The current economic slump has resulted from the 1999-2000 monetary tightening that generated slower demand, the negative supply shocks imposed by higher energy costs and the dramatically higher costs of capital that have constrained production and investment. The sharp reversal of these cyclical and structural factors that drove the earlier robust economic performance and soaring NASDAQ have produced an uneven economic deceleration: while consumer spending has slowed to a moderate growth pace and housing activity has remained firm, businesses are aggressively cutting production and capital spending, and profits are falling sharply, a reversal from their earlier doubledigit gains. Slowing imports and a narrowing trade deficit will provide a partial offset to weaker domestic demand. This pattern is expected to generate modest real GDP growth in the first half of 2001, with moderate downside risks posed by slower consumption growth. In lagged response, the unemployment rate is projected to rise to 5 percent by year-end. Recent and expected further monetary easing are projected to stimulate demand later this year, but lingering weakness in capital spending may inhibit the pace of recovery. Meanwhile, core inflation has drifted up, and is well above the Federal Reserve's long-run objective.
Insofar as the negative supply shocks constrain production and capacity growth while monetary policy influences aggregate demand, the Fed's job is difficult. Monetary policy is not capable of short-run smoothing of the negative implications of the supply constraints. Nevertheless, the Fed is pressured to ease dramatically; effectively it is being asked to address short-run issues beyond its control. In this environment, the Fed must avoid over-managing the economy (or the stock market) and return to the pursuit of its long-run objective of price stability.
