Mr. Chairman and members of the committee, I am pleased to be here today to
offer my views on the outlook for the U.S. economy.
The economy appears to have emerged around the middle of last year
from an extended stretch of subpar growth and entered a period of
more vigorous expansion. After having risen at an annual rate of
2-1/2 percent in the first half of last year, real GDP increased
at an annual pace of more than 6 percent in the second half. Aided
by tax cuts, low interest rates, and rising wealth, household spending
continued to post sizable gains last year. In addition, an upturn
in business investment, which followed several years of lackluster
performance, and a sharp rise in exports contributed importantly
to the acceleration in real GDP over 2003.
Although real GDP is not likely to continue advancing at the same
pace as in the second half of 2003, recent data indicate that growth
of activity has remained robust thus far this year. Household spending
has continued to move up, and residential home sales and construction
remain at elevated levels. In addition, the improvement in business
activity has become more widespread. In the industrial sector, nearly
two-thirds of the industries that make up the index of industrial
production have experienced an increase in output over the past
three months. More broadly, indicators of business investment point
to increases in spending for many types of capital equipment. And
importantly, the latest employment figures suggest that businesses
are becoming more willing to add to their workforces, with the result
that the labor market now appears to be gradually improving after
a protracted period of weakness.
Looking forward, the prospects for sustaining solid economic growth
in the period ahead are good. Monetary policy remains quite accommodative,
with short-term real interest rates still close to zero. In addition,
fiscal policy will likely continue to provide considerable impetus
to domestic spending through the end of this year.
Importantly, the caution among business executives that had previously
led them to limit their capital expenditures appears to be giving
way to a growing confidence in the durability of the expansion.
That confidence has, no doubt, been bolstered by favorable borrowing
conditions, ongoing improvements in efficiency, and rising profitability,
which have put many firms on a more solid financial footing.
Nevertheless, some of the strains that accompanied the difficult
business environment of the past several years apparently still
linger. Although businesses are replacing obsolescent equipment
at an accelerated pace, many managers continue to exhibit an unusual
reluctance to anticipate and prepare for future orders by adding
to their capital stock. Despite a dramatic increase in cash flow,
business fixed and inventory investment, taken together, have risen
only moderately. Indeed, internal corporate funds exceeded investment
over the course of last year for the first time since 1975.
Similar cautious behavior has also been evident in the hiring decisions
of U.S. firms, during the past several years. Rather than seeking
profit opportunities in expanding markets, business managers hunkered
down and focused on repairing severely depleted profitability predominately
by cutting costs and restricting their hiring. Firms succeeded in
that endeavor largely by taking advantage of the untapped potential
for increased efficiencies that had built up during the rapid capital
accumulation of the latter part of the 1990s. That process has not
yet played out completely. Many firms seem to be continuing to find
new ways to exploit the technological opportunities embodied in
the substantial investments in high-tech equipment that they had
made over the past decade.
When aggregate demand accelerated in the second half of 2003, the
pace of job cuts slowed. But because of the newfound improvements
in the efficiency of their operations, firms were able to meet increasing
demand without adding many new workers.
As the opportunities to enhance efficiency from the capital investments
of the late 1990s inevitably become scarcer, productivity growth
will doubtless slow from its recent phenomenal pace. And, if demand
continues to firm, companies will ultimately find that they have
no choice but to increase their workforces if they are to address
growing backlogs of orders. In such an environment, the pace of
hiring should pick up on a more sustained basis, bringing with it
larger persistent increases in net employment than those prevailing
Still, the anxiety that many in our workforce feel will not subside
quickly. In March of this year, about 85,000 jobless individuals
per week exhausted their unemployment insurance benefits--more than
double the 35,000 per week in September 2000. Moreover, the average
duration of unemployment increased from twelve weeks in September
2000 to twenty weeks in March of this year. These developments have
led to a notable rise in insecurity among workers.
Most of the recent increases in productivity have been reflected
in a sharp rise in the pretax profits of nonfinancial corporations
from a very low 7 percent share of that sector's gross value added
in the third quarter of 2001 to a high 12 percent share in the fourth
quarter of last year. The increase in real hourly compensation was
quite modest over that period. The consequence was a marked fall
in the ratio of employee compensation to gross nonfinancial corporate
income to a very low level by the standards of the past three decades.
If history is any guide, competitive pressures, at some point,
will shift in favor of real hourly compensation at the expense of
corporate profits. That shift, coupled with further gains in employment,
should cause labor's share of income to begin to rise toward historical
Such a process need not add to inflation pressures. Although labor
costs, which compose nearly two-thirds of consolidated costs, no
longer seem to be falling at the pace that prevailed in the second
half of last year, those costs have yet to post a decisive upturn.
And even if they do, the current high level of profit margins suggests
that firms may come under competitive pressure to absorb some acceleration
of labor costs. Should such an acceleration of costs persist, however,
higher price inflation would inevitably follow.
The pace of economic expansion here and abroad is evidently contributing
to some price pressures at earlier stages of the production process
and in energy markets, and the decline in the dollar's exchange
rate has fostered a modest firming of core import prices. More broadly,
however, although the recent data suggest that the worrisome trend
of disinflation presumably has come to an end, still-significant
productivity growth and a sizable margin of underutilized resources,
to date, have checked any sustained acceleration of the general
price level and should continue to do so for a time. Moreover, the
initial effect of a slowing of productivity growth is more likely
to be an easing of profit margins than an acceleration of prices.
As I have noted previously, the federal funds rate must rise at
some point to prevent pressures on price inflation from eventually
emerging. As yet, the protracted period of monetary accommodation
has not fostered an environment in which broad-based inflation pressures
appear to be building. But the Federal Reserve recognizes that sustained
prosperity requires the maintenance of price stability and will
act, as necessary, to ensure that outcome.