In the Current Economic Environment, Let’s Not Forget Long-Term Growth

Developments in economic theory and our experience over the past decade should have taught us two things, says the essay featured in the Federal Reserve Bank of Cleveland's2000 Annual Report. The first lesson is that cyclical fluctuations in output growth are part of the natural ebb and flow of economic activity. Central banks are limited in their ability to smooth out these fluctuations, and attempts to do so may inadvertently interfere with long-term economic growth.

The second lesson, according to the Report, is that the measurements we currently use for making sense of the economy are inadequate in a world where human, organizational, and other intangible forms of capital are as important as the physical capital stock. Until these measurement systems reflect the accumulated lessons of economic theory and evidence, says the Annual Report essay, monetary policy will struggle to deliver the successful outcomes that characterized the last two decades.

The essay, "Theory Ahead of Rhetoric: Measurement and the 'New Economy,'" builds upon arguments first outlined in the Federal Reserve Bank of Cleveland's 1999 Annual Report. Since the publication of that report in June 2000, economic conversations have shifted from New Economy wonder to very Old Economy anxiety.
Exhortations for central bankers to throw off their traditional ways of thinking and "let growth happen" have been replaced by retrograde appeals for the Fed to make growth happen by aggressively lowering the federal funds rate.

The Bank's 1999 Annual Report placed its sympathies squarely in the let-growth-happen camp. That essay expressed skepticism about the value of such concepts as "potential output," and argued against those who saw the rapid rate of output growth in the 1990s as an inflationary threat.

"It's not just that gaps between potential and actual output-to the extent they exist-are difficult to perceive," says the 2000 Annual Report essay. Rather, it's that they may be impossible to perceive, given our current inability to accurately measure economic activity."

Because of these measurement difficulties, the 2000 Annual Report cautions against overly aggressive easing in light of slower-than-expected economic growth.

The essay notes that central bankers' short-term actions suggest an aversion to output fluctuations, which sometimes trumps longer-run worries about inflation. But if most cyclical fluctuations represent the economy's largely efficient dynamic allocation of resources, then the objective of eliminating ups and downs in economic activity has dubious value, says the essay. And if mistakes feed back in a negative fashion to the growth path itself, then attempts to smooth output fluctuations may actually reduce long-term economic growth.

"Just as the public has come to recognize that complex ecological relationships can be upset as a result of damming a river or polluting a watershed, so too should it appreciate the long-term consequences of attempting to closely manage the business cycle," concludes the essay.

The Federal Reserve Bank of Cleveland is one of 12 regional Reserve Banks that, along with the Board of Governors in Washington, D.C., comprise the Federal Reserve System. As the nation's central bank, the Federal Reserve System formulates U.S. monetary policy, supervises certain banks and all bank holding companies, and provides payment services to depository institutions and the U.S. government. Payment services include check clearing, electronic payments, and the distribution and processing of currency and coin.

The Federal Reserve Bank of Cleveland, including its branch offices in Cincinnati and Pittsburgh, serves the Fourth Federal Reserve District, which includes Ohio, western Pennsylvania, eastern Kentucky, and the northern panhandle of West Virginia.