On the Record

New Challenges for Central Bankers

Atlantik-Brücke e.V. Frankfurt, Germany

I am delighted to have this opportunity to come to Frankfurt–not only to the financial capital of Germany, but also to the central banking capital of Europe–to deliver this lecture in honor of Arthur Burns. Arthur Burns was a remarkable man, who helped shape economic policy in a challenging time and left a lasting imprint on several American institutions, including the President’s Council of Economic Advisers, which he chaired for three years in the 1950’s, and the Federal Reserve Board, over which he presided for eight years in the turbulent 1970’s.

I recently reread two of Arthur Burns’ lectures–one delivered twenty years ago and one forty years ago–both of which still read very well. They give us snapshots of the preoccupations of an insightful economic thinker at two points in a long career, as well as a good starting point for talking about the economic dilemmas of today, especially those faced by central bankers.

The first, written long before he was a central banker, was his Presidential Address to the American Economic Association, entitled, “Progress Towards Economic Stability,” delivered in December, 1959, now forty years ago. It was a straightforward, generally upbeat and optimistic speech, reflecting the complacent mind-set of industrial country policymakers in the 1950s that the economic world was getting more stable and macroeconomic matters were under control.

Burns catalogued the reasons why industrial economies, especially the United States, had experienced so much less severe business cycles since World War Two than in the first part of the twentieth century. He talked about the relative growth of the corporate sector, with its tendency to keep paying dividends even when earnings dropped; the relative expansion of more stable white collar employment; and, especially about the growth of government with its built-in economic stabilizers, both on the tax and spending sides of the budget. He spoke with apparent approval of the Employment Act of 1946, which enshrined in law the widespread public recognition of the federal government’s responsibility to stabilize the economy and promote maximum employment. This was the law that created the President’s Council of Economic Advisers, which he had recently chaired.

Inflation was barely mentioned in the speech, which is not surprising, since the consumer price index hardly moved all in 1959. At the very end of his remarks, however, he conjectured that the fears of secular stagnation that had so haunted economists in the depressed 1930s and immediately after the War, might well be replaced in the future by fears of secular inflation.

The second lecture, the Per Jacobson lecture, delivered twenty years later at the IMF-World Bank meetings in Belgrade in September, 1979, had a completely different tone. It bore the colorful title, “The Anguish of Central Banking,” and was, indeed an anguished and pessimistic speech, reflecting a sense that macroeconomic matters were out of control. Not surprisingly, after the rapid escalation of world prices in the 1970s, Burns focussed entirely on the accelerating inflation that was overwhelming policy makers of the time. He acknowledged that there were multiple factors contributing to the inflation of the 1970s–oil shocks, crop failures, productivity slowdown and various fiscal and monetary policy mistakes–but he stressed his belief that the fundamental cause was governments’ assumption of responsibility for maintaining high employment, and governments= intervention in the market place in the name of social justice.

He described how the expansion of unemployment insurance and benefits for the poor and the elderly–the same programs that he had pointed to in his earlier lecture as stabilizing the economy–had imparted inflationary bias to the economy. The explosion, in the 1960s and 1970s, of programs and regulations aimed at bettering the lot of racial minorities and women and improving the environment, combined with continued public pressure to create jobs, only added to the inflationary forces. He characterized central bankers as deeply distressed by their inability to curb inflation:

“By training, if not also by temperament, they are inclined to lay great stress on price stability, and their abhorrence of inflation is continually reinforced by contacts with one another and with likeminded members of the private financial community. And yet, despite their antipathy to inflation and the powerful weapons they could wield against it, central bankers have failed so utterly in this mission in recent years. In this paradox, lies the anguish of central banking.” (Arthur F. Burns, “The Anguish of Central Banking,” 1979 Per Jacobsson Lecture, September 30, 1979, Belgrade, Yugoslavia, American Enterprise Institute mimeo, 1979, p. 5.)

Burns believed that the central bankers of the 1970’s were caught in a cruel trap. The inflationary forces were so strong that only drastic monetary policy action–guaranteed to throw a lot of people out of work–stood a chance of slowing the price escalation, and most central bankers, himself included, were unwilling to take risks that might cause political backlash and curb the ability of their banks to act in the future. Ironically, of course, immediately thereafter, Paul Volcker did take the risk inherent in drastic anti-inflationary action. (Indeed, he left the Belgrade meetings early to do so.) The Federal Reserve reined in hard on the money supply, and arguably started the United States and the World on a new disinflationary path, albeit at great cost in lost output and employment.

Now another twenty years have passed. The state of the world economy and the mood of economic policymakers, especially central bankers, have shifted dramatically. Inflation has declined over most of the period, and it no longer appears to be the dire threat to the stability and performance of industrial economies that Burns–and almost everyone else–perceived it to be in the 1970s. Attention has even shifted to the possible dangers of “deflation@Ca word hardly used since the 1930s. The Japanese economic situation has been a forceful reminder that it is difficult to use the standard tools of monetary policy to stimulate an economy when inflation and shorter interest rates are near zero.

Within the last few months, I have been in discussions with economists and central bankers on two subjects that Arthur Burns in 1979 might have doubted would ever be seriously discussed again:

(1) Can inflation be too low?

(2) How will central banks carry out monetary policy if the national debt disappears?

The latter is not an immediate problem, even in the United States–we still have plenty of outstanding government securities being traded and rolled over–but the fact that our federal government is now running a surplus, not a persistent deficit, in its unified budget has already forced some adjustments in the execution of monetary policy.

The future is in the realm of conjecture and should be approached with great humility. The example of Arthur Burns’ two speeches is enough to make anyone hesitate to venture predictions about economic trends. His complacent optimism of 1959 must have seemed naive to him even a decade later; and his anguish in 1979 over inexorable inflationary forces seems overblown and ironic to us in 1999, after two decades of declining inflation. Perhaps the word “secular trend” should be banished from the vocabulary of economists.

Nevertheless, the cost of not thinking about the challenges of the future is probably higher than the cost of trying to do so, and getting it wrong. The risks of preparing to fight the last war have often proved disastrous. For central banks the “last war” may prove to be the battle against inflation.

Puzzlement, not Anguish, at the Fed

During the three-year period I recently spent as Vice Chair of the Federal Reserve Board, the mood at the Fed was not anguish, but puzzlement–puzzlement at the persistence of good economic news. The United States economy has been performing above expectations on almost all measures. We have experienced more than eight years of healthy economic growth, spread quite evenly across regions and across sectors (except in some parts of agriculture). Instead of petering out as the upturn matured, growth actually accelerated in the second half of the decade.

Consumers have been buying houses, cars, durables, automobiles, services–in short, just about everything. Investment has responded to strong demand and new technology. Investors and entrepreneurs are exuberantly launching start-up companies. Investors are bullish, and the public mood, after a long period of pessimism about the economic future, has shifted to cautious optimism.

Job growth has been astonishingly strong, especially in services, and labor force participation is high. Almost everyone who wants a job can find one, and employers complain continously about the difficulty of recruiting and holding workers, especially those with technical and computer skills. Labor markets have been persistently described as “tight” for several years, as the unemployment rate, now at 4.2 percent of the labor force, edged down to levels not seen in three decades. Nevertheless, wages rose surprisingly slowly for most of the period, and good productivity growth kept employment costs from moving up as fast as wages.

Most surprising of all has been quiescent inflation. Inflation has actually been falling through most of the period, despite robust demand and supertight labor markets. The core Consumer Price Index, at last recording, was up 1.9 percent over the last twelve months.

Forecasters of U.S. economic performance have been continually wrong, but gratifyingly wrong. The Federal Reserve has a staff of top-notch, hard-working economic analysts armed with the latest economic data and a wide variety of statistical and modeling tools. Nevertheless, those forecasts, made about every six weeks for the Federal Open Market Committee, were proved wrong just about every time the Committee met. The staff persistently underpredicted growth and employment, and over-predicted inflation.

The Fed staff was, of course, not alone. The whole forecasting community found itself in uncharted waters. Their expectations, based on three decades of prior experience and embodied in statistical models, were that unemployment rates much below 6.0 percent could not persist for long without generating first wage and then price inflation. Those expectations had to be reexamined as the unemployment rate fell below 5.5 percent, then below 5.0 percent (more than two years ago) and then below 4.5 percent. Clearly some combination of forces was making the economy less inflation-prone at low levels of unemployment than it used to be, but no one knew exactly why this was true, or how long it would last.

Why the U.S. Economy Might Be Less Inflation-Prone

Clearly, some of the forces putting downward pressure on prices might be temporary and subject to reversal. A strong dollar was making imports cheap. Weak world demand in the wake of the Asian, Russian and Brazilian financial crises, was holding most commodity prices down. Fierce global competition in the face of weak demand was creating bargains in almost everything tradeable. As the rest of the world revives or the dollar weakens or both, Americans might well find themselves facing high import prices.

Even some domestic forces that have held down inflation might reverse. Health care costs, which are part of labor costs for large employers, rose rapidly in the 1970s and 1980s, but much more slowly in the 1990s, as Americans shifted from traditional fee-for-service medicine to various types of managed care, and employers and other group purchasers bargained harder with providers. But the managed care revolution has been accomplished and, indeed, has created some backlash of patient dissatisfaction. Health costs have accelerated recently, and most observers expect them to rise faster in the future, though certainly not at the double-digit rates of the 1980s.

On the other hand, many of the current anti-inflation forces may prove longer lasting. The federal budget, which had not been in balance since 1969, and whose deficits exceeded 4 percent of GDP in the early 1990s, is now in surplus. Moreover, future surpluses will mount rapidly if current tax and spending policies are not significantly changed (a big “if,” of course) and the economy continues to grow at least moderately. State and local governments are also running substantial surpluses which enable them to retire debt and build up their “rainy day funds.” Hence, fiscal forces are exerting some restraint on the exuberance of the economy and putting downward pressure on interest rates. They are likely to do this for some years in the future as balances are built up in the social security and other public pension accounts in anticipation of the retirement of the post-World War II baby boom generation and the long-run aging of the population.

Net government saving is highly appropriate long-run fiscal policy, for all industrial countries as we enter the twenty-first century–we all face the same demographics–but even more so for the United States because we have a low private saving rate. Fortunately, at least part of this message seems to have gotten across to the public and the Congress. Although some combination of tax cuts and increased spending may eat up much of the projected surpluses in the rest of the budget, it seems likely that the rising social security surplus will be protected.

Hence, fiscal policy, on balance, will remain anti-inflationary for some years into the future.

Deregulation also seems likely to continue and to exert at least moderate pro-competitive pressure in the future. Over the last couple of decades, the United States has dismantled a large part of its regulatory apparatus, allowing freer market entry and more competitive pricing in airlines, trucking, telecommunications, electricity and some other industries. Farm programs are also moving away from price supports.

Even the social and environmental policies that struck Arthur Burns as such undesirable proinflationary interferences with free markets have moved, for better or worse, in a direction he would have approved. The minimum wage has fallen far behind the average wage and now affects only a small proportion of the labor force. Two modest increases in the minimum wage in the mid-1990s, despite dire predictions to the contrary from opponents, caused neither a perceptible acceleration in inflation nor a decline in employment of low skilled workers.

Unemployment compensation is also less generous and utilized by a far smaller proportion of the unemployed. The “welfare” program that assists low-income families with children is in the process of being transformed into a temporary assistance program, with time limits, work requirements and sanctions on those who are deemed able to work and do not do so. Wage supplements for low-income working families with children also enhance incentives to work. In the strong economy, large numbers of welfare mothers have found jobs, and welfare rolls have plummeted. What the human cost might be when the time limits are reached, or the economy turns down, is not yet clear.

A major effort has also gone into making the attainment of environmental goals less costly and more market-oriented-trading of air pollution rights, for example. Technological advances have also reduced the cost of environmental compliance.

On balance, the public sector is probably contributing less inflationary bias to the economy than twenty years ago. The really important question, however, is whether the much larger private sector is only temporarily less inflation-prone, or whether we are seeing a more lasting shift toward flexibility and productivity–one that will enable the economy to grow faster with consistently low unemployment and low, non-accelerating inflation. Can we hope that the recent combination of U.S. economic indicators–growth above 3 percent, unemployment below 5 percent and inflation under 2 percent–might continue for a while longer, more or less and on the average, or is it all too good to last?

I can offer at least four reasons why the private sector in the United States might prove more flexible and competitive and less inflation-prone than it was in the past–reasons that at least partially apply to other large industrial economies as well.

First, there is the broadening of markets–more demanders as well as more suppliers. The rapid reduction of transportation, communication, and information costs, and the opportunity to comparison shop on the Internet, are giving buyers more knowledge and choices, and sellers access to more potential customers. Indeed, the Internet may be moving the market for many kinds of standardized products toward the economists’ textbook model of perfect competition (many buyers and sellers, perfect information) that most of us thought to be of dubious relevance to real-world markets outside agriculture.

The second is increased mobility of capital and labor, within and across borders. It is not just financial capital that is more mobile–again, thanks to the revolution in information technology–it is the firm’s invested capital as well. More and more companies produce products that do not require heavy machinery, bulky raw materials or access to a port or a railroad. Most of their capital is in the ideas and skills of their employees, who often use equipment that can be easily loaded onto a few trucks. They can go to where the customers are, to where the employees are–or would like to live–or to where taxes and regulations are business-friendly.

At the other end of the spectrum, low skilled labor is also now highly mobile. Low-wage jobs in industrial countries are increasingly performed by immigrants from the developing world, legal or illegal. We could not run restaurants, hotels, or hospitals in the United States now without a constant stream of new immigrants. It seems unlikely that this trend will reverse.

The third reason is the declining importance of bargained wage rates, more true in the United States than in Europe. I refer not just to the fall in union membership, now down to less than ten percent of private sector employees in the United States, but perhaps more importantly, to the declining importance of pre-set wage rates themselves. For an increasing proportion of employees, some part of compensation is variable–a bonus or profit share somehow reflecting the performance of the individual, team or company. Variable compensation may reduce the likelihood of cost-push inflation.

A fourth reason is the prevalence of better trained managers, more focussed on what productivity improvements can do for the bottom line. In the United States and increasingly in Europe and Asia, management ranks are filled with men and women, who, if they learned nothing else in their MBA courses took away a mind-set that propels them look for ways to restructure organizations and reengineer processes to make them more efficient. The confluence of this mind-set with tight labor markets and new technology has potential for pushing productivity up and inflationary bias down in the industrial countries generally.

If these four sets of trends dominate the U.S. and other industrial economies in the future, there may be a chance for solid growth and tight labor markets to coexist with low inflation at least for a while, which would be good news indeed.

Benefits of Tight Labor Markets

One lesson that the United States has learned in the last few years–or been reminded of–is that tight labor markets have enormous social benefits. When workers are scarce, those with limited skills and experience get a chance, which they would not otherwise have, to acquire skills and build a work history that may enable them to obtain better paid and more stable employment.

Workers at all levels get chances to move up, to obtain more training, to take on greater responsibilities at higher pay. Leaving a secure job to look for a new one in another community or another industry becomes less risky.

Tight labor markets may be especially beneficial when technology is evolving rapidly in ways that increase the demand for skills and education faster than the supply. For the last several decades income growth in the United States has been most rapid for people with more education, and the distribution of income has become increasingly unequal. Those with only a secondary school education have not only been falling behind their better educated peers. Those with even less education have found their real incomes declining. In the last 2-3 years, however, labor markets have been so tight that even those with less skills, education and experience have found their situation improving. The widening income gap between education groups appears to have stabilized, at least temporarily, and may even be beginning to narrow.

Moreover, economists’ expectation that supertight labor markets are bad for productivity growth–because they bring less skilled and experienced employees into the workplace–seems not to have been borne out this time. Productivity growth accelerated in 1997 and 1998 as labor markets tightened. Nobody knows exactly why or how long it will last. My own conjecture is that, combined with rapidly evolving information technology, scarcity of labor forces firms to reorganize their processes, use employees more effectively, provide or encourage additional training, and substitute machines for people. To the extent that tight labor markets actually contribute to faster productivity growth, their inflationary impact is diminished.

Europe and Japan

Some of the reasons to expect a less inflation-prone economy in the future may be weaker in Europe than in the United States. For example, labor is less mobile in Europe, and reducing a firm’s workforce is more difficult than in the United States.

However, stronger forces may be putting downward pressure on prices, as the advent of the euro provides an impetus for fuller development of the competitive potential of the common market.

The ease of comparing prices in euros on the Internet is likely to turn European consumers and business purchasers into avid bargain-hunters. The deepening of capital markets, and the consolidation and increased competitiveness of the financial sector, could also contribute to faster European growth with less inflation.

To an American observer, the most surprising aspect of European economic policy in recent years has been the tolerance by the public in the big continental countries of persistent high unemployment rates, in the range of 10 percent of the labor force. The surprised American observer is told that these unemployment rates are “structural.” They relate to generous benefits for unemployed workers, high minimum wages, restrictions on firing workers that make employers reluctant to hire, social commitments to shorter work-weeks and the fact that Europeans are less mobile than Americans. Attempts to stimulate higher growth would only bring inflation–more dreaded in Europe than in the United States–not lower unemployment.

But this tolerance for unemployment may change as Europe becomes a more integrated economy, and capital and workers flow more easily across borders. The social benefits of tight labor markets, which provide opportunities for work experience and skill development to marginal workers, especially the young, as well as opportunities for advancement and increasing responsibility to those already in the workforce, may become more attractive. Some may even argue that the U.S. experience with welfare reform shows that structural reform in labor markets is successful only when labor markets are tight.

As for Japan, everyone shares the hope that its economy is reviving, but the evidence of turnaround is still weak, and accelerating inflation hardly seems a realistic worry in the near future.

In the longer run, hope for a healthy Japanese economy in the midst of a fiercely competitive reviving Asia would seem to depend more on growth of domestic demand and less on exports than in the past, and more on services than on manufacturing. A growth strategy based on expanding domestic demand is likely to involve making the costly and antiquated Japanese distribution sector more efficient, as well as enhancing competitiveness in financial and other services. These moves are likely to make a recovered Japanese economy less inflation-prone than it used to be.

The Goals of Central Banking

The memory of rapidly accelerating inflation in the 1970s, and the high cost paid in the 1980s for bringing inflation down, left central bankers of the 1990s with the strong conviction that curbing inflation was their primary objective. The image of a perpetual battle against pervasive inflationary forces, described in Arthur Burns’ 1979 lecture, resonated in the central banking community.

In many countries the primacy of the inflation-fighting role of the central bank was enshrined in law or public commitment. In some, inflation rates were spelled out as targets against which the central bank’s success was to be measured. This approach, however, was not adopted in the United States, where the official mandate of the Federal Reserve encompasses multiple goals, including “maximum employment,” as well as “stable prices.” In my opinion, the best way to state the Federal Reserve’s objective is to say that the Fed aims to maximize the sustainable growth of the U.S. economy, recognizing that accelerating inflation is a clear threat to the sustainability of growth.

In any case, most industrial country central bankers in the 1990s perceived that their major task was to keep inflation at bay by tightening monetary policy to slow down economic growth when the economy seemed likely to overheat, and easing off when growth seem likely to sputter or die.

Since monetary policy was thought to operate with substantial lags–moving the short-term interest rate might not affect prices for a year or two–the trick was to anticipate what was likely to happen to the economy well before it happened, and act preemptively to keep the economy on as stable a track as possible. Absent central bank action, the expectation was that an economy recovering from recession would grow rapidly as unemployed workers and other idle resources were reabsorbed into productive activity.

But, when unemployment got to a certain point, wages would begun to rise as employers bid for scarce workers, wage increases would be followed by price increases, and inflation would begin to accelerate. If the central bank waited too long to raise short-term rates and slow down growth, inflation would take hold and begin to generate self-reinforcing expectations of more inflation. Then the central bank would be required to act more aggressively to curb inflation, might overdo it and create another recession. Preemptive action–tightening before the inflation became visible–was the key to engineering a “soft landing” that would enable the economy to grow at the maximum sustainable rate without overheating.

In 1994, the Federal Reserve tightened monetary policy in the belief that the U.S. economy was in danger of overheating and setting off an inflationary spiral that might be hard to stop. The economy did slow down, the Fed was able to loosen again in 1995. The preemptive moves arguably helped prolong the economy’s growth for the rest of the decade.

The inflation-restraining objective of central bankers appeared fairly easy to translate into policy action as long as: (1) inflation remained uncomfortably high; and (2) there was general agreement among economic analysts about how low the unemployment rate could fall before triggering a significant risk that inflation would accelerate. The puzzlement for Federal Reserve policymakers in the last half of the 1990s, as I discussed earlier, stemmed from the facts that (1) inflation came down to rates that no longer seemed troublesome to most people–and would have been even lower if measurement biases were corrected, and (2) the persistent coexistence of low inflation with tight labor markets left economic analysts without a firm basis for deciding when preemptive monetary tightening was needed.

At the same time, the rediscovery of the social benefits of tight labor markets dramatized the cost of erring in the direction of unnecessarily tight monetary policy. If it were reasonably certain that U.S. unemployment rates in the current range (around 4.2 percent) were unsustainable and would lead to a future acceleration of inflation, the lost jobs and income associated with tighter monetary policy could be regarded as a necessary cost of prolonging sustainable growth. If, however, the structure of the economy has shifted so that higher growth and lower unemployment are sustainable, at least for a while longer, without accelerating inflation, then the cost of tighter policy is not only unnecessary, but especially serious because it falls heavily on people with low skills, few opportunities and low incomes.

The decline of inflation has been understandably gratifying to central bankers. Some of the credit for the decline–though by no means all–certainly should go to monetary policy. The prestige and public approval of central banks and their policies has risen as the rate of price increase declined, especially where growth has been vigorous or at least trending up. In the United States the job growth, budget surplus and low inflation has made both fiscal and monetary policymakers feel good about themselves–never mind that a lot of factors, probably including luck, contributed to the results. Press and public criticism of the Federal Reserve, which at some times has been strident, has dwindled to an occasional quibble.

The reaction of many central bankers to the good inflation picture has been, “We must be doing something right!” Hence, current discussions of future monetary policy regimes now focus heavily on how to continue and wage even more successfully the long battle against inflation.

One question is whether it is helpful to have an explicit inflation target or target range. Central banks which have operated with explicit targets tend to believe that having such a target helped them reduce inflation. It gave them a visible goal to shoot for, and and be accountable for hitting, and it made it easy to explain to the public why painful actions, such as raising interest rates, were necessary if the goal was to be achieved. Central banks without explicit targets, who also view their monetary policies as successful in contributing to the decline of inflation, tend to be more skeptical of the need for an explicit target.

A second question being discussed, of course, is what the goal–whether made explicit or not–of inflation-fighting central banks should be. Should the goal be zero inflation? Should policymakers be even more ambitious and aim for a stable price level–meaning that any accidental deviation of inflation from zero in one direction would be corrected by policy-induced movement in the opposite direction and the price level, in principle, would remain the same forever. This strict interpretation of “price stability” might lead to greater fluctuations in output, and it would likely be hard to achieve in any case. Hence, the zero inflation target ma