Remarks before the Annual Conference of the American Economic Development Council
Dallas
June 5, 2000

I noticed that my picture in your program has the caption "New Paradigm Optimist." I guess the first question is, "Is that still true?" Yes, it is. Any doubts on that score are probably based on recent stock market events. But since my view of the new-paradigm economy never saw the Nasdaq rising more than 80 percent a year forever, the recent reality check hasn't destroyed my confidence.

The importance of not overstating your case is highlighted for me by the current popular view of supply-side economics. I believe supply-side economics was largely successful, but the consensus probably is that it was a failure since tax cuts never fully paid for themselves in increased tax revenue. The key word here is "fully." Supply side did lay the groundwork for a 17-year expansion with only eight months of recession, not to mention capitalism's victory over communism and hard-core socialism, and the emergence of the United States as the world's economic superpower. But the tax cuts didn't pay for themselves—fully. That part had been overemphasized.

A summary of my views on the New Economy is contained in the president's letter in the Dallas Fed's 1999 annual report. You can also find it on our web site at www.dallasfed.org. My letter is cleverly titled "Out on a New-Paradigm Limb." I wrote it in late February–early March. The annual report essay, titled "The New Paradigm," focuses primarily on the technology driving the new economy, but it also discusses how the economics of the new economy differ from the economics of the old economy.

My new-paradigm message is feeling a bit dated these days. That's true partly because the good guys have been winning. There are fewer and fewer doubters; they're mainly establishment economists at elite universities that don't have good football teams. They see it working in practice, but they still doubt it will work in theory. They should go to a good rodeo. If I'm not mistaken, the bull rider has to stay on the bull only eight seconds before the buzzer goes off and a couple of cowboys come along and help him make a graceful dismount. We've been riding this bull for four and a half years now. When does the buzzer go off? I'm afraid the game is rigged. As long as we're successful, it's still an experiment. The experiment doesn't end until it can be declared a failure. Hey, that's not fair.

My evidence that the good guys are winning comes mainly from the chatter on CNBC—which someone, not me, called the nerds' ESPN. They go on endlessly about Old Economy companies and stocks and New Economy companies and stocks and the Dow versus the Nasdaq. They probably have it right, but it is misleading. Yes, the New Economy does involve doing new things—even new, new things. But it also involves doing old things in new ways. Old dogs are learning new tricks, largely from the Stuarts of the world, behind closed doors. Business-to-business over the Internet by old companies may become more important than the business-to-consumer that gets more attention.

What do I mean by the new-paradigm economy? Does it mean an end to the business cycle, or, if you don't believe in the "cycle" part of it, does it mean the end of ups and downs in the economy? No, probably not. However, eight months recession in 17 years ain't bad. We have been in recession only eight months—in '90–'91—since November 1982. For that matter, the nine years since that eight-month recession hasn't been too bad either. Let's just say that, under the new paradigm, we're having more ups than downs. (I hope someone notices that the current nine-year expansion coincides almost precisely with my tenure as a policymaker, which began in February 1991).

What else besides wise monetary policy should get credit for fewer recessions? There are doubtlessly many candidates, but my vote goes to laser scanners and bar codes. They not only improve inventory management, but they lower the bar for store clerks, who no longer have to do arithmetic. If someone doesn't write "an ode to the lowly bar code" soon, I may have to do it myself.

Does the new paradigm mean inflation is dead? Obviously not. But it does appear that rapid growth and tight labor markets are less inflationary than they used to be. The trade-offs—if there are such things—are more favorable these days, and the so-called speed limit is higher. It's safer nowadays to "give growth a chance."

The old growth speed limit of 2 to 2 ½ percent—derived from the experience of the '70s and '80s—was based on productivity growth (output per hour worked) of just over 1 percent a year and labor force growth (hours worked) of a similar amount. In other words, 1 + 1 = 2 to 2½. Productivity growth accelerated during the '90s, especially in the second half of the decade, especially in the last couple of years, especially in the last year. Output per hour worked increased 3½ percent in 1999. In the third and fourth quarters, productivity grew at annual rates of 5 percent and 6.9 percent, respectively. It took a breather in the first quarter of this year, but hopefully it will be the pause that refreshes.

Let me do my duty here and give a little lesson in arithmetic—in case you've been depending on bar codes too much. An increase in productivity growth from 1 percent a year to 3 percent a year is not a 2 percent increase. It's a 200 percent increase. If 3 percent productivity growth is sustained and compounded, the difference in our standard of living would be—to put it in technical terms—humongous. Using the rule of 72, at 1 percent, productivity would double every 72 years; at 3 percent it would double in 24 years. I say, let's go for 4 percent.

As long as productivity growth is accelerating, good things happen. It means employees' wages can rise without a comparable rise in unit labor costs—up to a limit. The limit kicks in because high productivity is not sufficient to break the link. It also must be accelerating. That's the bad news. The good news is this: first quarter noise notwithstanding, productivity growth still appears to be accelerating.

Conventional wisdom has it that we're lucky productivity growth has occurred during this period of tight labor markets and muted the impact of higher wages and benefits on unit labor costs and inflation. That's right. We are lucky. But unconventional wisdom might take it a step further and suggest that productivity increases, or cost cutting, are to a significant degree a direct result of the tight labor markets. If necessity is the mother of invention, higher labor costs lead to labor-saving investment and innovation. The economy is making its own luck.

This is also true of monetary policy. In the inflationary environment of the 1970s, a squeeze on profit margins usually led to price hikes. Firms could get away with it because their competitors would follow along. With pricing power, who needs cost cutting? In the disinflationary environment of the '90s, however, the absence of pricing power made cost cutting the only option. The Old Economy: raise prices. The New Economy: cut costs.

I've suggested some things the new paradigm does not mean to me. What does it mean? It simply means that our rapid growth in technology—including its synergies and spillovers—and the rising profit prospects it engenders and the multiyear investment boom it has created, have been raising the economy's growth rate. At the same time, several factors are working to make the higher growth rate and the resulting tighter labor markets less inflationary than they might otherwise be.

Much technology is inherently disinflationary or deflationary—Moore's law, declining chip and PC prices, and all that. Output driven by monetary expansion and excess demand is one thing. Output originating from the supply side of the economy—from invention, innovation, deregulation, privatization, freer trade and freer investment—pushes inflation down, not up. The collapse of communism and hard-core socialism dramatically increased the number of countries and people participating in the world economy at a time when most economies are moving toward capitalism. Lower trade and investment barriers and international competition for capital often make global capacity more relevant than local capacity utilization. The Internet deserves special mention all by itself. It is changing everything.

Our annual report essay points out some significant differences in the economics of the old and new economies. The New Economy is more likely to feature declining long-run cost curves and increasing returns to scale. In that context, more growth means lower prices. For example, the first car in a new model line is very expensive to design and build. But the second and third are pretty costly as well. Contrast that with software or new medicines, both of which have high fixed cost but low and declining marginal costs. The larger the market, the lower the unit cost. In a network economy, the larger the network grows, the more valuable it is to those already in the network. In an information economy, consumption by one person does not preclude consumption of the same information by other people. Information and knowledge accumulate and compound. To the extent that New Economy elements grow relative to Old Economy elements, the deflationary winds coming from technology will help offset inflationary pressures emanating from traditional sources.

What are the implications for monetary policy? Speaking just for myself, I believe that if you don't know what the growth limits of the New Economy are, the best policy approach is not to use prosperity as a leading indicator of inflation. More precisely, I don't think policy should be tightened based only on rapid growth or low unemployment. As far as I'm concerned, unemployment can't be too low.

If, however, rapid growth and low unemployment are accompanied by more direct signs of inflation, that's a different story. The best place to look for inflation is in the inflation statistics. The next best place is in the leading indicators of inflation, such as rapid monetary expansion, rapidly rising commodity prices, a weakening currency and perhaps interest-rate relationships.

Preemptive tightening was called for in 1994, in my opinion, for two major reasons. First, commodity prices were rising rapidly throughout the year. Second, short-term interest rates, which had been in the 3 percent range for about a year and a half, were zero in real terms since the inflation rate was also around 3 percent. Neither of those conditions prevailed in early to mid-1999. Commodity prices had been declining for years, and real short-term interest rates were about at their historical norms. Incidentally, the headline CPI change in May and June of last year was zero in both months.

Unfortunately, the benign inflation picture did not last, although it is still relatively moderate. The inflation creep resulted primarily from higher oil prices, but core inflation has backed up a bit as well. As my hero, the late, great Lewis Grizzard, would have said about the March CPI and core numbers of 0.7 percent and 0.4 percent, respectively, "You can put lipstick on a hog, but it's still a hog." Fortunately, the April inflation numbers came in much better. I repeat: the best place to look for inflation is in the inflation statistics.

As you know, the series of modest tightenings that began on June 30 last year had raised the fed funds target rate from 4¾ percent to 6 percent before the latest move pushed it up to 6½ percent. Many people regarded the first three quarter-point moves as a reversal of the easing moves made in fall 1998 during the Asian crisis and consider that the "tightening" only began after that. Until very recently, the consensus was that the economy was not responding to the tightenings to date. The mood seems to have shifted. The budget surplus and debt management policies have offset some of tightening's impact on longer term Treasury rates, and the Treasury yield curve is inverted. Corporate rates, however, have risen relative to Treasuries, and one has to assume they are having some impact at the margin.

Even aside from curbing spending to hold down inflation, one might argue that in a new economy featuring higher profits and an investment boom, higher real rates are needed to keep saving and investment in balance. The excess of investment over domestic private saving has been made up recently by the budget surplus and a growing capital inflow from abroad, whose sustainability may be questionable. In other words, a higher investment, higher growth new economy may require higher rates for equilibrium than those appropriate in a lower investment, lower growth old economy.

I started by saying the stock market correction hasn't shaken my faith in the technology driven, deregulated, competitive New Economy. On the contrary, the sharp correction in portions of the market probably augurs well for sustainability going forward. A boom or a bubble in shares of companies with no profits—and no prospects of any in the foreseeable future—can't be the soundest basis for continued and sustained long-term growth. For me, containing inflation is a worthy goal in itself and is a necessary component of maximum, long-term sustainable growth. I don't want to contain inflation to slow growth. I want to contain inflation to promote growth. If that sounds contradictory, just ask yourself why race cars have brakes. Certainly not to slow their average speed, but to increase average speed by managing the curves and bottlenecks better.

I think that last year we could have tested the growth limits of the New Economy somewhat longer than we did. But don't forget the benefits of the forbearance that was shown up to that point. The decline in unemployment to a 4 percent average resulted in the lowest minority unemployment rates on record, helped make welfare reform a success and helped reduce crime and promote health. It helped many potential workers previously considered unemployable get their first jobs and on-the-job training. My guess is it even made your jobs promoting development in your communities a tad easier and your budgets a little flusher.

Let's not throw away the gains made by appropriately low interest rates by insisting on inappropriately low interest rates when conditions change. Credibility requires knowing when to hold 'em and when to fold 'em—and the courage to do both. For the record, that's a general statement of principle that has absolutely no relevance to any particular FOMC meeting.

About the Author McTeer is president and CEO of the Federal Reserve Bank of Dallas.