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 economy’s 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.

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 1960’s it was believed to be around 4 percent. In the 1970’s and 1980’s 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 1960’s 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 1930’s.

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.

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 1980’s and those deficits increased in size until the early 1990’s, 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 government’s 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.

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 attitudes.

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 1998.

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 Fed’s 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 Fed’s 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 Fed’s 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 market’s 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.

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.