Remarks by Vice Chairman Roger W. Ferguson, Jr.
At the Canton Forum Speaker Series, Canton, Ohio
February 27, 2002
A Review of Economic Developments in 2001 and the Economic Outlook
I am pleased to address the Canton Forum today. As always, the views I will be expressing are my own and are not necessarily shared by other members of the Board of Governors or of the Federal Open Market Committee.
Review of 2001
A year ago, signs of the recession that eventually unfolded were just beginning to materialize. After several years of booming growth, economic indicators started sending mixed signals. Although consumer sentiment had dropped around the end of 2000, consumers were still spending at a healthy clip. Though consumption growth had decelerated somewhat over the previous year, the modest slowing was consistent with the deceleration of aggregate demand necessary to better align supply and demand.
Businesses, however, appeared to be struggling. As data for the end of 2000 became available, it became clear that businesses--amid disappointing sales and earnings--had abruptly curtailed the record-setting expansion of investment spending. Of course, some reduction of investment usually accompanies the recognition of a downshift in the economy, as firms bring their capital stocks in line with a revised outlook for sales. But the severity of the adjustment last year appeared to reflect more than the usual reaction. Businesses seemed to be reassessing the profitability of additional fixed capital in a more fundamental way. New capital, especially capital that embodies new technologies, continues to promise efficiency gains, but expectations seemed to have gotten ahead of even the more favorable reality, resulting in an unsustainable buildup of capital and run-up of equity market values. Capital expenditures on high-tech equipment were especially hard hit. Moreover, the sudden drop-off in business demand, coupled with some slowing in the consumer sector, apparently caught producers off guard. And despite rapid cuts in production, inventories were uncomfortably high relative to sales. Early last year, manufacturers took steps to address the unwanted stocks and began liquidating inventories in earnest by slashing production of all types of goods.
Against this backdrop, the Federal Open Market Committee reduced the target for the federal funds rate sharply last January to contain the weakness and head off a more serious slackening. This was to be just the first installment of a series of policy easings to counter the weakness in the economy that emerged over the first half of last year.
In the business sector, a serious retrenchment in spending and production was under way. In addition to the initial causes of the pullback, the abruptness of the slowing seemed to jar business confidence, leading firms to postpone spending while they reassessed their situations. In this way, the investment downturn became self-reinforcing. At the same time, financial developments, including a stronger dollar, sharply lower equity prices, and tighter lending standards at banks and in security markets, tended to offset some of the influence of the lower federal funds rate. By midyear, investment--and high-tech investment in particular--was posting some of the largest decline in decades. The weaker job market and lower stock prices also began to weigh on consumers, though to a much lesser extent. With overall sales sagging, inventories remained excessive in many sectors.
As the weakness in the economy intensified, policymakers responded. In June, President Bush signed the Economic Growth and Tax Relief Reconciliation Act of 2001 into law. The first installment of the reduction in personal income tax rates went into effect in July. In addition, the act provided tax rebates of $300 to $600 per household that were paid directly to taxpayers.
As for monetary policy, between March and June, the FOMC voted to ease monetary policy four more times, bringing the cumulative reduction in the federal funds rate to 275 basis points in the first six months of the year--the most rapid reduction in the funds rate since the early 1980s. Despite both fiscal and monetary efforts to bolster sagging aggregate activity, by late summer only a few hard signs had surfaced that recovery was at hand.
The terrorist attacks on September 11--whose worst effects were felt by those people and their families directly touched by the tragedies--were a blow to our already weakened economy. In the weeks immediately following those events, most forecasters expected the damage to the economy to be extensive. The initial effects on the airlines and the travel industry were severe. Also, a rapid deterioration of business and consumer confidence seemed highly probable. In addition to immediate crisis-related injections of liquidity, the Federal Reserve moved to address the perceived shock to the macroeconomy by lowering the federal funds rate 50 basis points on September 17 and an additional 75 basis points by the end of the year.
Over the past few months, we have all been watching closely to see how aggregate activity would unfold in the aftermath of the terrorist attacks. No doubt a great deal of pain has been inflicted on the economy. But, given the magnitude of the shock, the economy has proved more resilient than initially anticipated. Though several industries have been hit very hard, the worst-case scenarios spun in late September have not materialized. In particular, households' views of the economy have remained relatively stable, all things considered. In fact, in one of the most recent readings, consumer confidence was not much lower than it had been in August. While spending has surely been buttressed by some temporary factors such as aggressive discounting on motor vehicles and other retail goods, the effect of terrorism on consumer spending has not been as severe as most had feared in late September.
To be sure, 2001 was a rough year for the economy--one of the roughest we have faced in a long time. The weak economic outcome despite sizable reductions in the federal funds rate has led some to question the effectiveness of monetary policy. But I believe that monetary policy substantially cushioned the negative forces weighing on the economy. Residential construction has been visibly buoyed by policy easing. Housing activity remained at a high level all year, as lower mortgage rates apparently offset the restraint from declines in employment, smaller gains in income, and lower levels of wealth. Also, although delinquency rates have risen, few restrictions have emerged on the availability of credit to consumers. Indeed, low interest rates have made it attractive to refinance mortgages to reduce mortgage payments, extract some home equity buildup, and pay down more expensive forms of consumer credit. Even businesses, which have been feeling the pinch of lower corporate profits, have benefited from lower interest rates; aggregate interest expense has remained fairly low relative to cash flow, and businesses have moved aggressively to bolster their financial stability by locking in more-certain, longer-term sources of funds. Automakers in particular have been able to offer inexpensive financing to customers because their own funding costs have fallen.
In many ways, the mechanism that propagated the weakness last year was quite traditional: A negative demand shock led to unwanted inventories and to an adjustment of production. That, in turn, idled workers and fed back into even weaker demand. But even before the shock of the terrorist attacks, two aspects of last year's slowdown were atypical. First, the main source of the negative hit to demand was a large shock to capital expenditures. In the past fifty years, investment spending has nearly always begun its decline one to four quarters after the peak of the economic cycle, not before it. What started out as a very gradual cooling of an overheated economy became much more serious because of the severe shakeout that hit the high-tech sector. Second, consumer spending on goods and services--which represents about two-thirds of the gross domestic product--held up remarkably well last year. In the past, consumption spending has almost always declined as a recession started. But last year, despite a sharp drop in consumer confidence and a decline in wealth from lower equity values, households kept buying.
At this point, it is still too early to classify this recession as mild or severe. In general, economic fluctuations in the past fifteen to twenty years have been tamer than their counterparts in earlier eras. Economists have conjectured that this is so because improved technologies allow businesses to monitor their demand more closely and manage their inventories better. Recent developments ought to give us more evidence on this subject. One thing is certain: Because of the unusual, investment-led nature of this recession, we cannot put too much weight on the shape and profile of past recoveries in trying to predict this one.
Current Situation and Near-Term Outlook
As we obtain more information on spending patterns since September, the behavior of households is increasingly proving to be the key stabilizing force on economic activity. Sales of cars and light trucks--though down from the extraordinary rates of the fourth quarter--have continued at quite healthy rates. In addition, retail sales outside motor vehicles were very strong in both December and January. Housing construction, too, has been robust, bolstered in part by favorable weather and low mortgage rates.
In the business sector, the very rapid pace at which companies liquidated inventories in the fourth quarter contributed to the weakness in manufacturing output. However, the downward adjustment of stocks to more desired levels now seems well along in most industries, and this drag on production may be diminishing.
Business fixed investment has not as yet shown consistent and sustained evidence of a turnaround, although there have been some positive indicators. After a year of dealing with an overhang of capital goods, many firms are being cautious in their capital spending. With corporate profits under pressure and capacity utilization rates near past cyclical lows, many businesses report that their expansion plans remain on hold. However, capital investments that allow businesses to reduce cost might be more attractive. Spending indicators have been more positive in the past few months, particularly with respect to computer equipment. Developments in this sector will importantly influence the strength of our economy in the months ahead, and will therefore warrant careful monitoring.
As you know, Chairman Alan Greenspan presented the Board's semiannual Monetary Policy Report to the Congress this morning. As he indicated, the central tendency of the forecasts of the members of the Board of Governors and the Federal Reserve Bank Presidents for real GDP growth this year was between 2-1/2 and 3 percent. I am comfortable with that range of forecasts. As I just noted, recent data indicate that household spending has been reasonably well maintained. In addition, there are some signs that capital spending may be improving, but the strength and durability of that improvement are still uncertain. Until there is a clearer perspective with regard to business investment, I believe that there is still reason for some reservations regarding the contours of the recovery.
The Longer-Run Outlook
Perhaps the most notable feature of our economy in recent years, however, has been the acceleration in productivity. In the second half of the 1990s, output per hour in the nonfarm business sector increased at an annual rate of almost 3 percent per year, well above the pace earlier in the decade. These efficiency gains allowed real GDP to rise 4 percent a year, on average, over the period. With these rapid increases in productivity, business costs were well contained, and the rate of price inflation was stable, despite a fall in the unemployment rate to below 4 percent.
Productivity growth continued over the four quarters of 2001. That it increased is impressive, given the historical tendency of productivity growth to turn negative when the economy enters recession. This performance provides additional evidence that the improvements in productivity growth that we have witnessed since the mid-1990s have been largely structural and will persist for a time.
But the fundamental factor leading me to be cautiously optimistic that much of the improvement is likely to be sustained is my outlook for the state of technological advancement in the United States. As Fed economists Dan Sichel and Steve Oliner have shown, one major source of the gains in output per hour were the high and rising levels of business investment, which increased the amount of capital per worker, thereby boosting productivity. Booming investment in the 1990s was due importantly to steep declines in prices of high-tech equipment, which largely reflected rapid technical progress. About � percentage point of the increase in productivity growth in the 1995-99 period can be attributed to this so-called capital deepening. Although the extraordinary pace of investment spending in those boom years was not sustainable, I believe that technological progress will continue to drive down the cost of information technology in the coming years, inducing still robust growth of the capital stock. Moreover, businesses have reaffirmed their intentions to improve productivity by substituting cost-saving high-tech capital for labor.
Though there are certainly risks to the view that improvements in productivity growth will persist, I do not believe the terrorism of last fall is going to permanently harm increases in output per hour (and thus the health of the economy). Most assuredly, in the aftermath of these attacks, many businesses have been forced to redirect resources from efficiency-enhancing investment to meet greater demands for security. Businesses may also have been compelled to increase redundancy to cope with the greater potential for supply disruption. However, these effects will be mainly a one-time hit to the level of productivity. They are not likely to change the trend growth rate of output per hour. Moreover, their effects will be ameliorated as businesses use new technologies and find creative ways to hold down the cost of enhancing security and providing for contingencies.