Regional President Speech

NATIONAL ASSOCIATION FOR BUSINESS ECONOMICS ANNUAL MEETING Chicago, Illinois September 12, 2000 ..................................................................... The Economic Frontier: Exploring New Possibilities Good morning and thank you for inviting me to speak here today. It’s always a pleasure to have the oppor- tunity to address a group whose members contribute so greatly to the economic policy dialogue. We were happy that many of you could attend the dinner last night at the Chicago Fed. Unfortunately, I was unable to attend personally. I was at the Federal Reserve’s System Leadership Conference, which the Chicago Fed had the honor of hosting this year, for the second year running. Your President, Diane Swonk, is a long- time friend of the Federal Reserve. And it’s good to see Harvey Rosenblum, here from the Dallas Fed, who chairs your program. Today I’d like to give you my perspective on some of the rapid transformations currently underway in our economy. But I’m not going to call it the “new economy.” Why? Because that term can be misleading. Because the term “new economy” too readily answers the complex question, “Are we indeed going boldly where no economy has gone before?” “New Economy” suggests we have arrived at our final destination, a place where the business cycle is dead, where inflation is a thing of the past, and where unemployment levels are always low. I don’t think we’re there yet. Instead, I view this as an economic frontier in which we’re exploring new possibilities in this, the longest expansion of our nation’s history. In truth, this economy may or may not be new. It may be that the cur- rent economy is the old economy in unusual circumstances — due to a fortuitous but temporary conflu- ence of economic phenomena. Or it may be that the current economy has opened us up to a different uni- verse of economic possibilities. In my talk today, I’d like to address the nature of these possibilities, and the challenges they present. How is the economy different today than in the past, and what does this mean for monetary policy? Michael Moskow Speeches 2000 325 By almost any measure, U.S. economic performance over the past several years ranks as stellar. The cur- rent expansion sailed into its 10th year this past April for a national record. The unemployment rate hov- ers near its lowest level in thirty years, and we have had relatively low inflation, as well as a significant appreciation in the market valuation of many firms. Over the last few years, the U.S. economy has hit the trifecta: rapid economic growth, low unemployment, and low inflation. A truly outstanding record. But even better, due to the extraordinary length of the expansion, many chronically unemployed individuals have now been brought into the workforce for the first time. Consequently, many of America’s poorest have seen their real incomes rise significantly and have gained valuable work experience that will help them for many years to come. Why has the national economy been doing so well? The low inflation environment deserves much of the credit. Obviously, the Fed can’t create long-term growth directly. Growth comes from investment in human and physical capital. The Fed can’t train the workforce, and it can’t build factories. However, the Fed can facilitate the necessary investment by creating an economic environment of low and stable inflation. As the 1970s showed, high inflation, especially when it’s volatile, disrupts economic efficiency. Since those dark days of double-digit inflation 20 years ago, the Fed has made significant strides toward price stability. This is not just an American development: we’ve seen an increased understanding worldwide of the critical importance of price stability. Explicit inflation targets are now the norm at many central banks through- out the world, including those in the U.K., Canada, New Zealand, and the European Monetary Union. This worldwide commitment to price stability may serve as a global nominal anchor, in the same way that the gold standard did during the late 19th and early 20th centuries. So much good news. Yes, there are many reasons for high hopes for the future. And yet, as in any time of prosperity, one great risk threatens a continuation of that prosperity: that risk, complacency. Those who claim there is a “new economy” tend to create false hopes that inflation and the business cycle might be things of the past. We know that the laws of demand and supply, as well as basic economic incentives, have not changed. In formulating monetary policy, we can not lose sight of the importance of price stability in maximizing sustainable growth. Recent economic developments have not changed these principles. In fact, these developments are more complex than the phrase “new economy” suggests, and they raise some sig- nificant challenges for the Federal Reserve. I’d like to hone in on three developments in particular. The first two are changes in the fundamental econom- ic structure and are likely to be permanent. I’m referring to the accelerating innovations in financial markets (including the growth of derivatives) and the increased globalization of the economy. The third is the recent acceleration in productivity growth. We don’t yet know if this third development is permanent, or whether the economy will fall back to the productivity growth rates that characterized the 1970s and ‘80s. Obviously these are broad and complex topics. I couldn’t do any of them justice in a semester course, let alone a short speech. But, in the limited time I have with you today, I’ll give you my personal perspective on the relationship between these three key developments and decision making at the Fed. As a caveat, I should note: there are numerous developments I cannot discuss today for lack of time. Increased household participation in financial markets sits at the top of the list. Let’s start with financial innovation. Appropriate, I think, for a talk given in this city, the birthplace of modern derivatives trading. Back in the 1950s, Nobel laureate Kenneth Arrow showed that if we had a suf- ficiently rich array of securities, we could transfer risk perfectly to those most willing to bear it. Arrow’s 326 Michael Moskow Speeches 2000 proposition was purely hypothetical at that time since financial markets were too poorly developed. But today is a different story. In fact, I would argue that the explosion of derivatives markets has brought us close to Arrow’s original vision. Let me give an example. Before the derivatives revolution, users of energy had no choice but to bear the risk of energy price increases. Now, they can purchase tailor-made derivatives contracts tied to energy prices that partially or completely immunize them from this risk. The dealers offering these contracts, in turn, can hedge most of their residual risk by using exchange-traded futures and options contracts. Some companies have offered these sorts of hedging services as a major source of value-added. For example, Enron trans- formed itself from a rather low-tech natural gas pipeline company into a firm that provides state-of-the-art risk-management services to its customers by developing a broad array of hedging contracts. So what does greater efficiency in the allocation of risk have to do with monetary policy? Put simply, it makes the economy less volatile. By shifting economic risks to those parties most capable of bearing that risk, derivatives allow the economy to stay on a more even keel. Remember the effect of oil price shocks during the 1970s. As we all know, the so-called “oil crisis” led both to markedly increased inflation and to recession. What impact would such oil price shocks have on economic activity today? Probably a much smaller one. Why? Using today’s financial products, petroleum- using firms can hedge their oil price risk. If they manage to do so adequately, they should be able to han- dle increases in petroleum prices with fewer layoffs and smaller price increases than in the past. This reduces the need for Federal Reserve action. Derivatives also reduce the need for Federal Reserve action on a much broader level. Derivatives (such as forwards, futures, options, and swaps) enhance price discovery, and thereby make expectations about future prices more explicit. Options, for example, give market participants and the central bank informa- tion about the market’s expectations — expectations about future volatilities of interest rates, foreign exchange rates, and commodity prices. This information is useful in formulating monetary policy. Derivatives reduce market frictions and make markets more efficient. They provide for optimal risk-bear- ing, price discovery, and reduced transactions costs. For these reasons, derivatives should allow for a more efficient, self-correcting and shock resistant economy. So what’s the downside to derivatives? Used properly to hedge risk, there isn’t one. But that’s an important qualification. Unfortunately, derivatives can also be misused. Derivatives allow firms to rapidly take on highly leveraged speculative positions. And this can make financial markets more fragile. The Federal Reserve must keep an eye out for evidence of derivatives misuse. But it can be tough to spot. Unlike ordi- nary garden-variety leverage, implicit leverage embodied in complex derivative contracts may be difficult to discern without a careful analysis of the particular contract. The Fed appreciates this problem. In fact, the Federal Reserve System has boosted its ability to detect and respond to the misuse of derivatives. The Chicago Fed in particular serves as a “Merchant Banking Competency Center” for the entire Federal Reserve System. In this capacity, we act as a resource for the examination of banks that act as derivatives dealers. Hopefully, our work will reduce the likelihood of systemic disruption to the financial system due to derivatives misuse. Let’s now move on to the second development, globalization. Cross-border flows of goods and capital are at their highest level since the end of World War II. The United States has been a net importer of capital since the early 1980s. This capital inflow has been a powerful agent of change. It has helped finance the Michael Moskow Speeches 2000 327 investment in information technology that lies at the heart of the recent productivity growth surge. More generally, globalization lets capital flow to its most productive use, â??and allows goods to be produced by the most efficient producers. On the whole, globalization makes the Federal Reserve’s job somewhat less difficult. The rest of the world acts as a safety valve of sorts — satisfying increased demand and absorbing shocks to American supply. For example, consider the events in the last half of 1997. At a time when increased inflationary pressures in the U.S. created some concern, the turmoil in Asia increased the flow of American imports as well as the flow of capital to the U.S. This countered upward pressures on prices and interest rates that may have been present. However, I should point out, and this is an important point, the increasing pace of econom- ic growth internationally has now made this safety valve a less potent anti-inflationary force. Having said all this, globalization does present real challenges for the Federal Reserve. Our current account deficit is unprecedented. At an annualized rate it’s running over 4 percent of GDP. Now I don’t mean to imply that we should be overly concerned about the deficit in the short term. Evidence continues to mount that rising potential rates of return on American investments are driving this deficit. And so long asforeigners want to hold ever-increasing quantities of American investments, the deficit can be sustained. But surely there must be a limit to the amount of the world’s savings our economy can claim. And what happens if the perceived return to American investment falls to more normal levels? Foreigners might not be willing to finance our current account deficit at the prevailing level. This could induce a depreciation in the value of the dollar, with attendant inflation risks. If this scenario emerged, the Fed would have to take this into account in determining the appropriate action pursuant to our policy of maximizing sustain- able growth through price stability. The third economic development I’d like to discuss has perhaps received the most attention: the increase in productivity growth. During the last half of the 1990s, we have reversed the so-called “productivity slowdown” of the 1970s and 80s. Productivity growth over the past 5 years has been exceptional. Indeed, in the manufacturing sector we’ve achieved an average productivity growth rate of over 5 percent per year, well exceeding the “golden age” of the 1950s and ‘60s. A consensus has emerged that something has changed — something fundamental. But a couple of unanswered questions remain: What are the causes of the productivity surge? And does it represent a permanent change? We won’t know the answers for some time, perhaps decades. The challenge for the Fed is that we can’t wait for those final answers. Many attribute increased productivity growth to developments in information technology. Certainly, we see many examples of how IT transforms business practices. In the Midwest, many manufacturing firms now depend heavily on high technology. For example, I recently visited Cummins, a long-time manufac- turer of diesel engines in Columbus, Indiana. Their headquarters plant has truly been revolutionized. It includes a high-tech workflow, automated engine painting and testing, and sophisticated information sys- tems designed to make them more competitive. And high-tech farming is increasingly common in our dis- trict. We have farms that use global positioning technology to determine how much fertilizer to put on each part of a field, depending precisely on fertility and soil type. I even had the opportunity to visit a dairyfarmin northwest Iowa in which a computer automatically measures and tracks how much feed each cow eats and how much milk she produces. But, where there are opportunities, there are always challenges as well. Recent technological developments have boosted the growth rate of potential output. What we don’t know is exactly how much this rate has increased, and for how long the growth rate of potential output will stay elevated. We’ve seen periods 328 Michael Moskow Speeches 2000 before during which productivity growth was strong for a few years only to see it drop back to lower lev- els. Will that happen again? Or will the current strong run of productivity growth continue? This uncertainty represents a challenge to monetary policy makers. It’s been known for a long time that inflationary pressures increase during prolonged periods when aggregate demand grows faster than its long-run potential growth rate. In the past, this long-run growth rate was believed to be little more than 2 percent per year. Suppose technological innovation has increased the potential growth rate to 31⁄ or 4 per- 2 cent. This would represent an enormous gain for the welfare of Americans. Even so, however, the 5 per- cent growth of aggregate demand that we’ve seen over the last six quarters could still have worrisome infla- tionary implications. Of course, if technological innovations are having a bigger effect on potential growth, then our recent high growth rates may be sustainable without higher inflation. So how should we proceed? First, we must study carefully the productivity trends to learn as much as possible about their character- istics. Second, we must continue to review incoming economic data very carefully to identify the early signs of inflationary pressures. And, third, we must continue to make monetary policy decisions cautious- ly, developing a better understanding of how rapidly aggregate demand can grow without seeing increases in inflation. In conclusion, what do I see? I think we are on an economic frontier, exploring possibilities presented by financial innovation, globalization, and our recent extraordinary productivity performance. I have high hopes that these developments will lead to long-term gains in prosperity and well being. They hold the promise of higher growth, less volatility, greater efficiency, and ultimately higher living standards for all Americans. But we can’t afford to be complacent. With any new possibility comes uncertainties. In the face of uncertainty, policy makers must be cautious and vigilant. We must increase our understanding of how the economy is evolving, while never losing sight of our overarching goal of maximum sustainable growth through price stability. On whatever terrain we find ourselves in the years to come, we must take steps now to make sure we’re always on firm footing. Michael Moskow Speeches 2000 329

Michael Moskow (2000, September 11). Regional President Speech. Speeches, Federal Reserve. https://whenthefedspeaks.com/doc/regional_speeche_20000912_michael_moskow

@misc{wtfs_regional_speeche_20000912_michael_moskow,
  author = {Michael Moskow},
  title = {Regional President Speech},
  year = {2000},
  month = {Sep},
  howpublished = {Speeches, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/regional_speeche_20000912_michael_moskow},
  note = {Retrieved via When the Fed Speaks corpus}
}