## July 17, 2002

### Forecasting Growth and Unemployment

The Federal Reserve expects average real GDP growth of 3.5% per year for the next six quarters. It projects that potential GDP will grow at about 2.75% per year. Thus the Federal Reserve expects that the gap between real GDP growth and potential GDP growth will shrink over the next six quarters. Since the unemployment rate is very closely related to the gap between potential GDP and actual GDP, this rate of growth should be enough to push unemployment down from its current 5.9% to 5.4% or so over the next eighteen months, or so the Federal Reserve expects.

From my perspective this is somewhat strange. I would have expected the Federal Reserve to estimate potential GDP growth at 3.5% per year or faster over the next year and a half. I see no reason for the undershoot in the procedures the Fed uses--or should be using--to construct its estimates of potential GDP growth.

Begin with the simplest possible estimate of potential GDP growth, derived from a regression analysis of the rate of real GDP growth as a function of the unemployment rate. Over the 1960-2001 period, real GDP grew at an average rate of 3.4% per year. When unemployment fell, GDP grew by more--a 1%-point fall in the unemployment rate being enough to push the annual rate of GDP growth up by 2%-points; a 1%-point rise in the unemployment rate being enough to push the annual rate of GDP growth down by 2%-points.

If we take this two-to-one ratio as gospel, then we can quickly and easily compute what each year's observation is telling us about the rate of growth of potential GDP. In a year in which the unemployment rate fell by 1%-points, real GDP growth was probably 2%-points higher than the rate of growth of potential. In a year in which the unemployment rate rose by %-point, real GDP was probably 2%-points lower than the rate of growth of potential output. If we perform these simple calculations and graph the results, we get the blue line in the figure below.

This blue line is jagged. It is jagged because in constructing it we have assumed that the relationship between unemployment and output growth--our two-to-one rule, what economists call "Okun's Law"--is perfect and holds exactly without disturbances. It doesn't. There are year-to-year deviations from and disturbances to Okun's Law: these all show up as the jagged movements in the year-by-year estimates of potential output growth. If we are willing to assume that one year's disturbance and deviation is unrelated to the next year's, we can get rid of the impact of most of these disturbances by taking a moving average of the year-by-year estimates. The pink line in the figure above takes a five-year moving average: the estimate of potential output growth assigned to each year is the average of the year-to-year observations from two years in the past to two years in the future.

The pink line tells a consistent story. Potential output growth was fast in the 1960s. Potential output growth slowed in the 1970s as technology-driven total factor productivity growth slowed, but this slowing was partly offset by a speed-up in labor force growth as baby boomers became of working age and as feminism led more women to enter the paid labor force. Portential output growth slowed further in the 1980s and early 1990s as labor force growth slowed and as the large Reagan deficits drained the pool of savings that would otherwise have funded investment, and so retarded the growth of labor productivity.

Then came the high-productivity growth high-investment boom of the late 1990s, driven primarily by the explosion of technology in data processing and data communications, and driven secondarily by the shift in the government budget to surplus and the willingness of foreigners to invest in America on a large scale that together provided the financing for investment spending to take advantage of high-tech opportunities. The past five year's year-to-year estimates of potential output growth average to 3.48% per year. That is the number--not the Federal Reserve's 2.75% per year--that I would take as my first, baseline estimate of what potential output growth is likely to be over the near future.

Why is the Federal Reserve thinking different? What factors are leading them to make their more sophisticated forecast so much lower than my simple back-of-the-envelope one? I don't know. But I'm going to find out...

Less Upbeat than Expected

In his semiannual Monetary Policy Report to Congress on Tuesday, Fed Chairman Alan Greenspan painted a mixed picture of the prospects for the US economy. Mr. Greenspan indicated that "the fundamentals are in place for a return to sustained healthy growth." However, he also warned that the recent weakness in equity prices will have a negative spillover effect on the economy. And he cautioned that policy makers are still confronted by considerable uncertainties, such as prospects for capital spending and corporate profits, the possibility of additional revelations of corporate malfeasance, global political risks, and further terrorist strikes. In general, the tone of the testimony was a bit less upbeat than we had expected.

Solid Baseline Forecast, but Asymmetrical Risks

The FOMC's economic forecasts, released in conjunction with the testimony, show that officials look for +3.5% average GDP growth during both the second half of 2002 and the four quarters of 2003. The unemployment rate is expected to drift down from 5.9% at present to the 5.25% to 5.5% range by the end of 2003. Meanwhile, inflation as measured by the PCE deflator is projected to hold at a rate of 1.5% to 1.75%. So it appears that the Fed's baseline case calls for a reasonably solid economic recovery. The problem is that the risks seem to be asymmetrically distributed around the baseline.

Fed on Hold until Uncertainties Start to Dissipate

On the policy front, Mr. Greenspan noted that the current very low level of the funds rate is not consistent with the Fed's long-run goals of sustained economic growth and price stability, repeating a point that he and other FOMC members have made previously. But with inflation pressures contained, he hinted that the accommodative stance of policy can be sustained until the "considerable uncertainties" confronting the Fed begin to dissipate. Clearly, Mr. Greenspan is signaling that he expects policy to be on hold for quite some time to come.

Emphasis on Corporate Governance, but Few Policy Specifics

From our standpoint, the most surprising aspect of the testimony was the lengthy discussion of the corporate governance issue -- almost half of the text was devoted to this topic. Mr. Greenspan didn't really offer any specific policy prescriptions nor did he provide any new insights on how these problems arose (for example, he noted that the root cause of the breakdown in corporate governance was that the sharply rising stock market of the 1990s created opportunities for "avarice"). The Fed chief observed that while the character of corporate officers cannot be directly addressed via legislation, measures could be enacted that alter the incentives and penalties. At the same time, Mr. Greenspan cautioned against overregulating because it could "distort the efficient flow of capital." Specifically, he indicated that market forces would eventually lead companies to move toward expensing of stock options.

On Wednesday morning, Mr. Greenspan will give a repeat performance before the House Financial Services Committee. Given the close proximity of the appearances, the second round is unlikely to include any market-moving revelations.

The Economist reports on Alan Greenspan's Humphrey-Hawkins Testimony:

Greenspan's soothing touch

Jul 16th 2002
From The Economist Global Agenda
The Federal Reserve chairman, Alan Greenspan, has sought to calm volatile stockmarkets by sounding an optimistic note about America's economic prospects. But even Mr Greenspan has had to acknowledge that risks to recovery remain.

CALL it a happy coincidence. Alan Greenspan's appearance before the Senate Banking Committee on Tuesday July 16th had been long planned. The powerful chairman of the Federal Reserve—America’s central bank—presents his monetary-policy report to both houses of Congress twice a year. (He will deliver the same report to the House of Representatives' banking committee on July 17th.) But with the world's stockmarkets in a panic--"skittish" was Mr Greenspan's adjective--the Fed chairman's appearance was fortuitously timed. It gave him the chance to try to soothe the markets without having to make an unplanned statement, a gesture which could easily have been interpreted as panicky rather than reassuring.

His remarks did succeed in halting the slide in share prices, both in New York and London. And yet this could well be just a temporary respite. Recently nothing seems to have brought lasting reassurance to shareholders and traders. Since the peak in January 2000, for instance, the Dow Jones Industrial Average has fallen by close to 30%; the FTSE 100 index is down by more than 40%. On most days in recent weeks, trading screens have glowed red as billions were wiped off share prices.

Nevertheless Mr Greenspan did have some encouraging news to impart. He continues to think the economic recovery is on track. It is also modest, but he has consistently said that it would be, in part because the recession last year was the mildest on record. Consumers, he again pointed out, shopped through the downturn; so there is little pent-up consumer demand to generate a sudden surge in economic activity.

All the same, American household spending has held up well in spite of the fall in equity prices because mortgage rates are low, the housing market has stayed buoyant, and incomes have also been rising. Business investment remains weak, but productivity has stayed unexpectedly strong, and as inventories have been run down, some restocking is likely to take place in the coming months.

As if on cue, new figures for industrial production were released shortly before Mr Greenspan started testifying. These showed an unexpectedly large rise in June, up 0.8% compared with May; and the May figures had themselves been revised upwards. Mr Greenspan is well-known for his obsessive scrutiny of economic data, and his analysis is clear: the underlying economic trend is for modest but healthy growth this year. He revealed that the Fed has revised its own forecast for economic growth in 2002 to between 3.5% and 3.75%--that is is slightly higher than when Mr Greenspan presented his last report, in February.

Fond as he is of numbers, though, Mr Greenspan knows that other factors can be equally important in times of stockmarket upheaval. Chief among these is confidence—in the economy, in companies and, on this occasion, in America’s capitalist system itself. The Fed chairman was frank about the shortcomings of some companies, and the extent to which recent corporate scandals have alarmed investors. He did not mention any of the culprits by name, but it is clear he was talking about Enron, WorldCom, Andersen and others. Shareholders are concerned now because, as Mr Greenspan pointed out, they had not been given access to accurate information about the companies they had invested in.

The problem was, said Mr Greenspan, that "lawyers, internal and external auditors, corporate boards, Wall Street security analysts, rating agencies, and large institutional holders of stock all failed for one reason or another to detect and blow the whistle on those who breached the level of trust essential to well-functioning markets." According to the Fed chairman, the root cause of this breakdown was the stockmarket boom of the late 1990s: this "arguably engendered an outsized increase in opportunities for avarice". In other words, corporate bosses got greedy. They tried to cream off too much of the stockmarkets gains for themselves.

This could all, in Mr Greenspan's view, be the result of a "once-in-a-generation frenzy" that might already be over. But that does not reduce the need for corporate-governance reform, apart from anything else because people have short memories. There has to be a better balance between shareholders and corporate officers. And Mr Greenspan ultimately laid the blame for any imbalance in the relationship firmly at the door of what he called "failed CEOs". A chief executive who wants objective accounts gets them, said Mr Greenspan.

This was tough talking from the mild-mannered Fed chairman. But he seems genuinely worried that a fundamentally healthy recovery could yet be undermined by the backlash against recent corporate failures. He pointed out that, ironically, one of the elements of executive remuneration that has recently caused trouble, share options, could have helped create a misleading impression of profits growth in the past couple of years. This is because share options were not counted as an expense for companies, enabling them to show higher profits. As share options lost their value because of declining share prices, they were replaced by other forms of pay which did hit the bottom line, and so reported profits suddenly appeared lower. More consistent government measures of profits, claimed Mr Greenspan, show a much sharper upturn since the third quarter of last year.

If markets did not find that reassuring, they should derive some consolation from Mr Greenspan's indication that interest rates will not rise any time soon. Using the familiar coded language with which he discusses such sensitive issues, the Fed chairman gave a pretty clear signal that interest rates will not rise until he is more certain that the recovery will not be dented by unexpected shocks or, though he did not say this explicitly, by further panic in the markets. It was the best he could offer. Given how little room the Fed has for manoeuvre--interest rates are already at their lowest for 40 years--a further cut is not much of an option.

Posted by DeLong at July 17, 2002 08:25 PM | TrackBack

"He pointed out that, ironically, one of the elements of executive remuneration that has recently caused trouble, share options, could have helped create a misleading impression of profits growth in the past couple of years. "

It will be even more ironic if any problems turn up as a result of an equally controversial accounting issue; the question of whether financial institutions should mark their holdings of bonds and derivative securities to market, or whether they can perform what one SEC chairman called "psychiatric accounting" by declaring that they intend to hold a security to maturity. Greenspan has a bit of a brass neck saying that "a chief executive who wants honest accounts gets them" when his signature is on a letter to the congressional committee supervising the SEC, effectively buying the entire party line of the banking industry's lobbyists on the subject of mark-to-market.

Posted by: Daniel Davies on July 18, 2002 02:33 AM

On the issue of potential GDP growth, I am a bit uncomfortable with the reduced-form Okun's Law approach. I wonder about a structural model, that might look at labor force growth, growth in the efficiency of labor, and growth in the capital-labor ratio. Maybe the labor force is not going to grow as fast going forward as it has the past decade?

Posted by: Arnold Kling on July 18, 2002 05:39 AM

The trend labor force growth rate is likely to slow over the next decade--but it will be a gradual slowing, not one that hits all at once over the next six quarters.

Oliner and Sichel (2002, forthcoming in an Atlanta Fed conference volume); Jorgenson, Ho, and Stiroh (I forget where); and me (2003; forthcoming in the NBER Macro Annual) have made crude attempts at structural modeling. But in the final analysis these structural models are calibrated to the late-1990s experience, so what they are really doing is taking the late-1990s experience, extrapolating it, and then using the modeler's-guesses-as-embodied-in-the-model of whether the economic salience of high tech is going to grow or shrink.