Regional President Speech

DRAFT V 10/23/86 S.S. SILAS KEEHN REMARKS ILLINOIS ECONOMIC ASSOC. MIDLAND HOTEL OCTOBER 24, 1986 Introduction In the last fifteen years we have lived through almost constant economic upheaval. Rapid structural change seems to have become a permanent part of the economic landscape. Deregulation in the financial industry, the internationalization of our domestic markets, massive increases in oil prices in 1973 and then again in 1979, followed by the recent large declines in oil prices, as well as the shifting winds of fiscal and tax policy have made the economic terrain change faster than the eye can see. These changes have created serious questions about how well we really understand the economy. Each passing shift seems to leave a previously reliable economic relationship dead in its wake. Both simple rules of thumb and complex econometric models have failed to cope with the size and scope of the changes we have witnessed. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 2 At the end of the 60s, macroeconomics seemed on the verge of solving the problems of recession and unemployment. We had enjoyed an entire decade of uninterrupted growth. Unemployment had been reduced from 6.7% in 1961 to 3.5% in 1969, while inflation increased from 1.0% to 5.4% in the same period. Economic policy had marched the economy down the Phillip's curve with a precision undreamed of by previous economic planners. Then the 70s arrived. Inflation continued to accelerate, but growth failed to keep pace. Oil shocks generated a massive stagflation which was not only unpredicted, but supposedly impossible. The Phillip's curve and, with it, the rest of classical Keynesian economics was in tatters. The sos have been even more traumatic for economics. In the international markets, the U.S. dollar appreciated steadily for 4 years, despite constant statements by international economists that because of the deteriorating trade picture, the dollar would soon fall and fall sharply. This nearly universal refrain did not cease until the beginning of 1985 when forecasters finally came to the conclusion that there was no immediate reason for the dollar to fall and began forecasting a modest appreciation. The timing Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 3 was doubly unfortunate. For not only had such pronouncements lost all credibility by this time, but the dollar finally began to fall and fall sharply. I am not sure whether to characterize this episode as demonstrating too much or too little faith in economic theory, but it certainly raises serious questions about how well these issues are understood. At the same time the dollar problem was occurring, the administration fought through a massive change in the tax system. The new tax bill was supposed to spur investment growth that would, in turn, fix the productivity problems we had experienced in the 70s. The reduced marginal tax rates, lower capital gains taxes, investment tax credit, and accelerated depreciation schedules did, as promised, create a massive boom in investment which, at least for the first 8 quarters of the expansion, caused equipment investment to grow faster than in any previous post-war recovery. Unfortunately, the much-talked-about connection between investment and procuctivity proved to be little more than wishful thinking. Productivity growth in manufacturing was slightly below average for a business cycle and nonfinancial productivity growth was actually the second lowest for any recovery in the post-war era, th averaging an anemic 1.8% rate since the 4 quarter Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 4 of 1982. While the exact interpretation of these numbers may be open to question, it is clear that investment incentives failed to live up to their promises. On the monetary policy side, the 80s played host to the fall of the money/income relationship. This is especially ironic since it was only in the sos that the money/income relationship came into its own as part of the policy process. The monetary aggregates did not receive official recognition until 1978 with the passage of the Humphrey-Hawkins Act. And it was not until October 1979 that the Federal Reserve actually began to put significant emphasis on the short-run control of Ml. However, the massive restructuring of our financial system that followed the Depository Institutions Deregulation and Monetary Control Act severely undermined money's usefulness as a policy guide. In 1982, Ml velocity growth strayed seriously from its 3% historical trend rate, actually falling 2.5%, as the recession exceeded expectations in both depth and length. In 1983, with the recovery underway, real growth returned to historical patterns. However, the inflation rate fell significantly below forecasts based on those same historical patterns. This caused Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 5 velocity to fall at an even faster rate of 3 1/4% rate. People continued to believe that the velocity decline was temporary, and that once the adjustment to the newly introduced interest-bearing accounts was over, the money/income relationship would return to normal. 1984 brought some credence to this prediction as velocity returned to historical trend. This, however, proved to be a case of compensating errors. A combination of below-forecast inflation and above-forecast real growth produced the appearance of normalcy. Some analysts suggested that this meant that we had a new and improved trade-off between real income and inflation. And since the shift was in a positive direction it was viewed as a minor problem. The typical response to incorrect forecasts is to complain only about worse-than-expected outcomes. In 1985, the money/income relationship failed once too often. The real side of the economy cooled off and the "good" inflation r.ews just kept coming, causing another major fall in velocity, this time at a 2 1/2% rate. These constant runs of new and different behavior took their toll. Many economists and policymakers lost faith in monetary models. And we have all begun to take a much more skeptical view of Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 6 the post hoc explanations that had been used to explain the constant problems with economic forecasts in the sos. Yet, from a pure policy perspective, it could be argued that we have coped quite well. We are enjoying the third longest period of sustained growth in the postwar era, 15 consecutive quarters of positive growth. Only the recoveries which began in 1961 and 1975 lasted longer, with 35 and 19 consecutive quarters of growth respectively. Unemployment, which was at 10.7% at the beginning of the recovery, has steadily declined to its present level of 6.8%. Almost 12 million jobs have been created in this recovery, 2 1/2 million in the last 12 months. There are no signals of an impending downturn. Inventories remain under control. We have no shortages of raw materials. Interest rates are actually below what they were at the beginning of the expansion. We currently expect steady growth through at least the end of 1987. The inflation outlook is equally optimistic. Inflation will probably remain below 4% next year and no significant rise is currently foreseen. In fact, many analysts think that a deflation is a real Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 7 possibility. Following the the double digit pace of the early sos, this represents a major victory for economic policy,--although I must admit the recent very low levels of inflation owe more to energy prices than to policy. So why am I worried about the health of economic theory, when economic policy seems to be doing quite well without it? Primarily because I am not nearly as sanguine about our future as the preceding summary might indicate. A 200-billion-dollar-a-year government deficit, a 160-billion-dollar-a-year trade deficit, which has in the last few years turned the United States from the largest creditor nation in the world to the largest debtor nation in the world, record consumer and corporate debt levels, the overhang of 566 billion dollars worth of LDC debt owed by countries with repayment difficulties are a few of the problems facing us that indicate all is not well. The problems facing the policymaker can be reduced to two fundamental questions. To what extent is our current prosperity an illusion? And to the extent it is illusion, how should we run policy differently than we have? To answer these questions, I need to be more specific. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 8 Inflation, for instance, seems well under control. Yet, the overall inflation rate hides a number of disturbing trends. If we look at service sectors or, more generally, sectors which are unaffected by imports, we see rates of inflation well above 5%, however if we look at commodity prices we seem to be on the verge of a major deflation. These conflicting trends make it very difficult to evaluate policy. Some have suggested that the Fed's continuing concern over inflation is misguided and suggest we should stop fighting the last war. I disagree. I think it is more appropriate to think of inflation as a kind of alcoholism that can never be cured but can be controlled though constant vigilance. Concerning our massive accumulation of debt, I wonder if those debt levels are not a symptom of some fundamental imbalance that is about to assert itself and throw the economy into a serious tailspin. If you had asked someone at the beginning of 1980, whether the U.S. economy could withstand a 200-billion-dollar-a-year government deficit and a 160-billion-dollar-a-year trade deficit, the answer would have been a resounding "No!". Nevertheless, the economy just keeps chuggin' along. There must be a limit but we don't know where that limit is. And we certainly don't know the consequences of correcting Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 9 these imbalances. It's rather like ordering dinner in a fancy restaurant where there are no prices on the menu. The food is good and you know the bill will be high--but you don't find out how high until the meal is over. Concerning the real economy, I would say that its performance has, in truth, been very good. For once, we seem to have managed to achieve the proverbial soft-landing. Job growth and unemployment, for example, seem to be on very healthy trends without creating any stresses in the labor markets. But, there is no unanimity about this. Some, including the administration and some members of the Federal Reserve Board, feel that 2 1/2% growth is inadequate and that as a long term growth trend it is simply unacceptable. Citing such problems as the lackluster performance in the manufacturing sector or regional imbalances, it is argued that greater growth is necessary if everyone is to share in our current prosperity. They, in turn, argue that a 5% growth rate for the real economy would be a better target. The guidance about this issue from Economics is vague and not really very helpful. Asking, "How much growth is enough?", seems to be like asking, "How high is up?". Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 10 Yet, I think that this is the most important question facing policy. It is here that I think we will find the answers about inflation and debt. For if we look at the policy errors of the past, we see that they all share a common thread of overly optimistic goals for the real economy. Trying to achieve too much creates problems for the future, either through the accumulation of debt, which produces an ever increasing drag on economic activity requiring greater and greater stimulus to offset, or often as a massive surge in inflation following an attempt by the monetary authorities to maintain unrealistic rates of economic expansion in an otherwise weak economy. The current situation is a prime example. We have borrowed a large part of our current prosperity from the future--from anyone and anything that would lend. But this was not due to some mass attack of Keynesian animal spirits that caused us to over-consume. After the economic hardships of the 70s and early 80s, the country desperately wanted petter times. As those times came, the good growth from the horribly depressed levels of 1982 created unrealistic expectations about what types of outcomes were possible. Policymakers' attempts to maintain those unrealistic levels of growth and satisfy those overly optimistic expectations led them to more and more Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 11 expansionary policies. The 1981 tax cuts which were supposed to pay for themselves by spurring undreamed of rates of economic expansion are an excellent example of wishful thinking in policy. So far, the deficit has grown larger every year, up to its current level of 224 billion dollars. The government, simply, cannot continue to spend 24% of GNP while collecting only 19% of GNP in taxes. Without the constant infusion of foreign capital the government would be using 30% of all private sector savings to cover its deficits. And, it is this fiscally induced need for foreign capital that is the primary reason behind our massive trade deficit. The government cannot import foreign capital without some part of the economy importing foreign goods. The dollar will remain high and our industries will continue to have trouble competing both domestically and in the international market place until we kick the foreign capital habit. The cost of postponing the inevitable readjustment may well be a severely damaged industrial base. The recent decline in the value of the dollar will help. It should at least stabilize the trade deficit and perhaps bring some moderate improvement. But, with the dollar still 26% above its level in 1980, when we last saw current account Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 12 balance, it is folly to expect a full correction in the trade account. However, we must not attempt to fix the trade problems by exchange rate movements alone. As I said earlier, if we fix the trade deficit without fixing the government deficit, the government will need to borrow 30% of all private savings to pay its bills. This would be double the crowding-out experienced anytime during the postwar era and 4 times the postwar average. Crowding out on this scale is unprecedented in peace time. The results are unlikely to be positive and are extremely likely to be very, very negative. Fiscal policy should and must take the responsibility for correcting these problems. But, I worry that the deadlock in fiscal policy will push the burden of dealing with these problems onto monetary policy. In the 70s, when we attempted to do more with monetary policy than it could accomplish, another example of overly optimistic policy, the result was a massive increase in the inflation rate. In the early 80s, we payed the price for those policies with a severe and extended recession which still only brought inflation back to manageable rates. Even though inflation forecasts for next year still seem low by today's standards, running around Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 13 3.5%, it should be remembered that Richard Nixon declared a national emergency in 1971 when inflation was only 4.1%. If we fail to find a political consensus on how to deal with the fiscal imbalances, we may have laid the foundations for another major acceleration in the inflation rate. However, because of the lack of strong Economic arguments, it has been impossible to achieve any consensus on how to deal with these issues. Attempts to rein in private debt creation by raising interest rates, besides potentially pushing an already fragile economy into recession, will exacerbate the Federal deficit by cutting revenues and raising borrowing costs. The increased interest rates might also push the LDC debt situation to crisis levels, since it would create large increases in their debt-servicing load. Further, higher interest rates would also force up the value of the dollar and thus worsen the trade deficit. Lower interest rates, on the other hand, while providing some relief to LDC nations and helping the fiscal situation, will only exacerbate the private debt problem and potentially create a crisis in the currency markets. Conceivably, such a crisis could severely reduce our access to new foreign capital. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 14 And the U.S. economy has become so addicted to foreign capital in the last few years that any large reductions in the flow of new capital could very easily cause a severe recession--and thus propel all of the debt problems to crisis proportions immediately. Fiscal policy seems totally paralyzed. Between the unwavering refusal on the part of the administration to consider new taxes and Congress's and the President's inability to agree on any significant spending cuts, no meaningful actions are likely to be forthcoming. I continue to hope that the stalemate will end. Gramm-Rudman-Hollings, though shotgun in approach, appeared to offer some hope, but as time has passed it seems less and less likely to bring about significant spending cuts. Without a well-defined and widely accepted macro policy framework, we have little option but to follow our current strategy of partial and piecemeal attacks on these problems. We must do better. But that will take better Economics as well as better policy. Many have suggested that these problems, which result from imperfect policies, indicate that we should not attempt to manipulate the economy through monetary and Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 15 fiscal policy. They argue we simply do not know enough to justify interfering with the economy and that we should let the economy find its own way. I would like to be able to agree with this proposition. I certainly must admit to the dangers of an active policy. We have lived through too many bad outcomes to deny the difficulties bad policy can create. Unfortunately, policy has no place to hide. Fiscal policy exists so long as there is a government that taxes and spends. And monetary policy exists so long as there is a government-backed currency. Turning policy over to a rule, such as a money growth rule or Gramm-Rudman-Hollings, only creates the illusion of passive policy. Given the rather weak real growth of the last two years with a 12% rate of money growth, imagine what type of economic chaos would have occurred if we had slavishly held to a money growth rule of 5%. The world had changed and 5% money growth meant something different than it had in the past. In our rapidly shifting world, a stable policy must evolve with other factors. A constant interest rate or steady money growth rule possesses only the appearance of stability. Simple rules may work fine in a simple unchanging world, but their effectiveness in our complex, rapidly changing world is, at best, doubtful. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 16 How then can we run policy--especially when our tools are broken? Once, we believed that a steady money growth rule could provide the guidance we needed to chart our course. Today, we have no such belief. Yet, if policy cannot hide, it must find a way to be a positive force in our economy--or at least not a negative one. How can this be accomplished? I think the key is to avoid the over optimistic assessments of our growth potential that have plagued policy in the past. We must set goals which promote today's well-being without stealing tomorrow's. It is only in this way, I believe, that we can avoid avoid mortgaging our futures in the foreign capital markets and returning to the disruptive and destabilizing inflations of the 70s. We must begin the hard process of understanding the art of the possible not just as a political precept, but as an economic precept. Our understanding of the underlying structure of economic growth is critical to this. Without a well-developed structure for formulating realistic goals, politics will inevitably win out and over optimism will continue to plague the policy process. At the Federal Reserve Bank of Chicago, we understand this only too well. And we have begun the long process of developing the tools necessary to set more Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 17 realistic goals. We invite you to join us in this essential endeavor. Now, I would like to take some time to describe a few of the projects we feel hold the most promise for answering this question. The first is new work on the determinates of unemployment. One of the basic goals set forth for economic policy in the Humphrey-Hawkins Act was to maintain full employment. At the time the bill was passed, this was taken to mean a 3 to 4% unemployment rate. Not surprisingly, this proved to be an unrealistic goal. What was not understood is that unemployment is affected by more than general business conditions and that, unless these other factors are taken into account, the unemployment rate can provide a very misleading picture of the economy. Our analysis indicates that the key adjustment concerns structural unemployment, that is, unemployment which is caused by reductions in the demand for specific types of labor rather than the general declines associated with changes in aggregate demand. The steady decline in heavy industry employment is the most common example. Structural unemployment is a necessary part of an economy that is evolving in response to changes in the marketplace. Changing market conditions often require moving large Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 18 amounts of resources from one set of industries to another. And while this type of unemployment may represent the most painful from a human standpoint, it is one that macroeconomic policy should not and, in truth, cannot address unless we are willing to have a centrally planned economy. It simply takes time for individuals to develop the new skills necessary to change careers. Thus, the unemployment rate must be interpreted with great care during periods of structural change. In creases in the unemployment rate may simply reflect the structural change and have nothing to do with general business conditions. Attempts to drive the unemployment rate down despite these necessary labor market adjustments is just the type of overly optimistic policy that has caused so much trouble in the past. For example, policymakers' attempts to offset the effects of the 1973 and 1979 oil shocks forced the unemployment rate below the equjlibrium rates implied by such large structural shocks. This was almost certainly a major contributing factor to the large accelerations in inflation that occurred in both of these periods. Yet, at the time, policymakers were actually criticized for not doing more to reduce the Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 19 unemployment rate. In another set of projects at the Federal Reserve Bank of Chicago, we have begun analyzing the business cycle on an industry-by-industry basis. We believe that the structural changes the U.S. economy has undergone have greatly changed the nature of the business cycle. These changes have in turn reduced the effectiveness of certain types of policy actions. This creates a special type of over optimism about what policy can do. From the industry-specific data we have found that much of the business cycle is concentrated in a specific group of industries. These industries share a number of characteristics, such as, a lack of foreign competition, high concentration, and a tendency toward high levels of unionization. Taken as a group, these factors determine the amount of competition in a given industry. We have found that highly competitive industries show very little cyclical behavior, while industries with significant monopoly or union power demonstrate strong cyclical patterns. Why is this important? In the last few years the penetration of foreign products into U.S. markets, the Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 20 decline of some highly concentrated industries such as steel, the general decline of unions, and the continuing trend toward deregulation have markedly increased the competitive pressures in the market place, and thus, have significantly reduced the general cyclical sensitivity of the economy. The policy implications of this are very large. As I mentioned earlier, in such an environment, the normal tools of macro economic policy will have less impact than they have had in the past. This is part of the reason why what could be considered highly stimulative fiscal and monetary policies have been unable to significantly spur growth in the last 18 months. The positive aspect of this is that policy is less likely to shift the economy significantly off track. If policy actions have less effect, they are less likely to over-stimulate the economy or to push the economy into recession. However, on the negative side, if policymakers are stubborn about achieving unrealistic outcomes, unprecedented amounts of government intervention may result. Looking at current policy, this research should give us all pause. One of the things which we believe will come out of Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 21 this line of research is an understanding of the way resource availability and foreign competition affect overall U.S. growth. By analyzing the specific effects of changes in foreign competition and energy prices on individual industries, we should be able to assess how changing conditions in the world will affect our ability to grow. The last project I would like to discuss today also follows the general theme of evaluating the effects of the world economy on the United States. We have begun a major project analyzing the effects of the value of the dollar on the competitiveness of U.S. industries. An economy cannot grow if it cannot sell what it produces. We believe that this has been a major factor suppressing growth in this country over the last few years, and that any attempts to adequately evaluate our potential growth must start with our ability to compete. our analysis is based on adjusting changes in exchange rates for the differing inflation rates in different countries. By adjusting for inflation, it is possible to get much better estimates of how the relative costs of production are changing through time. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 22 Preliminary analysis indicates that a real exchange rate index behaves much like the commonly used trade weighted dollar in the short run. However, when analyzing more extended periods the real exchange rate index shows more consistent relationships with trade flows than do indices based on nominal exchange rates. For instance, if we look at the three periods of time since the advent of floating exchange rates when our trade accounts were in balance, we find that the real index varies between 108 and 110 during these periods, a relatively narrow range. If we look at the trade-weighted dollar index over the same periods, it varies between 88 and 118, a much larger range. This has strong implications for evaluating the competitiveness of U.S. producers. In order for the value of the dollar to reach the level previously associated with trade balance, it will have to fall an additional 15%. It is little wonder why improvements in the trade balance have been so slow,-- a 15% cost factor is a little hard to overcome simply by cutting costs. But, as I said earlier, simply forcing the value of the dollar down would be a very dangerous way of dealing with the trade situation. Further declines will have to come as the result of other changes in Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 23 policy, which seek to address the other imbalances in the economy, such as the Federal deficit. In the future, the Chicago Fed intends to extend this research by designing indices which measure the dollar's effect on the competitiveness of specific industries. This should allow us to combine the work on the value of the dollar with the industry-specific studies discussed earlier. In closing, I would like to emphasize that I, at least, am optimistic, but not too optimistic. I think that the lessons of the last 15 years have not gone unnoticed. We at the Federal Reserve are determined not to repeat the mistakes of the past. While the current problems with the monetary aggregates make it difficult to evaluate the current posture of monetary policy, inflation has not been forgotten. We continue to monitor the course of the economy and we do not see any evidence that the destructive inflation rates of the 70s and early sos are going to return. Fiscal policy presents many problems. But it is clear that those problems are now getting the public attention they require. There is much work to be done. We, as policymakers, must learn to set goals which are realistic. And you, Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Page 24 as economists, must help us by developing ways of determining what is realistic. Specifically, I want to leave you with the two questions that I think are the most crucial for the formation and execution of monetary policy. First, how fast can the economy grow without creating serious imbalances that will come back to haunt us? Especially, how can we avoid excessive rates of inflation? We must not allow ourselves to recreate the trauma of the 70s,--inflation must be kept in check. And the second question, now that the monetary aggregates no longer work as a short-run policy tool, how can we manage policy on a day-by-day basis? Good long run goals are a fine thing, but if the steering mechanism is unreliable we are not going to reach our goals, realistic or not. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis

Silas Keehn (1986, October 23). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19861024_silas_keehn

@misc{wtfs_regional_speeche_19861024_silas_keehn,
  author = {Silas Keehn},
  title = {Regional President Speech},
  year = {1986},
  month = {Oct},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19861024_silas_keehn},
  note = {Retrieved via When the Fed Speaks corpus}
}