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p.m. EDT
PRICE STABILITY AI{D REGIONAL DIÍ/ERSITY
W. Lee l{oskins, President
Federal Resen¡e Bank of Cleveland
Pacific
N
al Economic Conference
lvleeting
on
Price Stability and Regional Diversity
I am pleased to have the opportunity to speak before this gathering of the
Twenty-fifth Annual Pacific Northwest Regional Economic Conference. I have stood
before many groups to discuss why I believe that price stabilify is the only policy
objective that the Federal Reserve System can achieve. I can think of few other groups
that should be more sympathetic to this view than one like yours, which recognizes and
appreciates the regional diversity of our national economy. My reason for saying this is
quite simple, and is vested in the nature of national business cycles.
Given your interest in regional issues, you well understand that the national
economy is an amalgam of diverse regional economies. The national busine+s rycle is
an average of regional business cycles, wlúch differ according to the timing of peaks
and troughs and the magnitudes of expansions and contractions. Consequently, just as
it is impossible for the Federal Reserve to pursue multiple national objectives, it
becomes clear that aiming a single monetary instrument at the national business cycle,
which is made up of separate and perhaps independent regional cycles, would be a
futile exercise that could yield only unpredictable and mostly undesirable results.
Weak national economic conditions have once again raised the issue of
whether the Federal Reserve should take steps to stimulate the economy and of how
large those steps should be. As you know, the System repeatedly reduced the discount
rate and the federal funds rate late last year and early in 1991 in response to the
economic slowdown. I sometimes have disagreed with the underlying motive, but
I
have not been troubled by these policy actions, because I do not think that they are
inconsistent with progress toward lower inflation. Nevertheless,I am troubled by the
inference made by many analysts and policymakers that the Federal Reserve, by simply
turning on the money spigots, can restore the economv to an acceptable ancl sustainable
long-run growth path.
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Therefore, I want to spend my time this evening discussing with you why
I
believe that price stabilify is the only objective the Federal Resen¡e can achieve, and
why I believe that a monetary policy that pursues price stabilily is optimal in a country
whose regional diversity is as broad as ours.
I have publicly discussed my reasons for not tyiog monetary policy objectives
to the business cycle many times. My position stems from what policymakers can
reasonably be expected to know about the economy and how poliry affects the
economy. As I explain my position tonight,I hope to convince you that regional
economic diversity strengthens my arguments.
Should the Federal Reserve Respond to Business Cycles?
It is generally accepted that monetary policy affects the general price level in
the long run, and aggregate output and employment in the short
run. Therefore, why
not simply pursue different monetary policies at different stages of the business cycle?
Why not pursue a policy of stimulating output during a recession and promoting price
stability when the economy has recovered and begins expanding again? Actually, that
was essentially what the Federal Reserve did in the 1970s, and the results were not
good. We achieved neither price stability nor full employment.
We simply don't have the forecasting accuracy to fine-tune the economy with
the precision necessary to expand the money supply more rapidly when the risk of
recession is higher, and restrict the monetary expansion when the threat subsides but is
replaced by a greater likelihood of inflation. Given the imprecision in forecasts and the
inabiliry to predict shocks, such a policy would be like riding in a car with someone
who drives with one foot on the accelerator ancl the otl'ter on the brake. It makes for
a
very jerky ride. This policy alone would exacerbate btrsiness cvcles, not smooth them.
-3-
A smooth policy ride would require the abilify to identify, at every point in
time, the exact state of the economy. Furthermore, since monetary policy influences
business conditions with a considerable lag of six to twelve months, accurate forecasts
of at least six months into the future are required for today's policy actions to have the
desired effect six months from now. That is, in order to respond to economic conditions
today, we should have foreseen perfectly as far back as last October the current state of
the economy. With that information, we would have had to make the appropriate
policy decisions.
A retrospective view of typical forecasting accuracy drives home my point.
Over the past bwenby years, the average real quarterly growth rate
an annual basis) was
of the economy (on
around2s/t percent. The median range of forecast errors one
quarter ahead is about 4 percent. That means that if the forecast for real GNP one
quarter ahead was2 percenÇ the realized growth rate would have ranged between a
recession (-2 percent) and a boom (6 percent) roughly two-thirds of the time.
Even in the dullest of times, the world abounds with enough random events of
significant economic consequence to make accurate forecasts virtually impossible. And
dramatic events like the Persian Gulf conflict can only play complete havoc with our
best, but still imperfect, forecasts. Who would have thought last May that Iraq would
invade Kuwait and that by October oil prices would more than double, to over $40 a
barrel? Obviously, shocks by definition are unpredictable, and their effects on the
economy are not known with precision.
A second reason that the Federal Reserve cannot fine-tune the economy is that
the only variable the Fed can control over long periods of time is the price level. It is
clear from both economic theory and practice that attempting to stimtrlate the econonìy
through an easy monetary policy results only in higher inflation. An unstable price
level leads to greater uncertainty for households and businesses, which reduces
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productivity and economic well-being. By anchoring the price level, the Federal
Reserve maintains the value of our currency and promotes long-term economic
efficiency.
Third, switching back and forth from a recession poligr to an inflation policy
creates its own uncertainty in the economy about the Federal Reserve's willingness to
control inflation. Moreover, high and variable rates of inflation generally cause
mistakes in investment decisions. For example, the run-up in inflation during the late
7970s was a boost to the wood products
industry in Oregon and throughout the Pacific
Northwest, inducing many resources to flow into this industry. The boom in the
timber industry can also be traced to the structure of deposit insurance. This
subsidization of market risk allows financial institutions to seek out and pursue
excessively risky investment opportunities, such as certain mortgage lending and real
estate ventures. Flowever, because the housing boom that initiated the timber boom
was built largely on the desire to hedge against inflation, the subsequent steep rise in
interest rates engineered by the Federal Reserve to curb inflation had ruinous
consequences for the wood products industry and for the communities it supported.
If market signals had not been distorted by a general price rise, then some of
the resources that went into the wood products industry would have been diverted to
other industries. A boom would have been less likely, and a subsequent and
immediate bust would not have followed.
Reeional Business Cvcles
I have made these first three arguments for a stable-price policy on numerous
occasions, and I believe that they alone are sufficient grounc{s for the Fed to pursue
such a poliry exclusively. Yet, there is another dimension to the national economy -- its
regional diversity -- that I believe makes my arguments even more convincing.
-
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When addressing the issue of whether the Fed should respond to business
cycles, one must askuhich business cycle. Policymakers typically think of the U.S.
economy as monolithic and make policy decisions accordingly. When monitoring the
pulse of the United States, they look at gross national product (GNIP), the national
unemployment rate, and the national consumer price index (CPI). But, as the past few
economic downturns have dramatically demonstrated, regional economies behave
differently. Instead of each region marching in step with the national economy, it
appears that some states enter and leave national recessions at different times, and that
some states can even remain untouched by national downturns. So far in this episode,
for example, no more than sixteen states have experienced year-over-year employment
loss.
State business cycles exhibited disparate patterns even during the
twin
recessions bebween 1980 and 7982 -- the most severe since the Great Depression. As the
U.S. economy fell into a recession in L980, the energy-producing states of Texas,
Louisiana, and Oklahoma showed no significant slowdown. The same held true during
the subsequent and much deeper recession that began in late 1981. Yet, as the rest of
the nation began to climb out of the second recession, the oil states slipped into their
own downturn. After enjoying a brief recovery within a year after the national trough,
these three states again descended into a period of employment decline, lasting well
into
1.987.
The distinction among regional business cycles has been accentuated in recent
years to the extent that some analysts have even coined the term "rolling recessions."
During the 1980s, farm states, energy states, and then Midwest manufacturing states
experienced downturns while the nation as a wl'role was expanding. Nor,v, several New
England states, centered around Massachusetts, are having severe prolrlems. After
years of seemingly unprecedented growth during the late 7970s and early 1980s, the
Massacl'rusetts economy abruptly changed course in June 'J,986, when
it entered
a
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protracted period of employment decline that still persists. Rhode Island and New
Hampshire immediately joined Massachusetts, and Vermont and Maine were pulled
into the regional recession soon thereafter. These states have yet to recover.
Whv the Differences in Regional Economic Performance?
What, then, explains the variation in regional business cycles? fames Tobin,
the Nobel Laureate economist, and William Nordhaus once stated that the veil of
macroeconomic aggregates conceals "... all the drama of the events -- the rise and fall of
products, technologies, and industries, and the accompanying transformation of the
spatial and occupational distribution of the population."
1 Each regional economy
plays out its own drama against the backdrop of its natural resources, industrial
structure, human capital, and physical and cultural infrastructure.
Fluctuations in the national economy are a combination of structural slr.ifts and
cyclical patterns within each regional economy. These structural shifts affect industries
and regions differently, depending on the industry's productivity and the region's
comparative advantage. For example, because of factors such as relatively high wages,
entrenched special-interest groups, aging private and public capital stock, and foreign
competition, manufacturing employment and population in many Midwestern states
have declined relative to states in the South and Southwest, as well as to other
countries.
Within the Pacific Northwest itself, we see diverse industrial and regional
differences. The timber industry during the last decade has come under intense
competition from Canada and the southeastern United States, in part
as a
result of
technological changes in process and in end-ttse prodtrcts. The result has been
a
significant decline in the share of total jobs in related inclustries. At the same time, the
aircraft and ancillary industries, riding the crest of unprecedented worldwide demand
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for commercial aircraft, have brought a tremendous number of new job opportunities
to the region. Considerable differences emerge even within relatively small
geographical areas. The diversified and bustling economy of the Portland area stands
in stark contrast to the struggling timber-based economies of southwestern Oregon.
Whether these regional shocks are sufficiently large to spill over into other
regions and evenhrally generate a downturn large enough to affect the national
aggregates or averages depends on the severity of tl're regional shock and the linkages
among regional economies. For instance, of the rúne recessions recorded since World
War II, the Great Lakes states have ushered in three. This crrrrent recession marks the
first time that the New England region has led the way.
Regional business cycles are also caused by broader but more temporary
factors. These broader shocks often hit regions simultaneously, such as when oil prices
rise suddenly. As a result of differences in industrial composition and relative
industrial productivity, regions may be affected differently by an oil price shock, but
the simultaneous impact may be enough to affect the aggregate economy. Tlús may
explain why there is strong evidence that all but one of the previous eight national
recessions have been preceded by an oil price shock.
Monetary surprises are another example of shocks that hit regions
simultaneously and have widespread but differing effects. In the early 1980s, we had
two recessions caused by the monetary policy mistakes of excessive money growth
during the 1970s. The shock produced by a disinflationary poliry that was necessary to
get our economy back on an acceptable real growth trend left 46 of the 48 contiguous
states
with year-over-year employment losses at some point during the bwin recessions.
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Federal Reserve Policl¿ within a Regional Context
It is clear, then, that the national economy is an amalgam of regional
economies, each coping with different struclural shocks. Should the Federal Reserve
use a short-term money-based solution to try to correct long-term structural shocks
facing perhaps only a handful of regions? The answer is clearly no for three reasons.
First, the Fed does not have policy instruments tl'rat can target one region differently
from another region. Second, the regional economies within this country already have
market mechanisms that can accommodate adjustments to regional shocks. Third,
monetary policy mistakes can distort the price signals necessary for these regional
market adjustment mechanisms to work efficiently.
The Federal Reserve System is unusual among central banks in that it has the
institutional structure to take a regional view of the national economy. Each of the
twelve District Bank presidents participates in the eight Federal Open Market
Committee meetings held every year. The meeting agenda includes an opportunity for
each president to share
with the entire Committee current economic conditions within
his District. The Federal Resen¡e System also compiles and releases a synopsis of
District conditions, prepared by each of the twelve regional Banks, in what is popularly
called the "Beige Book." Flowever, after these regional presentations are made, the
FOMC forms a consensus view of the national economy and conducts monetary policy
according to this view.
In its early days, when the discount window was the Fed's principal poliry
instrument, each Federal Reserve Bank could (and to some extent did) pursue its own
separate monetary policy by charging member banks cl.ifferent discount rates,
depending on the state of their regional commerce. Toclay, lìr''r.vever, regional, national,
and international integration of money and capital markets precludes this possibility.
Although regional economies maintain distinct identities, the money that flows
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tluough and circulates within them does not. Consequently, monetary policy has no
way of responding to the economic conditions of one region without affecting all
regions.
Even if monetary policy could be targeted to individual regions, this would
not necessarily be the most efficient way to combat structural shocks. The economy
already has mechanisms -- market mechanisms -- that can accorunodate adjustments to
these regional shocks. Although the country is a patchwork of different regional
economies, these economies are linked by a market system through which people,
capital, ideas, and technology move back and forth. The ease with which resou¡ces
respond to regional market incentives enhances the capability of the U.S. economy to
absorb regional shocks.
The United States is unique among industrial countries in that its regional
economies are unified under one corrunon currency. Other economies of similar size,
such as those encompassed by the European Community and the emerging Pacific Rim
countries, are segmented into nations with separate monetary and fiscal institutions
and typically disparate monetary policy goals. Furthermore, with these national
boundaries delineating regional economies, goods and resources typically flow less
freely across those economies than within ours. For these countries, adjustments to
"regional" shocks occ'Lrr to a large extent through exchange rates.
Labor and capital flows are the primary mechanisms by which regional
economies in the United States adjust. A phrase once used by Chairman Greenspan --
"migration arbitrage" -- captures the essence of this regional adjustment process:
resources flowing to the region in which they receive their greatest return. The
regional flow of workers is one of several factors tl'rat allor,vs for ou.r economv's
relatively quick adjtrstment to shocks. For example, t''ecause
c''f
the easv flow of labor
among regions in this country conrpared to labor flows within Europe, one study
shows that regional unemployment rates adjust to one another 20 percent faster in the
United States than in the European Communiry.
2
Even within a single country
-
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Germany, for instance
- it has been estimated that labor migration
plays a surprisingly
minor role in labor-market adjustment compared to the United States. 3 In
a
similar
faslúon, capital flows are also instrumental in the adjushment process. In fact, one of
the principal objectives of the European Community's single market policy is to
promote economic growth through a greater reliance on market adjustment
mechanisms.
In addition to market mechanisms, the United States has institutions that
enhance the regional adjustment process. The government system of fiscal federalism
essentially provides regional insurance, in that the combination of federal tax pa¡rments
and transfers are countercyclical, attenuating the impact of regional shocks on
interregional income differentials. The Federal Reserve System, through its function
as
lender of last resort, also acts as an interregional conduit of funds. The liquidify
necessary to prevent widespread failure of solvent financial institutions in a specific
region is transferred from other parts of the country by the Fed.
Finally, with well-greased market adjustment mechanisms and institutions
already in place to promote the regional adjustment process, I believe that there is no
place in this framework for a monetary policy that responds principally to business
cycles. Why should one look to short-term monetary policy as a way to alleviate these
typically longer-term regional shocks, many of which are structural? We cannot
forecast with enough precision; the economy responds to policy with a lag; and a
stimulative monetary policy carurot alleviate structural problems. By acting as if the
implementation of monetary policy can overcome these problems, at best we risk
making policy mistakes that would distort price signals that are essential for these
regional markets to adjust to economic distttrbances. In acldition, since regional
economies are typically at different phases of their or.vn Lrtrsiness cvcles, a monetary
response to any one regional shock, even if it is manifested in a national business cycle,
may only intensify the business cycles of other regions.
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Conclusion
A thoughtful consideration of the nation's regional economic structure
strengthens my belief that the Federal Reserve should focus solely on long-term price
stabilify. By viewing the national economy
is easy to see thè
as a conglomerate of regional economies,
futilify and potential harm that could result by acting
as
it
if fine-tuning
the money supply could remedy the different structural shocks that impact regional
economies. It is equally apparent that such monetary policy mistakes could send
shocks through all regions, which could exacerbate regional business cycles and make
it difficult for regions to absorb these disturbances.
The only policy that the Federal Reserve should pursue is price stabilify. Price
stability maximizes the efficiency of money
as a
vehicle of trade across regions, nations,
and time. This is especially important in a region such as the Pacific Northwest, which
is becoming increasingly sensitive to international trade. Price stability also eliminates
hedging against unanticipated inflation, thereby channeling resources to their most
productive uses, wlúch is vitally important for the prudent use of the region's valuable
natural resources. Price stability encourages long-term investment, which is important
for technological advancement, and enables people to allocate labor and capital across
regions intelligently
- all factors that contribute to the real growth of a region.
Economic diversity has served our nation well, both as a source of growth and
as a
buffer against shocks. Monetary policy should respect this diversity by not
encumbering the markets through which resources move. A monetary policy that
promotes price stabiliby is the best way to ensure long-term national and regional
economic growth.
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Footnotes
Nordhaus, William D., and fames Tobirç "Is Growth Obsolete?" in Economic
F. Thomas ]nster
Eichengreen, Barry,
"One Money for Europe? Lessons from the U.S.
-Economic
"
Curren-cv
tlnion,
Poficv, 1.0, 1990, oo. 117 -187 .
-
Flouseman, Susan 8., and Katherine
Responses
Ger-man¿"
Policy Ana
-
G
ket
West
ic
@FedFRASER