Introduction

Mr. Chairman and members of the Committee, my name is John Lipsky and I am the Chief Economist and Director of Research for Chase Manhattan Bank. It is a pleasure to be here this afternoon to give my views on U.S. monetary policy.

The Committee's kind invitation to appear at this session indicated that the intent is to examine the state of the economy and review the conduct of monetary policy. There are four main points that I would like to make today regarding these topics.

1. The U.S. economy is performing exceptionally well, compared both with our industrial country partners, and with our own post-WWII experience.

2. This economic success isn't a result of only temporary factors or luck, but rather derives in large part from good economic policy choices and from favorable structural shifts. Of the former factors, sustained anti-inflationary monetary policy has been the most important.

3. The outlook remains free of expansion-threatening imbalances, as near-term growth likely will be somewhat more moderate than is reflected in current consensus views. Thus, inflation risks will remain quiescent, and potential pressures for additional tightening of Federal Reserve monetary policy likely will be absent in the coming months.

4. Looking beyond near-term issues, Fed officials need to examine possible new guides for setting policy, because the changing structure of the U.S. economy has rendered traditional monetary policy indicators less reliable. A new class of so-called feedback rules look particularly promising.

Unexpected U.S. Economic Success

The U.S. economy's performance during the past few years has exceeded even the most optimistic forecasts. Following a sluggish initial recovery from the 1990-91 Gulf War recession, growth has quickened, keeping employment gains robust and lowering the unemployment rate to 5% or less. Yet, inflation has remained tame: The year-on-year increase in the core consumer price index dropped to 2.5% in June, the lowest rate in 30 years. The improved price outlook has helped to lower long-term interest rates, thereby boosting investment and improving the economy's long-term growth potential.

Accelerating productivity growth -- aided by double-digit growth in capital investment during the past few years -- has permitted both noninflationary wage gains and robust increases in business profits. The rise in U. S. asset prices -- including the stunning stock market rise of past the two years -- no doubt derives in large part from unexpectedly favorable corporate earnings, and the prospect that the benign economic environment will be sustained.

The excellent U.S. performance of the 1990?s stands in stark contrast with the disappointing recent record of our G-7 partners. Without exception, they have suffered deeper recessions and weaker recoveries than has the United States (see Chart 1). Investment growth in these countries generally has been sluggish, and job gains have been paltry or nonexistent for years.

The recent U.S. economic success in effect represents a ?New American Challenge? to other industrial countries. International investors have grown more confident that the U.S. outlook will remain favorable in the future. It isn't surprising therefore that the dollar has strengthened over the past two years, and that net long-term private capital inflows have accelerated to a record pace.

This is not to claim that the U.S. economy today represents some theoretical ideal, and that all problems have been overcome. Nor is it evident that the business cycle has been rescinded for all time. Nonetheless, to claim that nothing new is going on ignores the obvious: U.S. GDP has grown in every quarter save four since the Fall of 1982. This is the best record of the post-WWII era, and suggests that we need to examine closely the structural shifts currently underway, and to rethink traditional notions of the business cycle.

Assessing the Sources of the U.S. Expansion

A debate has emerged whether the U.S. economy is being governed by a new paradigm. Analysts, investors and policymakers alike have wondered whether the unexpectedly good U.S. economic performance has resulted from temporary forces and simple good luck, or rather improved economic policy decisions and/or favorable structural changes. The answer is important: If the U.S. performance reflects good decisions, then it likely will be sustainable. Moreover, U.S. policy may represent a prototype for other industrial countries.

In my view, the U.S. economy's low inflation expansion has not resulted from good luck, but derives in large part from four basic factors: 1) Sustained anti-inflationary monetary policy; 2) Economic liberalization, including financial market deregulation, the elimination of price controls and reductions of barriers to entry in several key sectors, such as telecommunications; 3) Declining budget deficits; and, 4) Improved inventory controls, and the trend decline in inventory/sales ratios that, together, have reduced troublesome inventory cycles.

Of these four factors, the persistent application of serious anti-inflationary monetary policy has been the most important. Since Mr. Paul Volcker became Federal Reserve Chairman in 1979, and subsequently under the leadership of Mr. Alan Greenspan, the Fed has pursued price stability as its primary policy goal. As inflation has declined, the Fed's credibility has grown, while inflation fears have waned. Given the focus of this hearing, and in the interest of brevity, I will not offer further comments regarding the other factors, beyond noting that the combination of credible monetary policy and significant regulatory reform has been unique to the United States among the G-7 economies in the past two decades.

The fruits of the Fed's anti-inflationary policies have been evident particularly during the past few years. The reason for this apparently delayed impact is straightforward. A central bank earns credibility the same way that Cal Ripken, Tony Gwynn and Ken Griffey, Jr. have earned their reputations as hitters: That is, by stepping up to the plate and swinging their bat with consistent success. The Fed earns credibility by successfully resisting inflationary pressures. Unlike baseball players -- who get to bat hundreds of times in a season, and whose batting average is calculated anew every year -- the Fed faces reputation-setting inflationary challenges infrequently, but the results cumulate. By resisting inflation pressures vigorously in the late 1970?s, again in the late 1980?s, and most recently in 1994/95, the Fed's reputation has been enhanced progressively.

By now, the Fed's message is widely understood: There will be no return to higher inflation. The clarity and credibility of the Fed's commitment to price stability has lowered both inflation expectations and long-term interest rates, bolstering the prospects for sustained investment-led growth. Declining mortgage rates have bolstered the housing sector. What economists and many others recognized some years ago -- that there is no long-term tradeoff between low unemployment and low inflation -- is evident increasingly in the historical record. In the post-WWII era, the periods of strongest growth in output and income per capita -- and the lowest unemployment rates -- have coincided with the lowest inflation.

The U.S. Outlook

Many analysts and financial market participants harbor pessimistic views about U.S. prospects. Consensus expectations encompass higher inflation and higher interest rates in the next few quarters -- including new Fed rate hikes and the risk of an eventual cyclical downturn. The pessimists maintain that when the U.S. unemployment rate falls below 5.5% to 6% -- that is, below the pre-existing consensus estimates of the Non-Accelerating Inflation Rate of Unemployment (or NAIRU) -- inflation will accelerate necessarily. Moreover, with the stock market allegedly levitating on a tidal wave of mutual fund purchases, and with second quarter income growth outpacing consumption, a new acceleration of private spending toward an inflationary pace is viewed by many as a foregone conclusion.

I do not find these arguments convincing, however. Several factors suggest that U.S. economic growth in the coming quarters likely will be somewhat weaker -- and inflation risks somewhat less acute -- than is reflected in the current market consensus. First, the combination of good productivity growth and strong investment is boosting the economy's productive capacity at a faster pace than has been typical in past decades. Second, the NAIRU almost certainly has declined in recent years, reflecting increased labor mobility and shifts in demographics, economic expectations, and cultural attitudes. Thus, the near-term risk of inflationary wage pressures is less convincing than would have been the case in the past few decades. Third, the widely-used concept of consumer spending ?momentum? is overstated in the consensus view. Current income trends provide powerful explanations of current spending, but offer little guidance about future spending. Yet, the outlook for future income trends is uncertain. Fourth, two related factors -- the consumer investment cycle and the so-called wealth effect on spending of rising equity and other asset prices --appear to be winding down. Finally, the dollars continued rise and sluggish growth in our main trading partners will keep imported inflation low.

The prospects are good, therefore, for continued moderate growth and quiescent inflation pressures. In this case, the Fed may not need to tighten policy further in this expansion phase. Indeed, it is conceivable that in time the Fed's next policy decision could be an easing.

Setting Federal Reserve Policy

Looking beyond the near-term policy challenges, a long-run issue remains to be addressed: Whether a reliable, objective procedure can be developed for setting monetary policy.

Fed officials can no longer rely on many traditional monetary policy indicators. Money supply rules, for example, have been rendered problematic by structural changes in the financial sector. As has been mentioned already, economic indicators such as NAIRU appear to be more useful in explaining the past than in predicting the future. At the same time, monetary policy techniques in use in several other countries, such as formal inflation targeting, seem more helpful in establishing credibility than in providing operational guidelines. Finally, pegging the dollar's value to some external anchor -- such as gold or a basket of commodities -- enjoys limited theoretical or practical support .

In recent years, the Fed has been forced by the absence of a reliable policy rule to operate in a highly pragmatic fashion. This provides one explanation for the heightened attention paid to public speeches by Fed officials. In any case, uncertainty is sufficiently great about whether the current combination of good growth, low unemployment and steady inflation can be maintained that the Fed must remain flexible with regard to upcoming policy decisions. That is, the policy-setting Federal Open Market Committee (FOMC) must sift through myriad data series as well as qualitative factors in order to determine as best as possible the appropriate Fed funds rate.

A more systematic approach to setting Fed policy might rely on so-called feedback monetary policy rules. These rules use readily available and easily understood data to help set Fed policy in a self-correcting framework. The best-known is the Taylor Rule, named after its author, Professor John Taylor of Stanford University. This rule relies on both output and inflation data to indicate when Fed policy shifts are needed to meet a specified inflation target.

Regardless of the analytical method used, the basic question that needs to be answered is whether there exists a policy-driven or other imbalance in the economy, and if so, whether Fed action would be an appropriate remedy. At present, it is difficult to develop a strong case for additional Fed tightening. Unless more convincing evidence emerges of growing inflationary pressures, the FOMC can leave policy unchanged.

These remarks have addressed several complicated issues in a highly summarized fashion. I would be very happy to respond to any questions you might have.