So what does the limited research on resource utilization and output gaps tell us? There are a few key, but preliminary findings from work done at the Bank for International Settlements...and some as yet unpublished work done by several of our Dallas Fed economists. Here are a few key points:
- The relationship between measures of domestic economic slack, such as industrial capacity utilization, and domestic inflation seems to have declined across a broad range of advanced countries in recent years.
- At the same time, proxies for global slack—such as unemployment rates and output gaps in a wide array of countries—seem to be of growing importance.
- And for some countries, including—and to my mind especially—the United States, the proxies for global slack have become more important predictors of changes in inflation than measures of domestic slack.

I’m not convinced that foreign capacity is a major reason to shrug off concerns about the possibility of overshooting capacity in U.S. labor and product markets. And, as I’ve said, it appears that the economy is near full usage of resources, but it’s not clear whether we are slightly above capacity or below.

If one were confident that observed imbalances simply reflected a more efficient allocation of the world’s stock of saving to its most productive uses, that relative prices adjust freely in response to changing fundamentals and that economies are flexible and agile in adapting to those changes, then we might also reasonably expect these imbalances to resolve themselves through smooth and gradual adjustments in relative prices and flows of goods and services. These conditions do not fully exist today. We do not yet live in a world of perfect capital mobility, one in which savings move across borders to their most productive use without constraint in the form of capital controls or without distortions affecting the behavior of private actors. Recognizing this is important to understanding both why the U.S. imbalance has grown as large as it has and, perhaps, more importantly why it has been financed with such apparent ease despite obvious concerns about its sustainability...The anomaly is that these imbalances have persisted on a seemingly unsustainable path with relatively low interest rates and very little evidence of rising risk premia.

The robust productivity outlook for the United States relative to the rest of the world is consistent with an increase in the U.S. current account deficit, such as we experienced in the late 1990s. If this gap in potential growth were sustained, the United States would be able to sustain a larger external imbalance than we might have thought historically would be the case. But the present magnitude of the U.S. external imbalance seems difficult to reconcile with plausible estimates of future productivity and potential output growth.

Even with the broad shift globally to more flexible exchange rates, a substantial part of the world economy now run monetary policy regimes targeted at limiting the variability in their exchange rate against the dollar, or a basket in which the dollar plays a substantial role. Sustaining that objective in the past several years has required a large accumulation of dollar assets...The significant rise in the earnings of the energy exporters, many of whom also run exchange rate regimes that seek to shadow the dollar, has also generated a substantial rise in investments in U.S. assets. A large share of the capital flows to the United States that have financed our current account imbalance come from these official sources. These flows add to other sources of private demand for U.S. assets. At the margin, they put downward pressure on U.S. interest rates and upward pressure on other asset prices. Through this effect, the monetary policy regimes that prevail in parts of the world help explain at least part of the persistence of these anomalies...Research at the Federal Reserve and outside suggests that the scale of foreign official accumulation of U.S. assets has put downward pressure on U.S. interest rates, with estimates of the effect ranging from small to quite significant.

In the international sector, continued strong growth in the rest of the world will slow the growth of the trade deficit.  An expanding world economy is expected by many economists to generate increasing demand for U.S. exports.  Such growth, however, is also likely to further increase global demand for natural resources.  This implies that prices for commodities such as oil may remain at elevated levels for an extended period of time.

You cannot have the dynamic progress Tom Friedman describes in his book without the well-functioning, reliable monetary regimes central banks have been sustaining. It is an especially intense responsibility for the Federal Reserve, as the primus inter pares central bank, serving the largest economy in the world and circulating the world’s most utilized currency. One cannot make monetary policy at the Federal Reserve without being cognizant of the forces of globalization acting upon our economy. Nor can one be oblivious to the need to conduct our policy with an awareness of how our actions impact markets and, therefore, economic potential worldwide. Keeping inflation in check is a central bank’s sacred mission. By spurring productivity and fomenting tectonic economic changes, globalization has acted as a tailwind for the Fed’s—and other central banks’—efforts to hold down inflation. I believe the Federal Reserve has been able to contain inflation with faster growth than would have been possible in the absence of globalization. In short, globalization has made the Fed’s job easier over the past few years.

Globalization makes it harder to sustain a Social Security system based upon intergenerational transfers.  It exposes much more rapidly and acutely the inherent limits of such policies.  If our fiscal authorities were to take this and other real world verities into account, it might just encourage better policies.  And putting our fiscal house in order before our competitors do would further enhance our edge as an investment destination, securing the future of successive generations of Americans.

I should like to raise the hypothesis that the reason the historically large US current account deficit has not been placing pressure on the exchange rate of the US dollar, at least to date, is that the deficit is a reflection of a far broader and long-standing financial development in the United States and elsewhere.  An ever-growing proportion of US households, nonfinancial busineses, and governments, both national and local, fund their capital investments from external sources...What is special about the past decade is that the decline in home bias, along with the rise in IT productivity growth and the rise in the dollar, has engendered a large increase by US residents in purchases of goods and services from foreign producers.  The increased purchases have been willingly financed by foreign investors with implications that are not as yet clear.

If the currently disturbing drifit toward protectionism is contained and markets remain sufficiently flexible, changing terms of trade, interest rates, asset prices, and exchange rates will cause US saving to rise, reducing the need for foreign finance and reversing the trend of the apst decade toward increasing reliance on it.  If, however, the perncicious drift toward fiscal instability in the United States and elsewhere is not arrested and is compounded by a protectionist reversal of globalization, the adjustment process could be quite painful for the world economy.

Contributing to the disinflationary pressures that have been evident in the global economy over the past decade or more has been the integration of in excess of 100 million educated workers from the former Soviet bloc into the world's open trading system. More recently, and of even greater significance, has been the freeing from central planning of large segments of China's 750 million workforce. The gradual addition of these workers plus workers from India...would approximately double the overall supply of labor once all these workers become fully engaged in competitive world markets...Over the past decade or more, the gradual assimilation of these new entrants into the world's free-market trading system has restrained the rise of unit labor costs in much of the world and hence has helped to contain inflation.

To be sure, the integration of newly industrializing economies into the global trading system is exerting downward pressure on costs and prices. But the effect on inflation--the rate of change in prices--has probably not been large to date, and the extent and duration of its damping influence on inflation in the future are open questions.

In a global economy that grows more competitive every day, the words "education" and "opportunity" are becoming increasingly synonymous. For the individual, a high-quality education is a decisive stepping-stone to increased earning power. For the region, creating a civic culture that supports education is the most promising pathway to creating a base for innovation.

The emergence of new players in the world economy has increased the competitive pressures facing US firms--both exporters and those that compete with imports.  To address this issue, we must insure that we remain competitive in those sectors in which we have a comparative advantage.  I would suggest that those sectors involve capital-intensive technologies and skilled labor.  In this regard, a strong general and advanced education system is important.  In addition, incentives for R&D (but not industrial policy) may also play an important role in enhancing our comparitive advantage.

We cannot ignore the fact that some workers will lose their jobs as the result of intense foreign competition.  I believe the proper policy response is to ease the trasition costs through retraining, upgrading, and aquisition of new skills.