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Fed Focus: Spokane: Partners w ith Business Spokane, Washington For delivery October 5, 1995 12:30 PM The Role of the Federal Reserve in the Economy and the National Economic Outlook I. Good afternoon. It's a pleasure to be here. A. B. C. II. My topic today is in tw o parts — 1. first, the role of the Fed in the economy, 2. and, second, the national economic outlook. Now, from the discussions you heard earlier today, you've already gotten some idea about certain Fed responsibilities — 1. such as banking supervision, 2. and the Fed's efforts to track the regional economy. This afternoon, I w ant to focus on monetary policy, because th a t's the most important w ay in which the Fed affects the national economy. To begin w ith, Congress has delegated to the Fed the responsibility for managing monetary policy. A. Our goals include p:\parry\pi-cra\9-29-95.2 l B. C. D. 1. stable prices and 2. the maximum sustainable employment and economic growth. Of course, monetary policy is only one out of a number of factors that affect the U.S. economy. 1. For example, there's also fiscal policy, which involves taxation and government spending, 2. as well as developments in world markets, 3. and, of course, advances in technology and know-how that make our w ork force more productive. The way the Fed tries to achieve its goals is to balance the demand for goods and services w ith the national economy's capacity to produce them. 1. If the economy's out of balance w ith too much demand, then we end up w ith inflation. 2. If the balance tips toward too little demand, then we end up w ith sluggish growth and rising unemployment.. Our tools for maintaining the balance are open market operations — 1. p:\parry\pi-cra\9-29-95.2 —that is, the purchase and sale of government securities on the open market, which serves to lower or raise short-term interest rates. 2 E. F. G. The conditions for doing the job of conducting monetary policy are the subject of a lot of stu d y— 1. —not only by the Federal Reserve and other central banks, 2. but also by researchers in economics, political science, game theory, and a number of other disciplines. And much of this research confirms the wisdom of the founders of the Federal Reserve System: 1. They knew very well that it was important to keep the people who control the country's supply of money and credit independent of the people who frame the government's spending decisions. 2. That's w hy they structured the Fed to be "independent w ithin government." One of the hallmarks of Fed independence is that power isn 't concentrated in Washington, D.C., but is shared w ith the District Banks. 1. As President of the T w elfth District, I attend all meetings of the Federal Open Market Committee, which sets monetary policy. 2. One of the key contributions the District Bank Presidents make to the Committee's deliberations is a regional perspective. p :\parry\pi-cra\9-29-95.2 3 a. And an important source of help on this is our Boards of Directors. b. Our Boards comprise people who represent banking, business, labor, and consumers. (1) c. H. In addition, they have their fingers on the pulse of regional economic events. Regional economic conditions are very important in helping us put together a detailed picture of the national economy. 1. Indeed, monetary policy m ust focus on the national economic picture rather than on the regional picture for a couple of reasons. 2. The first reason is a practical one. p :\parry\pi-cra\9-29-95.2 And they often have a very different perspective from people on Wall Street or the Washington, D.C. Beltway. a. The Fed ca n 't ease up or tighten up on short-term interest rates in just one region b. because monetary policy works through national credit markets. (1) These markets are very efficient, (2) processing transactions from coast to coast in a split second. 4 c. So, working through these markets, monetary policy affects the whole econom y— (1) 3. III. —in fact, th a t's w hy it's sometimes called a "blunt" policy instrument. Beyond the practical difficulties, there's also a real danger of focusing too much on any one region of the economy th a t's having a hard time. a. Often enough, some state or region is going through a recession of its own while the national economy is humming along. b. If the Fed stimulated whenever any state had economic hard times, w e'd be stimulating almost all the time. c. And the upshot of that would be a very pro-inflationary environment, and, ultimately, a deteriorating economy as well. This brings me to the outlook for the national economy. Let me begin by looking at the recent course of events, and I'll try to sketch out the Fed's view on them. A. Last year, the Fed became concerned about rising inflationary pressures. p :\parry\pi-cra\9-29-95.2 5 1. 2. The concern was that for about three years—from '92 to '9 4 —the economy grew rapidly. a. It averaged growth rates of between 3 and 4 percent— b. —well above the 2 to 3 percent long-run potential rate. This long stretch of rapid grow th ultim ately pushed goods and labor markets to operate beyond their long-run capacities. a. For example, signs of strain showed up in manufacturing capacity utilization rates. b. And the unemployment rate fell to just under 5 1/2 percent, (1) B. 3. So, based on these indicators, the overall picture suggested that we had overshot capacity. 4. That's w hy we raised short-term interest rates from February 1994 to February 1995. Since the beginning of this year, the pace of economic activity has cooled. p :\parry\pi-cra\9-29-95.2 which appeared to be somewhat below the rate that can be sustained w ithout rising inflation. 6 1. The first quarter numbers showed substantially slower growth — a. 2. In the second quarter, the numbers showed an even greater slowdown — a. C. IV. —from a 5 percent pace at the end of 1994 to 2% percent. —to a meager 1-1/4 percent. As a result of this slowing in the economy, inflationary pressures receded a bit. 1. In fact, they receded enough that we felt a modest reduction in short-term interest rates was warranted. 2. That's w hat led to our % percentage point cut in the funds rate in July. Looking ahead, I'm optim istic that w e'll have a fairly quick return to the kind of moderate, sustainable growth that the economy needs. A. For one thing, the second quarter GDP figures w eren't as weak as they appeared on the surface. 1. Most of the weakness occurred in inventory investment, as firms made progress in working o ff excess stocks. 2. But it now appears that inventories are in better balance w ith sales, p:\parry\pi-cra\9-29-95.2 7 a. 3. In addition, the demand of households and firms for goods and services held up quite well in the second quarter, a. B. V. so a good deal of this depressing factor appears to be behind us. growing at a modest and sustainable 2Vz percent rate. It looks as if demand probably will continue to hold up at about that pace in the future. Now, so far, A. I've described 1. the Fed's concerns, 2. its course of action, 3. and the effects on the economy. B. W hat I'd like to do in closing is show you how these actions and outcomes are consistent w ith a set of goals and procedures the Fed has adhered to for quite some time now. C. The primary goal, of course, is to deliver stable prices. 1. p :\parry\pi-cra\9-29-95.2 There's a good reason we focus on price stability: 8 a. it's the main way monetary policy can promote the maximum sustainable advance in the country's economic output and the people's standard of living. 2. This isn't just a theoretical matter. 3. For one thing, we're not the only central bank w ith that focus. a. b. 4. In the 1980s, a number of countries—both developed and developing —shifted their emphasis to reducing inflation. (1) Let me just rattle o ff a short list: (2) There's Australia, Canada, New Zealand, Sweden, the United Kingdom, France, and Argentina. Of course, Germany and Japan have had this emphasis for a lot longer. For another, here in the U.S., we learned about the need for price stability from hard experience: a. In the 1970s, when inflation rose to double digits, (1) p :\parry\pi-cra\9-29-95.2 we had economic and financial instability, 9 (2) and ultim ately a big, double-dip recession in the early 1980s. Since that episode some 1 5 years ago, the Fed has basically been follow ing the same policy regime: 1. While being responsive to cyclical ups downs in the economy, w e're also seeking to lower inflation gradually. 2. And the emphasis is on gradual change, a. because we w ant monetary policy to have the smallest possible adverse effect on economic activity during the transition. Both the interest rate increases from 1994 to early this year—as well as the recent cut in rates—were in keeping w ith this policy regime. 1. 2. As I said, we raised rates when it became apparent a. that the economy had overshot capacity b. and that inflation would be on the rise unless the economy slowed. Well, it did slow, and therefore inflationary pressures receded enough to warrant a modest reduction in rates. Now, pursuing this policy isn't a straightforward, mechanical proposition. 1. It calls for frequent reassessments and readjustments, as economic conditions develop. 2. But there is a constant in this policy regime that you can count on. 3. And th a t's the policy goal— a. —providing the maximum sustainable economic growth through fostering price stability. wc 1455 p :\parry\pi-cra\9-29-95.2 li
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