Fed vice chair reviews 2001 economy, looks ahead

(The following is excerpted from Federal Reserve Board Vice Chairman Roger W. Ferguson Jr.'s review of economic developments in 2001 and an economic outlook, as presented at the Can-ton Forum Speaker Series in Canton, Ohio, Feb. 27.)

2001 in review

... 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.

Although delinquency rates have risen, few restrictions have emerged on the availability of credit to consumers. In-deed, low interest rates have made it at-tractive to refinance mortgages to reduce mortgage payments, extract some home equity buildup, and pay down more ex-pensive 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 re-mained 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 have offered inexpensive financing to customers because their own funding costs dropped.

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.

The main source of the negative hit to demand was a large shock to capital ex-penditures. In the past 50 years, investment spending has nearly always begun its decline one to four quarters after the economic cycle peak, not before it.

What began as a very gradual cooling of an overheated economy became much more serious because of the severe shakeout that hit the high-tech sector.

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 15 to 20 years have been tamer than their counterparts in earlier eras. Econ-omists 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 re-cession, we cannot put too much weight on the shape and profile of past recoveries in trying to predict this one.

Near-term outlook

That said, the data we have received in recent weeks have been encouraging and suggest that economic activity is in the process of turning up. Although payroll employment continued to fall in January, the pace of that decline was slower than in the fourth quarter of last year.

Initial claims for unemployment insurance have moved lower over the past two months another hopeful sign of recovery. Industrial production fell in January, but here, too, the rate of decline was well below the pace in preceding months.

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 De-cember 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 Green-span presented the Board's semiannual Monetary Policy Report to the Congress (Feb. 27). 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 in-vestment, I believe that there is still reason for some reservations regarding the contours of the recovery.

Longer-run outlook

One of the main forces that will lead to the recovery from this temporary slowdown is the confidence of businesses and households that, in the long run, the outlook for the U.S. economy is still bright. Despite our current problems, the fundamentals of this economy are strong. Our work force is well-educated and adaptable. Our banking system is healthy and our capital markets, which are flexible and multifaceted, are well-equipped to handle shocks.

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 in-creased 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. ... 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 pro-gress. About a half 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 in-crease 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. More-over, 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. ...