. But the big story in the West has been California. If it had followed its usual pattern, its growth rate would have Page 2 moderated along with the nation's. And that would have been bad news, since the state's own expansion was only moderate. But California didn't follow the usual pattern. Instead, economic activity accelerated to a pace that was well above the national average last year. One reason is California's prominence in fast-growing sectors— like high tech, business services, and entertainment. Statewide, employment growth in these sectors has been in the 4 to 6 percent range. The electronics industry and other sectors in California also have been able to capitalize on the state's proximity to the booming Asia-Pacific region. Last year, the U.S. exports were very strong to Japan and the Newly Industrialized Countries in Asia, like Hong Kong, Korea, Singapore, and Taiwan. This was good news for California. a relatively larger share of the state's exports goes to these Asian countries, and its exports also grew faster than overall U.S. exports to these countries. Now, I should note that California certainly hasn't completely adjusted from the negative shocks of the recession. The unemployment rate is still well above the U.S. rate and higher than it was at the start of the past recession. Defense cutbacks will continue to dampen employment growth in the state. And the devalued peso and weak Mexican economy are offsetting some of the state's strong export growth. What's the bottom line? Page 3 Now that the state has just about regained the jobs that were lost during the recession, it looks as if California is ready to move from recovery to expansion. Now let me broaden the focus and turn to the issue of the country's “potential” economic growth. Basically, it’s the growth rate that the economy can sustain in the long run without generating inflationary pressures. And it’s measured as the long-run trend of economic growth— —that is, abstracting from the ups and downs of the business cycle. It depends on two things: the number of people available to work— —that is, the size of the labor force, and how much output those people can produce an hour— —the productivity of the labor force. Potential growth—or, potential GDP— is a matter of real importance, since it reflects the potential for growth of jobs and income in the economy. It also matters for the conduct of monetary policy. The Fed looks at potential GDP as a benchmark. Although we don’t have a target for real GDP growth, we know that if it consistently exceeds its potential, higher inflation eventually and inevitably will result. Until recently, a conventional estimate of potential GDP growth was close to 2 Vi percent a year. There’s been a lot of debate about this, mainly because some analysts argue that the estimate is way too low. And the debate is likely to intensify, since revised GDP data constructed by the Commerce Department suggest that potential growth is close to 2 percent, and that it actually slowed from 2V* percent in the 1980s to 2 percent in the 1990s. Let me explore this issue by looking at the likely explanation for a slowdown in the 1990s. It appears that the slowdown has to do mainly with the first point—the size of the labor force. For one thing, the working age population is growing more slowly. Its annual growth rate has gone from 1'A percent in the 1980s to about 1 percent in this decade. But there’s an even more significant change— and it has to do with the role of women in the workforce. While the pattern of men’s participation has been pretty much the same for the last 35 years, the pattern of women’s participation has changed dramatically. From 1960 to 1990, women’s participation rate rose from under 40 percent to just under 60 percent. But since then, it’s stayed right about there. This is due to a leveling off in a couple of things: the number of women entering the workforce and the number of hours women are working. For example, in 1960, they averaged fewer than 40 weeks a year and then gradually increased it to about 48 weeks— —close to the number of weeks that’s been typical for men for quite some time. We can’t say for sure what will happen to women’s participation in the future, but we can say that the proportion of women working and the number of weeks they’re working recently has reached a plateau. Now—what about productivity? Well, according to the new Commerce Department data, the trend growth rate hasn’t changed in over 20 years— — it’s still about 1 percent a year, with no sign of a pickup in the 1990s. As I said, a lot of analysts would argue with that. They’d claim that productivity growth is underestimated. More than that, they’d also say actual productivity growth has been rising faster in the 1990s. Their reasoning is that current measures aren’t accounting for the improvements computers have made. They focus on the fact that much of the growth in computer use has been in the service sector, where it’s hard to measure exactly what the output is. Unfortunately, there’s no consensus on whether computers have led to a major productivity surge. For example, some economists have done elaborate studies looking for evidence of a pickup in productivity growth due to computers. But they haven’t found it. Their reasoning is that computers make up only about 2 percent of the U.S. capital stock, and therefore can’t make a large contribution to overall productivity even if each computer is highly productive. So, what we’re left with is a lot of uncertainty about productivity. And that means there’s also uncertainty about potential GDP. Now, what does this uncertainty about potential GDP mean for policy? It basically raises the following question: If potential GDP growth is being underestimated, does that mean that monetary policy’s likely to be unduly restrictive? The answer’s “no.” Let me explain why: As I mentioned earlier, the Fed uses potential GDP as a kind of benchmark for judging whether actual GDP growth is “fast” or “slow”. In other words, it’s the gap between actual and potential GDP that enters into monetary policy. But since potential GDP is simply estimated from the GDP data itself, it’s probably not crucial if those data are biased toward underestimation. Both rates are likely to be biased to about the same degree, so the gap isn’t likely to be seriously affected by measurement problems. Moreover, although potential GDP is a very important benchmark for the Fed, it’s certainly not the only thing we look at. So if it turned out we weren’t reading potential GDP correctly, we’d get signals about that from other indicators. For example, if actual GDP had been below potential GDP in recent years, we’d have seen increases in unemployment rates and unused industrial capacity, as the demand for workers and capital fell short of potential gains. At some point, this would have translated into downward pressure on inflation. But, in fact, we haven’t seen this happen. Let me conclude by saying that the Fed certainly would be just as happy as anybody to see faster growth in potential GDP. But it’s important to remember that the Fed can’t create it. Page 7 If we were to try— by consistently pushing GDP growth beyond its potential—the inevitable result would be higher inflation. What we can create is an environment of low, stable inflation. It’s that environment that allows our market economy to function as efficiently as possible and that leads to investment in capital and labor in the long run. Ultimately, that’s the kind of environment we need to promote productivity and improve the living standards of all Americans.
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