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National Update
Policy at a Crossroads
June 2004

Evan F. Koenig reviews recent economic conditions in the United States.

Headwinds that have held back growth in the U.S. economy finally seem to have abated, and accommodative monetary policy has begun to provide impetus for strong job gains. The big question now is how quickly accommodation will have to be withdrawn. The evidence that can be brought to bear on this issue may be more ambiguous than is generally recognized.

Policy Highly Accommodative
Every standard measure of the stance of monetary policy is sending much the same signal: policy is highly accommodative. For example, the inflation-adjusted (“real”) short-term interest rate—which is normally 2 percent or more—is currently well below zero (Chart 1). Low real interest rates like these provide households and firms with a strong incentive to push planned purchases forward, stimulating current economic activity.

Chart 1

The Economy (Finally) Responds
In late 2002, it looked like accommodative policy might be succeeding in stimulating job growth. However, tensions in the Middle East (and, possibly, corporate scandals) subsequently put a year-long damper on hiring (see purple line in Chart 2). Now, increasingly, the recovery appears to be back on track. Following a sequence of small monthly gains in late 2003, over 237,000 jobs were added to private payrolls each month, on average, during the first five months of 2004.

Chart 2

Financial indicators like the real short-term interest rate, stock prices and the spread between junk and high-grade corporate bond yields have proven to be useful long-leading indicators of future employment gains. Forecasts of job growth three to nine months ahead, based on these financial indicators, appear in Chart 2 as a blue line. The forecasts suggest that job growth is likely to accelerate further late this year and on into early 2005. The recovery, in other words, looks to be on solid ground.

Room to Maneuver?
With real growth apparently gathering steam, estimating the amount of slack left in the economy—or, more generally, assessing the amount of upward pressure on inflation—has become increasingly important. Current low rates of manufacturing capacity utilization have been cited as one reason for optimism on the inflation front. Federal Reserve capacity utilization data must be interpreted cautiously, however, both because these data are subject to large after-the-fact revisions and because the capacity estimates upon which they are based may currently include an unusually large quantity of obsolete plant and equipment.

Chart 3 shows current Fed capacity utilization estimates, Fed estimates as first released and an alternative utilization measure based on a semiannual survey conducted by the Institute for Supply Management (ISM). The ISM’s numbers tend to be higher than the Federal Reserve’s because whereas the Fed tries to measure current output as a fraction of maximum sustainable output, the ISM asks corporate executives to indicate at what percent of “normal capacity” their companies are operating. Nevertheless, movements in the ISM survey match up well with movements in the Federal Reserve’s latest estimates up through 2000. Indeed, the ISM estimates often track the latest Fed data better than do the Fed’s own initial releases! After 2000, the ISM survey does not show nearly as sharp a decline in utilization as Federal Reserve data, suggesting either that post-2000 Federal Reserve estimates will eventually be revised upward or that an unusually wide gap has opened up between maximum sustainable output and normal output.

Chart 3

The high current gap between labor productivity and the real wage—the high markup of prices over unit labor costs—is another reason for optimism about inflation, according to some analysts. Standard economic theory says that with a high markup, firms have a strong incentive to cut their prices and/or expand their workforces and their production. Consistent with theory, current markup data have a powerful long-leading relationship with the unemployment rate (Chart 4) and have significant explanatory power for inflation.

Chart 4

Unfortunately, the markup data that are available to us in real time are almost wholly unreliable. Chart 5 illustrates this fact by plotting the nonfinancial corporate markup as it appeared when first released and as it appears today. Over a 1981:Q4–2000:Q4 sample, the correlation between today’s data and the first-release data is only 0.15. The fact is, first-release markup data are so poor that they are useless as predictors of inflation. They have negligible predictive power in a conventional Phillips-curve forecasting model or as a supplement to surveys of professional inflation forecasters.[1]

Chart 5

Concluding Remarks
At its June meeting, the Federal Open Market Committee (FOMC) took the first step toward a less accommodative monetary policy. Reestablishing a more normal policy stance is likely to take some time. The pace at which the adjustment is accomplished will depend on unfolding events and on some difficult judgments about the outlook for inflation.The data available to policymakers when making these judgements are, unfortunately, often ambiguous and unreliable.

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