Greenspan reviews state of nation?s economy - Part 2

Aggregate demand

The more modest pace of increase in domestic final spending in recent months suggests that aggregate demand may be moving closer into line with the rate of advance in the economy's potential, given our continued impressive productivity growth. Should these trends toward supply and demand balance persist, the ongoing need for ever-rising imports and for a further draining of our limited labor resources should ease or perhaps even end. Should this favorable outcome prevail, the immediate threat to our prosperity from growing imbalances in our economy would abate.

But as I indicated earlier, it is much too soon to conclude that these concerns are behind us. We cannot yet be sure that the slower expansion of domestic final demand, at a pace more in line with potential supply, will persist. Even if the growth rates of demand and potential supply move into better balance, there is still uncertainty about whether the current level of labor resource utilization can be maintained without generating increased cost and price pressures.

Inflation

As I have already noted, to date costs have been held in check by productivity gains. But at the same time, inflation has picked up even the core measures that do not include energy prices directly. Higher rates of core inflation may mostly reflect the indirect effects of energy prices, but the Federal Reserve will need to be alert to the risks that high levels of resource utilization may put upward pressure on inflation.

Moreover, energy prices may pose a challenge to containing inflation. Energy price changes represent a one-time shift in a set of important prices, but by themselves generally cannot drive an ongoing inflation process. The key to whether such a process could get under way is inflation expectations. To date, survey evidence, as well as readings from the Treasury's inflation-indexed securities, suggests that households and investors do not view the current energy price surge as affecting longer-term inflation. But any deterioration in such expectations would pose a risk to the economic outlook.

As the financing requirements for our ever-rising capital investment needs mounted in recent years beyond forthcoming domestic saving real long-term interest rates rose to address this gap. We at the Federal Reserve, responding to the same economic forces, have moved the overnight federal funds rate up 1-3/4 percentage points over the past year. To have held to the federal funds rate of June 1999 would have required a massive increase in liquidity that would presumably have underwritten an acceleration of prices and, hence, an eventual curbing of economic growth.

By our meeting this June, the appraisal of all the foregoing issues led the Federal Open Market Committee to conclude that, while some signs of slower growth were evident and justified standing pat at least for the time being, they were not sufficiently compelling to alter our view that the risks remained more on the side of higher inflation.

As indicated in their forecasts, FOMC members and nonvoting presidents expect that the long period of continuous economic expansion will be extended over the next year and one-half, but with growth at a somewhat slower pace than over the past several years. For the current year, the central tendency of Board members' and Reserve Bank presidents' forecasts is for real GDP to increase 4 to 4-1/2 percent, suggesting a noticeable deceleration over the second half of 2000 from its likely pace over the first half. The unemployment rate is projected to remain close to 4 percent. This outlook is a little stronger than anticipated last February, no doubt owing primarily to the unexpectedly strong jump in output in the first quarter. Mainly reflecting higher prices of energy products than had been foreseen, the central tendency for inflation this year in prices for personal consumption expenditures also has been revised up somewhat, to the vicinity of 2-1/2 to 2-3/4 percent.

Growth

Given the firmer financial conditions that have developed over the past 18 months, the Committee expects economic growth to moderate somewhat next year. Real output is anticipated to expand 3-1/4 to 3-3/4 percent, somewhat less rapidly than in recent years. The unemployment rate is likely to remain close to its recent very low levels. Energy prices could ease somewhat, helping to trim PCE inflation next year to around 2 to 2-1/2 percent, somewhat above the average of recent years.

The last decade has been a remarkable period of expansion for our economy. Federal Reserve policy through this period has been required to react to a constantly evolving set of economic forces, often at variance with historical relationships, changing federal funds rates when events appeared to threaten our prosperity, and refraining from action when that appeared warranted.

Early in the expansion, for example, we kept rates unusually low for an extended period, when financial sector fragility held back the economy. Most recently we have needed to raise rates to relatively high levels in real terms in response to the side effects of accelerating growth and related demand-supply imbalances. Variations in the stance of policy or keeping it the same in response to evolving forces are made in the framework of an unchanging objective to foster as best we can those financial conditions most likely to promote sustained economic expansion at the highest rate possible.

Maximum sustainable growth, as history so amply demonstrates, requires price stability. Irrespective of the complexities of economic change, our primary goal is to find those policies that best contribute to a noninflationary environment and hence to growth. The Federal Reserve, I trust, will always remain vigilant in pursuit of that goal.