Introduction

The current economic expansion just keeps on going. Through 1998, the national economy will exhibit moderate growth of 2.6 percent, low unemployment, with inflation remaining in check. That is a scenario which, not long ago, many would have said was simply unattainable following six years of continuous growth. However, a number of factors have combined to justify this positive outlook. Chief among these are the increased competitive pressure produced by a more global business environment, as well as the Federal Reserve Board’s aggressive anti-inflation stance. To these factors we add impressive rates of worker productivity growth, in part the legacy of the painful corporate restructuring of the 1980’s and early 1990’s, as well as the increasing incorporation of new computer-based information technologies. Both the restraining effect of the above factors on inflation, and the dampening effect the economic crisis in Asia could have on the U.S. economy, make it very unlikely that the Federal Reserve Board will increase short-term interest rates between now and the end of 1998.

Given its unique features, the current economic expansion may well break the record set in the 1960’s for the longest period of uninterrupted economic growth. Now in its 84^th month, the current expansion is already the third longest on record since World War II. That it followed directly on the heels of the 1982 to 1990 expansion, the second longest on record, has led many economists to suggest that the national economy is now being governed by a "new paradigm" under which we can expect longer expansions characterized by more moderate growth. Below, we examine the relationships among various indicators such as prices, wages, and productivity growth in order to assess whether the expansion is indeed in its twilight or is just entering mid-life.

Wall Street

The financial markets appear confident that the Federal Reserve is committed to maintaining a low inflation environment. This confidence is evident in both the strong bond market and the dramatic stock market growth we have experienced for the last three years. As the world’s financial capital, New York City’s economy has benefited immensely from the recent surge of financial market activity. Although the Federal Reserve’s current wait-and-see stance with respect to inflation is unlikely to change, it is uncertain how the Asian crisis will affect the bull market. However, financial market firms derive their revenues from a broad array of sources other than stock trading. One of the most lucrative of these activities is the management and underwriting of mergers and acquisitions. Although a strong secondary market in securities certainly contributes to an auspicious environment for merger and acquisition activity, there are many other factors at play, some global in scope, which also contribute to creating that environment. Upon closely examining these factors, we conclude that we can still expect a successful year on Wall Street related to continuing high levels of merger and acquisition activity.

The New York State Economy

Both the strength and duration of the national economic expansion are having a positive impact on the New York economy, on both Wall Street and Main Street. The services sector continues to lead the State economy in net job growth as the manufacturing sector continues its decline. Particular strength is observed in such high wage industries as business and professional services. Although these trends are generally visible across all of the State’s diverse regional economies, the upstate economy has begun to significantly lag that of the more vibrant downstate regions. This phenomenon represents a distinct reversal of fortune since the end of the last recession.

Has New York been a full participant in the "new paradigm" which appears to be ruling the national economy? The State’s rate of job creation continues to lag that of the nation by almost fifty percent. New York’s weak position relative to the national economy leads us to examine in depth the nature of the State’s job creation dynamics. As we have emphasized in the past, the downsizing of large corporate workforces had a disproportionately large impact on the New York economy during the late 1980’s and the first half of the 1990’s. Between 1992 and 1996, large firms continued to experience a net decline in employment.

Part of the legacy of corporate restructuring has been the growing importance of small business as the engine of State job growth. This finding highlights the importance of maintaining a favorable environment in which small business may continue to flourish. However, small firms tend to pay lower wages than large firms. Therefore, reliance on small business for the creation of new employment might generate an expectation that State wage growth will decline. For many of the State’s upstate regions, wage growth is a concern as corporate downsizing continues to take its toll.

New York State Wage Growth

Despite the impact of both public and private sector restructuring, overall State wages will continue to exhibit solid growth due to both continued growth on Wall Street and the durability of the national expansion. The Committee staff predicts New York wages and salaries to grow 5.7 percent in 1998, following 6.6 percent growth in 1997. However, the impact of the three trends which have dominated the New York economy during the period—the durability of the national expansion, strong growth on Wall Street, and corporate downsizing—has varied significantly by industry. We conclude that any meaningful discussion of the outlook on State wage growth is necessarily a discussion of industry-specific trends.
 

The National Expansion: It Just Keeps Going

Figure 1

Although all of the major forecasting groups expect a slowdown due to events in Asia, all are predicting continued growth. The Blue Chip economic consensus, which combines the outlooks of 50 private sector forecasters, predicts that the national economy, as measured by real U.S. Gross Domestic Product, will grow 2.6 percent during 1998. Based on a decline in the rate of economic growth in Asia from 2.6 percent in 1997 to 1.6 percent in 1998, the Committee staff is also predicting real GDP growth of 2.6 percent.1 Under this scenario, the current expansion by year’s end will have surpassed the duration of that of the 1980’s. Below we examine those features of the current period which we believe make it likely that the current expansion may go on to become the longest expansion on record.
1. The results of a sensitivity analysis of a more pessimistic scenario are presented on page 47.

The national economy grew a brisk 3.8 percent during 1997, the fastest pace in nine years (see Figure 1). National employment grew by a robust 2.3 percent over 1996. Wages and salaries grew 6.7 percent during 1997, even faster than the 5.9 percent growth we experienced in 1996. Corporate profits also exhibited impressive growth. The unemployment rate is lower than it was at this time last year, while interest rates remain stable. Finally, the stock market grew at 30.1 percent during 1997, almost eight percentage points higher than the growth experienced in 1996.

Inflation

Despite the strong pace of growth in 1997, the economy continues to exhibit low inflation. This remarkable feature appears to defy recent historical experience. Figure 2 compares the path of consumer price inflation to that of the unemployment rate since 1957. As the economy expands, the unemployment rate falls. Low rates of unemployment tend to indicate that at least some sectors may be experiencing labor shortages, inducing firms to offer higher wages. Rising wages put upward pressure on prices causing an acceleration of the rate of inflation. Hence, as the economy heads toward the end of an expansion, the consumer price index tends to rise. The only exception to this pattern is the short-lived expansion of 1980-81. Accelerating inflation impels the Federal Reserve to raise short-lived interest rates to slow the economy.

Figure 2

At present, inflationary pressure can scarcely be detected. Indeed, since last year, the rate of consumer price growth has declined. It is also true that, even taking into account last year’s strong pace of growth, the current expansion is marked by the lowest average rate of GDP growth of all post-war expansions (again with the exception of the short-lived 1980-81 expansion). Judging by these indicators, the current expansion appears to lack some of the key characteristics of a mature expansion, despite its long length.

Several factors account for these low rates of inflation. First is the legacy of the Federal Reserve Board’s tightening during the period from February 1994 to February 1995. The looming threat of additional tightening, should the economy appear to be overheating, may be reducing the impulse to raise prices. However, there are two additional factors which lie outside the realm of government policy—increasing global competition and rising worker productivity.

Globalization

The increasing globalization of the international economy has been critical in keeping inflationary pressures at bay. Since 1970, the flow of foreign-produced goods into the U.S. has expanded more then three times faster than the economy overall, yielding unambiguous evidence that the U.S. economy is becoming increasingly integrated into the global economy. Between 1970 and 1997, the real value of imports into the United States increased by no less than 395.9 percent. In contrast, the overall economy, as measured by real GDP, grew by only 111.7 percent. Moreover, in 1970, the foreign sector of the U.S. economy, defined as the total value of imports and exports, was only 11.2 percent of the size of national GDP. By 1997, the foreign sector had grown to 30.6 percent of the size of GDP.

Globalization has had an impact on national employment. During the late 1980’s and early 1990’s, many large corporations responded to the pressures presented by this more global environment by restructuring or downsizing their workforces. Although the pace of internal restructuring has slowed since the early part of the decade, the recent announcement by Kodak of an additional 16,600 in layoffs indicates that New York, as home to many of the nation’s large firms, continues to feel the impact of corporate downsizing.

Increased global competition limits the ability of businesses to pass cost increases on to consumers in the form of higher prices. The threat of losing market share to foreign firms has resulted in less price flexibility for most industries, depending on the degree of import penetration. For example, because commodities industries face more foreign competition than do service industries, commodities prices have tended to rise more slowly than service prices (see Figure 3). The short period following the first oil shock in 1973 represents a rare exception to this trend.

Figure 3

Moreover, this effect is strongest in those markets where competition with foreign producers is most intense, such as the new car and apparel industries. Unable to raise prices, firms have been forced to find ways to reduce their production costs in order to boost their profits. The anticipated drive by troubled Asian economies to boost their exports can be expected to put further downward pressure on internationally traded commodity prices. This represents a significant contrast with earlier expansionary periods, particularly those prior to the 1980’s.

 The Contribution of the Computer Industry

Another factor favoring a low inflation environment is the decline in computer industry prices. The growth in this industry alone accounts for a significant component of overall macroeconomic growth. During 1997, expenditures for computer industry goods grew by 44.8 percent, following a 48.0 percent increase in 1996. Absent that growth, overall GDP growth for 1997 would have been reduced from 3.8 percent to 1.6 percent. The importance of this industry to the overall direction of the macroeconomy cannot be over-emphasized. Hence, the decline in computer prices has made an important contribution to lower consumer prices overall.

Labor Productivity and Wage Growth

Finally, the current low inflation environment is also being maintained by strong gains in labor productivity. It is presumed that new technological developments, especially the expanded use of computer-based information technologies by almost every sector of the economy, are having a significant impact on overall economic growth. The sheer magnitude of the investment being made by businesses in computers suggests that computers are perceived by firm managers to be improving worker productivity. Unfortunately, it is very difficult to measure these productivity increases, particularly within the service industries. Since all of the published official measures of productivity are still manufacturing-based, there is good reason to believe that these measures underestimate the actual rate of productivity growth.2
2. The difficulty in measuring productivity springs from the difficulty in measuring the total value of production of the national economy. There are two measures of the size of the economy: the total value of production and total income. Since both measure the same thing, they must, in theory, be equal. In practice, there is always a slight difference between them. This difference is known as the statistical discrepancy. However, recently, the income measure of GDP has been found to be consistently greater than GDP measured from the production side. Moreover, the statistical discrepancy has been growing for the last three years, suggesting that there is more than random error at play. Since it is believed that the measurement of income is more reliable, the growth in the statistical discrepancy may be taken as an indication of systematic underestimation of the total value of goods and services on the production side.

Exceptionally strong productivity growth may provide an important key to understanding the enduring coexistence of low rates of both inflation and unemployment. During 1997, the unemployment rate averaged 5.0 percent, quite low by recent historical standards. Conventional wisdom suggests that a tight labor market creates upward pressure on wages and salaries, which in turn produces inflationary pressures as firms pass their higher labor costs on to consumers. As long as productivity grows faster than wages, firms can afford to both pay higher wages and maintain their profit margins without raising prices. The result is healthy wage and profit growth coupled with low inflation.

A comparison of productivity and wage growth during the recent period yields additional evidence that the current expansion has not yet fully matured. Productivity growth has been higher than the growth in the workers’ real compensation index, as measured by real average hourly compensation, throughout the current expansion (see Figure 4), continuing a trend that was established during the 1980’s expansion. With the exception of the turbulent 1970’s, wage compensation typically grows faster than productivity toward an expansion’s end. This phenomenon is evident in the behavior of labor costs, a measure of labor compensation corrected for productivity growth. Figure 5 compares the most recent ten quarters with the final ten quarters of the typical expansion of at least that length. Unit labor cost growth during the last ten quarters has been well below the historical average.

Figure 4

Figure 5
 

What Will the Federal Reserve Do?

The Federal Reserve has clearly articulated that its policy scope is focused on maintaining price stability. Indeed, evidence of declining non-labor production costs has led some economists to believe that for the first time in many years, the threat of deflation has become a cause for concern.3 The currently low rate of consumer price inflation we have been experiencing has been accompanied by even slower growth in producer prices as measured by the Producer Price Index (PPI). The present expansion has exhibited a very small increase in producer prices for the last 30 months, including nine monthly declines during 1997. In addition, a measure of price growth tied to GDP, the implicit price deflator, rose at an annualized rate of only 2.0 percent during the fourth quarter of 1997, the slowest growth since 1965. Finally, we note that most economists believe that the CPI as currently measured overstates the true extent of consumer price growth.4
3. See "What’s Different Now, Economist Sees Zero Inflation Playing Havoc With Conventional Wisdom," Barron’s, July 28, 1997, pp. 19 – 23.

4. See U.S. Senate. Committee on Finance. 1996. Final Report of the Advisory Commission to Study the Consumer Price Index. Senate Print 104-72, 104 Congress, 2 session, Government Printing Office.

While global competition has restrained domestic price inflation, the recent appreciation of the dollar has insulated the economy from import price inflation as well. In addition, the healthy rates of productivity growth we have been observing leave room for wage growth without producing inflation. A search for pockets of potentially inflationary pressure leads to the service sector. Technological change is not expected to have as much of an impact on labor productivity in service industries as it would in the more capital intensive goods producing sectors. Moreover, the price reducing effects of globalization will not be observed as much in the services sector since services are not as subject to international competition as are commodities. However, these pockets do not appear to be sufficiently threatening to pull the overall rate of inflation into dangerous territory, particularly with the impact of the Asian crisis yet to be felt.

In summary, none of the major price indices suggests that the economy is on the verge of overheating. The Committee staff predicts growth in the Consumer Price Index of 2.2 percent for 1998, slightly down from 1997. Given the uncertainty surrounding the impact of the crisis in Asia, we therefore conclude that the Federal Reserve Board is as likely to reduce short-term interest rates as it is to increase them, between now and the end of 1998.