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Online Extra: "We Can Adjust in a Measured Way"


Anthony M. Santomero took over as President of the Philadelphia Federal Reserve Bank in 2000 after spending 30 years as a finance professor at the University of Pennsylvania's Wharton School. During his tenure, he has made a determined effort to raise the profile of the regional Fed bank, sponsoring conferences of top economists and making numerous speeches. He recently spoke with BusinessWeek Senior Writer Rich Miller about inflation, employment, productivity, and interest rates. Edited excerpts of their conversation follow:

Q: Are you worried about the pickup in inflation that we've seen this year?

A: We are getting anecdotal evidence of isolated areas of price movement, but we have to keep in mind that competition still keeps this under control. International competition has not gone away. Productivity remains strong, implying that the underlying pressure [on inflation] from a cost perspective has not really developed to any great extent. We also have some degree of excess capacity both in labor and capital. I think that slack in both areas will keep prices, at least in the short run, relatively contained.

As we move forward, we'll have to be cautious and watchful as it relates to how much slack is left in the economy and how the global economy impacts price pressures here. We're at a point in the cycle where one would logically think about price pressures as one sees the expansion progressing, income and jobs rising, and GDP [gross domestic product] coming in above potential.

Q: But now that the jobs market has picked up, won't productivity growth tail off?

A: Usually at this point in the expansion, overall productivity growth declines relative to where it had been. But given the [underlying] trend, we're still likely to see productivity growth in the 2.5% to 3% range, which would allow the economy to grow at about 4%. While we're not going to get the downward price pressure associated with high productivity, productivity will keep prices from moving up.

Q: In a recent speech, you suggested there might be less slack in the labor market and less spare capacity at factories than thought because of rapid technological change. Can you elaborate on that?

A: Capacity utilization is an imprecise number. With technological change, it becomes more difficult to bring back on line older plants because the productivity [at the plants] is lower. They may be obsolete.

On the labor side we have a similar phenomenon going on. As technology pervades the workplace, the required skills of virtually every job go up. In our business outlook survey, we got quite a few companies indicating that they were having some difficulty finding the right workers for the jobs they had available. I hear that from to time in a number of areas, not just high tech.

Q: But so far wage gains seem to be contained.

A: That's my judgment. What I'm hearing from Main Street is that it takes companies longer to get the kinds of people they want than they thought it would, given the slack in the labor market. But they haven't said they can't find them, except for very isolated cases, like nurses.

Q: In that same speech, you also suggested that the Fed would want to raise interest rates to the so-called neutral level several quarters before the economy settles into a long-run sustainable growth path. Why?

A: It takes a while for monetary policy to work through the economy, and it takes a while for inflation to be manifest in the aggregate data. We have to be cognizant of those lags and move monetary policy anticipating that it has a lagged effect on the economy.

In this expansion, the growth rate of GDP, while above potential, is not wildly above potential. So it allows the economy to deploy resources in a more evenhanded and calmer way, and allows us to respond and adjust interest rates in what we think will be a measured fashion going forward.

If you look at the previous postwar recoveries and subsequent expansions, what you'll discover is that the recovery causes a real bounce back in GDP and employment growth. Then you have the problem of trying to constrain the bounce back. Here, with the economy growing in a more measured fashion, above potential but within broad range of potential, we can adjust policy in a measured way.

Q: But do those lags suggest that the Fed needs to reach neutrality by the middle of next year?

A: It depends upon how the economy evolves. Professional forecasters are predicting a tick down in GDP in 2005. To the extent that 2005 backs up a little, then we may be in a world where demand, while close to potential, isn't exceeding potential as we move rates up. That will give us a bit more time. We have to look at the dynamics, not only of what we're doing, but the circumstances in which we are making those decisions. At this point I can't tell you where it's going to be.

Q: Will interest rate increases carry more punch than in the past because of the huge increase in debt in recent years?

A: It is true that movements in interest rates will have an effect on the consumer sector. But it's dampened by the fact that only a minority of consumer debt is at floating rates. The household balance sheet is in pretty good shape. It has accumulated some additional wealth as a result of the surge in homeownership and refinancing. And we have perhaps more resiliency than usual on the business side, with retained earnings financing a lot of their business investment.


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