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Tuesday, February 14, 2006

Economic Forecasts and Monetary Policy

Cleveland Fed president Sandra Pianalto on the use of economic forecasts in monetary policy and the importance of structural interpretations of the numbers used to assess current and future economic conditions:

Economic Forecasts and Monetary Policy, by Sandra Pianalto, Cleveland Fed President: Today I would like to share with you some of my thoughts about economic forecasts and monetary policy. I will begin with some comments about the economy's recent performance and the outlook for 2006. Next, I will explain why making sound policy decisions requires me to think about both the demand and supply sides of the economy. Finally, I will describe how the stories behind the forecasts directly relate to the way I think about the appropriate course for monetary policy. ...

Although the national economy in 2005 was not as strong as it was in 2004, overall we saw solid growth for the year. ... Now, it is true that the advance estimate for fourth-quarter GDP growth was only 1.1 percent. Some may interpret this weak performance as a sign that the energy shocks may have finally taken their toll. However, ... these are preliminary numbers. Third-quarter GDP growth was substantially revised upward, so we may learn in a few weeks that fourth-quarter growth was not quite as weak as the initial estimate indicates. ...

Please understand that I am not suggesting we should be complacent about the weak statistic for fourth-quarter growth. I will be watching the incoming data very carefully over the next several months. In fact, the early data for January have been reasonably good.

Assuming the preliminary fourth-quarter report holds up, though, GDP still grew last year by 3.5 percent. For the year as a whole, it is clear that employment growth accelerated, business fixed investment was relatively strong, and core inflation remained subdued.

What about the outlook for 2006? Most forecasters are expecting another solid performance. Forecasts ... generally call for real GDP to expand by roughly 3-1/4 to 3-1/2 percent this year. Housing investment is generally expected to slow, while business fixed investment is expected to increase. These forecasts call for interest rates, the unemployment rate, and core inflation to remain steady...

Any forecast is only as good as our ability to look into the future and foresee the unforeseeable. ... Forecasting is a tough business, leading some people to question the value of forecasting altogether. I find forecasts to be helpful. However, achieving better forecast accuracy is less important to me as a member of the Federal Open Market Committee than understanding the forces that drive the economy. ... In other words, I need to think hard about the demand- and supply-side assumptions that underlie economic forecasts. ...

Here is an example. Just recently, a major newspaper ran an article that stated: "Largely because consumer spending slowed to a near halt in the fourth quarter last year, overall economic growth fell." On the surface, that statement seems pretty straightforward: If spending is strong, the economy grows. If spending is weak, the economy grows by less. Is that really the best way to think about U.S. economic performance in 2005?

It is certainly true that GDP growth last year was off the pace of 2004. But, as we are all painfully aware, energy prices rose dramatically over the course of the year. ... Clearly, energy-market disruptions - a supply condition - could go a long way toward explaining why economic activity, including consumer spending, was more restrained than in the recent past.

So, which interpretation is right? Did economic growth slow in 2005 because ... demand in the economy was too weak, or did it slow because productive capacity in the economy was reduced by adverse supply effects? For me, from a policymaker's perspective, these are important questions. My job is to help find the course of monetary policy that is consistent with price stability and with the economy ... growing at its potential.

This means that we have to have an idea of where "potential" is, and we have to be able to identify factors that affect potential, as opposed to factors that affect only aggregate demand. ... And the reason we must be able to make these distinctions is that demand and supply effects can have different implications for the appropriate course of monetary policy.

Now I will turn to how the stories behind the economic forecasts directly relate to the way I think about the appropriate course for monetary policy. ... Each story that I might consider rests on some hypothesis about potential GDP, full employment, and other concepts such as the neutral real rate of interest. ...

Let me suggest some concrete examples to help clarify what I mean. From 1997 through 1999, real GDP growth averaged almost 4.4 percent, which is well above most traditional estimates of how fast the economy can grow without accelerating inflation. But several members of the FOMC - among them, former Chairman Alan Greenspan and Jerry Jordan, my predecessor as president of the Federal Reserve Bank of Cleveland - argued that growth itself is not inflationary if it is driven by productivity gains. ... They saw favorable supply-side conditions as the cause of the rapid growth, while others saw overheated demand conditions. In my view, history has proven that the supply-side perspective was correct.

Consider a more recent example. Many people expected job growth to bounce back more quickly over the past four years than it did. .... A reasonable interpretation of this period is that demand for goods and services was not strong enough to create more robust demand for workers. That view implies that the economy had generally been operating below its potential. If an economy is operating below its potential because of weak demand, then a relatively more accommodative monetary policy is the right medicine - and it can be administered without fear of stoking inflation. Indeed, the FOMC followed this course for a considerable period of time.

It is true that even today, new jobs are still being created more slowly than the roughly 3 million jobs created each year between 1994 and 2000. How can we account for this performance? Does a demand-side story make the most sense? In this case, I think that trends on the supply side of the economy suggest that we might need to interpret sluggish labor markets differently today.

Perhaps the most interesting trend is the pattern of labor-force participation - that is, the fraction of people who either have a job or are actively seeking a job. Since 2001, the labor-force participation rate of all age groups, except those 55 and older, has declined. The change has been especially noticeable among younger workers - 16- to 24-year-olds. Those participation rates have declined by about 5 percentage points. That amounts to 1.9 million young people who, for now, are no longer potential workers.

Has this episode of slower employment growth resulted from demand conditions, supply conditions, or some combination of both? If it is defined as a demand condition, perhaps poor job prospects have discouraged people from even attempting to find work. ... And does that mean that monetary policy should be accommodative until the economy is once again generating substantially more than 2 million new jobs per year?

Alternatively, if the lower labor-force participation rate is defined as a supply condition, then it may be driven by younger workers' deferring entry into the labor force - perhaps to obtain more schooling and skills. If that is the correct explanation, then potential employment will be calculated much differently from the number we saw in the 1990s. In that case, ... an accommodative monetary policy is exactly the wrong thing to do. It will not accomplish the goal of maximum sustainable growth in the long run, and it may threaten our goal of price stability...

    Posted by on Tuesday, February 14, 2006 at 12:03 AM in Economics, Fed Speeches, Monetary Policy | Permalink  TrackBack (0)  Comments (1)


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