Regional President Speech

THE U.S. ECONOMY: CURRENT CONDITIONS AND FUTURE GROWTH Thomas M. Hoenig President Federal Reserve Bank of Kansas City Omaha, Nebraska April 16, 1992 2 I appreciate this opportunity today to share with you my views on the outlook for the U.S. economy. My overall message is one of cautious optimism. I believe that by the end of this year we will be well into recovery. I am, however, somewhat less sanguine about the longer term outlook for the economy, unless policies are focused firmly toward promoting sustainable economic growth. As you know there is much discussion these days about what policies we need for the future and it is well worth the effort to draw attention to some of the relevant issues. But before discussing longer term matters let me first turn to the near-term outlook. The Economy in 1992 Our economy admittedly has been in difficulty for the past several quarters. Total output has grown little. Job losses have mounted, spurred in part by a retreat in the auto and commercial real estate industries from the boom years of the 1980s. Moreover, until very recently consumer confidence measures have shown that the American people are uneasy about the economic recovery. Despite this earlier pessimism I am increasingly confident that the nation is in a recovery, although a modest one. With this improvement, household and business confidence should continue to improve and contribute to a faster pace of economic growth over the second half of the year. I believe that real economic growth will be above 2.0 percent this year, maybe as much as 2.5 percent. There are a number of reasons for my view. Among the more important is the general decline in interest rates that has occurred. The federal funds rate has come down 1 3/4 percentage points since last summer. At 3 3/4 percent, the funds rate is at the lowest level since 1972. Other short-term interest rates are also at or near their lowest levels in years. Just as importantly, long-term rates also have declined. Despite some uptick since the first of the year, 30-year Treasury bonds now yield 3 below 8 percent, down about three-quarters of a percentage point from last summer. This decline in interest rates will stimulate activity throughout the economy. We have already seen, for example, a pickup in the housing industry in response to lower mortgage rates, and homebuilding is likely to improve further as families take advantage of the most affordable financing terms in several years. Increased sales of new homes will boost sales of home furnishings and appliances, contributing to higher demand for consumer durables. Automobile sales also will benefit from lower interest rates, although I am certainly aware that 1992 will not be a boom year for the Big Three automakers. Nevertheless, from the low base of 1991, some improvement in production of American cars should be evident this year, and I would expect employment in the automobile and related industries to stabilize in the months ahead. Beyond these basic industries, U.S. businesses more generally will benefit from a low interest rate environment. The cost of new equity capital is declining. The ability and incentive to raise capital are, therefore, far greater now than they have been in recent memory. In 1990, for example, equity capital raised in the markets was a mere $26 billion; in 1991 this figure was $71 billion, almost three times the earlier level. The effect of such equity additions is to strengthen corporate balance sheets, ease funding strains, and facilitate expansion. Thus, I expect some moderate increase in business spending on new plant and equipment. The extent of the increase in business investment will, of course, depend on any tax package that might be passed. Although proposals for accelerated depreciation or investment tax credit are very uncertain at the moment, if these proposals become law, investment spending could be quite robust later in the year. Proposals to provide tax relief to middle-class households would boost consumption spending. 4 American products are quite competitive in today's world market and I therefore expect further expansion of U.S. exports this year. However, this expansion will no doubt be impeded somewhat by expected slow growth in other countries. Canada already may have slipped back into recession, Germany has experienced declining output in adjusting to reunification, and even Japan is experiencing a pronounced slowdown in growth as it attempts to correct previous asset-price inflation. Thus, while exports will show some growth, the rate will unlikely match that of last year. Government spending will be a drag on U.S. growth this year, despite this being an election year. The budget agreement is still a restraint on federal spending, and the collapse of the former Soviet Union has allowed for further reductions in military outlays. Moreover, many state and local governments are in the midst of a fiscal tightening. They certainly will not be expanding programs until they can stanch the flow of red ink. With all of these factors coming together to suggest a moderate recovery, the unemployment rate may remain above 7 percent for the remainder of the year. This is the downside of having moderate rather than robust growth. As the economy continues to recover, we expect no serious pick up in inflation. Although this past month witnessed some rise in prices, the underlying inflation rate should remain less than 4 percent for the year. In summary, I expect a strong stimulus to the economy from lower interest rates. I expect demand for housing, durable goods, and automobiles to strengthen, and inflation to stay in check. Also, business fixed investment should increase, as corporate balance sheets improve and the recovery gets underway. However, the recovery will be slowed to some degree by reductions in government spending and a slowdown in the rate of export growth. 5 Prospective Policies Generally, then, I am cautiously optimistic about the prospects for economic recovery in the near term. Within the context of this modest improvement however, I want to take the opportunity to focus attention on some difficult issues affecting long run growth and the sustainability of the recovery. I would point out that over the past two decades the real growth rate in GDP in the U.S. has fallen from an average of 4 percent to 2.5 percent. There are any number of reasons for this decline; some are out of our control, such as a change in demographics, but others are tied to public policy and these need to be forcefully addressed. Indeed, if policies were implemented that raised the potential growth rate of the U.S. economy an average of one-half percentage point over the next 50 years, it would, in the end, raise real GDP by 25 percent. Such improvement is certainly worth pursuing. To move the economy toward a path of higher growth, most economists and many others agree that more capital should be directed toward productive capacity. It is worth noting that in private business investment the U.S. lags well behind that of a number of other industrialized economies. Over the last decade, for example, U.S. investment has averaged about 12 percent of output, below comparable figures for Germany (14.4 percent) and Japan (16.4 percent). In this context, the need to enhance capital spending becomes more apparent, and if the U.S. is to remain a competitive, world-class economy into the next century, the issue needs to be addressed. To encourage capital development, again, many economists and others agree that we should ease the tax burden on capital. For one thing reducing the capital gains tax would give American industry tax treatment similar to that in other industrial economies. In addition, investment tax credits 6 now being considered would not only increase investment in the long run but would also help "jump start" short-run economic recovery. When we speak of the need to increase capital, however, we must also remain aware that for investment to increase, savings (domestic or foreign) must be available and must increase also. In the United States, the savings rate, like investment, has been consistently low. For example, over the past decade, personal U.S. savings as a percent of GDP averaged about 4.5 percent, while in Japan the average was nearly 11 percent and in Germany it was above 8 percent. The U.S. savings rate clearly lags that of other industrialized countries, and appears also to be too low. Thus, discussions of tax incentives realistically must be directed toward savings as well as investment. Finally, for private U.S. investment and savings to accelerate, one major factor still must be addressed; that is government spending and deficits. The federal government currently has direct debt outstanding to the public of approximately $4 trillion. The government is spending $1.5 trillion dollars annually and is adding $400 billion of new debt this fiscal year. To fund this deficit, savings must necessarily be drawn from the private sector. Indeed, U.S. net domestic savings adjusted for government deficits and exclusive of depreciation charges averaged only 3.5 percent of GDP between 1980 and 1991. Unless this drain is replaced by savings from abroad, private investment necessarily must be lower than it otherwise would be; and as I noted earlier, investment currently is lower than in other industrial countries. A country's wealth, its ability to create jobs, rests importantly on its technological, manufacturing and industrial base, and the growth in this base depends critically on a country's ability to generate investment and savings. And for the United States, increasing savings and investments will depend importantly on not only tax incentives but on the federal spending and deficit programs 7 we choose to pursue over the next several years. Some fear that eliminating deficits would inevitably require onerous tax hikes. But higher taxes are not the only way to achieve this end. The collapse of the Soviet Union presents obvious opportunities to cut defense-related expenditures. However, entitlement programs, which account for over half of government spending, also should be scrutinized to determine which might be reduced and which might be desirable but are unaffordable. If we can convince ourselves that spending reductions are needed and if we pursue these matters equitably, then we can address our deficit problem without resorting necessarily to significant tax increases. Finally, there is one other very important factor that will influence U.S. growth well into the next century, and that is international trade. U.S. imports and exports of goods and services currently represent more than 10 percent of GDP. Moreover, over the past decade the U.S. has consistently run trade deficits in the tens of billions of dollars. These deficits are obviously bothersome and have led many groups to call for trade restrictions as a means of saving jobs within the United States. Such actions, I believe, would be counterproductive. Remember that the U.S. is among the world's largest exporters, having sent well over $400 billion in goods to the rest of the world last year alone. Before we initiate trade restriction, we must ask ourselves what will happen to these exports and the jobs they represent if we allow ourselves to be drawn into a trade war with the rest of the world. Trade barriers –whether here, in Japan, in Europe, or elsewhere – benefit primarily special interests, not the general public or domestic workers. Protectionist legislation did not work in the 1930s and I doubt that it will work in the 1990s. Instead, the United States should continue to lead the world toward greater free trade, which has raised world living standards since World War II. 8 Existing trade barriers should be systematically negotiated away. Pursuing open trade, and encouraging investment and savings in our domestic economy will best ensure a continued increase in U.S. jobs and living standards. Conclusion In summary, the U.S. economy is improving. Interest rates are at their lowest levels in decades, equity issuances are at recent historical highs, and corporate balance sheets are strengthening. We in the United States should take advantage of this opportunity to begin to focus our attention on the long-run needs of this economy and our desire to ensure sustained economic growth. Our efforts must be directed toward investment and savings; and these areas can only be properly addressed if we first examine and prioritize government spending. The process I have outlined will not be easy, but it is absolutely essential if our nation is to provide the long-run standard of living we want for our children and grandchildren.

Thomas M. Hoenig (1992, April 15). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_19920416_thomas_m_hoenig

@misc{wtfs_regional_speeche_19920416_thomas_m_hoenig,
  author = {Thomas M. Hoenig},
  title = {Regional President Speech},
  year = {1992},
  month = {Apr},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_19920416_thomas_m_hoenig},
  note = {Retrieved via When the Fed Speaks corpus}
}