Academic journal article Federal Reserve Bulletin , Vol. 85, No. 8
As emphasized by the important hearings this committee has held in the past few days, an impressive proliferation of new technologies is inducing major shifts in the underlying structure of the American economy. These fundamental changes appear to be far from complete. The way America does business, including the interaction among the various economic players in our economy, is in the midst of a significant transformation, though the pace of change is unclear.
As a consequence, many of the empirical regularities depicting the complex of economic relationships on which policymakers rely have been markedly altered. The Federal Reserve has thus been pressed to continuously update our understanding of how the newer forces are developing in order for us to address appropriately our underlying monetary policy objective: maximum sustainable economic growth.
The failure of economic models based on history to anticipate the acceleration in productivity contributed to the recent persistent underprediction of economic growth and overprediction of inflation. Guiding policy by those models doubtless would have unduly inhibited what has been a remarkable run of economic prosperity.
And yet, while we have been adjusting the implicit models of the underlying economic forces on which we base our decisions, certain verities remain.
Importantly, the evidence has become increasingly persuasive that relatively stable prices--neither persistently rising nor falling--are more predictable, hence result in a lower risk premium for investment. Because the nation's level of investment, to a large extent, determines our prosperity over time, stability in the general level of prices for goods and services is clearly a necessary condition for maximum sustainable growth.
However, product price stability does not guarantee either the maintenance of financial market stability or maximum sustainable growth.
As recent experience attests, a prolonged period of price stability does help to foster economic prosperity. But, as we have also observed over recent years, as have others in times past, such a benign economic environment can induce investors to take on more risk and drive asset prices to unsustainable levels. This can occur when investors implicitly project rising prosperity further into the future than can reasonably be supported. By 1997, for example, measures of risk had fallen to historic lows as business people, having experienced years of continuous good times, assumed, not unreasonably, that the most likely forecast was more of the same.
The Asian crisis, and especially the Russian devaluation and debt moratorium of August 1998, brought the inevitable rude awakening. In the ensuing weeks, financial markets in the United States virtually seized up, risk premiums soared, and for a period sellers of even investment grade bonds had difficulty finding buyers. The Federal Reserve responded with a three-step reduction in the federal funds rate totaling 75 basis points.
Market strains receded--whether as a consequence of our actions or of other forces--and yield spreads have since fallen, but not all the way back, to their unduly thin levels of last summer.
The American economy has retained its momentum, and emerging economies in Asia and Latin America are clearly on firmer footing, though in some cases their turnarounds appear fragile. The recovery of financial markets, viewed in isolation, would have suggested that at least part of the emergency injection of liquidity, and the associated decline of 75 basis points in the funds rate, ceased to be necessary. But with wage growth and price inflation declining by a number of measures earlier this year and productivity evidently still accelerating--thereby keeping inflation in check--we chose to maintain the lower level of the funds rate.
While this stellar noninflationary economic expansion still appears remarkably stress free on the surface, there are developing imbalances that give us pause and raise the question: Do these imbalances place our economic expansion at risk? …