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April 4, 2006
Will the continuation of globalization and productivity increases keep inflation at bay?
Dallas Fed President Richard Fisher thinks so:
Until recently, the econometric calculations of the various capacity constraints and gaps of the U.S. economy were based on assumptions of a world that exists no more. [Former Fed Governor Laurence] Meyer’s book is a real eye-opener because it describes in great detail the learning process of the FOMC members as the U.S. economy entered a new economic environment in the second half of the 1990s. At the time, economic growth was strong and accelerating. The unemployment rate was low, approaching levels unseen since the 1960s. In these circumstances, inflation was supposed to rise—if you believed in the Phillips curve and the prevailing views of potential output growth, capacity constraints and the NAIRU. That is what the models used by the Federal Reserve staff were saying, as was Meyer himself, joined by nearly all the other Fed governors and presidents gathered around the FOMC table. Under the circumstances, they concluded that monetary policy needed to be tightened to head off the inevitable. They were frustrated by Chairman Greenspan’s insistence they postpone the rate hikes.
We now recognize with 20/20 hindsight that Greenspan was the first to grasp changes in the traditional relationships among economic variables. The former chairman understood the data and the Fed staff’s modeling techniques, but he was also constantly talking—and listening—to business leaders. And they were telling him they were simply doing their job of seeking any and all means of earning a return for shareholders. At the time, they were being enabled by new technologies that enhanced productivity. The Information Age had begun rewriting their operations manuals. Earnings were being leveraged by technological advances. Productivity was surging. Inflation wasn’t rising. Indeed, it just kept on falling.
If the advice of Meyer and the others had prevailed, the Fed would have caused the economy to seriously underperform. According to some back-of-the-envelope calculations by economists I respect, real GDP would have been lower by several hundred billion dollars. Employment gains would have been reduced by perhaps a million jobs. The costs of not being right on the critical calibrations of monetary policy would have been huge.
We live in a globalizing era. Just consider what the fall of the Soviet Union, the implementation of Deng Xiaoping’s “capitalist road” in China and India’s embrace of market reforms mean to business operators. Consider labor alone. In the early ’90s, the former Soviet Union released millions of hungry workers into the system. China joined the World Trade Organization at the turn of the century and injected 750 million workers into play. And now India, with over 100 million English-speaking workers among its 1 billion people, has joined the game. Just two weeks ago, a CEO told me his company posted ads for people to apply for 9,000 jobs in a new facility in India. Do you know how many applications they received?—1,400,000.
How does this affect the American manager—paid to enhance returns to shareholders by growing revenues at the lowest possible costs? Because labor accounts for, on average, about two-thirds of the cost of producing most goods and services, the managers will go where labor is plentiful and cheapest. They will have a widget made in China or Vietnam, or a software program written in Russia or Estonia, or a center for processing calls or managing a back office set up in India.
...
You could sense something was wrong with the econometric equations if you listened to the troops on the ground, fighting in the trenches of the marketplace. This is what I did at the U.S. Trade Representative’s office in negotiating market-opening trade rounds with China, Vietnam, Mexico, Brazil and others. It is what my colleagues and I at Kissinger McLarty did while advising dozens of U.S. companies seeking entry into China and the former Soviet satellites and India and Latin America. It is what my colleagues and I on the FOMC do by making dozens upon dozens of calls to CEOs, COOs and CFOs of businesses, large and small, every month to prepare for FOMC meetings.
We are simply observing managers at work expanding the capacity of our economy, expanding the gap between what their previously limited resources would allow them to produce and what their newly expanded globalized, technologically enhanced reach now allows them to produce.
From this, I personally conclude that we need to redraw the Phillips curve and rejig the equations that inform our understanding of the maximum sustainable levels of U.S. production and growth. How can economists quantify what the U.S. can produce with existing labor and capital when we don’t know the full extent of the global labor pool we can access? Or the totality of the financial and intellectual capital that can be drawn on to produce what we produce?
Jeffrey Lacker of the Richmond Fed also gave a speech today. See Mark Thoma's recap. Lacker sounds confident that inflation is under control, and he's upbeat on the overall economic growth picture. Fisher's speech quoted above suggests that globalization is keeping inflation down. Note how he also references the debates within the Fed from the '90s that put Governor Meyer and Chairman Greenspan at odds over interest rates. It's not hard to tell whose camp he's in.
How's the media interpreting this? Here's a check of Reuters:
"The combination of a decline in oil prices, however slight, and some fairly upbeat comments (by Fed officials), may have led Fed watchers to conclude the Fed may raise interest rates at its meeting in May, and then stop," said Hugh Johnson, chief investment officer of Johnson Illington Advisors.
"Conclude" might be a bit strong at this point. Personally, I would probably advocate pausing in June, even if only just for one meeting. However, I'm not prepared to call it anything but an even bet at this point. The markets, at least as of Monday, would seem to concur (hat tip to macroblog). David's comment about the employment numbers coming out on Friday seems on the mark. Also between now and June we'll get two news releases on 1st quarter GDP. I'm not going to "conclude" anything for a while.
But Lacker and Fisher have staked their ground. Let's see how the others position themselves.
Posted by William Polley at April 4, 2006 4:16 PM
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Comments
Maybe you can help me figure out Lacker. (See mine and Calmo’s comments to the Mark Thoma post you cite.) Lacker is expecting strong but not spectacular growth (3.5%); he expects “healthy advances” also in consumer spending; and he says he is not worried about housing. Calmo and I are worried about housing, not because we expect some dreadful crash, but because we think that housing prices are flattening out (or at least slowing their growth dramatically) and that the reduced potential for equity extraction will reduce consumer spending.
Or else it won’t, but then you need some other explanation for why the personal savings rate is negative, and Lacker doesn’t give one. It is a critical issue because, barring dramatic (but conceivable) changes in the distribution of income, 3.5% growth, along with healthy advances in consumer spending, will not get us back to a sustainable (positive) savings rate any time soon. (I suppose it depends on what one means by “healthy advances.” Is 0.5% annually a healthy advance?)
Calmo is convinced that Lacker is just being disingenuous, foregoing intellectual honesty in order to reassure the public. I, on the other hand, am quite willing to believe that Lacker has a consistent story in mind somehow, but I am frustrated at not knowing what that story is. Any ideas?
Posted by: knzn at April 5, 2006 9:04 AM
On a more topical point (referring now to Fisher’s speech above), I’ve always thought that the great mistake (the greatest mistake, anyhow) of the traditional NAIRU approach is that it looks at the domestic labor market from the supply side rather than the demand side. Unemployed people don’t make wage-setting decisions directly, but businesses do. Of course businesses are not really price-makers in the labor market, but they do have to make a conscious decision to raise wages, and they won’t do so unless they have a reason to do so. For most businesses, under most circumstances, a low unemployment rate would not be a sufficient reason. Potential difficulty in hiring (due to a paucity of job seekers) is not a problem unless one actually wants to hire.
A demand-side examination suggests to me that the US labor market is even weaker now than it was back in the mid-90s, when the unemployment rate was at a similar level (and most people mistakenly already thought it was too low). Help wanted advertising has been in a secular downtrend since the late 80s (even when I take into account the shift from newspapers to the Internet) and it remains only slightly elevated from its lows in 2002. (Newspaper help wanted advertising is actually lower now than it was in 2002, according to the Conference Board.) Employment data also show a paucity of employees with short tenure, which indicates that recent hiring has still been very slow, and the Business Employment Dynamics data show the rate of gross job gains still at its 2002 level. (Employment is growing because the rate of job losses is even lower. This indicates to me only that businesses are finished cleaning house from the last recession, not that their demand for labor is strong.)
Posted by: knzn at April 5, 2006 10:08 AM
I've never been a big fan of NAIRU either. The data you describe is consistent with the finding that unemployment has become more structural and less cyclical with the last couple of recessions. Instead of seeing people laid off for a few months and then returning to work, we are seeing entire job classifications shrink while others expand. New firms take a while to get into the surveys, and perhaps don't advertise in the same way. I don't necessarily see it as a sign of weakness. It's just not your father's labor market.
On savings, I look at it through the lens of I+G+EX=S+T+IM.
Posted by: William Polley at April 5, 2006 11:14 AM
The way you’ve stated the savings equation tends to obscure the behavioral relationships that determine S. I think those relationships are critical at this point since S (at least, the household component) is now in the unusual state of being negative. My point (assuming that G-T is stretched to its limit, and IM won’t fall unless there is a recession or a dollar collapse) is that I+EX has to rise at a very rapid rate if S is to get back to a more normal level over the next year or so.
Maybe S won’t get back to a more normal level soon, but this begs the question, behaviorally, why is S negative to begin with? The best explanation I have heard is housing equity extraction. If this is the correct explanation, then the expected deceleration of housing appreciation has to be of concern, because it probably means that S is likely to return to a more normal level soon. If so, anyone who hopes for things to turn out well has to hope for dramatically rapid growth in I+EX.
Which would be fine if I+EX existed in a vacuum. But private investment usually depends on an expectation of consumer spending, and both I and EX add to incomes, which tend to induce greater consumer spending. This means that, if I+EX rises very rapidly, consumption will typically be rising too, so total output will also be rising at a rapid rate. My concern is that 3.5% is not rapid enough to do the trick.
There are two possible ways out of this. One is a dramatic drop in the dollar, causing IM to fall and EX to rise so rapidly that consumer spending is not required to justify a rapid increase in investment. Another is a dramatic shift in distribution from businesses to households (either higher dividend payout rates or wages growing more quickly than profits), which would give households something to save. If either of these is what Lacker expects, I wish he would say so.
Posted by: knzn at April 6, 2006 9:20 AM
A low savings rate (now negative) is not new. There's no reason that I can see that a slowing of housing appreciation would cause such a reversal that would require, as you put it, a "dramatic" increase in I+EX. In other words, I haven't given up on the "soft landing" even if housing appreciation slows.
Your comments have, however, given me an idea for something to write about later. Thanks for taking the time.
Posted by: William Polley at April 6, 2006 10:55 AM
I haven’t given up on the soft landing either, but I expect that, if it happens, it will involve 4+% overall growth. (This goes along with my view that the labor market has a lot of slack, and I’m also fairly optimistic about productivity.)
But I also think we’re in a situation where one has to be careful to make sure that ones forecasts are consistent with the national income identity and that they make sense behaviorally. I suppose, though, that adjectives aren’t very enlightening unless we put numbers on them.
Posted by: knzn at April 6, 2006 1:01 PM