The U.S. Economy in 1998:
Christopher J. Waller
The year 1998 saw many
macroeconomic events not seen in more than two decades and in some cases not since the
Great Depression. While most of these events were good, such as federal
government surpluses, low unemployment, near zero inflation, and solid growth of national
income, 1998 also produced a tremendous burst of volatility in asset markets, record trade
deficits, and perverse interest rate relationships. This has made the Federal
Reserves job of navigating the U.S. economy much more complicated and uncertain.
While the outlook for next year is murky, the economy should be able to avoid a recession
and continue to grow at a respectable rate, although probably at a lower rate than we have
observed in the last couple of years.
In 1998, the U.S. economy experienced some of the best
macroeconomic outcomes that policymakers could imagine. Yet by the end of the year, there
was considerable uncertainty and fear about the direction of the economy. In this article,
I document the economys recent exceptional performance and contrast it with U.S.
macroeconomic history. Given that we are doing so well, I then discuss events that
generated the uncertainty and fear that manifested itself in the form of severe financial
market volatility. I then address the issue of why our current status is not always a good
indicator of the future and why policymakers do not make policy on the basis of the
current state of the economy. Finally, I discuss why the current macroeconomic situation
has created problems for the Federal Reserve in navigating the U.S. economy.
It Was the Best of Times . . .
The year 1998 saw many macroeconomic events not seen in
more than two decades and in some cases not since the Great Depression of the 1930s.
In assessing the performance of the economy, macroeconomists tend to focus on the
Growth rate of the economy (national income)
Growth in real wages
Federal budget deficit/surplus
Behavior of asset prices and interest rates
Dollars exchange rate
Real gross domestic product (GDP) growth, which measures
the value of all domestic goods and services, for 1998 has been in the range of 3.0 - 3.5
percent, which is above the long-run average of 2.5 - 3.0 percent that we have observed
since the early 1970s. Figure 1 shows the percentage change in growth domestic
product for 1990 through the third quarter of 1998. Although above average, GDP growth
began to slow in 1998, and this has led many to question whether or not the U.S. was
heading into a recession in 1999, particularly given the worldwide slowdown due to the
Asian economic crisis. Some estimates put the effect of the Asian crisis on the U.S.
economy as a one percentage point reduction in the growth rate for 1999.
In May 1998, the national unemployment rate, as shown in
Figure 2, reached 4.3 percent, its lowest level since the late 1960s. A low unemployment
rate signals a tight labor market, and consequently, real wages will tend to be pushed up.
Real wages and productivity have increased recently and there is evidence that wage
inequality is moderating after considerably widening over the last 25 years. Upward
pressure on real wages has always been a key market signal that the Federal Reserve
watches since it may indicate a surge in nominal wages which gets passed along as higher
output prices for consumers. As a result, the Fed is worried that the current tight labor
market may be a harbinger of inflation. If labor productivity rises due to technological
advances, however, workers can produce more output per unit of labor time and, as a
consequence, higher wages are justified. Wage increases of this form can be paid without
raising the price of final goods. Therefore, tight labor markets may provide a false
signal of future inflation.
One may ask, "Why is 4.3 percent unemployment viewed as being an
indicator of a tight labor market?" Economists believe that a zero unemployment rate
is unlikely due to the fact that in a dynamic economy, people change jobs in an effort to
find a more productive match between employee and employer. As a result, some amount of
unemployment is the "natural" outcome of a dynamic economy.
The question is, what is the "natural" rate of unemployment?
In the 1960s it was believed to be around 4 percent. In the 1970s and
1980s it was estimated to be around 5.5 percent. So when the unemployment rate falls
below this natural rate, there is more employment in the economy than normal and firms are
hiring more than usual, which means there is less slack in the labor market.
Since the unemployment rate in 1998 was below the long-held estimate of
5.5 percent for the natural rate of unemployment, some economists believe that this will
cause the economy to overheat, thereby causing higher inflation. Furthermore, at some
point unemployment will start to increase back to its natural level. Other economists,
however, have argued that the natural rate of unemployment has actually fallen back to its
1960s level of around 4 percent. Hence, the current rate of unemployment is in the
neighborhood of the natural rate. Consequently, the current low unemployment rate should
not be viewed as a signal that the economy is overheating.
The U.S. inflation rate continues to fall and, upon correcting for
measurement bias, is between zero and one percent, something that again has not been seen
since the early 1960s. In fact, a common belief is that we may be in or headed for a
deflationary state (negative inflation), something that has not occurred since the Great
Depression of the 1930s.
In recent years, the Fed has increasingly shifted its attention towards
generating a slow and steady disinflation with the goal of driving the inflation rate to
zero or nearly so. The recent data suggests that the Fed has been very successful at doing
this without generating a recession, as is commonly feared will result from a
disinflationary monetary policy. But some economists now fear that the Fed has been too
successful in its drive towards zero inflation and that we are about to enter a period of
Deflation is just as damaging to the economy as inflation. One need
only look at the last major episode of deflation in the U.S, the Great Depression, to find
evidence. The Producer Price Index (PPI), for example, has displayed a steady downward
trend over the last year or so. Since the PPI is often viewed as an early warning for what
will happen to the Consumer Price Index (CPI), then the recent evidence suggests the
potential for deflation in the CPI in the coming year. Figure 3 shows the annual
percentage changes in the Consumer Price Index and the Producer Price Index.
A major macroeconomic development over the last year or two has been
the surprising decline in the size of the federal government budget deficit. The U.S.
began generating large deficits in the early 1980s and those deficits increased in
size until the early 1990s, reaching a peak of nearly $300 billion. Since then, due
to a robust economy and a combination of fiscal restraint and tax increases, the deficit
began to fall dramatically until it was eliminated at the beginning of 1998.
At present, the federal government is running a surplus of nearly $70
billion, as shown in Figure 4. The last annual budget surplus in the U.S. was in 1969.
Many economists believe that this has had a reinforcing effect on the economy because as
the governments demand for debt financing falls, more funds are available to finance
private investment in capital goods, which in turn spurs economic growth. On the other
hand, this means that there has been a significant decrease in the ratio of
"risk-free" debt (issued by the U.S. government) and "risky" debt
(issued by private firms). This dramatic change in the relative supplies of risk-free and
risky debt comes back into play when we discuss the behavior of financial markets in 1998.
It Was the Worst of Times . . .
Financial markets were roiled during the fall of 1998
with large ups and downs being observed on a weekly basis. The market continued the
spectacular pace observed in the prior two years with the Dow Jones Industrial Index
starting the year around 7,800 then climbing to a high of over 9,300 in July 1998, an
annualized rate of change of nearly 40 percent. Then came an extraordinary sequence of
price drops and price rises, and the Dow fell all the way to 7,500 at the end of August, a
staggering 24 percent loss in value in little more than a month. By November 1998 the
market had regained a large portion of its value with the Dow reaching 8,900 (at the time
this article was written). Figure 5 shows the weekly Dow Jones Industrial Average from
1994 to 1998.
This volatility in world international markets reflected the continued
effects of the Asian crisis and the anemic performance of the Japanese economy. Investors
in emerging markets worried that the Asian "flu" would spread to other
countries, leading to speculative attacks on those currencies. Then came the collapse of
the Russian ruble, which startled international markets and led to a tremendous portfolio
reallocation between equities in emerging markets and equities in developed economies. As
with all contagion-type panics, the loss of confidence in equities of emerging markets
spilled over to create doubts about the stability of equity markets in developed markets.
This led to a further portfolio reallocation and a classic flight to
safety as investors began to seek shelter in the safety of U.S. government Treasury bills.
The increased demand for bonds forced bond prices higher and drove down bond yields. On
top of this increasing demand for risk-free debt, we observed the U.S. government
dramatically decrease the supply of risk-free debt because of the elimination of the
budget deficit. This combination of increasing demand and decreasing supply led to a
dramatic increase in bond prices and plunging bond yields. The most noticeable aspect of
this was that mortgage rates fell to 30-year lows in the U.S. since mortgage rates are
tightly tied to interest rates on long-term U.S. government debt. Figure 6 shows weekly
30-year fixed rate mortgages from 1972 to 1998.
While such a shift into safe assets could reflect a permanent shift in
investor attitudes, the evidence suggests otherwise. The evidence that this was a
temporary flight to safety rather than a shift in long-term risk preferences appeared in a
dramatic one-day ½ percentage point rise in mortgage rates driven by an announcement by
the Japanese government that it would initiate policies to revive the Japanese economy.
This announcement caused investors to sell off U.S. government debt and shift into
yen-denominated assets. Bond prices in the U.S. fell, yields rose, and mortgage rates
increased as a result of this one-day portfolio reallocation. Such lightning quick
portfolio reallocations on such whimsical news hardly reflect a permanent shift in risk
The U.S. trade deficit exploded as a result of the Asian crisis, which
has created great concern about the movement of the dollar exchange rate over the coming
year. The rise of the dollar relative to the value of Asian currencies increased the
relative price of U.S. goods to foreign goods. This caused a significant decline in U.S.
exports and a large increase of imports into the U.S.. As a result, the U.S. trade deficit
with its trading partners doubled. The drop in demand for U.S. exports has led some to
fear that the economy will slow down in the coming year as exporters reduce output and
employment to deal with the loss of orders from abroad. Estimates suggest the U.S. could
lose up to 1.0 - 1.5 percentage points off its growth rate in the coming year as a result
of the continuing Asian crisis. Figure 7 shows the monthly U.S. trade deficit from 1992 to
The uniqueness of the current U.S. macroeconomic
situation relative to the world macroeconomic condition has created a fair amount of
concern and uncertainty for the Federal Reserve. The superb performance of the U.S.
economy has led many to believe that we have just been "lucky" and that there is
no place to go but down from here. In short, the current U.S. performance is an outlier
and not the norm. Thus, there is a fear that we are heading for a recession with rising
unemployment and rising inflation. On the other hand, it can be argued that the exemplary
performance of the U.S. economy is the result of 1) stable Federal Reserve policy, 2) the
investment in high-tech capital over the last decade, and 3) tax and regulatory reforms
over the last decade that have promoted free market capitalism. From this point of view,
the recent performance of the economy is normal and not an outlier.
The recent success of the U.S. economy presents a puzzle for the
Federal Reserve in terms of how to implement monetary policy. The Fed has traditionally
viewed a booming economy and a tight labor market as the result of a high demand economy.
When rising aggregate demand for goods and services is the source of economic expansion,
higher prices and inflation are not far behind. Consequently, a forward-looking
policymaker would want to push up interest rates to stem demand and relieve some of the
pressure on future prices. The point to remember is that the Fed is trying to stop
inflation before it occurs. Thus, even though there is relatively little inflation at the
current moment, the Fed is trying to anticipate the onset of inflation and head it off
before it starts.
The problem is that if the economy is being driven instead by a boom in
the supply of goods (arising from increases in productivity of labor and capital), then
the high supply of goods will put downward, not upward, pressure on prices. In this
situation, if the Fed increases interest rates, it lowers demand for goods and services,
which puts even further downward pressure on prices.
As a result, rather than heading off future inflation, the Fed may
actually be contributing to a deflationary environment. Consequently, the Fed faces the
difficult task of trying to determine whether the booming U.S. economy is occurring
because of booming demand for goods or a booming supply of goods. Since the economy has
been booming for the last couple of years without any appearance of inflation, the
Feds traditional method for forecasting inflation appears to have lost its
predictive power. It is in this sense that the Fed is sailing in uncharted waters.
Through the first half of 1998, there was growing evidence that the
economy was booming as the result of a surge in demand. Growth rates of the money supply
were too high relative to the growth rate of the economy to sustain low inflation, which
led some inside the Fed to believe that inflation was just around the corner. Hence, the
view from this camp was that the Fed needed to raise interest rates to head off inflation.
The problem facing the Fed was that, due to the inflow of capital into the U.S. as
investors sought safety, any further increase in U.S. interest rates would simply lead to
a greater inflow of capital as investors sought the higher return on U.S. assets. This
would exacerbate the rise in the dollar exchange rate and the fall in the value of Asian
currencies, and also undermine efforts by the International Monetary Fund to stabilize the
Asian economies. Furthermore, it would worsen the U.S. trade deficit.
Given the flight to safety into U.S. Treasury bills and the Feds
steadfastness in keeping the federal funds rate constant, the term structure of interest
rates flattened out dramatically and, in some cases, turned negative. By late summer, the
federal funds rate, which is the interest rate banks charge each other for overnight
loans, was very close to the rate charged on long-term debt. For example, one-year
adjustable mortgage rates were very close to the federal funds rate at one point, as shown
in Figure 8. This means that households buying relatively illiquid assets (houses) for a
year could borrow at about the same rate that banks could borrow from each other for a
24-hour loan of a highly liquid asset (cash reserves).
Such a distortion in the term structure could not last. A flat or
negatively sloped yield curve will not persist unless markets believe that there will be
significant deflation over the coming year(s). Although the specter of deflation was
significant, we had not seen such an event in over 60 years. So it was unlikely that the
term structure would remain flat or negatively sloped. In short, something had to give:
either the federal funds rate had to fall or long-term interest rates had to rise.
Confronted with weak international economies and an inverted yield
curve, the Fed reluctantly cut the federal funds rate by ¼ percentage point in September
1998. The financial markets felt much more was needed and lost confidence in the
Feds willingness to stabilize not only the U.S. economy but the world economy. The
market dove dramatically, creating even more uncertainty about the world economy. The Fed,
realizing it had made a mistake, cut the federal funds rate another ¼ percentage point
and lowered the discount rate to try to signal its seriousness about stabilizing the
economy. This boosted the markets confidence that the Fed was an effective steward
of the economy. Since then, markets have rebounded, long-term interest rates have
stabilized, and the U.S. economy seems to be weathering the storm.
Where Are We Headed?
The important question now is, where are we heading?
Consumer spending data in late 1998 showed that U.S. consumers did not appear to be
deterred by the volatility of world financial markets or weakness in international
countries. This suggests that the U.S. economy should continue growing at a steady pace in
1999. If the Fed continues down the path of cutting the federal funds rate, then we should
see demand strengthening, which helps maintain a robust economy. The flow of cheap imports
into the U.S. will help keep inflation down even if the Fed cuts interest rates. U.S.
unemployment rates may rise some as a result of the drop in demand for U.S. exports but
further interest rate cuts may offset that. As Asian economies begin to stabilize and if
Japan undertakes policies to pull itself out of its six-year recession, then we will see
an outflow of capital from the U.S. to these economies. This will show up as falling
long-term bond prices, rising long-term interest rates, and a fall in the dollar exchange
rate. Consequently, by mid- to late-1999, we may see mortgage rates rise even though the
Fed is pushing short-term interest rates down.
In summary, the forecast for the U.S. economy in 1999 is stable
economic growth, a slight rise in U.S. unemployment rates, a slight rise in inflation, and
a rise in long-term interest rates. Although this is worse than observed in 1998, given
the uncertainty and instability that permeated the U.S. economy in the fall of 1998, the
outlook could have been much worse.
This document is a © of CBER, Center for Business and Economic
Research, located at the University of Kentucky, Gatton
College of Business and Economics.