The role of economic policy in current economic performance

Business Economics, Jan, 1998 by Jack Guynn

The economy has performed surprisingly well over the past several years. The combination of robust economic growth, low unemployment, and modest inflation, while not unprecedented, is the best in a generation. A number of developments have been used to explain this "happy" outcome, including the low price of oil, the strong dollar, slack economic activity outside the U.S., increased globalization that has intensified international competition, and the productivity pay-off from investment in computers. Nevertheless, it is the stance of monetary and fiscal policies that distinguishes this expansion from those of the past twenty-five years. These policies have clearly been abetted by positive shocks, but some of those shocks can themselves be attributed to the low inflation environment. The current challenge is to continue to provide the low, stable inflation environment that is a critical necessary condition for good economic performance.

This paper focuses on the role of economic policy, both monetary and fiscal policy, in the current economic expansion. The economy has performed surprisingly well during the past several years. However, the conventional explanations for those good times do not recognize the central role of the monetary policy decisions made by the Federal Reserve during the past seventeen years and the more recent contribution of improved fiscal policy.

SURPRISES OF THE CURRENT EXPANSION

When we reflect on the current expansion, we see first and foremost a combination of robust economic growth, low unemployment, and modest inflation. This combination, while not unprecedented, is the best in a generation. The current expansion is now in its seventh year, and to date is the third longest in the post-World War II period. It shows no signs, yet, of slowing significantly, and we see few of the imbalances that suggest either speculative excess or developing vulnerabilities. The job growth we have experienced during the past six years has pushed the unemployment rate down to a level not seen in more than twenty-three years. Even this impressive unemployment statistic conceals, in part, the true strength in the labor market, for, as you know, it reflects both a technical adjustment in the household survey (made in January 1994), as well as unprecedented peacetime increases in labor force participation. Both of these developments tend to raise the measured level of the labor force and, other things being equal, the measured unemployment rate. Without these two adjustments, the unemployment rate would almost certainly be flirting with 4-1/2 percent by now. At the same time that the unemployment rate has declined, the inflation rate, by any measure, has fallen and is now lower and more stable than at any time since the mid-1960s, while GDP growth has averaged about 3 percent in real terms.

But what are the surprises of the current environment? And importantly, should we really be surprised?

The main surprise has been the economy's ability to sustain simultaneously good conditions in three measures of performance -- GDP growth, unemployment and inflation - and to continue to improve on them during the past several years. A number of developments have been used to explain this "happy" outcome. These include the low price of oil, the strong dollar, slack economic activity outside the United States, increased globalization that has intensified international competition, and the productivity payoff from investment in computers. These have certainly boosted the level of real GDP.

However, many analysts have gone further and asserted that these factors are responsible for keeping inflation low. I think those claims about inflation may miss the boat, as I'll explain later. Interestingly, there has been less notice, and perhaps less appreciation, of the role of economic policy in all this. But before I talk about that, let us examine what I think the factors I have just enumerated have really meant for the economy.

The Price of Oil

First, let's think about the low price of oil. Because inflation followed quickly upon the major oil price increases in the 1970s, a rise in the price of oil is seen by many people as inflationary. However, the price of oil is just a relative price. It is, of course, an important one, given the few close substitutes for oil in the short run.

What happens when oil costs rise? The CPI almost immediately reflects a higher price for an important component, but this change is temporary, lasting only until the substitution and income effects kick in, because that change in the CPI is a function of its fixed-weight design. What's really happening is that higher oil prices give us less money to spend on other things but not less total income. After the major oil price shocks of the 1970s, the Federal Reserve eased monetary policy to try to mitigate the effect of having so much less to spend on other things, and the inflation that ensued was entirely predictable.

But it was the monetary policy response, not the oil price increase, that led to inflation. The effects of an oil price decline are simply the other side of this story. A decline in the price of energy, like the drop we saw earlier this year, leaves us better off in the aggregate, but there are no consequences for inflation if the Federal Reserve, as we saw in recent periods, keeps monetary policy unchanged.