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's 2000 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 inadequatein 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 andevidence, 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 Exhortations for central bankers to throw off their traditional ways of thinking and "let growth happen" have been replaced by retrograde appeals for the Fed to make growth happen by aggressively lowering the federal funds rate.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 thevalue 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 Reportessay. 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 theeconomy'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 tothe 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 ofattempting to closely manage the business cycle," concludes the essay.

Federal Reserve Bank of Cleveland

The Federal Reserve Bank of Cleveland is one of 12 regional Reserve Banks that along with the Board of Governors in Washington DC comprise the Federal Reserve System. Part of the US central bank, the Cleveland Fed participates in the formulation of our nation’s monetary policy, supervises banking organizations, provides payment and other services to financial institutions and to the US Treasury, and performs many activities that support Federal Reserve operations System-wide. In addition, the Bank supports the well-being of communities across the Fourth Federal Reserve District through a wide array of research, outreach, and educational activities.

The Cleveland Fed, with branches in Cincinnati and Pittsburgh, serves an area that comprises Ohio, western Pennsylvania, eastern Kentucky, and the northern panhandle of West Virginia.

Media contact

Doug Campbell, doug.campbell@clev.frb.org, 513.218.1892