For release: Oct. 14, 2003

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FOMC Must Focus on Longer-Run Forces
To Promote Path of Balanced Growth:
St. Louis Fed’s Poole

Link to speech.

Providence, R.I. — At some point in the economy’s recovery from the 1990-91 recession, usually dated 1995, the economy’s plodding long-term productivity growth rate increased to about 2 ½ percent. Real household income would double every 30 years at that productivity pace.

During the last two years, nonfarm business sector productivity has grown about
4 ¾ percent annually. At that rate, real household income would double at an astonishing 16 years.

Those key points were among several on economic growth made by William Poole, president of the Federal Reserve Bank of St. Louis, at a speech at Bryant College.

“Two years is too short a time to reach firm conclusions about persistent changes in the trend pace of productivity growth,” said Poole. “Certainly, some of the productivity gains seem to be connected with an unwillingness of firms to hire additional labor over the last two years while they wait for economic conditions to improve. To the extent this is true, productivity gains may be lower when employment starts growing at a sustained, healthy pace,” he said.

Still, Poole pointed out, earlier lessons with trend productivity changes and the impact they have on real (inflation-adjusted) interest rates and on the level of output consistent with balanced growth suggest caution. “There is a distinct possibility that the underlying pace of productivity growth has increased again,” Poole said. “If so, and if the FOMC does not make appropriate policy adjustments, inflation could drift away from current low levels.”

Over the longer run, Poole said, higher productivity growth will probably require higher interest rates. He noted that he was drawing on theory and not predicting near-term rate changes. “If monetary policy adjustments don’t keep up with a rising equilibrium real rate of interest, then the inflation rate may ultimately rise,” he said. “However, my best guess is that the current policy stance makes adequate allowance to offset the risk that the current low inflation will turn into a period of deflation. Fed vigilance over the longer run will, I believe, keep inflation under control.”

Poole said that four years ago, real interest rates were high because of the increase in productivity growth in the mid-1990s and also because “excessive optimism - excessive in retrospect, anyway - led to an unsustainable investment boom. Over the last several years, real rates have been low as the investment slump has gradually worked off excess capital stock and as a series of shocks -9/11, major bankruptcies and corporate governance scandals - created a pervasive air of caution.”

Those shocks were “oscillations” around the economy’s long-run growth path, Poole said. “Short run adjustments in monetary policy have been of enormous help in damping the oscillations, but it’s beyond the FOMC’s power with our current knowledge to eliminate them altogether.”

As important as short-run policy adjustments are, said Poole, if the FOMC focuses only on transitory disturbances and doesn’t understand the longer-run forces, it runs the risk of falling behind as the economy converges toward a balanced-growth path.

“That’s part of the story behind policy mistakes of the 1970s,” he said. “I don’t know what the trend rate of productivity growth will turn out to be, but if it’s in the neighborhood of 3 percent, then a reasonable guess at the equilibrium real rate of interest is about 4 percent - 3 percent from productivity growth and 1 percent from population growth. In the meantime, the Fed’s task is to promote as rapid a return to the long-run growth path as is consistent with keeping inflation low and steady."

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