(The Goldilocks Economy) Too hot? Too cold? Or just right?
BY BEN S. BERNANKE
Monday, October 24, 2005 4:00 p.m. EDT
(Editor's note: This article appeared in The Wall Street Journal on July 27. Today President Bush nominated Mr. Bernanke to replace Alan Greenspan as chairman of the Federal Reserve Board.)
On Friday, the Bureau of Economic Analysis will provide its first estimate of economic growth for the second quarter of 2005, and the experts will be debating: too hot, too cold, or just right? It's a good moment to pause to reflect on how far the American economy has come in the past couple of years and to consider the prospects for future growth.
The recent strength of the U.S. economy makes it all too easy to forget how difficult the economic situation was just a few years ago. Between 2000 and 2002, the economy was hit by an extraordinary series of shocks, including an extended decline in stock prices (the S&P 500 index fell almost 50% from its peak in the spring of 2000), a recession, the 9/11 attacks, prosecuting the war on terrorism, and a string of corporate scandals. In March 2003, the Federal Reserve, citing "unusually large uncertainties," declared itself unable even to characterize the balance of risks to its goals of economic growth and price stability. U.S. businesses became extremely reluctant to make new investments or to hire new workers. GDP growth went negative in the third quarter of 2000 and averaged only 1.5% at an annual rate from mid-2000 to mid-2003. The unemployment rate reached 6.3% in June 2003.
Fortunately, good economic policies helped to turn the situation around. President Bush's tax cuts provided much needed and remarkably well-timed stimulus. Reducing tax rates on work and saving and providing incentives to companies to make new investments also set the stage for ongoing economic growth. The Federal Reserve cut short-term interest rates sharply and kept them low. Together, these policies jump-started the U.S. economic engine. While growth varied from quarter to quarter, real GDP grew at a strong 4.4% annual rate from mid-2003 through the first quarter of this year. Since May 2003, the economy has created 3.7 million payroll jobs, despite a marked rise in energy prices and diminishing monetary and fiscal stimulus in the past few quarters. For comparison, over the same periods, the euro-zone economies and Japan have grown at rates of 1.7% and 2.4% respectively and created, between them, only about 2.3 million jobs. America's economy is growing faster than that of any major industrialized country in the world.
The economy today is thus on a far stronger footing than it was two or three years ago. Where will we go from here? To consider the short-term situation first, economists are divided about what to expect for Friday's GDP release. Spending by consumers, businesses, governments, and overseas purchasers of our exports appears to have grown strongly in the second quarter. However, much of that demand appears to have been satisfied out of inventories rather than from new production. For example, automakers enjoyed strong sales last quarter--in part because of special promotions--but auto production rose by less than sales, as the auto companies and auto dealers took the opportunity to reduce the number of cars sitting on their lots. Because only new production is counted in GDP, Friday's initial estimate of second-quarter growth may come in below the 3.8% growth rate achieved in each of the last two quarters. The good news is that slimmer inventories should set the stage for stronger subsequent growth in production, and many economists consequently would expect strong growth in the third quarter.
In the medium term, U.S. economic growth will depend primarily on two factors--employment growth and productivity growth. When the economy is operating at full employment, the highest level of employment that can be sustained without creating inflationary pressure, employment growth is largely determined by growth in the underlying labor force. However, in periods in which slack remains in the labor market, and that slack is being absorbed, employment can grow faster than its long-run sustainable pace. So far this year the economy has created about 180,000 net new payroll jobs each month, well above the 130,000 to 140,000 jobs per month that economists estimate are necessary to absorb new entrants to the labor force. That's why unemployment has fallen from 5.4% at the end of 2004 to only 5% in June. As the economy approaches full employment, we can expect job creation rates to decline slowly toward the lower, sustainable level determined by labor-force growth, causing overall economic growth to slow as well. When will this happen? The amount of slack in the labor market is difficult, perhaps impossible, to measure with precision. The administration forecasts that job growth will remain elevated well into 2006 at least, supporting above-trend economic growth.
The faster productivity grows (the amount a worker produces in an hour), the faster the economy can grow without inflation. Productivity growth over time leads to higher wages and standards of living. From 2001 through 2004, productivity growth in the U.S. averaged 3.7% per year, making this one of the strongest periods of productivity growth in modern U.S. history. Economists generally do not expect that very high rate to be maintained, with most forecasting a sustainable rate of productivity growth of about 2.5% per year. Even that rate would be quite impressive by historical standards.
In the long run the most important issue isn't which experts are right about this week's estimates of economic growth. The U.S. economy is fundamentally strong. What's important is whether we continue to pursue good economic policies--taking the actions necessary to increase the skills of the work force, keep our economy open to the world, increase our energy security, reduce the government deficit, keep taxes low, curb frivolous lawsuits, ease unduly burdensome regulations, and ensure that Social Security and other entitlement programs are placed on solid long-term footing.
Mr. Bernanke is chairman of the President's Council of Economic Advisers.
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