February 15, 1999

Federal Reserve Bank of Cleveland

Construction and : A View from the Sidelines

by Sandra Pianalto

The Federal Reserve’s popularity in unemployment that was 1½ percentage the business community is as high as it points higher than the national average. has been in the 15 years I’ve been in the On January 27, Sandra Pianalto, System, and perhaps as high as ever in For some reason, the business commu- First Vice President and Chief Oper- our 86-year history. I often hear someone nity is quick to give us the credit. Or per- ating Officer of the Federal Reserve say, “The Fed sure is doing a good job.” haps I’ve said that backwards. It is often Bank of Cleveland, spoke at the an- supposed that the Federal Reserve has nual forecast dinner held by the As Chief Operating Officer of the Fed- given borrowers, and your industry in Home Builders’ Association of eral Reserve Bank of Cleveland, I’m particular, access to relatively cheap Greater Akron. This Economic Com- tempted to interpret such a compliment credit, which has allowed our mentary is adapted from her remarks. as a statement about how efficient we to grow. If this is what “doing a good have become at clearing checks. And job” means regarding the performance indeed we have. But that isn’t what you of the Federal Reserve, then it’s a back- But here the analogy breaks down. We mean, is it? handed compliment at best. are not the arbiters of credit; the finan- cial system is. A better analogy, I think, Do you mean that the Fed is monitoring Judging the performance of monetary is that we are the makers of the monetary banks effectively, providing leadership policy is like judging the quality of NFL football. That thing you pass back and in electronic payments development, and officiating (an especially apt analogy forth between you. It’s a crucial part of working hard to ensure that all financial tonight, just four days before Super the business game to be sure, but a pas- institutions are Y2K compliant well Bowl XXXIII). Officiating is best when sive part. I’ve been at many football before New Year’s Eve? We are, you it is noticed least—when the game is games and not once have I heard some- know, but these accomplishments don’t what generates the thrills, not the rules one say, “Wow, what a great ball.” It usually get us noticed in the business of the game. If part of the crowd heaps goes unnoticed, and the players take for community. praise on officials, it’s generally in granted its constancy, its sameness, its response to a decisive call that helps predictable shape and size. Perhaps “doing a good job” means that create a wished-for outcome. And that, we are providing the world with one of of course, implies that there is another, I wonder if football manufacturers are its best known and most confidently used unhappy group to whom the officials’ ever tempted to make the ball a bit products, the dollar. And so we are. But I call seems less clearheaded. smaller to give the offense a boost. Or doubt this is what accounts for our recent maybe they’d like to let some air out of popularity—at least not directly. Indeed, for all the wonderful compli- the ball and turn things in favor of the ments we have received from the busi- defense. Thankfully, rules prevent the No, I am sure that satisfaction with the ness community recently, the Fed has ball from varying from contest to con- reflects happiness over busi- gotten less-than-glorious reviews from test. The caretakers of the NFL want the ness conditions. You are prospering, and pensioners and others on fixed incomes game to be about the athletics on the have been, for one of the longest uninter- who believe that low interest rates have field, not about the whims of those who rupted periods in modern U.S. history. created a hardship for them. Like a foot- provide the footballs. This is precisely Here, in my hometown, we’ve seen the ball referee, I might be inclined to say why many of us in the Federal Reserve rate of joblessness fall to less than 4 per- that we call ’em as we see ’em. In what I System would like to see Congress give cent of the labor force. A remarkable will refer to as the “conventional view” the central bank a single objective—the level when you consider that this is ½ of of monetary policy, the Federal Reserve attainment of price stability—so that 1 percentage point under the very low is often presumed to be the judge of you can take for granted the predictabil- U.S. average—and in a region that, just what the “right” amount of credit in the ity and consistency of the dollar. a decade ago, had an average rate of economy should be. ISSN 0428-1276 ■ The Fed, Interest Rates, and (what economists call “real” interest of dollars in the marketplace, we do not Purchasing Power Uncertainty rates) are set in the marketplace through alter real values but only measured val- The invitation I received billed tonight’s the negotiations of investors who supply ues. We create the illusion of growth and event as an “annual forecast meeting.” capital to the credit market and the prosperity, not the real thing, and then And I clearly understand your expecta- entrepreneurs who use that capital to come to regret it. Once we learn that our tions for my remarks: The health of the fund business expansion. wealth has not grown in real terms, but construction industry is sensitive to the rather that the dollar has shrunk, we level and direction of interest rates; you The conventional view has popular ap- must reverse all the bad decisions that would like me, as a representative of the peal because people don’t always make were based on that erroneous measure- Federal Reserve, to tell you what those the necessary distinction between nomi- ment. Further, we must protect the dollar interest rates will be. On this score, I’m nal and real values. By altering the from further debasement. afraid I must disappoint you. Not be- amount of reserves, we alter the supply cause there’s a deep secret that I can’t of money, which is distinct from credit. Here the distinction between nominal disclose, but because of a popular mis- By changing the supply of money rela- and real interest rates becomes crucial. conception about what the Fed actually tive to its demand, we change the pur- Credit markets want to be rewarded for does and how it does it. chasing power of a dollar. That is, we providing entrepreneurs with credit. change all measurements based on dol- That is the real . But they I do not doubt that credit availability lars. In other words, we create money, also want to be paid back in dollars that may be the single most important factor not wealth; a dollar is only a measure- have the same purchasing power as the in the near-term outlook for your indus- ment of wealth. ones they lent out. So the interest rate try. But how, exactly, do we control the will also have an premium in it, amount of credit in financial markets? Perhaps an example would be useful. making nominal rates somewhat higher The conventional view of monetary pol- Suppose you live in a 3,000-square-foot than real ones. Finally, because lenders icy explains the process something like house, but you want more space. One know that the value of the dollar can this: If the Federal Reserve believes the thing you could do is to build a larger change at the whim of monetary policy, economy is overheating (or, in econo- house. This takes resources: lumber, an added bit of risk must be priced into mists’ vernacular, “operating beyond its concrete, drywall, and the knowledge to the real interest rate, something financial potential”), then it drains reserves from put them together. If, after all this effort, analysts call the inflation risk premium. the banking system. This, in turn, drives you had added 1,300 more square feet of up interest rates, and the higher rates living space, you would be happier The only way the Federal Reserve can cool the economy off. On the other hand, because you would have made a real lower real interest rates predictably and if we think the economy needs a little gain in your standard of living. sustainably is by eliminating the threat perking up, then the conventional view of inflation from the contract between would have us do the opposite—add Alternatively, suppose the government borrowers and lenders. In short, an reserves to the banking system, push wanted to help you out a bit. While they accurate, steady dollar may be the most interest rates downward, and in so doing might not take on any of the burden of indispensable tool used in the construc- boost . building a new house, they could easily tion industry. change the number of square feet in your This conventional view of monetary pol- present home by redefining the foot. The ■ The Outlook icy has at least two major shortcomings. Bureau of Weights and Measures in What about tonight’s subject, the out- To begin with, its adherents would have Washington, D.C. could decide that from look for the economy? We all know that you believe that the economy is inher- now on, the U.S. foot is to contain only economic forecasting falls somewhere ently unstable and, if left alone, is 10 inches. They would then rightly note between rocket science and the occult, doomed to unnecessarily long periods of that your house, formerly 3,000 square but I’d like to note an especially curious unemployment and stagnation. It is the feet, is now a little more than 4,300 fact: In 1998, economists underpre- job of the Federal Reserve, they say, to square feet! It has grown by the same dicted the overall U.S. growth rate for ensure that the economy marches to a amount as before, but without any of the the sixth consecutive year. Persistent, steady, more predictable beat. mortar, nails, or sweat! large misses like this should make us cautious about attaching too much sig- I have a more optimistic view of the Of course, as you walk through your nificance to economic predictions. marketplace. I believe it marches to a home you are sure to notice that your beat of its own making, and the best new 4,300-square-foot house looks the But maybe we ask the wrong questions judges of its tempo are the entrepreneurs same as the old 3,000-square-foot model. of an economic forecast. Let me go back and laborers whose efforts are the origin In fact, they are the same; all that has to an example from football. When the of its growth. changed is the standard by which we season began, few gurus saw the Atlanta measure space. Since the new foot con- Falcons in the Super Bowl. Why? Be- My second dispute with the conven- tains just 10 inches, your house has cause an enormous, indeed an uncount- tional view of monetary policy concerns changed in nominal value only. Every- able, number of factors determine which the notion that we can control interest thing real remains as it was. teams win and which lose, and many of rates in such a way as to determine the these factors are simply unpredictable. spending behavior of borrowers. I No doubt this example seems absurd to object to this for essentially the same you, but no more so than talk about I believe that the value added by an an- reason—because I think that the interest increasing wealth through monetary pol- nual forecast meeting comes not only, rates that influence economic growth icy seems to me. By altering the supply and perhaps not even primarily, from the ultimate accuracy of the forecast. The I suspect that the soft residential con- changes as “the technological revolu- forecast provides a framework for evalu- struction numbers in the consensus fore- tion,” which is generally thought to be ating our risks, and this dinner is an op- cast have more to do with basic arithme- about the power of computers. And that portunity to weigh the risks before us and tic than economic fundamentals. Despite may be its origin. But the key word in debate alternative strategies for con- their outward sophistication, forecasts the phrase is really revolution. We are fronting them. rely heavily on averages. If the economy rapidly transforming how we go about goes through a period of better-than- doing what we do, where we do it, and Consider what economists are telling us average growth, such as we have seen in with whom. The revolution has radically about 1999. Next month, the economy this industry over the past few years, altered the relationships that bind manu- will have completed its eighth consecu- economic forecasts almost invariably facturers to retailers, retailers to con- tive year of growth. Still, economists project a less-than-average performance sumers, workers to jobs, and yes, fami- are holding to the view that our expan- until the economy returns to its historical lies to houses. sion in business activity will moderate trend. After all, the average must be somewhat sharply this year. But there is maintained. These breaks from our observed history scant data to indicate that such a slow- introduce a great deal of uncertainty or ing has begun or soon will. Indeed, on Returning to our football analogy: The risk into the outlook, and there seems to Friday [January 29], we are likely to get Atlanta Falcons surprised the football be even more uncertainty in the current a GDP report indicating that, at year’s world by winning five of their first six housing market outlook than is typical in end, the economy was growing at an games. Quite an accomplishment for a this very volatile industry. When we annualized pace exceeding 4 percent— team that traditionally wins about half its examine the range of publicly available well above what most would consider a contests and that won only three games forecasts, we find that the 10 most pes- typical growth rate. two years ago. Did this year’s strong start simistic ones see housing starts falling cause analysts to predict that Atlanta by nearly 9 percent from 1998—a The key to whether the economy can would lose five of their next six games? decline of almost recessionary magni- continue its string of unusually large No. Analysts reacted, as would any stu- tude. But the economic optimists are growth rates, it seems to me, is the ulti- dent of statistics, by predicting that they projecting that the industry will grow by mate strength of U.S. capital expansion would play according to their history and more than 5 percent in real terms during —our enormous and virtually unprece- win half of their remaining games. the next year, another new record high dented growth in construction and the for the industry. production of machinery. Your industry, But even this proved an overly pes- residential construction, has been an im- simistic outlook, and Atlanta closed the Some of the risk we face tonight comes portant variable in the national growth season by winning nine of their last 10 from circumstances outside the U.S. equation in recent years. Last year, resi- games. Come playoff time, some pre- economy. While this country continues dential construction almost certainly dicted that Atlanta’s “luck” would run to move strongly and steadily ahead, topped 4 percent of GDP, its largest con- out—a rational response if one weighs many of our major foreign trading tribution to the economy in a decade. But the Falcons’ long history too heavily. partners have seen economic growth according to the consensus view, U.S. amounting to less than half of ours. The housing starts are expected to be about There is a forecasting lesson here. Aver- of Japan, Korea, and much 1.54 million units in 1999, a 4 percent ages are of little use when fundamental of South America are at best flat and, in drop-off from last’s year record. And changes are introduced into the economic most cases, still shrinking. These weak- economists on average see U.S. housing system. Consider the year just past. If nesses have begun to affect certain seg- construction falling another 4 percent you had asked economists in 1997 what ments of the U.S. manufacturing sector. next year. they were expecting for 1998—and we Not only have our exports to these did—they would have said 1.42 million nations dried up, but now these nations What factors have gone into this rather units, a small drop from the strong 1996 are fierce competitors. America’s steel, lackluster projection? It’s hard to see in rate of 1.48 million units. You see, that chemicals, and textiles industries have the industry’s economic fundamentals. 4 percent decline I told you they are pro- all seen production levels drop sharply The December surveys of homebuilders jecting for this year was the general view since August in the face of a brutal for- and homebuyers revealed unusually for 1998 as well. But last year’s starts eign economic environment. positive assessments of homebuying came in at a phenomenal 7½ percent conditions, and favorable housing increase over the 1997 level! And in I don’t deny that these international “affordability” indicators are generally 1996, economists projected a 1.39 mil- issues cause significant problems in expected to persist well into the year lion unit pace—again a retreat from the companies and communities. Certainly 2000. In fact, economic forecasters good growth of the year before—only to those of us who have lived in this city expect long-term interest rates to fall be surprised by a 1.48-million-start for any length of time remember the modestly from their current levels, at result. The fact is that economists have plant closings and unemployment asso- least over the next two years. Further- seriously underestimated housing con- ciated with the changes in the worldwide more, joblessness is low and productiv- struction activity for each of the past rubber and tire industry. But our eco- ity growth continues to make solid three years. nomic system has tremendous resiliency, gains; the combined influence of the two which manifests itself in several ways. is expected to keep income growth in the Persistent misses like this indicate that U.S. economy reasonably strong over something fundamental is changing the For example, the economic weakness the forecast horizon. U.S. economic landscape and it’s having that has characterized Japan and other a dramatic impact on the construction nations has caused the prices of basic trades. We euphemistically refer to these construction commodities, like lumber “easy” money policy causes interest One day monetary policy may achieve and steel, to remain low, despite the U.S. rates to rise, not fall—and construction the status of the football and become a building boom. Perhaps even more to languish, not flourish. passive rather than an active participant importantly, our weakening trade bal- in the economy. I will know when that ance implies that investment dollars— When we conceive of monetary policy day arrives, because the business head- which had been flowing abroad—are in this light, we focus on the appropriate lines will not be about the Federal now flowing back to the United States. role of the central bank in creating Reserve or monetary policy but about More savers, quite simply, make for wealth. If the Federal Reserve has con- you—the builders and other investors lower interest rates, and this too has had tributed to the revolution driving our who are now, and always have been, the a positive, unpredicted influence on the economy, and this industry in particular, real source of economic prosperity. construction industry. it has done so only by providing the nation with a steadier measure of value. ■ Conclusion In this way, the unnecessary risk pre- In the past, the great unknowns facing mium in capital market interest rates your industry rarely came from the in- caused by inflation uncertainty has been Sandra Pianalto is First Vice President and ternational environment. They came reduced. This—not easy money—has Chief Operating Officer of the Federal from government policy or, more to the made credit cheaper. Reserve Bank of Cleveland. point, from changes in that policy. Al- The views stated herein are those of the ternating tax treatments of structures Creating an environment of steady author and not necessarily those of the Fed- have been both the boon and the bane prices has helped to liberate the invest- eral Reserve Bank of Cleveland or the Board of the construction market—more bane ment potential of the nation, opening up of Governors of the Federal Reserve System. than boon, I would guess. previously unobtainable trade opportu- nities abroad and encouraging more Economic Commentary is available elec- And fiscal policy is certainly not alone research and development. In other tronically through the Cleveland Fed’s site on in this criticism. Using the monetary words, reducing the risks associated the World Wide Web: http://www.clev.frb.org. We also offer a free online subscription serv- authority to “manage” the level of con- with an uncertain purchasing power of ice to notify readers of additions to our Web struction activity is fraught with peril. money has made more room for other site. To subscribe, please send an e-mail mes- At best, policy’s effectiveness is unpre- risks, those associated with entrepre- sage to [email protected]. dictable and temporary. In the end, neurial inspiration.

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