Monetary Policy Report

C { I use at 1 O a.m., ~.. ruary 19, 1980 LIBRARY MAR 6 1~M .•··f·cci1;-.. Board of Governors of the Federal Reserve System . . . .. . 'I. II ' , ' J . . ~ . - . . "' .. "1'- .-.• -. ~~-. •. ... ~: ... • '; Monetary Policy Report to Congress Pursuant to the Full Employment and Balanced Growth Act of 1978 February 1 9, 1 980 ..• ·:;cci1>. . .. • "/4-4-=-"'-" • . . . . . .·o ,, ~"' : ·..- \ t;.: . . • ~~~. ...... •. ALR\:. •• • Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., February 19, 1980 THE PRESIDENT OF THE SENATE THE SPEAKER OF THE HOUSE OF REPRESENTATIVES. The Board is pleased to submit its Monetary Policy Report to the Congress pursuant to the Full Employment and Balanced Growth Act of 1978. Sincerely, Paul A. Volcker, Chairman TABLE OF CONTENTS Page Chapter 1. Federal Reserve Policy and the Outlook for 1980 Section 1. The Objectives of Monetary Policy in 1980 2 Section 2. The Growth of Money and Credit in 1980 4 Section 3. The Outlook for the Economy in 1980 7 Section 4. The Administration's Short-term Economic Goals and the Relationship of the Federal Reserve's Honetary Objectives to those Goals 10 Chapter 2. A Review of Recent Economic and Financial Developments Section 1. Overview of Developments 13 Section 2. Economic Activity in 1979 15 Section 3. Prices, Wages, and Productivity 32 Section 4. Labor Markets 37 Section 5. Domestic Financial Developments 40 Section 6. Foreign Exchange Markets and the Dollar 51 Appendix A Description of the Newly Defined Monetary Aggregates Appendix B Description of the New Procedures for Controlling Money CHAPTER 1 FEDERAL RESERVE POLICY AND THE OUTLOOK FOR 1980 -2- SECTION 1. THE OBJECTIVES OF HONETARY POLICY IN 1980 Frequently in the past the decisions about stabilization policy seemed-perhaps sometimes misleadingly--to come down to a choice of how strongly to encourage recovery or to retard expansion. Decision-makers face a much more complicated set of circumstances today. For some time now, most forecasters have suggested that the economy is on the verge of recession, but the recession has not appeared. Over the same period inflation has con tinued apace. The outlook for the economy remains obscured by major uncer tainties, ranging from the possible economic effects of current international tensions and the prospects for wprld oil prices and supplies to the attitudes of investors around the world toward the dollar and the threat that inflation may bring increasing distortions of traditional spending and saving patterns. It is not within the powers of monetary and fiscal policy to resolve all of these uncertainties and to ensure a fully satisfactory economic perfon:.iance. Nonetheless, the appropriate direction for policy is clear. The greatest contribution the monetary and fiscal authorities can make is to impart a sense of long-range stability in policy and in the economic environment. In present circumstances, that requires an approach that provides assurance that the momentum of inflation will be arrested. Inflation not only represents an imminent threat to the sustainability of the current business expansion, but it also lies at the heart of many of the longer-range problems of the economy, such as the inadequacy of business capital formation, and the related declines in the productivity and real earnings of American workers, and the vulnerability of the dollar in foreign exchange markets. -3- Honetary policy clearly has a major role to play in the restoration of price stability. Regardless of the source of the initial impetus, inflation can be sustained over the long run only if the resulting higher level of dollar expenditures is accommodated through monetary expansion. The Federal Reserve is determined not to provide that sustenance, but will adhere instead to a course, in 1980 and beyond, aimed at wringing the inflation out of the economy over time. If recessionary tendencies should develop during 1980--as many expect--the steady anti-inflationary policy stance represented by continuing restraint on growth in the supply of money and credit would be consistent with an easing of conditions in financial markets, as demands for money and credit weaken. That would provide support for economic activity, and would help assure the avoidance of a cumulating, deepening downswing. If, on the other hand, inflationary pressures mount, a policy of restrained growth in money and credit would lead to greater tautness in financial markets, thereby damping the expansion of aggregate demand. In any event, prospects for dealing with the inflation problem without serious economic disruption will be materially enhanced if other elements of government also exhibit a firm anti-inflationary commitment and if workers and management recognize that a moderation of their wage demands and pricing policies is in their own long-range interests as well as those of the nation as a whole. -4- SECTION 2. THE GROWTH OF MONEY AND CREDIT IN 1980 At its meeting earlier this month, the Federal Open Market Committee established ranges of growth for the monetary aggregates that it believed, in light of the prospects for fiscal policy and for private demands, would impose appropriate restraint on inflationary forces in 1980. Measured from the fourth quarter of 1979 to the fourth quarter of 1980, the ranges are: for H-lA, 3-1/2 to 6 percent; for M-lB, 4 to 6-1/2 percent; for M-2, 6 to 9 per cent; and for M-3, 6-1/2 to 9-1/2 percent. These ranges are based on the newly adopted definitions of the monetary aggregates; a description of this redefinition, which was announced on February 7, is included in Appendix A to this report. The FOMC also projected that bank credit will expand between 6 and 9 percent during the current year. The FOMC's ranges indicate the Federal Reserve's intention to seek an appreciable slowing of monetary expansion from the rates observed in 1979, and thus to move toward non-inflationary rates of growth. The deceleration is especially marked in the case of the narrower aggregates. The midpoint of the range for M-lA, for instance, is 4-3/4 percent; in 1979, M-lA increased 5.5 percent. The difference between these two figures actually understates the degree of deceleration in economic terms, however, since the adjustment of the public to the introduction of ATS and New York State NOW accounts probably reduced the growth of M-lA last year by roughly 1-1/4 percentage points as funds were transferred out of existing demand deposits to such accounts. In setting the range for 1980, the FOMC assumed, in the context of present law, that the public's adjustment process is about completed and that such shifting from demand deposits to ATS and NOW accounts will have little -5- further impact on M-lA this year. Of course, if NOW accounts were authorized on a nationwide basis, some downward ~djustment of the present M-lA range could be needed in order to take account of the accelerated shift out of con ventional demand deposits that might result. The range for M-lB--which includes checkable interest-bearing deposits in addition to currency and demand deposits--also implies a sub stantial slowing; the mid-point of the range, at 5-1/4 percent, is well below the actual 7.3 percent expansion in 1979. Of course, because ATS and NOW accounts are included in M-lB, the expansion in 1979 was enlarged by one-time transfers from regular savings deposits and probably other assets to the newly offered transactions accounts--the reverse of the experience with M-lA. For similar reasons, enactment of nationwide NOW account legislation would be expected to raise the growth of this money stock measure this year, and the present range would have to be reconsidered in that light. M-2 likely would not be affected importantly by NOW account legis lation, since it encompasses the major categories of assets that are close substitutes for NOW accounts. Besides M-lB, M-2 includes savings and small denomination time deposits at commercial banks and thrift institutions, plus certain other highly liquid instruments--namely, money market mutual fund shares, overnight repurchase agreements, and overnight Eurodollar deposits at Caribbean branches of U.S. banks. The recently introduced 2-1/2 year certificate, which has no specified minimum denomination and carries a ceil ing rate close to that on Treasury notes, should serve to bolster growth of small time deposits. Six-month money market certificates likely also will remain popular. Nonetheless, absent a steep decline in market interest -6- rates, the total of intere~;-bearing deposits subject to federal rate ceilings probably will continue in the months ahead to grow slowly by historical stan dards. However, growth of M-2 should be buoyed in 1980 as in 1979 by sizable flows into the money market funds. On balance, the prospect is that tf-2 this year will grow at a rate somewhat below the 8.8 percent increase of 1979. The final monetary measure, M-3, includes, in addition to M-2, large denomination time deposits of ~100,000 or more and term (more than one-day) RPs at banks and thrift institutions. It is thus a very broad aggregate, encompassing most of the liabilities of the depositary institutions plus money market mutual funds. Given the moderation of demands for credit--especially at commercial banks--anticipated for the current year, M-3 appears likely to grow less than the 9.5 percent increase recorded in 1979. It should be emphasized that, although we view these new monetary definitions as better measures of financial behavior today than the old definitions, the institutional framework is changing rapidly, and this implies an inevitable uncertainty about the behavior of any monetary aggregate. Further more, the Committee recognizes that other aspects of financial and economic developments will require careful monitoring in the process of policy deter mination and implementation. The ranges specified for the monetary aggregates appear adequate to the Committee to provide the necessary degree of flexibility. -7- SECTION 3. THE OUTLOOK FOR THE ECONOMY IN 1980 It is never an easy matter to project the course of the economy, but the current circumstances pose exceptional difficulties for forecasters. Aside from the uncertainties associated with international political tensions, we find ourselves in an economic environment characterized by historically high rates of interest and inflation, so that past experience may provide only a limited guide to prospective behavior. In order, though, to give the Congress an indication of the Federal Reserve's views about the outlook for the economy, the Board of Governors has assembled in the table, below, ranges that encompass the judgments of its individual members about the most likely outcomes for several key variables. Actual Projected 1979 1980 Change from fourth quarter to fourth quarter, percent Nominal GNP 9.9 7-1/2 to 11 Real GNP 0.8 -2-1/2 to 1/2 Implicit price deflator 9.0 9 to 11 Average level in fourth quarter Employment (millions) 97.7 97 to 98-3/4 Unemployment rate (percent) 5.9 6-3/4 to 8 Annual rate of change in fourth quarter, percent Consumer Price Index 13.2 8-3/4 to 12 The Board members' projections, it must be emphasized, rest oncer tain important assumptions. It is, for example, assumed that, although the cost of imported oil may rise moderately further over the course of this year, there will not be a repetition of the 1979 price run-up and fuel supplies -8- will not be disrupted. It. is also assumed tha_t overall federal spending in 1980 will generally be in line with the Administration's current forecast and that there is no federal tax cut. As can be seen, even with these common assumptions, the range of probable outcomes is relatively wide. Even so, there is recognition that, while considered less likely, the actual outcomes could fall outside of the indicated ranges. Such is the nature of the uncertainties in the economic outlook at present. Most members of the Board believe that a downturn in activity is likely sometime in 1980. Production cutbacks in the auto sector, and a drop in residential construction activity already have occurred; meanwhile, a rising oil import bill continues to act as a drag on aggregate demand. With these depressants on employment and income growth, consumer spending is expected to slacken in the months ahead. It is likely that che tighter consumer and mortgage credit conditions now existing and the already high debt obligations of households will encourage some recovery in the abnormally low personal saving rate in coming quarters. The weakening of consumer demand would also tend to damp plant and equipment spending as softer markets tend to deter businesses from outlays that would add to excess productive capacity. Net exports might rise somewhat, however, owing to the impact on import volume of the weakness in domestic spending and production. In the labor markets, employment may be flat this year, and could well decline somewhat in the goods-producing sectors. At the same time, the growth of the labor force probably will slow, reflecting in part the reduced growth of the working age population but also the usual cyclical response to -9- slack demand for workers. The unemployment rate, which turned upward last month, is likely to remain in an uptrend over the remainder of the year. Even in such an economic environment, progress in reducing inflation will be delayed. Indeed, in the first quarter, the rise of the Consumer Price Index could accelerate, owing in large measure to the latest round of oil price increases and to the lagged impact on the index of the rise in mortgage rates last fall. Throughout the coming year, wage demands will reflect efforts of workers to catch up with past inflation, and pressures on unit labor costs may be intensified by cyclical weakness in productivity. Energy prices probably will continue to rise rapidly, as recent increases in OPEC prices are passed through to consumers and as domestic gas and oil markets are gradually freed from controls. Should aggregate demand prove relatively strong, as some think possible, inflationary pressures across the economy could prove more persis tent. For example, it must be recognized that any s11bstantial increase in defense spending beyond what already is contemplated in the Administra tion's budget could significantly alter the economic outlook. The lag between authorization and actual federal outlay may be quite long in the case of military hardware, but expectational impacts on employment, production, and private spending can emerge fairly quickly. -10- SECTION 4. T~E ADMINISTRATION'S SHORT-TERM ECONOMIC GOALS AND THE RELATIONSHIP OF THE.FEDERAL RESERVE'S MONETARY OBJECTIVES TO THOSE GOALS The President's Economic _Report, submitted to the Congress last month, lays out the following short-term goals for the economy: 1980 1981 Change from fourth· quarter to fourth quarter, percent Real GNP -1.0 2.8 Consumer prices 10.7 8.7 .s Real disposable income 1.1 Productivity -.3 1.3 Average level in fourth quarter Employment (millions) 97.8 99.7 Unemployment rate (percent) 7.5 7.3 These goals, the Economic Report indicates, should be viewed aP forecasts rather than as indications of the Administration's desires. The Admini~t~a- tion expects a mild recession, not lasting much past the middle of 1980. A recovery then begins and carries through 1981. The Consumer Price Index rises much less rapidly this year than in 1979 (when it increased 13.3 per cent), largely in reflection of an expected slowing in the rise of energy prices and of home purchase and financing costs. A broad price measure less affected by these special factors, the implicit GNP deflator, is projected to rise 9 percent in 1980, the same as in 1979, and to slow only to 8.6 percent in 1981. There is no apparent incompatibility between the Federal Reserve's 1980 monetary growth ranges and the economic forecast of the Administration for 1980. The Administration has projected a rise in nominal GNP of about -11- 8 percent; this figure is well within the capacity of the FOMC's monetary ranges to finance. With regard to the more distant future, the pattern of developments that appears likely this year would seem to be consistent with the resumption of moderate expansion in economic activity in 1981. However, the chances of sustaining an advance over time would be greatly enhanced, in an environment of continued monetary restraint, if there were greater progress in reducing inflationary pressures than is suggested by the Administration's price fore cast. Such progress would depend on, among other things, continued fiscal prudence, moderate wage and price behavior by labor and business, an improved productivity performance, and maintenance of a strong dollar on exchange markets. CHAPTER 2 A REVIEW OF RECENT ECONOMIC AND FINANCIAL DEVELOPMENTS -13- SECTION 1. OVERVIEW OF DEVELOPMENTS IN 1979 One year ago, the Federal Reserve reported to the Congress, as required by the Full Employment and Balanced Growth Act, its objectives for 1979. The Board indicated that, in light of growing pressures on resource availability, a moderation in the rate of economic expansion was essential if inflationary forces were to be contained. The pace of price advance had already accelerated over the preceding year, and it was recognized that if this tendency toward faster inflation was not reversed the progress that had been achieved by the November 1, 1978, program to bolster the dollar on foreign exchange markets would be jeopardized and the dangers of serious economic disruption would be heightened. Consequently, at its February meeting, the Federal Open Market Committee had set growth ranges for the major monetary aggregates that would be consistent with reasonable restraint of demands for goods and services in the economy. The first half of 1979 saw a number of unanticipated, negative developments. Economic activity was depressed by inclement weather, by labor disputes, and by gasoline shortages. More critically, foreign oil producers posted drastic price increases, giving added impetus to inflation and draining income from the U.S. economy. In this environment, the Board reported in July that there appeared a significant threat of a mild recession in the months ahead. It also noted that there was little hope of a near-term slowing of inflation. Under these circumstances, the Federal Open Market Committee reaffirmed the previous monetary aggregates ranges at its July meeting. -14- Aggregate demand actually proved stronger than generally expected in the second half of 1979, largely.because consumers displayed a surprising willingness to spend, reducing their rate of saving to an extraordinarily low level. Real gross national product rose moderately, and the overall unemployment rate remained stable. Inflation, as measured by the implicit GNP deflator, didn't abate, but neither did it accelerate, as labor costs and food prices behaved somewhat more favorably than anticipated. Taking 1979 as a whole, monetary expansion was broadly consistent with the FOMC's objectives--with the major money stock measures falling close to or within the upper halves of the Committee's announced ranges. Meanwhile, real GNP growth was somewhat less rapid and inflation somewhat more rapid than might have been expected last February. Energy supply and price develop ments provide much of the explanation for this adverse mix of output and inflation; they also represent a major peril to the satisfactory performance of the economy in 1980. Indeed, more secure energy supplies and control of inflation are necessary conditions for the longer-range progress of our economy, and must remain priority matters for public policy until they are achieved. -15- SECTION 2. ECONOMIC ACTIVITY IN 1979 Economic activity registered only a small gain last year, following almost four years of brisk expansion. Real gross national product increased about one percent over the four quarters of 1979; industrial production rose a bit early in the year, but then edged off, finishing the year just margin ally above the December 1978 level. Two fundamental factors exerted:a per vasive damping influence on aggregate private demand: a near doubling of the average cost of imported oil, which drained income to foreign producers and exacerbated underlying inflationary pressures, and a posture of increasing restraint on the parts of monetary and fiscal policy to contain those pres sures and to prevent a worsening of long-range price trends. While these factors were tending to moderate growth of output and expenditure throughout the past year, quarterly movements in activity were importantly influenced by a series of unexpected shocks. In the winter months, unusually severe weather in many parts of the nation depressed activity in several sectors. In the spring, real GNP declined appreciably in response to strikes that disrupted production and transportation and to shortages of gasoline. As the strikes ended and gasoline lines disappeared in the summer, activity snapped back smartly, especially in the retail sec tor where auto sales were boosted by price incentives offered by dealers and manufacturers in an effort to cut back inventories. Real GNP growth slowed again in the final months of the year, as the special elements of strength in the third quarter dissipated and the basic restraining influences in the economy dominated. -16- Real GNP Change from previous period, annual rate, percent 6 L......_ ____ _.__ ___ __._ ___. .,____ __- '---'H.:...;1 _ ___;_H:..2::. _ _. 2 1975 1976 1977 1978 1979 Real GNP and Major Sectors Percent change, 04 to 04 am 1978 ]2 . 1979 Business Fixed Investment 8 Personal Consumption GNP Expenditures 4 Government Purchases + 0 4 8 -17- Among the major sectors of the economy, the greatest weakness during 1979 was in residential construction and consumer durables. This pattern is typical of periods when aggregate activity levels off, particularly when there is a tightening of financial markets, as there was last year. In 1979, however, the softness of spending on consumer durables was exacerbated by the effects of gasoline price and supply developments on the demand for automobiles. Consumer spending on other items proved quite robust, and total personal consumption expenditures rose even though real disposable income was virtually flat. Business fixed investment, which normally lags cyclical turn ing points, posted a small real gain in 1979; at the same time, perhaps because an economic slowdown was widely anticipated, firms maintained a tight rein on stocks, and despite the problems of the auto sector, inventory accumulation was reduced over the year. Governmental outlays were flat in 1979, reflect- ing at least partly public sentiment for restraint on taxes and spending. The one major area of strength was the international trade sector; in constant dollar terms, the net export balance grew substantially as a result of the relatively faster expansion of foreign economies and the continuing effects on exports and imports of past exchange-rate changes. Personal Consumption Expenditures Real consumer outlays grew 1-1/2 percent during 1979, compared with a 4-1/2 percent gain during 1978. Underlying the weakness in consumer spend ing was a still sharper deceleration in real disposable income, which rose only 1/4 percent during 1979 after rising 4-1/4 percent in the preceding year. Growth of nominal income slowed significantly, and household buying power was further eroded by accelerating inflation and by the rise in tax burdens -18- D Real Personal Consumption Expenditures ■ Real Disposable Personal Income Change from previous period, annual rate, percent 6 4 2 H1 H2 1975 1976 1977 1978 1979 3avings Rate Percent 10 8 6 4 1975 1976 1977 1978 1979 Household Debt Repayment Relative to Disposable Personal Income Percent 23 22 21 20 1975 1976 1977 1978 1979 -19- related to higher social s~curity taxes and to the interaction of inflation and a progressive income tax. All of the advance in real consumer spending occurred in the second half of the year when the saving propensities of households fell to histor ically low levels. The personal saving rate in the fourth quarter was about 3-1/4 percent--one percentage point less than the previous post-Korean War record low. The rise in consumer spending after mid-year was to some extent a rebound from the weak second quarter, when gasoline shortages had disrupted normal spending patterns and cut demand for large fuel-inefficient cars. In response to falling sales and excessive inventories, domestic automobile pro ducers instituted major sales promotion campaigns in the third quarter and again near the end of the year. As a result, sales were boosted noticeably; indeed, the higher selling rates may well have involved some "borrowing" from future periods. Consumer sentiment, as measured by opinion surveys, began to deteri orate in 1978 and worsened in 1979, reaching levels that in the past have been associated with recessionary periods. Previous experience with these surveys suggests that there should have been a cyclical downturn in consumer spending. That such a decline did not occur appears at least partly attributable to the strength of inflationary expectations, which encouraged a buy-in-advance men tality. In the latter part of the year, however, consumers began to exhibit less eagerness to purchase durable goods in anticipation of future price increases and to show greater concern about high interest rates and lessened credit availability. Given the already reduced liquidity of the household sector associated with further heavy borrowing in 1979, a turn toward some what more cautious spending patterns would not be at all surprising. -20- Residential Construction Expenditures for residential construction, in constant dollars, fell about 8 percent in 1979; given the magnitude of the rise in interest rates over 1978 and 1979, this is a modest decline by historical standards. The demand for housing was sustained by underlying demographic trends--including sub stantial population migration and rapid household formation--and by the grow ing interest in homes as an investment and as an inflation hedge. The combined effects of rising house prices and mortgage interest rates caused the monthly carrying costs of homeownership to climb steeply, but buyers were willing to devote an increasing share of their income to housing. At the same time, the potentially disruptive effects of rising market interest rates on mortgage credit availability were considerably ameliorated by such institutional develop ments as the improved ability of thrift institutions to compete for lendable funds, most notably through issuance of 6-month money market certificates, and the increasing use of mortgage-related securities. Private housing starts averaged 1.8 million, at an annual rate, during the first three quarters of 1979, down from the 2.1 million pace in the latter part of 1978. Starts fell to about a 1.5 million rate in November and December, however, when the terms and availability of construction and mortgage credit tightened dramatically in response to the October 6 monetary actions by the Federal Reserve. Home sales also fell in the closing months of the year, and prices gave some sign of leveling off. In contrast, though, to the 1973 housing downturn, builders are not saddled with outsized inven tories of unsold units and rental vacancy rates generally are very low. Over the course of 1979, single family starts fell almost a third from the very high level of the preceding year. Starts of multi-family units -21- Private Housing Starts Annual rate, millions of units 2.5 2.0 1.5 1.0 0.5 1971 1973 1975 1977 1979 New Home Prices Monthly Carrying Costs and CPI and Personal Income Index, 197601 = 100 Index 197601 = 100 160 180 140 Monthly Single Family Home Carrying Costs, Price Index Mortgages on 140 New Homes 120 100 100 1976 1977 1978 1979 1976 1977 1978 1979 -22- declined only 10 percent. ~ ,increase in starts of multi-family units built for sale as condominiums or cooperatives was more than offset by a decline in unsubsidized rental units. • Building under the Section 8 rental-subsidy pro gram of the Department of Housing and Urban Development accounted for one quarter of all multi-family units, about the same proportion as in 1978. Business Spending Spending policies·of businesses were generally cautious last year as firms, anticipating some slowing of sales, attempted to avoid creating excess capacity or accumulating unwanted inventories. Real business fixed investment rose only 1-3/4 percent during 1979 compared with 10-1/2 percent in the previous year. As has been common in the advanced stages of economic expansions, spending increases were concentrated in structures, for which there is a long lag between the formulation of plans and the completion of new facilities; earlier in the expansion, capital spending had been dominated by shorter-lived producers' durable equipment such as trucks and fleet autos. Most of the advance in nonresidential structures during 1979 was for commer cial and industrial buildings. Investment in equipment was little changed over the year, with gains in machinery and aircraft offsetting declines in motor vehicles. Given the continuing need for new capital to improve productivity, and thereby to alleviate inflationary pressures and to support rising living standards, the level of business fixed investment last year left much to be desired. After allowance for replacement requirements, the net addition to the nation's capital stock was small. At the end of 1979, the ratio of the stock of business fixed capital to the size of the labor force differed little from the 1975 level; in contrast, the capital-labor ratio increased -23- Real Business Fixed Investment Billions of 1972 dollars 150 130 110 1975 1976 1977 1978 1979 Producers' Durable Equipment Percent change, Q4 to Q4 1972 Dollars 10 + 0 10 1975 1976 1977 1978 1979 Nonresidential Structures Percent change, Q4 to Q4 1972 Dollars 15 10 5 + 0 5 1975 1976 1977 1978 1979 -24- Change In Business Inventories Annual rate, billions of dollars 1972 Dollars, NIA Basis 30 20 10 + 0 10 1973 1975 1977 1979 Auto Inventories Domestic-type Models Millions of units 1.2 .8 .4 1973 1975 1977 1979 Business Inventories Relative to Sales Ratio 1972 Dollars, NIA Basis 3.6 3.4 3.2 1973 1975 1977 1979 -25- at an average annual rate of 2.7 percent over the decade of the 1960s, when productivity and real income per capita grew rapidly. Businesses generally attempted to maintain lean inventories last year. Total inventory investment in constant dollars did accelerate during the first half of the year, however, reflecting primarily an inventory im balance for large domestic automobiles. After mid-year, however, auto makers combined production cutbacks with price incentives to bring stocks back into line with sales. Outside of the automobile industry, businesses generally succeeded in controlling inventory positions throughout 1979. This goal be came especially important toward the end of the year when short-term interest rates rose substantially, increasing inventory carrying costs. By year-end, the real stock-sales ratio for manufacturing and trade was in the normal range, suggesting an absence of the kind of inventory imbalances that frequently have aggravated recessionary tendencies in the past. Government Sector Government outlays for goods and services were about unchanged during 1979 following a moderate rise during the previous year. Public senti ment for spending restraint continued to affect decision-making by all levels of government; federal fiscal policy was additionally influenced by the need to avoid any aggravation of inflationary forces in the economy. Real federal purchases grew about one percent during 1979, as higher defense spending more than offset slower outlay growth in the strategic petro leum reserve and farm price support programs. Total federal expenditures- including transfers-recorded a faster rate of growth in 1979 than in 1978, owing in part to a large mid-year cost of living increase for social security recipients and to higher interest payments on the public debt. However, -26- Federal Government Purchases of Goods and Services Percent change, 04 to 04 1972 Dollars 1975 1976 1977 1978 1979 State and Local Government Purchases of Goods and Services Percent change, 04 to 04 1972 Dollars 2 1975 1976 1977 1978 1979 -27- inflation-induced increases. i~ nominal incomes_and previously legislated in creases in social security taxes resulted in a sizable rise in federal tax collections, and, as a result, the federal budget deficit--on a national income accounts basis--declined considerably over the year. The high employ ment budget surplus, an indicator of the thrust of discretionary fiscal policy, increased, signaling greater restraint on aggregate demand. At the state and local level, real purchases of goods and services declined marginally during 1979 following a sizable increase a year earlier. Construction spending was particularly depressed following federal cutbacks in grants for local public works and public employment programs. Moreover, states and localities also attempted to limit spending by holding down employ ment growth; the increase in employment during 1979 was about the same as in the previous year but was considerably less than the average annual gains recorded earlier in the decade. Despite this slowdown in the pace of spending, the fiscal position of states and localities deteriorated in 1979 as revenue growth fell far short of the gains posted in the previous year. Tax cuts by many governmental units and lower car sales and gasoline consumption limited the growth of income and sales tax revenues. As a result, states and local ities showed their first operating deficit (budget position net of social insurance funds) in three years. International Trade and Payments Net exports of goods and services were the only major sector that turned in as strong a performance in 1979 as in 1978. On a GNP basis, real net exports increased about $8 billion last year. The U.S. merchandise trade deficit, although swollen by a $18 billion increase in the cost of imported oil, was $29 billion in 1979, $5 billion less than in 1978. -28- U.S. Current Account and Trade Balances Seasonally adjusted, billions of dollars 20 Current Account Balance + 0 Merchandise Trade Balance 20 International Accounts Basis 40 1973 1975 1977 1979 Nonagricultural Exports Seasonally adjusted annual rate, billions of 1972 dollars Seasonally adjusted annual rate, billions of dollars 160 160 120 120 100 80 80 60 60 1973 1975 1977 1979 -29- The volume of exports continued to expand rapidly during the past year. Agricultural exports jumped to record rates in the second half as drought in the Soviet Union and Eastern Europe boosted sales. More impor tantly, the volume of nonagricultural exports rose about 12 percent in 1979; U.S. producers benefited from an improved competitive position brought about by the depreciation of the dollar in 1977 and 1978 and from relatively robust economic growth abroad. In contrast, U.S. import demand was damped by the sluggish perfor mance of domestic income and industrial production. Imports other than oil rose only marginally in volume terms in 1979, although foreign auto pro ducers captured a record share of the U.S. market as consumer preferences shifted toward fuel-efficient cars. At the same time, the volume of oil im ports was virtually unchanged from the 1978 level, with reduced consumption offsetting the impact of a rebuilding of inventories. World oil prices, after remaining flat for two years, jumped sharply. The average cost per barrel of imported oil in December, 1979, was 87 percent above the level at the end of 1978. By the fourth quarter, U.S. oil imports were at an annual rate of $75 billion, compared with a $43 billion rate a year earlier. The current account, which was in deficit by about $14 billion in each of the two previous years, was roughly in balance in 1979. Net receipts from service transactions, continuing their rapid growth of recent years, off set the merchandise trade deficit. The net return on foreign direct investment was especially strong, reflecting continued economic expansion abroad, the favorable effects of the 1977-78 depreciation on the dollar value of foreign profits, and the surge in overseas earnings of U.S. oil companies. Total earnings on U.S. direct investments abroad were on the order of $37 billion; -30- Oil Imports Millions of barrels per day Annual rate, billions of dollars - Value 60 11 40 10 9 20 Volume 8 0 7 6 1973 1975 1977 1979 U.S. Direct Investment Receipts Seasonally adjusted annual rate, billions of dollars 40 32 24 16 1973 1975 1977 1979 -31- perhaps half of these earn~ng~ were reinvested abroad and therefore recorded also as an outflow of U.S. private capital. Earnings of foreign direct invest ments in the United States :also rose, but they are on a much smaller scale. -32- SECTION 3. PRICES, WAGES, AND PRODUCTIVITY In 1979 prices advanced at historically high rates, primarily as a result of pressures from energy and labor costs. The fixed-weighted price index for gross domestic business product, a broad measure of aggregate prices, rose about 10 percent during 1979, a pace more than 1-1/4 percentage points above the previous year's rate of increase. Other price measures increased even more: the fixed-weighted price index for personal consumption expendi tures rose 10-3/4 percent while the Consumer Price Index increased 13-1/4 percent, the differences between these two indicators reflecting mainly alter native conceptual treatments of homeownership costs. At the producer level, prices of finished consumer goods were up about 12-1/2 percent over the course of last year. Rapid increases in energy prices, particularly for petroleum pro ducts, dominated inflation developments during the year. Imported oil priced under long-term contracts rose steadily, from an official OPEC contract price of $12.91 per barrel in December 1978 to prices ranging from $24 to $30 per barrel one year later. Moreover, the stockpiling of petroleum by some coun tries and production cutbacks in Iran resulted in spot market prices that were considerably above official OPEC levels. At the same time, in the U.S. market the Producer Price Index for crude oil was up about 50 percent during 1979, reflecting both price increases for domestic uncontrolled oil and the initiation of the Administration's decontrol program on June 1. The large increases experienced in petroleum prices had signifi- cant direct and indirect effects. Retail gasoline prices rose more than 50 percent, and fuel oil prices advanced almost 60 percent despite some softening -33- Labor Costs and Prices Change from year earlier, annual rate, percent Gross Domestic Business Product 10 8 6 Energy 40 GDBP Fixed-weighted Price Index 30 20 10 10 GDBP Fixed-weighted Price Index 5 + 0 5 Unit Labor Costs 12 9 6 Fixed-weighted Price Index Ex. Food and Energy Ex. Food and Energy 3 1975 1976 1977 1978 1979 -34- in demand that was attributable both to conservation and to mild weather late in the year. In addition, rising energy costs led to faster price increases for a number of other consumer goods, including transportation services and residential rents. At the producer level, prices of goods such as industrial chemicals and plastics also reflected the steep runup in energy costs. In contrast to energy prices, food prices increased less sharply in 1979 than in 1978. Over the .four quarters, consumer food prices rose 10-1/4 percent, following an 11-3/4 percent intrease in 1978. Although beef remained in relatively short supply during 1979, the greater availability of other meats and poultry contributed to some deceleration of food prices during the summer. Inflationary pressures persisted in sectors outside energy and food. Prices of consumer goods excluding food and energy accelerated during 1979: the PCE fixed-weighted price sub-index for such items rose 7-3/4 percent in 1979 compared with 7 percent the previous year, and the corresponding CPI sub-index rose at an even faster rate. Prices of capital equipment and nonresidential structures rose at a faster pace in 1979 than in 1978. Price movements in commodity markets were quite volatile throughout the year and reflected con siderable speculative activity related in part to international political and military tensions. Wage increases in the nonfarm business sector moderated very slightly to 8 percent in 1979, compared with 8-1/2 percent the year before. Compensa tion per hour, which includes fringe benefits and employer contributions for social insurance as well as wages, rose almost 9 percent, just a shade less than in 1978. The Administration's voluntary pay standard probably restrained the advance in compensation somewhat in the face of accelerated price inflat' .)•1; -35- Unit Cost Indicators Nonfarm Business Sector Change from year earlier, annual rate, percent Compensation per Hour 10 8 Output per Hour 4 2 + 0 2 12 Unit Labor Costs 8 4 1975 1976 1977 1978 1979 -36- however, sectors in which cost-of-living protection is prevalent, such as manufacturing, generally experienced the largest gains even though demand for labor in those sectors was relatively weak. Labor productivity--that is, output per hour worked--declined 2-1/4 percent in the nonfarm business sector. As a result, despite the slowing of compensation, the rise of unit labor costs accelerated sharply, from 8 percent in 1978 to 11-1/2 percent in 1979. The poor performance of productivity re flected in part the continuation of the weak trend of recent years, associated with sluggish growth of the capital stock, changes in the composition of the labor force, and other long-range factors. In addition, however, there was a cyclical element in the drop in productivity; there is normally a tendency for output per hour to drop when economic expansion decelerates, as employers initially are loath to lay off trained workers for what might prove a short period of slack. Many workers saw their wage gains outstripped by price increases during 1979. The lack of progress in re£1 wages is not surprising, given the drop in productivity and the adverse terms-of-trade impact of the surge in foreign oil prices. Nonetheless, American workers have become accustomed to an upward trend in their purchasing power, and there are likely to be strong catch-up wage demands this year. The Administrations's 1980 wage standards take this fact into account, permitting somewhat bigger wage hikes for those workers who experienced relatively small gains in 1979. -37- SECTION 4. LABOR MARKETS The demand for labor remained quite strong in 1979, despite the sluggishness of output growth. Firms experiencing gains in sales added to their payrolls, while those encountering dips in the demand for their prod ucts evidently tended to retain their workers--with the negative consequences for productivity and unit labor costs noted in the preceding section.· Over the year as whole, the number of workers on the payrolls of nonfarm establish ments increased 2.1 million, less than in 1978, but nonetheless a sizable gain. The major area of greatest strength in hiring was the service sector, where employment rose fairly steadily throughout the year. Manufacturing pay rolls, in contrast, declined slightly in the second half of 1979. This weak ness was concentrated among durable goods producers, especially in the motor vehicles and steel industries. By the end of the year, about 130,000 auto workers were on indefinite layoff. The strength of labor demand in the service sector may help to explain the large increase in the number of women in the labor force last year. Many of the occupational groups in the service sector traditionally have had high proportions of female workers. Adult women have accounted for a large percentage of labor force growth in the past several years, and this pattern continued in 1979, when they accounted for two-thirds of the expan sion in both the labor force and total employment. The overall labor force participation rate grew less rapidly in 1979 so that the smaller increase in employment was still sufficient to hold the unemployment rate almost constant throughout the year, at about 5.8 per cent. This is a level that, given the composition of the work force and other -38- Nonfarm Payroll Employment Change from December to December, millions 4 2 + ---10 1975 1976 1977 1978 1979 Manufacturing Employment Change from December to December, millions + JlWL----~-.-1 0 1975 1976 1977 1978 1979 Unemployment Rate Percent 9 8 7 6 1975 1976 1977 1978 1979 -39- characteristics of the labp! ~arket, most analysts agree is today consistent with relatively tight labor supplies. Certainly, the proportion of the popu lation employed remained at: an all-time high during 1979, and many employers continued to report difficulty in finding well qualified workers. Some statistical indicators of labor market tautness did, however, begin to move in the direction of greater ease as the year progressed; for example,_ the share of the labor force on· layoff, the unemployment rate for males 25 and over, and the blue collar jobless rate all increased a bit after the first quarter. In January of this year, when the unemployment rate rose from 5.9 to 6.2 percent, the increase largely reflected layoffs of adult male, blue collar workers. There were no significant changes over the past year in the structure of unemployment. The jobless rates for nonwhites, for teenagers, and for black teenagers have not improved relative to those for other major population groups. This January, the nonwhite unemployment rate was 11-3/4 percent, teenage unemployment was 16-1/4 percent, and black teenage unemployment was 34-1/2 percent. The unemployment rate among nonwhites has remained about twice the level for whites, and teenage unemployment continues to be about three times the rate for adults. -40- SECTION 5. DOMESTIC FINANCIAL MARKETS Interest Rates Market rates of interest rose substantially during 1979, surpassing the previous highs recorded in 1974. As in that earlier year, sharply accel erated inflation created strong demands for money and credit, and correspond ingly intense upward pressures on interest rates. These pressures were most evident in the second half of the year, when the Federal Reserve had to adopt an increasingly restrictive posture in order to keep the monetary aggregates within the ranges set earlier and reported to the Congress. On October 6, the System took certain actions aimed at providing greater assurance that its monetary objectives would be achieved. A fundamental change was made in the System's operating procedures, shifting the day-to-day focus of open market operations from the federal funds rate to the growth of member bank reserves. 1 At the same time, the discount rate was raised one percentage point, to 12 percent, and an 8 percent marginal reserve requirement was applied to certain managed liabilities of commercial banks. 2 Over the course of 1979, interest rates on short-dated money market instruments such as Treasury bills, large CDs, and commercial paper generally rose 2-1/2 to 3 percentage points. In long-term debt markets, taxable bond 1/ Appendix B to this report describes the new operating procedures. 2/ The marginal reserve requirement applies to increases, above a base level, in the total managed liabilities of member banks, Edge corporations, and U.S. agencies and branches of foreign banks. These liabilities include large time deposits ($100,000 and over with maturities of less than a year), Eurodollar borrowings, repurchase agreements against U.S. government and agency securities, and federal funds borrowings from nonmember institutions. (Federal funds borrowings from member banks, Edges, and agencies and branches are exempt to avoid double counting for reserve requirements, and a deduction is permitted against RPs for U.S. government and agency securities held in trading accounts.) -41- lnterest Rates Short-term Percent 4-6 Month Prime Commercial Paper 12 10 8 3-Month Treasury Bill 6 4 1973 1975 1977 1979 Long-term Percent 12 Home Mortgage Rates 10 Aaa Utility Bond New Issues 8 6 1973 1975 1977 1979 -42- yields increased 1-1/2 to 2 percentage points, and interest rates on conven tional home mortgage loans increased about 2-1/2 percentage points. Short- term rates have fluctuated around their year-end levels during the past several weeks, but bond yields have risen to new highs, apparently at least partly in reflection of concerns about the consequences of a possible step-up in defense spending on the federal budget and inflation. Monetary Aggregates! The major monetary aggregates grew more slowly in 1979 than they had in 1978. As may be seen in the chart on page 43, the deceleration was particularly marked in the case of M-1. The Federal Open Market Committee (FOMC) last February established a range of 1-1/2 to 4-1/2 percent for growth of M-1 (currency and demand deposits) in the year ending with the fourth quarter of 1979; this compared with an increase of 7-1/4 percent in the preceding year. As the Board indicated to the Congress in its initial report under the Humphrey-Hawkins Act, it was estimated that growth in M-1 during 1979 might be reduced as much as three percentage points by the shifting of funds from existing demand deposi ts to newly authorized automatic transfer saving (ATS) accounts across the nation and negotiable-order-of-withdrawal (NOW) accounts in New York State. This meant that the observed growth rate of M-1 might understate by three percentage points its expansion in terms of actual economic impact. In its midyear report, the Board stated that the FOMC had reaffirmed the 1-1/2 to 4-1/2 percent range, with the understanding that this range would 1/ The discussion in this section is cast in terms of the former definitions of the monetary aggregates, since those were the basis for decisions during 1979. -43- Money Stock Growth Former Concepts M-1 Percent change, 04 to 04 12 9 6 3 1975 1976 1977 1978 1979 M-2 Percent change, 04 to 04 12 9 6 3 1975 1976 1977 1978 1979 M-3 Percent change, 04 to 04 12 9 6 3 1975 1976 1977 1978 1979 -44- be adjusted upward to the ~xt,ent that the impact of ATS/NOW account shifts fell short of the original three percentage point estimate. With inflows to ATS and NOW accounts falling off sharply, the FOMC employed an adjusted M-1 range of 3 to 6 percent during the remainder of the year, based on an expected ATS/NOW effect of around 1-1/2 percent. In the event, M-1 increased 5.5 percent during 1979, and the esti mated depressing effect of·ATS/NOW accounts amounted to about 1-1/4 percentage points. The aggregate was approaching the upper bound of its range in the late summer, but its growth moderated in the closing months of the year (see chart on page 45). This slower growth has continued into 1980. M-2, which includes, in addition to M-1, bank time and savings deposits other than large negotiable CDs, increased 8.3 percent between the fourth quarters of 1978 and 1979. This is slightly above the FOMC's range of 5 to 8 percent, established last February and reaffirmed in July. Expansion of the interest-bearing component was strong, as small denomination time deposits grew at a very brisk pace, offsetting a contraction in passbook savings accounts. Six-month money market certificates (MMCs) accounted for all of the growth in small time and savings accounts; inflows were especially strong after March, when the federal regulatory agencies eliminated (for periods when the 6-month Treasury bill rate exceeds 9 percent) the one-quarter percentage point interest differential that had previously given thrift insti tutions a competitive advantage in the MMC market. The agencies in March also prohibited the compounding of MMC interest. These actions were taken partly to reduce cost pressures on thrift institutions and partly to help moderate the flow of funds to depositary institutions so as restrain inflationary pressures. -45- Growth of Money and Credit in 1979 M-1 Former Concept Billions of dollars - Actual --- Range Adopted by FOMC for 1978 04 to 1979 04 390 380 --- ------ --·3% --- ---------- 370 360 0 N D J F M A M J J A s 0 N D 1978 1979 M-2 Former Concept Billions of dollars -- Actual - - - Range Adopted by FOMC for 1978 04 to 1979 04 960 930 ------- ----- -· 5% ------ -- -- --- ... 900 870 0 N D J F M A M J J A s 0 N D 1978 1979 -46- Growth of Money and Credit in 1979 M-3 Former Concept Billions of dollars -- Actual - - - Range Adopted by FOMC for 1978 Q4 to 1979 Q4 1650 1600 ----... --6% ---- ---- ---- ...... ...... ---- ---- ...... ...... ... ...... 1550 __ --- ... - ....... 1500 0 N D J F M A M J J A s 0 N D 1978 1979 Commercial Bank Credit Billions of dollars -- Actual --- Range Adopted by FOMC for 1978 04 to 1979 Q4 1200 1150 1100 1050 0 N D J F M A M J J A s 0 N D 1978 1979 -47- M-3, which is M-2 plus deposits at thrift institutions, rose 8.1 percent in 1979, within the FOMC's .range of 6 to 9 percent. Deposits at savings and loan associations, mutual savings banks, and credit unions ex panded 7-3/4 percent, down from about 10-1/2 percent in 1978 but still well above rates recorded in previous periods of high market interest rates. The key to the sustained growth of thrift institution deposits--particularly for S&Ls and MSBs--was the MMC; however, there was also a sizable increase in large denomination time deposits outstanding at S&Ls. Credit Flows Because market interest rates rose further relative to the returns on fixed interest ceiling time and savings deposits at commercial banks and thrift institutions, a large volume of funds was placed instead in market debt instruments and in mutual funds or investment trusts during 1979. Money market mutual funds registered spectacular growth, their total assets increasing from $10 billion to $45 billion. (A record surge since year-end has boosted their total assets above the $55 billion mark.) However, the depositary institutions, confronted with heavy credit demands, were able to obtain the lendable funds they desired through the issuance of ceiling-free liabilities such as large CDs, RPs, federal funds, and Eurodollar borrowings and, in the case of savings and loan associations, through borrowings from Federal Home Loan Banks. Consequently, depositary institutions continued to account for a large proportion of credit provided to nonfinancial sectors of the economy, in contrast to the pattern observed at other times when market interest rates have been high. Commercial bank credit increased 12.2 per cent over the year ending in the fourth quarter of 1979--as compared with -48- Funds Raised by Domestic Nonfinancial Sectors Billions of dollars U. S. Government 350 State and Local Governments Households 250 150 Nonfinancial Business 50 1975 1976 1977 1978 1979 -49- the FOMC's projection of 7-1/2 to 10-1/2 percent--despite a leveling off in the fall. The total volume of funds raised by domestic nonfinancial sectors of the economy in 1979 was about the same as in 1978. Reduced borrowing by governmental units approximately offset an increase in takings by business firms. Aggregate credit expansion was greatest in the first three quarters of the year, as the tighten-ing of financial markets that accompanied the System's October actions contributed to a steep drop in borrowing by house holds and businesses in the fourth quarter. The credit needs of the U.S. Treasury declined markedly in 1979 owing to the reduction in the federal budget deficit. The operating budgets of state and local governments meanwhile moved in the opposite direction, from surplus to deficit, but their net borrowing, too, diminished. Although the tax-exempt market was used much more extensively as a source of funds for residential mortgage finance, restrictive IRS regulations brought a virtual cessation of the advance refunding activity that had swelled state and local government bond issuance in the previous year. The strong demand for housing, both as shelter and as an investment, and an evident desire to maintain past spending levels in the face of declin ing real disposable income kept borrowing by the household sector at an historically high level during 1979. Over the first three quarters, debt expansion exceeded income growth, and loan repayments as a percent of dispos sable income moved to a new high. By the latter part of 1979, signs had begun to emerge--in data on loan delinquencies and bankruptcies--that families were encountering some difficulty in meeting their financial obligations. -so- The heavy debt burdens may have combined with the higher level of interest rates to damp household credit use in the fourth quarter. In addition, however, credit availablity became a significant factor as institutions tight ened credit standards or curtailed lending in response to greater uncertainty about financial prospects and reduced earnings margins. Credit supplies were most severely constrained in those parts of the country with low usury ceilings; the year-end federal legislation providing a three month override of state usury ceilings may provide some relief for borrowers in such areas. Borrowing by nonfinancial business firms increased substantially in 1979, as the growth of outlays for inventories and fixed capital outstripped the advance in internal funds generated. This "financing gap" was particularly large during the first three quarters of the year; in the fourth quarter the gap narrowed somewhat with the slowing of inventory accumulation. Increases in business loans at banks and in net issuance of com mercial paper accounted for most of the growth in borrowing by nonfinancial enterprises. Mortgage loans rose somewhat, reflecting the strength of com mercial construction, but corporate bond issuance remained around the moderate 1978 level as companies were reluctant to incur long-term debts at historically high interest rates. The relatively heavy reliance on shorter-term borrowings was reflected in a further deterioration of traditional measures of balance sheet strength. Flow-of-funds account estimates for nonfinancial corporations indicate that their aggregate ratio of short-term debt to total debt has reached a record high and that the ratio of liquid assets to current liabilities has reached a low level seen before only in 1974. Perhaps partly for this reason, the drop-off in business borrowing in the fourth quarter was concentrated in the short-term area. -51- SECTION 6. FOREIGN EXCHANGE MARKETS AND THE DOLLAR The dollar was quite strong on foreign exchange markets in the first five months of 1979, following the tightening of U.S. money market conditions and the announcement by the Treasury and the Federal Reserve of a dollar support program on November 1, 1978. The dollar rose more than 5 percent on a trade-weighted average basis, gaining 5-1/2 percent against the mark, 7-1/2 percent against the Swiss franc, and 14-1/2 percent against the yen between the end of December and the end of May. During this period, U.S. and foreign monetary authorities entered the markets to moderate ex change rate movements, reversing in the process a large portion of their 1978 intervention purchases of dollars. By the end of May the Federal Reserve had repaid all its outstanding swap debts to other central banks, the Treasury had reconstituted all of the balances it had raised through the issuance of foreign-currency denominated notes, and the Federal Reserve and the Treasury both completed repayment of their pre-1971 Swiss franc indebtedness. In early summer, however, the dollar weakened, apparently mainly in response to the failure of U.S. inflation to moderate and to the absence of a concerted U.S. program to solve its energy problem. The dollar's weakness intensified in early June and continued into September, despite a series of increases in the Federal Reserve's discount rate, a gradual rise in the federal funds rate, and renewed heavy exchange market intervention in support of the dollar. By early October the dollar had retraced all of its rebound of earlier in the year, and selling pressures were mounting rapidly amidst accelerating price rises in gold and other commodities and other signs of a -52- Weighted Average Exchange Value of U. S. Dollar* March 1973=100 105 100 95 90 85 1977 1978 1979 1980 3-Month Interest Rates Percent 16 12 8 Weighted Average of Foreign Interbank Rates* 4 1977 1978 1979 1980 * Weighted average against or of G-10 countries plus Switzerland using total 1972-76 average trade of these countries. -53- worsening in expectations of inflation. In these circumstances, the Federal Reserve's announcement on October 6 .of a series of anti-inflation measures- described in the preceding section--was accompanied by a sharp advance of the dollar on exchange markets. By mid-November, the dollar had risen about 4 percent on a weighted-average basis from its early October lows. Foreign monetary authorities subsequently tightened their policies to deal with similar inflationary pressures abroad, and the dollar lost strength. From mid-November through the end of the year the dollar drifted lower in thin markets unsettled by developments associated with the taking of American hostages in Iran. At year-end, the dollar stood close to its early October lows on a weighted-average basis. The dollar has been relatively stable in recent weeks, with trading rather light in an environment of heightened international political uncertainties. APPENDIX A DESCRIPTION OF lHE NEWLY DEFINED MONETARY AGGREGATES A-1 THE REDEFINED MONETARY AGGREGATES I. Background The Federal Reserve has redefined the monetary aggregates. This action was prompted by the many fina~c!al developments that have altered the meaning and reduced the significance of the old me~ures. Some of these developments have been associated with the emergence in recent years of new monetary assets--for example, NOW accounts and money market mutual fund shares--while others have altered the basic character of standard monetary assets--for example, the growing similarity of and the growing substitution be- 1/ tween the deposits of thrift institutions and those of commercial banks.- In the process of redefinition a set of Board staff proposals was published in January 1979.J:./ Comments on these proposals received from the public and from invited experts, together with deliberations within the Federal Reserve System and further research by Federal Reserve staff, contributed to the Board's selection of the newly defined measures. Given the changes that have occurr~d in financial practices in recent years, the new measures should aid both the Federal Reserve and the public in interpreting monetary developments. However, many of the changes in the payments mechanism and in the character of financial assets that have rendered such a redefinition necessary--some of which are ongoing- have also added significantly to the complexity of the monetary system. As 'J:./ A discussion of many of these developments can be found in, "A Proposal for Redefining the Monetary Aggregates," Federal Reserve Bulletin (January 1979), pp. 14-17. J:./ See "A Proposal," pp. 13-42. The potential need for redefinition, in light of numerous financial -innovations, was recognized by the Advisory Com mittee on Monetary Stati~t:lc_s. S~e _ Improving the Monetary Aggregates: Report of the Advisory CoIImlittee on Monetary Statistics (Board of _Governors of the Federal Reserve System, June 1976)°, pp. 5-6, 9-12. A-2- a consequence, it is recognized that no one set of monetary aggregates can satisfy every purpose or every user. For this reaso~, the principal com ponents of the new measures--along wit? several related series--will be published regular 1, with the new aggregates. In this way, users will be able to analyze separately the components and to construct alternative measures. The following section, Section II, presents the new aggregates and compares them to the old measures. This is followed in Section III by a discussion of the rationale underlying the redefinition. The histori- cal behavior of the new aggregates is examined in Section IV. A final section, Sectio V,discusses some technical issues associated with the redefined mea sures: consolidation and seasonal adjustment procedures used in constructing the redefined aggregates and new data sources used in the redefinition. Three appendix tables contain annual and quarterly rates of growth of the new measures and their old counterparts. II. The New Monetary Aggregates Four newly defined monetary aggregates replace the old M-1 through M-5 measures. In addition, a broad measure of liquid ~ssets has been adopted. The new aggregates are presented in Table 1. Two narrow transactions measures--M-lA and M-lB--have been adopted. M-lA is basically the same as the old M-1 aggregate, except that it excludes demand deposits held by foreign commercial banks and official institutions.11 The other n~~row \. measure--M-lB--adds to M-lA interest-earning checkable deposits at a1i· depositary institutions--namely negotiable order of withdrawal (NOW) ];/ The removal of demand deposits due to foreign commercial banks and official institutions follows a recommendation of the Advisory Committee on Monetary Statistics. See Improving the Monetary Aggregates: Report, pp. 15-19. A-3 Table 1 New Measures of Money and Liquid Assets Amount in billions of dollars (not seasonally adjusted) Aggregate Component November 1979 M-lA 372.2 Currency l/ 106.6 Demand deposits- 265.6 M-lB 387.9 M-lA 372.2 Other checkable deposits~/ 15.7 M-2 1510.0 M-lB 387.9 Overnight RPs issued by commercial banks 20.3 Overnight Eurodollar deposits held by U.S. nonbank residents at Caribbean branches of U.S. banks 3.2 Money market mutual fund shares 40.4 Savings deposits at all depositary institutions 31 420.0 Small time deposits at all depositary institutions 640.8 M-2 consolidation component~/ -2.7 M-3 1759.1 M-2 1510.0 La rge ti•m e d epos•i ts at a 11 d epos•i tary i•n sti• tuti•o ns 5 -/ 219.5 Term RPs issued by commercial banks 21.5 Term RPs issued by savings and loan associations 8.2 L 2123.8 M-3 1759.i Other Eurodollars of U.S. residents other than banks 34.5 Bankers acceptances 27.6 Commercial paper 97.1 Savings bonds 80.0 Liquid Treasury obligations 125.4 Note: Components of M-2, M-3 and L measures generally exclude amounts held by domestic depositary institutions, foreign commercial banks and official institutions, the U.S. Government (including the Federal Reserve), and money market mutual funds. Exceptions are bankers acceptances and commercial paper for which data sources permit the removal only of amounts held by money market mutual funds and, in the case of bankers acceptances, amounts held by accepting banks, the Federal Reserve, and the Federal Home Loan Bank System. · 1/ Net of demand deposits due to foreign commercial banks and official institutions. fl Includes NOW, ATS and credit union share -draft balances and demand deposits at thrift institutions. 3/ Time deposits issued in denominations of less than $100,000. ~/ In order to avoid double counting of some deposits in M-2, those demand deposits owned by thrift institutions (a component of M-lB) which are estimated to be used for servicing their savings and small time deposit liabilities in M-2 are removed. i/ Time deposits issued in denominations of $100,000 or more. accounts, aµi:;omatic transfer from savings (ATS) a.ccounts, and credit ' ' union share draft balances--as well as a small amount of demand deposits at thrift institutions that cannot, using present data sources, be separated • ' ' 1/ from interel3t-earning checkable deposits.- The new M--2 measure-adds to M-lB overnight repurchase ~greements ·(RPs) issued by commercial banks and certain overnight Eurodollars held by_U.S. nonbank residents,!/ money market mutual fund shares, and savings and small-denomination time deposits at all ' J/ depositary institutions. Also, in order to avoid double counting of some deposits in this aggregate, the construction of the new M-2 involves sub tracting a consolidation component-an estimate of those demand deposits thrift institutions use in servicing their savings and time deposit liabili- .¥ ties included in this aggregate . Redefined M-3 is equal to new M-2 plus large-denomination time deposits at all depositary institutions (including negotiable CDs) plus term RPs issued by commercial banks and savings and loan 1/ M-lB is the same as the M-1 measure that was proposed by the Board staff in January 1979. See "A Proposal," pp. 17-20. Y Overnight Eurodollars in M-2 are those issued by Caribbean branches of mem ber banks. Other overnight Eurodollars and longer-term Eurodollars of U.S. residents are included in the broad measure of liquid assets, L. Data on overnight Eurodollars included in M-2 are available on a timely basis, but data on other Eurodollars--at both U.S. and non-U.S. banks abroad--are available only with a lengthy lag and do not permit a separation of over night from term Eurodollars. As improved data sources become available, adjustments may be made to the new measures. For example, the possible inclusion of Eurodollars held bi nonr,esidents other than banks and official i~stitutions could be reviewed. Moreover, with Euro~olla~ data on a more timely basis, consideration CQuld be given to including -Eurodollars of longer than overnight matuxities in a .broader monetary aggregate, rather than only in L. 1/ Small-denomination time deposits are those issued in denominations of less than $100,000. Depositary institutions are commercial banks (including U.S. agencies and branches of foreign banks, Edge Act Corporations, and foreign investment companies), mutual savings banks, savings and loan associations, and credit unions. ii At present, because of the small amount of checkable deposits at thrifts, this M-2 consolidation adjustment removes all demand deposit holdings of mutual savings banks and savings and loan associations. See Section IV for a further discussion of consolidation procedures. associations.!/ Finally, the very broad measure of liquid assets-L--equals new M-3 plus other liguid assets consisting of other Eurodollar holdings of 2/ . U.S. nonbank residents,- bankers acceptances, commercial paper, savings bonds, and marketable liquid Treasury obligations.l/ The relationship between the redefined and the old monetary aggregates is shown in Table 2. As already noted, the new M-lA measure is very similar to the old M-1 and differs in excluding demand deposits owned by foreign conmercial b anks and o ff i•c•i a 1"in sti•t uti•o •n s.- 4/ M- lB t h us di" ff ers f rom t h e o ld M- 1 b y exc 1u d"i ng these deposits, on the one hand, and, on the other, by including other checkable deposits at both commercial banks and thrift institutions. New M-2 is closer in concept to old M-3, which included savings and time deposits liabilities at all deposit/ry institutions (other than negotiable CDs at large commercial banks), thari it is to old M-2, which excluded the public's holdings of savings and time deposits at thrift institutions. The major differences between the new M-2 and old M-3 measures are that new M-2 includes money market mutual fund shares and overnight RPs and Eurodollars--none of which appeared in any of the old monetary aggregates--and that it excludes all large-denomination time deposits. The only large-denomination time deposits removed from the old M-3 (and the old M-2) measure were negotiable CDs at large commercial banks--amounting to $95.9 billion in November 1979--while, as the table shows, it contained $151.2 billion of other large-denomination time deposits at both commercial banks and thrift institutions. By including all large-denomination time deposits at all de~ositary institutions, the new M-3 is closer in concept to the old !/ Large-denomination time deposits are those issued in denominations of $100,000 or more. 2/ See footnote 2, page 4. 3/ In general, the components of M-2, M-3, and L exclude amounts held by depositary institutions, money market mutual funds, the Federal govern ment (including the Federal Reserve), and foreign commercial banks and official institutions. Marketable liquid Treasury obligations are those with remaining maturities of 18 months or less. 4/ The new M-lA also includes a very small amount of M-1-type balances at certain U.S. banking offices of foreign banks outside New York City, which are not in the old M-1. Table 2 Relationship Between New ~nd·Old Monetary Aggregates Amount in billions of dollars (not seasonally adjusted) Aggregate and Component November 1979 Old M-1 382.6 Less demand deposits of foreign commercial banlts and official institutions 10.4 1/ Equals: New M-lA--:. 372.2 Plus other checkable deposits 15.7 Equals: New M-lB 387.9 Old M-2 945.3 Plus savings and time deposits at thrift institutions 664.2 Equals: Old M-3 1609.5 Plus overnight RPs and Eurodollars 23.4 Plus money market mutual fund shares 40.4 Plus demand deposits at mutual savings banks~/ 1.0 Less large time deposits at all depositary institutions in current M-3 151.2 Less demand deposits of foreign commercial banks and official institutions 10.4 31 Less consolidation component=. 2.7 Equals: New M-2 1510.0 Plus large time deposits at all depositary institutions 219.5 Plus term RPs at commercial banks and savings and loan institutions 29.8 Equals: New M-3 1759.1 Memo: Old M-2 945.3 Plus negotiable CDs at large commercial banks 95.9 Equals: Old M-4 1041.2 Old M-3 1609.5 Plus negotiable CDs at large commercial banks 95.9 Equals: Old M-5 1705.4 Also includes a very small amount of M-1-type balances at certain U.S. banking offices of foreign banks outside New York City which were not in the old M-1 measure. Demand deposits at mutual savings banks were not included in any of the old monetary aggregates. Consists of an estimate of demand deposits included ,in M-l:1;3 . t_ha~ are held_ py tht:ift institutions for use in servicing their savings and small time deposits liabilities included in. the new M-2. ' ) A--7 M-5 measure than to the old M-4 (both shown as memo items on Table 2). Of course, the new M-3 aggregate is more inclusive than the old M-5, since it contains RPs, certain overnight Eurodoll~-r depo~its, and llloney market·_ nmtual fund Elh&-res. Some of the new aggregates and· their components will continue to be -• published on a weekly basis while others will be available only monthly. The publication schedule calls for publication of weekly and monthly data on the new 1/ M-lA and M-lB measures.- Data on redefined M-z' and M-3_will be available only • . - • ZJ, on a monthly basis, on a schedule similar to that of old M-3.- In addition, ·~data--on-the-domestic coumerc-ial bank, componen.ts of the' new measures,, together with currency, money market mutual fund shares, and overnight Eux::odottars, will be published on a weekly basis, while the other components will be available only on a:monthly basis. III. Underlying Rationale· The organizing principle undedying tile-redefined monetary aggre gates. is that of combining similar kinds o-f monetary assets at eac'h level of aggregation. This principle has the largest impact on the new. M-lB, M-2, and M-3 measures. Thus M-lB combines checkable deposits at thrift instututions--NOW deposits, credit union share draft balances, and demand deposits at mutual savings banks--with demand, NOW, and ATS balances at 1/ The Federal Reserve intends to publish M-lA and M-lB on Fridays (except occasionally when holiday periods are involved), for the statement week ending nine days earlier. ~/ Monthly data on the new M-2 .and M-3 measures normally will be published about 10 to 15 days following the end of the month. Because of lengthier delays associated with some -of the other components of L, this aggregate will be published about 6· ·to 8 _wee\(s ~ollowing the end of each month. A-8 •. 1/ commercial banks.- Ordinary savings and small-denomination time deposits at commercial banks and thrift institut_ions are included in the new M-2. Moreover, money market mutual fund shares, ·whose liquidity characteristics are most like those of savings accounts, are also included in this measure, as are overnight RPs and Eurodollars. M-3 includes large-denomination time deposits at both commercial banks and thrift institutions, as well as term .J:./ RPs Two M-1 measures were adopted primarily because of uncertainties that would arise during a transition period should legislation be enacted that permits NOW accounts to be offered nationwide. NOW accounts have prop erties of both a transactions-type account and a savings-type account, and thus newly opened NOW accounts would tend to attract funds both from house- 3/ hold demand deposits and from savings accounts and other liquid assets.- Evidence based on the NOW account experience in New England and New York ' . State clearly indicates that during the transition period, when the bulk of NOW accounts was opened, growth in total NOW balances was buoyed by shifts from savings balances and other liquid assets. This suggests that during a ±/ The Federal Reserve intends to include the volume of travelers checks of non bank issuers at the M-1 level at some future time, once all major issuers begin submitting such data regularly to the Federal Reserve and once these data have been thoroughly reviewed. Travelers checks likely will be added to the new aggregates in conjunction with a benchmark or annual revision. '];_/ Available evidence indicates that savings and loan associations are the only thrift institutions with a significant amount of RP liabilities out standing. Moreover, nearly all of the savings and loan RPs are believed to be of the term variety. 1,./ Turnover data on NOW accounts corroborate this poin~. The turnover rate of NOW accounts at both commercial banks and thrift institutions is approximately 10 per year; for comparison, the turnover rate for ordinary savings accounts is about 3 per year and that of consumer demand deposit accounts is estimated to be about 35 per year. conversion period associated with nationwide NOW accounts, irowth in M-1B could significantly overstate underlying growth iµ. the publi.c 's • transactions balances.l/ M-lA, by contrast, would.tend to.understate such .growth, as households converted demand deposit ~alances into NOW accounts. In practice, since the extent of shifting from demand deposits or other accounts to NOW accounts· is uncertain, the·availability of both M-1 measures is expected to help in the interpretation of narrow money stock growth during the transi tion period, should Npw accounts be offered nationwide~ Some other financial assets have been recommended for inclusion at the M-1 level, but for several reasons were not added in the new M-lA or M-lB measures. The most common recommendations have involved shares in money market mutual funds, RPs, and certain Eurodollars owned by U.S. resi dents. Each of these assets has transactions-related characteristics. Many money market mutual funds offer their customers check-writing privileges- subject to a minimum amount per check which has typically been $500--while balances placed in overnight RPs and in certain overnight Eurodollars are available for spending the next business day.]:_/ 1/ The problem of seasonal adjustment would also be magnified by nation- wide NOW accounts; the currency and demand deposit components of M-lA can be seasonally adjusted using historical data but historical data on NOW accounts and these other checkable balances appearing in M-lB are not yet sufficient for reliable seasonal adjustment. Conversions from demand deposit accounts to NOW accounts could also influence the seasonal be havior of the demand deposit component" bf-M-lA; ·should the funds shifted from demand accounts and those remaining have different characteris- tics. 2/ Only Eurodollars settled in same-day or immediately available funds meet this condition. By contrast, an overnight Eurodollar deposit arranged in clearing house funds is not available for spending for two business days. Because of time zone considerations. and other conveniences, it is believed that the bulk of overnight Eurodollars arranged in immediately available funds is at Caribbean branches. A-10 However, these instruments also have attractive characteristics as liquid investments and their behavior in many portfolios appears to be influericed by such considerations: Evidence on turnover rates indicates that balances in money market funds turn over much like balances in ordinary savings accounts--about three times per year--and thus on the average are not being actively used for transactions purposes.!/ Professional opinion currently is divided over whether RPs are mainly liquid investments or transaction-type balances. Some observers hold that RPs are very similar to demand deposits and that the unexpected weakness that has emerged in the public's demand for M-1-type measures at times since the mid-1970s can be traced largely to the behavior of RPs. Others stress that in practice RPs are qualitatively different from demand deposits--that they are more like other short-term investments--and that recent weakness in the public's demand for the narrow money stock was not mirrored in any single liquid asset, 2/ including RPs.- Furthermore, empirical research by the staff indicates that the addition of money market mutual fund shares to M-lB has not on balance enhanced the performance of this aggregate since mid-1974. For those studies emphasizing the transactions properties of RPs, see Peter A. Tinsley, Bonnie Garrett, and Monica Friar, "The Measurement of Money Demand," (Board of Governors of the Federal Reserve System, Division of Research and Statistics, Special Studies Section, November 1978; pro cessed); Gillian Garcia and Simon Pak, "Some Clues in the Case of the Miss- ing Money," American Economic Review, 69 (May 1979), pp. 330-34; and John Wenninger and Charles Sivesind, "Changing the M-1 Definition: An Empirical Investigation" (Federal Reserve Bank of New York, April 1979; processed). An alternative interpretation can be found in Richard D. Porter, Thomas D. Simpson, and Eileen Mauskopf, "Financial Innovation and the Monetary Aggregates Brookings Papers on Economic Activity 1: 1979, pp. 213-29; Richard D. Porter and Eileen Mauskopf, "Cash Y.a.anageir.ent and the Recent Shift in the Demand for Demand Deposits" (Board of Governors of .the ·Federai Reserve System, Division of Research and Statistics, Econometric and Computer Applications Section, - November 1978; processed); and Thomas D. Simpson, "The Market for Federal Funds and Repurchase Agreements," Staff Studies 106 (Board of Governors of the Federal Reserve System, July 1979), pp. 43-58. A summary and evaluation of some research on this subject can be found in J-ohn H-. Kalchbrenner, "Re- · cent Innovations in Financial Markets and Their Relationship to Money Demand," paper presented at the XI Meeting of Technicians of Central Banks of the American Continent, Port-of-Spain, Trinidad, November 19-24, 1978 (Board of Governors of the Federal Reserve System, November 1978; processed). A.;,.11 Nevertheless, in recognition of the increasingly prominent role played br these assets and their potential trartact.ions-related features, data on overnight RPs and Eurodollars and money market mutual fund shares. will be conveniently shown in conjunction iith figures for M-lA and·M-IB on the first page of the weekly money stock release containing the money stock measures. Also, these items will be included in the new M-2 measure, as noted above. In addition to money market mutual funds and overnight RPs and Euro dollars, savings and spiall-denomination time deposits are included at the M-2 level. Savings deposits and small-denomination time deposits have different 11 liquidity charact·eristics . Nevertheless, recent innovations-most importantly the six-month money market certificate and more recently the two-and-one-half year variable-ceiling certific~te--have substantially added to the availability of attractive alternatives to holding savings balances, and hne led to shifts from savings to these new time deposits at all depositary institµtions. In addition, the six-month money market certificate has tended to ~everse a trend toward longer maturities of small-denomination time deposits and thus to increase the overall liquidity of such deposits. The share of small-denomination time deposits at connnercial banks has been affected by regulatory changes applying to the ceiling rates that commercial banks have been able to offer on certain time accounts relative to !/ Customers can normally withdraw funds from ordinary savings accounts when they wish, often by telephone, although depositary institutions have the right to require a 30-day notification prior to withdrawal. Time deposits, by contrast, are subject to a substantial penalty for withdrawal prior to maturity. i-i2 ceilings applicable to thrift institutions.l/ As a consequence, the historical relationship-between the public's demand for small-denomination time deposits at commercial banks and at thrift institutions has been altered in ways that . - cannot be fully determined at this time. Because small-denomination time deposits at both commercial ba~ks and thrift institutions are combined in the M-2 aggregate, along with the savings deposit liabilities of both, shifts of these kinds affect only the composition of M-2 and not its size or rate of growth. ·similarly, the growing availability of money market mutual fund shares has tended to reduce the public's demand for savings and small-denomination time deposits at conmercial banks and thrift institutions, but such shifts are captured within the new M-2 aggregate, inasmuch as it includes money market mutual fund shares.~/ Furthermore, growth in new M-2 likely would not be affected much by conversions to NOW accounts, should they become available nationwide, because funds absorbed by these accounts would be drawn mainly from other kinds of accounts included in this aggregate . ., !/ Thrift institution shares of small-denomination time deposits were augmented following the introduction of the six-month certificate by a regulatory ceiling that permitted them to offer the auction rate on six-month Treasury bills; by comparison, the ceiling rate on these deposits at conmercial banks was 25 basis points below the auction rate. However, in March 1979 the differential on money market certificate ceiling rates was removed--for aution rates on six-month bills in excess of 9 percent--and the commercial bank share of these deposits subsequently tended to expand. ~/ Empirical analyses by the staff indicate that the behavior of new M-2 in recent years has generally not departed far from what would be expected on the basis of longer-term historical relationships, in contract to old M-2 and some other measures of money. See David J. Bennett, Flint Brayton, Eileen Mauskopf, Edward K. Offenbacher, and Richard D. Porter, "Econometric Properties of the Redefined Monetary Aggregates" (Board of Governors of the Federal Reserve System, Division of Research and Statistics, Econometric and Computer Applications Section, February 1980; processed). A-13 By including large-denomination time deposits, the new M-3 is most comparable.to _the old M-5 measure. The new M-3 aggregate aiso 'includes , . . • term RPs which have some similarities to large time deposits. •· :The new M-_3 definition is based on the view _tlJ.at large-denomination tit!le deposits and term RPs substitute for each other in many portfoli.o. s and that these items, especially negotiable CDs, are relatively liquid. The liquid assets, or L, measure adds to M-3 other liquid assets held by the public. S~me of. these are liabilities of depositary institutions- term Eurodollars held by U.S. nonbank residents and bankers acceptances-- while others are obligations of the U.S. Treasury--savings bonds and liquid marketable debt"J=I The commercial·paper component consists of obligations of a variety of issuers, bot;_h financi_al institutions and nonfinancial corporations. Some observers note such a broad measure of liquid assets is especially meaningful because many financial innovations in recent years have altered the public's demands for narrower measures. They argue that these kinds of shifts are absorbed in a very broad aggregate, such as L because reductions 1 in demands for narrower measures-of money are mirrored in increases in the demands for other components of the broadest measure, leaving demand for the total unaffected. Others who focus on the volume of credit view such an aggregate as better reflecting the amount of credit extended to the economy, both through the commercial banking system and through other channels. 1/ Eurodollar deposits of U.S. nonbank residents other than those overnight Eurodollars that are already tneorporated at the M-2 level might appro priately be included in the new M-3 ineasure, since they share many charac teristics with domestically issued, large-denomination time deposits. However, lags on obtaining data on such Eurodollars are much longer than for the other components of this aggregate, and staff work su~gests that estimations of this component based on information that might be available on an earlier schedule would be subject to large revisions. A-14 · IV. Historical Behavior of the New Aggregates An examination of the growth rates and velocities of the new measures affords a better understanding of their behavior and their relationship to • the old 'measures.-!/ Chart 1 shows growth rates of M-lA and M-lB in the upper panel, and old M-1 in the lo~er panel.-.?./ All three narrow measures have generally moved closely together. In recent years, though, M-lB has tended to inc+ease more rapidly than either M-lA or old M-1, because of growth of NOW and ATS accounts. During 1979, for example, with shifts in mone- tary asset holdings in response to the availability of new deposit services, M-lB expanded at a rate that was 2-1/2 percentage points faster than M-lA and old M-1; this difference reflected conversions to NOW accounts in New York State and to ATS accounts nationwide.-l/ Average rates of growth of these measures over two long time periods and several cycles are shown in Table 3. The growth rates for all three have been very similar, both on a trend and a cyclical basis, except in the most recent expansion when, because of adjustment by the public to new deposit services, average annual growth in M-lB exceeded growth in M-lA and old M-1 by slightly more than 3/4 percentage points. Should NOW account powers be extended to depositary institutions nationwide, a more sub stantial differential in rates of growth between M-lA and M-lB could persist for some time. 1/ For econometric evidence on che new aggregates, see Bennett and others, "Econometric Properties." '];./ Appendix Table 1 contains growth rates for these aggregates annually over the 1960 to 1979 period and quarterly for the years 1973 to 1979. ]_/ A portion of this differential in growth rates can be attributed to con versions from demand deposit accounts to ATS and NOW accounts, and the remainder represents shifts from ordinary sav~ngs accounts and other liquid assets. A-15 Chart 1 Rates _of Growth of New and Old M-1 Measures (Quarterly, seasonally adjusted at annual rates) ; Percent 12 ~ak· rough Peak Trough Peak Trough 12 9 9 \ I \ I 6 6 I I . I I I I I I j 3 '• 3 ' New MclA 0 0 12 12 Old M-1 9 9 6 6 3 3 0 ......- -+--+---w---------tl------.---+--~----~-+--------tli--t 0 __,-3 -3 _ .___ ______________ .__~_. ....._ _._~_. ......_ _._--1.._. ......_ ___ _._ __ 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 Note: Peaks and troughs as designated by the National Bureau of Econonµc Research. Table 3 Trend and Cyclical Behavior of Growth Rates of New and did.Measures of Money Average annual rates of growth in percent New New Old New Old Old New Old Old Period M-lA M-lB M-1 M-2 M-2 M-3 M~3 M-4 M-5 1960-1979 4.9 5.1 4.9 8.3 7.6 8.5 9.0 8,1 8.8 1960-1969 3,7 3.8 3.8 6.9 6.2 7.0 7.2 6.5 7.2 1970-1979 6.0 6.4 6.1 9,6 8.9 9.9 10.8 . 9 .6 10. 3 1/ Peak to trough- 1960:2-1961:1 1.9 1.9 1.9 6.5 5.6 7.1 7-.0 5.7 7.2 1969:4-1970:4 4.8 4.8 4.8 5.7 7.1 7.2 8.7 9.8 8.9 1973:4-1975:1 4.2 4.3 4.4 6.2 7.3 7.3 8.2 9. 7- 8.8 2/ Trough to peak- ~ I-' 0\ 1961:1-1969:4 4.2 4.2 4.2 7.2 6.7 7.3 7.5 7 .o. 7.5. 1970:4-1973:43/ 6.8 6.8 6.9 10.8 10.1 11,4 12. 9 11.8 12.5 1975:1-1979:4- 6.2 7.1 6,3 10.6 9,1 10.3 10.6 8,1 • 9. 7 1/ Averages of annualized quarter-to-quarter rates of growth. The base quarter for each calculation is the quarter following the peak (peak is first quarter shown). 'l:.I Averages of annualized quarter-to-quarter rates of growth. The base quarter for each calculation is· the quarter following the trough (trough is first quarter shown). '1/ Data for 1979:4 are most recent quarterly data available, and this quarter may not be a cyclical peak. The public's demands for these M-1 measures relative to .the gross national product vary inversely with their velocities, which are shown in the upper panel of Chart 2. Shown in the lower panel is the Treasury bill rate, representing the return on a money market alternative to holding M-1 balances. Since growth in all three of these aggregates has.been very similar, movements in their.velocities have b~en very close, although the velocity of M-lB has risen less rapidly in rec~nt years than the velocities of M-lA an4 old M-1, reflec ting shifts to NOW and ATS accounts of funds held in demand deposit accounts and in relatively inactive savings accounts. Average rates of increase-in these velocities • over longer intervals of time and over cycles are presented in the first three columns of Table 4. During economic expansions, the velocities of all three mea sures have tended to expand at annual rates in excess of 3 percentage points while in economic contractions levels of velocities of all three measures tend to decline or their growth at least slackens. Further, in more recent ·cycles the velocities of all three measures have eXpai;ided:at· suecessively moi:-e rapici--rates. Growth in the new M-2 measure is shown in Chart 3 (upper panel), 1/ along with growth in the old M-2 and M-3 aggregates (center panel).- The bottom panel displays the differential between the yield on Treasury bills and the ceiling rate on passbook savings accounts at commercial banks which can be viewed as an indicator of the attrac·tiveness of money market instru ~ts relative to the interest-earning deposit components of these aggregates. This chart illustrates that growth in new M-2 has tended to vary closely with that of old M-3 and, to a lesser extent, of old,M-2. In addition, growth in !/ Appendix"Table 2 contains ~ual ~ recent quarterly growth rates for these naas~ea. • ·A:...f8 Char.t 2 Velocities of New and Old M-1 Measures (Quarterly, seasonally adjµsted at annual rates) 7.0 7.0 Peak Trough Peak Trough Peak Tough ,~ 6.5 6.5 ·' New M-lB ✓j 'I • ,, ..f .6.0 6.0 _. '/ _ ';I/ " ~_, ,,• . 5.5 r' 5.5 I •✓ I • 5.0 5.0 4.5 4.5 4.0 4.0 3.5 3.5 0 Percent Treasury bill rate 13 13 10 10 7 7 4 4 0 0 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 Note: Peaks and troughs as designated by the National Bureau of Economic Research. Table 4 Jr~nc$ and Cyclical Behavior of Velocities of New and Old Measures of Money Averase annual rates of growth in percent New New Old New Old Old New Old Old Period M-li M-1B M-1 M-2 M-2 M-3 M-3 M-4 M-5 1960-1979 3.2 3.0 3.2 -0.1 0.5 -0.3 -0.8 0.1 -0.6 1960-1969 2.9 2.9 2.9 -0.2 0,4· -0.3 -0.6 0.1 -0.5 o.o 1970-1979 3.6 3.1 3.5 0.6 -0. 3 -1.1 0.0 -0. 7 1/ •raak to trough- l'960:2-1961d ... 1. 7 -1. 7 -1. 7 -6.3 -5.3 -6.8 -6.7 .. 5. 5 -6.9 1969:4-1970:4 -0.3 -0.3 -0.3 -1.2 -2.6 -2.5 -4.1 ~5. 2 -4. 3 , 197-3:4-1-975 :l 1..5 1.4 1.3 -o. 5 -1.5 -1.4 -2.4 -3.9 -3.0 2/ > Trough to eea~ ' ..I. . 1.0 196!:1-1969:4 3.l 3.1 3.1 0.1 0.6 o.o -0.2 o·. 3 -0. 2 ' 1970:4-1973:43/ i.6 3.5 3.5 -o.4 0.3 -1.0 -2.4 -1. 4 -2.0 1975:1-1979:4- 4.9 4.1 4.9 0.6 2.1 0.9 0.6 3.0 1.5 !I Averages of ttl.'"1,Uzed quarter-to-quarter rates of growth. The base quarter for each calculation is the quarter follovjq the peak (peak is first quarter shown). 1:,/ Averages of •-llaed quarter-to-quarter rates of growth. The base quarter for each calculation is the quarter follOlling the trough (trough is first quarter shown). 'J/ Data for 1979:4 are most ucent quarterly data available, and this quarter may not be a cyclic~l peak. A-20 Chart l Rates of Growth of New M-2 and Old M-2 and M-3 Measures {Quarterly, seasonally adjusted at annual rates) Pere~ Trough Peak Trough Peak Trough 20 Peak 20 16 16 12 12 8 8 4 4 C 0 Old M-2 and M-3 16 16 12 12 8 8 Old M-2 4 4 I 0 -4 Yield spread (Tr~asury ·b~ll rate -l_ess passb_ook~c eiling_r ~te) 9 9 6 6 3 3 0 0 -3 L......Ll-lL--L---JI--...L----l-:.L---&.-.1.-,...J.---JIL-..,.a.,...,...,J-,-,-,1-..,...1~-11,,--J~~--------'-3 1960 1962 1964 • 1966 1968 1970 1972. 1974 1976 1978 Note: Peaks and troughs as designa~ ted by the National Bureau of Economic Research. A-21 new M-2, along with growth of the two other measures shown, has ]?een se~sitive to the yield spread, tendin.g to slow as market rates have advanced above deposit ceiling rates. The interest sensitivity of new M-2, however, can be expected to moderate in the future, if- the proeortion of this aggregate:accounted for by components with yields that vary with money market conditions continues to expan~ .. As ·shown in Chart 4, the share of new M-2 in money market certi- • ficates has risen sharply _since these accounts were introduced in mid-1978 and the money market mutual fund and overnight R,P and Eurodollar shares have also increased in recent years. By contrast, the M-lA and ordinary savings account shares have generally declined. • Trend and cyclical growth rates of new M-2 and old M-2 and. M-3 are • shown in the middle three columns of Table 3. Over longer periods of time, especially during economic expansions, growth in new M-2 has been faster than old M-2. In comparison with old M-3, growth in new M-2 has been moderately slower, except during the most recent .economic expansion ~hen sharp increases in money . . market mutual fund shares and expansion in: overnight RP.a and Eurodollars con- • 1/ _t tibuted to somewhat mare rapid -growth·.in new M-2.- The .velocity of new M-2, along with velocities of old M-2 and M-3, is shown in Charts. New M-2 velocity has shown very little trend movement over the past two dP-cades, although it has displayed a tendency to vary directly with the spread between market rates of interest and regulatory ceilings. ·By contrast, the velocity of old M-2 tended to increase,·especially in recent years, while the velocity of old M-3 has shown a very st~ght-cendency to decline over the 1960s and 1970s.2/ y During economic contractions, newM-2 has tended to weaken relative to old M-2 and M-3, mainly because growth in old M-2 and M-3 was buoyed by their large-denomination time deposit components. Trend and cyclical rates of growth-of the velocities, of these three··mea sures are shown in the middle three columns of Table 4. A-22 Chart 4 Principal Components of New M-2 As a percent of total l/ (Quarterly, seasonally adjusted=') Percent Percent 100 100 90 90 M-lA 80 80 70 70 60 50 50 Savings deposits 40 40 30 30 Small time deposits (Excluding MMCs) 20 20 Money market certificates (MMCs) 10 10 Money market mutual fund share 0v rni ht 0 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 1/ Other checkable deposits, MMCs, money market mutual fund shares, and overnight RPs and Eurodollars are not seasonally adjusted. A-23 Chart 5 Velocities of New M-2 and Old M-2 and M-3 · Measures (Quarterly, seasonally adjusted at annual. rates):·, • 2.8 2.8 Peak Tough Peak Trough Peak Trough_. 2.6 2.6 2.4 2.2 2.2 2.0 2.0 1.8 1.8' 1.6 1.4 o~__......_. ... 0 _1---L-..a....---1---'------L-..,____..1--_.__,___._....__ __ _.__ __ __._ _____. Percent Yield spread (Treasury bill rate less passbook ceiling rate) 9 9 6 6 3 3 1960 1962 1964 1966 1968 1970 1972 1974 1976 1978 Note: Peaks and troughs as designated by the National Bureau of Econam:l:.c l.esearch. A-24 The·rate of growth of new M-3 is shown in Chart 6 (upper panel), along with rates_o f growth of the old M-4 and-M.-5-measu-res. . (center panel) .. • Also shown in -the upper,panel of Chart 6 is-.tbe rate .of growth of L, the . " 1/ broad measure of. liquid·assets.- Chart 6 illustrates that growth rates of new M-3 and old M-5, which are similar in content, have moved closely together, although expansion in new M-3 has generally exceeded that of both of its old counterpart•• The. disparity between growth in new M-3 and old M-4 and M-5 widened in the late-1970s with si-zable increases- in RPs, IDOlleY market mutual fund shares, and overnight Eurodollars; these items are components of • the-new M-3 aggregate but were not included in the old M-4 and M-5 aggregates. Growth in total liquid assets, L, has been similar to-althougn somewhat steadier than--that of new M-3. In recent years, there bas been a tendency for L to grow more rapidly than M-3 and other broad monetary aggregates, reflecting a growing proportion of liquid assets that is being issued outside domestic depositary institutions. The yelocity of new M-3 is shown in Chart 7, together with veloci ties of Land of old M-4 and M-5. While the velocity of the new M-3 has generally declined over the period shown, in recent years it has displayed M' -4 some tendency to level off. The responsiveness of new M-3--and the old and M-5 measures--to cha~ges in the intere_st rate spread was, dampened by · ;.. . . l ·- ' the removal of regulatory ceilings on some large-denomination time deposits in 1970 and on the remainder in 1973. : The velocity of L has ~lso declined ', • over the period shown. . . Annual and quarterly rates of growth of nhe new M-3 and L measures -and the , old M-4 and M-5 measures are presented ·in Appendix Table 3, along with rates of growth of the~r velocities. A-25 Chart 6 Rates of Growth of New M-3 and Land Old M-4 and M-5.Measures (Quarterly, sea~onally adjusted at annual rates) Percent New M-3 and L Peak. Trough Peak Trough Peak rough 16 16 12 12 8 8 4 .4 0 0 -4 -4 Old M-4 and M-5 16 16 Old M-5 12 12 8 8 4 4 0 0 -4 -4 -8 -8 Yield spread 9 (Treasury bill rate less passbook ceiling rate) 9 6 .6 3 3 ____ 0 __ ____ 0 _______________. .,._ ...., __.._...._ ______. ..._ ....___. -3 -3 1960 1962 • 1966 1968 1970 1972 1974 1976 1978 Note~ Peaks and troughs as designated by the National Bureau of Economic Research. A-26 Chart 7 Velocities of New M-3 and L and ·oid.M-4 and M-5 Measures (Quarterly, seasonally adjusted at annual rates) • Peak Trough Peak Trough 2.4 2.4 2.2 2.2 2.0 2.0 1.8 1.8 Yield spread (Treasury bill rate less passbook ceiling rate) 9 9 6 6 3 3 o r--r-~::;:::==;:::s:::=-------¥----r-~~r--t---lr~~----1 0 -3 -3 ---------........- ~_. ...._ _.~. .....- ..&.----111--;...a. .........._ ....._ _.lJ.-,..--ll,,-......- ----.,......1----'--..I 1960 1962 1964 1966 1968 1970 1972 1974 i976 1978 Note: reaks and troughs as designated by.the National Bureau of Economic Research. A-27 IV. Some Technical Issues · The new aggregates incorporate consolidation and seasonal adjustments. In addition·, several new data _s ources are being ·used. or will ..b _e used in their construction. A. Consolidation Consolidation adjustments have been made ·in th.e construction of each of the new measures, in orde~ to avoid double counting of the public's monetary assets.1/ A major consolidation adjustmen_t involves the netting of deposits held by depositary ins~itutions with _other depositary insLitutions. In construc ting M-lA, demand deposits held by connnercial banks with other commercial banks have been removed. The procedure also calls for the removal from M-lB of those demand deposit holdings of thrift institutions that are estimated to be used in servicing their checkable deposits, although at present the amount is negligible. Similarly, at the M-2 level all o.ther, demand d.epos-it holdit!&$ o.f thr.ift institu tions are deducted; currently that means all such demand deposits are netted from M-2.l/ Savings and time deposits held by depositary institutions are also appro priately netted at the M-2 and M-3 levels. The other major kind of consolidation adjustment involves removing the assets held by money market mutual funds from several components appear- • 3/ ing in the M-2, M-3, and L measures.- These institutions issue shares to the public and use the proceeds to acquire a variety of liquid assets that are 1/ A discussion of consolidation issues can be found in Advisory Conmittee on Monetary Statistics, Improving the Monetary Aggregates; pp. 12-14, 31-27, and in "A Proposal," pp~---32,, 40-41.· Y It has been assumed that all demand. deposits owned by thrift institutions are held to service their checkable deposits and their ordinary savings deposits. lbe portion of thrift instituti-0n holdings of demand deposits to be removed at the M-lB level is determined by the ratio of checkable deposits at thrift institutions to the smn of their checkable and savings deposit liabilities. 'J/ In general, the components against which a money market mutual fund adjustment is made exclude holdings hy depositary institutions, the U.S. Government (including the Federal Reserve), and foreign conmercial banks and official institutions. A-28 components of the new M-2, M-3 and L measures. In order to avoid_ first count ing these amounts as money market mutual fund share·s and then counting them again as money market furid holdings of RPs, CDs, commercial paper, and so forth, holdings of each of these assets by money market funds are subtracted from the relevant components. Thus money market fund holdings of RPs are deducted in the construction of the p~blic's overnight RPs that appear in M-2, holdings of domestic CDs are deducted from the large time deposit component of M-3, and holdings of each of the assets appearing in Lare appropriately netted. Each of the principal components of the new aggregates will be published on the money stock release on a consolidated--and not a gross--basis, as it appears in the new aggregates. Thus differences between the published M-lB and M-2 aggregates and the smn of their published components will equal the conso lidation components associated with thrift institution demand deposits. B. Seasonal Adjustment The procedure for constructing the new seasonally adjusted aggre gates has been to seasonally adjust each component--wherever possible--and then to sum each component in deriving the appropriate total. Some components, however, have not been seasonally adjusted because of insufficient historical data.!/ They will be seasonally adjusted once adequate data are available. The most important of the components that have not yet been seasonally adjusted (and the aggregate in which they first appear) are as follows: !I In some cases, even though data are available for a sufficiently long period to technically perform a seasonal adjustment, the series are dominated by strong trend and thus it is unlikely tha.t actual seasonal patterns can be measured accurately. A-29 1. Other checkable deposits (M-lB) 2. Overnight RPs and Eurodollars (M-2) 3. Money market mutual fund shares (M-2) 4. Term RPs at both connnercial banks and savings and loan associations (M-3) 5. Other Eurodollars held by U.S. residents (L). A standard option of the Census X-11 program was used in the seasonal adjustment of the separate components of the new aggregates, following an examination of several alternative options. However, it should be noted that the overall issue of seasonal adjustment of the monetary aggregates has been under review by a panel of outside experts, The Connnittee of Experts on Seasonal Adjustment Techniques, under the chairman ship of Geoffrey H. Moore, which is scheduled to report to the Board in a few months):/ C. New Data Sources Several new data sources are being used in connection with the redefined aggregates. Most of these new sources are associated with components that are either new or appear separately for the first time, and they have been obtained in order to improve the accuracy and the timeliness of the redefined measures. It is felt that with them the quality of monetary statistics for the new measures will be at least comparable to that of the old measures. 1/ Other members of this committee are George Box, Hyman Kaitz, James Stephenson, and Arnold Zellner. A-30 A number of new data series began around year-end 1979 and some others are scheduled to begin in early 1980.!/ The most important new data sources are shown in Table 5. Most of these are collected on a sample basis, and are then benchmarked to less frequent reports of condition in order to obtain timely estimates of the total volume of each item. A sample of nonmember banks is being used to estimate demand deposits, other checkable deposits, and small and large-denomination time deposits on a weekly basis. Similarly, a sample of mutual savings banks, which began to be surveyed in early 1980, is being used to construct the various components of deposits at these institutions. In 1979, the Federal Home Loan Bank Board started collecting sample data three times a month from savings and. loan associations on the various com- ponents of the new aggregates. A new sample of credit unions is scheduled for implementation in the spring of 1980 and should provide timely data on several components for these institutions. Data on money market mutual fund shares are being collected in a new weekly survey by the Investment Company Institute. In addition, in a monthly survey this institute collects data on the industry's holdings of various assets, for use in the consolidation process. Data on overnight Eurodollars at offices in the Caribbean are now being collected on a daily basis from all member banks with significant amounts of these deposits. Finally, a new daily report on selected federal funds and RP borrowings of 123 large member banks serves as the basis for the overnight and term RP series. 1/ Other data sources are discussed in "A Proposal," pp. 33-40. Table 5 New Data Sources Being Used or Scheduled to be Used in Cqnstructing the Redefined Monetary Aggregates Component (Aggregate first Coverage Frequency Lag appearing in) Demand deposits (M-lA) Nonmember banks !_I sample weekly (daily avg) 2-3 weeks Other checkable deposits (M-1B) Member banks (ATS & NOW) universe weekly (daily avg) 1 week Nonmember banks (ATS & NOW) sample weekly (daily avg) 2-3 weeks MSBs (NOW & demand deposits) sample weekly (Wednesday) 2-3 weeks S&Ls (NOW) Z/ sample thrice-monthly 1 week Credit unions (share drafts)- sample weekly (Wednesday) 2-3 weeks Savings and small-denomination time deposits (M-2) Nonmember banks sample weekly (daily avg) 2-3 weeks MSBs sample weekly ( Wednesday) 2-3 weeks S&Ls sample thrice-monthly 1 week ►• .I...,.) Credit unions~/ sample weekly (Wednesday) 2-3 weeks Overnight repurchase agreements (M-2) Member banks 125 large member banks weekly (daily avg) 1 week Overnight Eurodollars at Caribbean branches (M-2) Member banks approx. universe weekly (daily avg) 1 week Money market mutual funds shares (M-2) universe weekly (Wednesday) 1 week •· Large-denomination time deposits (M-3) Nonmember banks sample weekly (daily ~vg) 2-3 weeks MSBs sample weekly (Wednesday) 2-3 weeks S&Ls sample thrice-monthly 1 week Term repurchase agreements (M-3) Member banks 125 large member banks w~ekly (daily avg) 1 week 1/ In addition, data on demand deposits of U.S. branches and agencies of foreign banks would be collected on a regulatory report of deposits with an application of reserve requirements to these institutions under the International Banking Act. At present, all U.S. branches and agencies of foreign banks report their deposits once each month and large institutions in New York City report deposits on a daily basis. 1/ Scheduled to begin in March 1980. Weekly sample consists of approximately 70 of the largest credit unions. In addition, a sample of smaller credit unions will be collected once each month, as of the last Wednesday of the month. A-32 Appendix Table 1 Rates of Monetary and Velocity Growth for New and Old M-1 Measures Rates of Moneta!I Growth Ratts of Velocity Growth Year1- 1 New M-lA New M-lB Old M-1 New M-lA New M-lB Old M-1 1960 0.6 0.6 0.4 1.7 1.7 1.8 1961 2.8 2.8 2.8 4.3 4.3 4.2 1962 1.8 1.8 1.4 4.0 4.0 4.4 1963 4.0 4.0 4.0 2.6 2.6 2.6 1964 4.3 4.4 4.5 1.4 1.4 1.3 1965 4.4 4.4 4.3 5.8 5.8 5.8 1966 2.7 2.7 2.9 5.3 5.3 5.1 1967 6.4 6.3 6.4 -0.3 -0.2 -0.3 1968 7.4 7.4 7.6 1.8 1. 7 1.6 1969 3.8 3.8 3.9 2.6 2.6 2.5 1970 4.8 4.8 4.8 -0.3 -0.3 -0.3 1971 6.6 6.6 6.6 2.7 2.7 2.8 1972 8.5 8.5 8.4 3.0 3.0 3.1 1973 5.7 5.8 6.2 5.2 5.1 4.6 1974 4.7 4.7 5.1 2.4 2.4 2.0 1975 4.7 4.9 4.6 5.1 4.9 5.2 1976 5.5 6.0 5.8 4.2 3.7 3.9 1977 7.7 8.1 7.9 4.2 3.9 4.0 1978 7.4 8.2 7.2 5.6 4.8 5.8 1979 5.5 8.0 5.5 4.2 1.8 4.2 2/ Quarter-- 1973--1 8.2 8.4 8.5 6.7 6.5 6.4 2 4.9 4.9 5.1 2.4 2.4 2.2 3 4.4 4.5 5.2 4.6 4.5 3.8 4 4.8 4.8 5.4 6.5 6.6 5.9 1974--1 6.7 6.7 7.3 -2.6 -2.6 -3.1 2 3.6 3.6 4.1 5.4 5.4 4.9 3 3.1 3.1 Li .1 5.4 5.4 4.5 4 4.9 5.0 4.6 1.4 1.2 1.6 1975--1 2.6 2.9 2.0 -2.0 -2.3 -1.3 2 5.9 5.9 5.8 6.0 6.1 6.2 3 7.0 7.3 7.2 10.3 10.0 10.0 4 2.9 3.2 3.0 5.7 5.4 5.6 1976--1 5.4 5.7 4.6 8.4 8.1 9.2 2 5.8 6.3 6.4 1.3 0.8 0.7 3 3.4 3.9 4.1 4.3 3.8 3.6 4 7.0 7.6 7.4 2.4 1.8 1.9 1977--1 8.8 9.3 7.4 5.6 5.2 7.0 2 6.7 6.9 7.4 5.5 5.3 4.8 3 6.0 6.5 8.6 5.6 5.0 2.9 4 8.4 8.7 7.4 0.1 -0.2 1.1 1978--1 7.6 7.9 6.6 0.5 0.2 1.4 2 8.7 9.1 9.2 9.6 9.1 9.0 3 7.1 7.3 7.9 3.4 3.2 2.6 4 5.6 7.4 4.3 8.3 6.5 9.6 1979--1 0.2 4.8 -1.3 9.9 5.3 11.6 2 7.8 10.7 8.1 -1.2 -4.0 -1.5 3 8.8 10.1 9.7 2.6 1.3 1.7 4 4.7 5.3 5.0 5.1 4.6 4.8 1/ Fourth quarter over fourth quarter growth rate. "ii Annualized growth rates based on seasonally adjusted data. A-.33 Appendix Table 2 Rates of Monetary and Velocity Growth for New H-2 and Old M-2 and M-3 Measures Rates of Moueta!I Growth Rates of VelocitI Growth Year!/ New M-2 Old M-2 Old M-3 New M-2 Old M-2 Old M-3 1960 4.6 2.6 4.8 -2.3 . -0.3 -2.4 1961 7.1 5.4 7.1 0.0 1.7 0.0 1962 8.0 5.9 7.7 -2.0 -0.0 -1.7 1963 8.6 7.0 8.7 -1.8 -0.3 -1.9 1964 7.9 6.7 8.3 -2.0 -0.8 -2.2 ~ 1965 8.0 8.6 • 8.6 2.2 1.7 1. 7 1966 4.9 6.0 5.4 3.1 2.0 2.7 1967 9.3 9.9 9.7 -2.9 -3.4 -3.3 1968 8.0 9.0 8.1 1.2 0.3 1.1 1969 4.2 3.2 3.6 2.3 3.2 2.8. 1970 5.8 7.2 7.2 -1.2 -2.6 -2.s· 1971 13.5 11.3 13.5 -3.5 -1.6 -3.5 1972 12.9 11.2 13.3 -1.0 C.5 -1.3 1973 7.3 8.8 9.0 3.5 2.1 1,9 1974 6.0 7.7 7.1 1.1 -0.5 0.1 1975 12.3 8.4 11.1 -2.0 1.5 -1.0 1976 13.7 10.9 12.7 -3.3 --,Q.9 -2.5 1977 11.5 9.8 11.7 0.7 2.2 0.5 1978 8~4 8.7 9.5 4.6 4.3 3.6 1979 8.8 8.3 8.1 1.0 1.4 1.6 Quart erf:./ 1973--1 10.3 9.8 10.9 4.7 5.2 4.1 2 6.9 7.7 8.3 0.4 -0.4 -1.Q 3 6.0 7.7 7.4 3.0 1.3 Lb 4 5.4 9.0 8.2 6.0 2.4 3.1 1974--1 8.0 10.3 9.6 -3.9 -6.1 -5.3 2 5.2 7.0 6.4 3.8 2.1 2.6 3 4.4 6.1 5.2 4.2 2.4 3.3 4 5.8 6.6 6.4 0.5 -0.4 -0.2 1975--1 7.8 6.4 8.2 -7.1 -5.7 -7.5 2 14.9 9.5 12.4 -2.7 2.5 -0.3 3 14.6 10.0 12.8 2.8 7.2 4.5 4 9.9 6.8 9.4 -1.1 ,1.9 -0.7 1976--1 13.0 10.5 12.0 0.9 3.3 1.9 2 12.7 10.0 11.9 -5.4 -2.8 -4.7 3 11.3 8.9 11.0 -3.4 -1.1 -3.1 4 15.2 12.6 13.8 -5.6 -3.1 -4.3 1977--1 13.7 10.9 12.4 0.9 3.6 2.1 2 11.2 9.0 10.5 1.0 3.2 1.7 3 9.6 10.1 11.8 1.9 1.5 -0.2 4 9.7 7.9 10.1 -1.2 0.5 -1.6 1978--1 7.5 7.0 8.1 0.6 1.1 0.0 2 7.5 8.4 8.4 10.8 9.9 9.8 3 8.2 9.8 10.3 2.3 0.8 0.3 4 9.5 8.5 9.8 4.4 5.4 4.1 1979--1 6.3 2.8 5.3 3.9 7.3 4.8 2 10.2 8.8 7.9 -3.5 -2.1 -1.3 3 10.3 11.9 10.5 1.1 -0.5 0.9 4 7 .2· 8.9 7.8 2.7 1.0 2.1 1/ Fourth quarter over fourth growth rate. y Annualized growth rates based on seasonally adjusted data. A-34 Appendix Table 3 Rates of Monetary and Veloci.ty Growth for New M-3 and L and Old M-4 and M-5 Measures Rates of Moneta!)': Growth Rates of VelocitI Growth YeaJJ New M-3 New L Old M-4 Old M-5 New M-3 -New- L Old M-4 Old M-~ 1960 4.8 3.5 2.6 4.8 -2.5 -1.2 -0.3 -2.4 1961 7.7 6.2 6.5 7.9 -0.5 0.9 0.6 -0.7 1962 8.8 8.0 7.1 8.5 -2.7 -2.0 -1.2 -2.4 1963 9.5 8.4 8.3 9.6 -2.6 -1.6 -1.6 -2.7 1964 8.9 7.3 1;8 9.0 -2.8 -1.4 -1.8 -2.9 1965 9.2 8.1 9.5 9.1 1.1 2.2 0.9 1.2 1966 5.2 5.5 5.5 5.0 2.8 2.5 2.6 3.0 1967 10.4 8.5 10.7 10.3 -3.9 -2.2 -4.2 -3.8 1968 8.7 9.5 9.3 8.3 0.6 -0.2 0.0 0.9 1969 1.5 4.4 0.1 1.5 5.0 2.0 6.4 4.9 1970 8.9 6.5 10.2 9.2 -4.1 -1.9 -5.1 -4.3 1971 14.8 10.4 12.8 14.3 -4.6 -0.8 -2.9 -4.2 1972 14.0 12.9 12.3 13.9 -2.0 -1.0 -0.5 -1.9 1973 11.7 12.3 12.0 11.0 -0.5 -1.1 -0.8 0.1 1974 8.7 9.6 10.7 9.0 -1.4 -2.2 -3.1 -1.7 1975 9.4 9.8 6.6 9.7 0.6 0.2 3.3 0.3 1976 11.4 11.0 7.1 10.2 -1.3 -1.0 2.6 -0.3 1977 12.6 12.6 10.1 11.7 -0.3 -0.3 2.0 0.5 1978 11.3 12.3 10.6 10.6 1.9 1.0 2.5 2.5 1979 9.5 n.a. 7.5 7.6 0.3 n.a. 2.2 2.1 guarteJ/ 1973--1 14.0 14.0 14.2 13. 7 1.0 1.1 0.9 1.3 2 11.7 12.3 13.8 12.2 -4.3 -4.8 -6.3 -4.7 3 11.2 11.8 11.0 9.6 -2.2 -2.7 -1.9 -0.6 4 8.0 9.1 7.0 7.1 3.3 2.2 4.4 4.3 1974--1 10.1 11.0 11.4 10.2 -5.9 -6.7 -7.1 -6.0 2 10.6 11.1 12.8 10.3 -1.5 -1.9 -3.6 -1.2 3 7.7 8.4 9.9 7.8 0.9 0.1 ·-1.3 0.8 4 5.4 6.6 6.9 6.7 0.8 -0.3 -0.7 -0.4 1975-1 7.2 7.1 7.6 8.9 -6.4 -6.4 -6.9 -8.1 2 9.4 9.5 5.5 9.5 2.6 2.5 6.5 2.5 3 10.7 10.5 6.2 10.1 6.5 6.8 11.1 7.1 4 9.1 10. 7 6.2 8.8 -0.4 -1.9 2.4 -0.1 1976--1 9.9 10.1 6.0 9.0 4.0 3.7 7.8 4.8 2 11.3 11.1 6.0 9.4 -4.L -3.9 1.0 -2.2 3 10.3 10.0 6.3 9.2 -2.5 -2.2 1.5 -1.4 4 12.1 10.8 9.5 11.8 -2 .. 6 -1.4 -0.1 -2.3 1977--1 12.4 11.5 10.1 11.8 2.2 3.0 4.4 2.7 2 11.4 11.8 8.3 10.0 0.8 0.4 3.9 2.2 3 11.7 12.2 10.0 11.7 -0.1 -0.6 1.6 -0.1 4 12.5 12.8 10.4 11.5 -3.9 -4.2 -1.9 -2.9 1978--1 10.5 11.2 10.2 10.0 -2.3 -3.0 -2.1 -1.8 2 11.1 12.4 10.6 9.8 7.2 5.9 7.6 8.4 3 10.3 11.3 9.9 10.4 0.2 -0.7 0.6 0.2 4 11.5 12.2 10.1 10.7 2.4 1.8 3.8 3.3 1979-1 7.9 10.4 5.4 6.8 2.3 -0.2 4.7 3.4 2 8.8 13.1 3.7 4.9 -2.2 -6.3 2.9 1.7 3 10.3 11.7 9.2 8.9 1.1 -0.3 2.2 2.5 4 9.8 n.a. 11.0 9.1 0.1 n.a. -1.0 0.8 n.a.--Not available as data for December 1979 are incomplete. 1/ Fourth quarter over fourth quarter growth rates. II Annualized growth rates based on seasonally adjusted data. APPENDIX B DESCRIPTION OF THE NEW PROCEDURES FOR CONTROLLING MONEY B-1 The New Federal Reserve Technical Procedures for Controlling Money As part of its anti-inflationary program announced on October 6, 1979, the Federal Reserve changed open market operating procedures to place more emphasis on controlling reserves directly so as to provide more assurance of attaining basic money 'supply objectives. Previously, the reserve supply had been more passively determined by what was needed to maintain, in any given short-run period, a level of short-term interest rates, in particular a level of the federal funds rate, that was con sidered consistent with longer-term money growth targets. Thus, the new procedures entail greater freedom for interest rates to change over the short-run in response to market forces. 1/ This note describes the new technical operating procedures and how the linkage between reserves and money involved in the procedures is influenced by the existing institutional framework and other factors. This linkage is relatively complicated and variable, particularly over the short run, so that, for example, it does not necessarily follow that rapid expansion of reserves would be accompanied by, or wo.uld presage, rapid expansion of money. The exact relationship depends on the behavior of other factors besides money that absorb or release reserves, and consideration must also be given to timing problems in connection with lagged reserve accounting. In setting reserve paths to control money under existing conditions account must be taken of: (i) the prevailing reserve requirement structure, with varying reserve requirements by type of deposit (some of which may not be included in targeted money measures) and by size of deposit; (ii) the public's demand for currency relative to deposits; (iii) availability of reserves at bank initiative from the discount window; (iv) lags in response Consistent with this, the federal funds rate range adopted by the Federal Open Market Committee for an intermeeting period has been greatly widened. B-2 on the part of the public and banks to changes in reserve supply through open market operations; (v) the growing amount of money-supply type deposits at institutions not subject to reserve requirements set by the Federal Reserve; (vi) lagged reserve accounting. To help insure that operations are under taken most effectively, the Federal Reserve has the new operating technique and related factors under continuous examination in light of experience gained. At present, studies are under way on such elements as lagged reserve accounting and the role of the discount window. Possible changes in otheL elements involved with the technique would require Congressional action--such as extending reserve requirements to nonmember institutions and certain aspects of simplifying reserve structure. The principal steps in the new procedure are outlined below. (1) The policy process first involves a decision by the Federal Open Market Committee on the rate of increase in money it wishes to achieve. For instance, at its October 6 meeting, taking account of its longer-run monetary targets and economic and financial conditions, the Committee agreed upon an annual rate of growth in M-1 over the 3-month period from September to December on the order of 4~ percent, and of M-2 of about 7\ percent, but also agreed that somewhat slower growth was acceptable. (2) After the objective for money supply growth is set, reserve paths expected to achieve such growth are established for a family of reserve measures. 'lhese measures consist of total reserves, the monetary base (essentially total reserves of member banks plus currency in circulation), and nonborrowed reserves. Establishment of the paths involves projecting how much of the targeted money growth is likely to take the form of currency, of deposits at nonmember institutions, and of deposits at member institutions (taking account of differential reserve requirements by size of demand deposits ajd between the demand and time and savings deposit components of M-2). B-3 'Moreover, estimates are made of reserves likely to be absorbed by expansion in other bank liabilities subject ·to_ reserve requirements, such as large CD's, at a pace that appears consistent with money supply objectives and also takes account of tolerable ch~nges in bank credit. Such estimates are necessary because reserves that banks use to support expansion of CD's, for example, would not be available to support expansion in M-1 and M-2. 'Ihus, if the reserves required behind CD's were not provided for in the reserve path, expansion in M-1 and M-2 would be weaker than desired. The opposite would be the case if the reserve path were not reduced to reflect contraction of large CD's. For similar reasons, estimates are also made of the amount of excess reserves banks are likely to hold. (3) The projected mix of currency and deposits, given the reserve requirements for deposits and banksJ excess reserves, yields an estimate of the increase in total reserves and the monetary base consistent with FOMC monetary targets. The amount of nonborrowed reserves--that is total reserves less member bank borrowing--is obtained by initially assuming a level of borrowing near that prevailing in the most recent period. For instance, following the October 6 decision, a level of borrowing somewhat above that of September was initially assumed. Following subsequent meetings, the assumed level of borrowing for the nonborrowed path was always close to the level pre vailing around the time of the FOMC meeting, though varying a little above and below that level. (4) Initial paths established for the family of reserve measures over, say, a 3-month period are then translated into reserve levels covering shorter periods between meetings. These paths can be based on a constant seasonally adjusted rate of growth of the money targets on, say, a month-by month basis, or can involve variable monthly growth rates within the 3-month period if that appears to facilitate achievement of the longer-run money targets. B-4 (5) Total reserves provide the basis for deposits and thereby are more closely related to the aggregates than nonborrowed reserves. Thus total reserves represents the principal over-all reserve objective.l/ How ever, only nonborrowed reserves are directly under control through open market operations, thoug~ they can be adjusted in response to changes in bank demand for reserves \obtained through borrowing at the discount window. (6) Because nonborrowed reserves are more closely under control of the System Account Manager for open market operations (though subject to a small range of error because of the behavior of non-controlled factors affecting reserves, such as float), he would initially aim at a nonborrowed reserve target (seasonally unadjusted for operating purposes) established for the operating period between meetings. To understand how this would lead to control of total reserves and money supply, suppose that the demand for money ran stronger than was bei~g targeted--as i t did in early October of last year. The increased demand for money and also for bank reserves to support the money would in the first instance be accompanied by more intensive efforts on the part of banks to obtain reserves in the federal funds market, thereby tending to bid up the federal funds rate, and by increased borrowing at the Federal Reserve discount window. As a result 1/ In the control process, the monetary base in practice is given less weight than total reserves. This is principally for a technical reason. If currency, the principal component of the base, is running stronger than anticipated, achievement of a base target would require a dollar for-dollar weakening in member bank reserves. But, because of fractional reserve requirements, the weakening in reserves would have a multiple effect on the deposit components of the monetary aggregates (it could weaken the demand deposit component by about 6 times the decline in reserves). Achievement of a base target in the short run could there- fore lead, in this example, to a much weaker money supply than targeted. If a total reserve target were achieved, the money supply would be stronger than targeted, but only by the amount by which currency is stronger than expected. Thus, the variation from a money supply target would be less under total reserves than under a monetary base guide. Of course, should currency persistently run stronger or weaker than expected, compensating adjustments could be made to either a total reserves or monetary base target. B-5 of the latter, total reserves ~nd the monetary base would for a while run stronger than targeted. Whether total reserves tend to remain above target for any sustained period .depends in part on the nature of the bulge in reserve demand--whether or not it was transitory, for exarnple--and in part on the degree Lo which emerging market conditions reflect or induce adjust ments on the part of banks and the public. These responses on the part of banks, for example, could include sales of securities to the public (thereby extinguishing deposits) and changes in lendtng policies. (7) Should total reserves be showing sustained strength, closer control over them could be obtained by lowering the nonborrowed reserve path (to attempt to offset the exp~nsion i.n member bank borrowing) and/or by raising the discount rate. A rise in the discount rate~would, for any given supply of nonborrowed reserves, initially tend to raise market interest rales, thereby working to speed up the adjustment process of the public and banks and cncouragi.ng a more prompt move back to the path for total reserves and the monetary base. Thus, whether adjustments are made in the nonborrowed path--the only path that can be controlled directly through open market operations--and/or in the discount rate depends in part on emerging behavior by banks and the public. Under present circumstances, however, both the timing of market response to a rise in money and reserve demand, and the ability to control total reserves in the short run within close tolerance B-6 limits, are influenced by the two-week lag between bank deposits and required reserves behind these deposits.!/ (8) Other intermeeting adjustments can be made to the reserve paths as a family. 'lllese may be needed when it becomes clear that the multiplier relationship between reserves and money has varied from expecta tions. The relationship can vary when, for example, excess reserves and non-money reservable liabilities are clearly running higher or lower than anticipated. Since October 6 such adjustments during the intermeeting period have been made infrequently. Given the naturally large week-to-week fluctuations in factors affecting the reserve multiplier, deviation from expec'tations in one direction over a period of several weeks would be needed before it would be clear that a change in trend has taken place. A variable relationship between expansion of reserves and of money is implicit in the description of procedures just given. This is i llustrated by experience in the fourth quarter, as shown in the table on the next page. It can be seen from panel I that M-1 increased at only a 3.1 percent annual rate (seasonally adjusted) in that period and M-2 at a 6.8 percent rate. At the same time, as shown in panel II, nonborrowed reserves, total reserve and the monetary base rose at substantially more rapid rates--by annual rates of about 13, 13i, and 8 percent, respectively. There were a number of reasons for the much more rapid growth in reserves and the base than in the monetary aggregates. Only about 1 per centage point of the 13\ percent annual rate of increase in total reserves !/ Under lagged accounting, banks are not required to hold reserves against deposits until two weeks later. With required reserves fixed at that time, the Federal Reserve in its operations is limited in its ability to control total reserves within a given week (since the total of reserves is determined by required reserves and banks' excess reserves), but can more readily determine whether the banking system satisfies its reserve requirement through the availability of nonborrowed reserves, or is forced to turn to the discount window (or to reduce excess reserves, though most banks are usually close to minimal levels in that respect). B-7 Changes in Reserve and Monetary Aggregates September to December 1979 (Seasonally adjusted) Percent l/ - Change in Annua 1 Rate- Millions $ I. Changes in Monetary Aggregates:· A. M-1 3.1 2845 1. Currency outside banks 5.3 1400 2. Member bank demand deposits 2.3 972 3~ Nonmember bank demand deposits 2.1 473 B. M-2 6.8 15961 II. Changes in Reserves and Related Items: 1309 A. Nonborrowed reserves 12.9 B. Borrowings 131 c. Total reserves (A+ B) 13.8 1430 D. Currency 'l:/ 5.9 1606 E. Monetary base (C + D) 8.1 3046 Percentage Points Contributed Towards Growth of Change in Total Reserves Millions$ III. Total Reserves Absorbed by: A. Private demand deposits 1.1 111 B. Interbank demand deposits 2.7 280 o.o C. U.S. Government demand deposits 3 D. Large, negotiable CD's 3.6 378 E. M-2 time and savings deposits 4.5 -466 F. Nondeposit items o.o -3 G. Excess reserves 2.0 205 Addendum: Impact of lagged reserve accounting on: 1. Total reserves 2. Reserves against private demand deposits -64 3. Reserves against M-2 time and savings deposits 121 4. All other items subject to reserves 230 1/ Growth rates of reserves adjusted for discontinuities in series that result from changes in Regulations D and M. 2/ Includes vault cash of nonmember banks. 11 Reflects change in total reserves during period attributable to fact that required reserves are based on deposits two weeks earlier, rather than on deposits contemporaneous with reserves. Thus, adjusted to a basis contem poraneous with deposit growth from September to December, total reserves would have expanded $287 million, or 2.8 percentage points, less than they actually did. B-8 supported growth in the member bank demand deposit component of M-1 (as may be seen from line III.A of the table). An additional 4~ percentage points supported the member bank interest-bearing component of M-2 (line III.E). Thus less than half of the increase in reserves supported expansion in targeted monetary aggregates. More than half of the reserves supported expansion in interbank demand deposits, excess reserves, and large negotiable CD's. If these reserves had not been supplied, growth in M-1 and M-2 would have been much slower. In fact, actual growth in M-1 and M-2 was a bit slower 1/ than targeted, though not less than the Committee found acceptable.- As this example from recent experience helps demonstrate, the behavior of reserve measures in relation to money can be expected to vary with shifts in the currency and dep9sit mix, with changes in bank demands for excess reserves and borrowing, and with timing problems related to lagged reserve accounting. But even in evaluating money growth itself, which the Federal Open Market Committee sets as a target in the policy process, recognition has to be given to the likelihood that money growth can vary substantially on a month-to-month basis in view of inherently large and erratic money flows in so vast and complex an economy as ours. 1/ Moreover, the relatively rapid expansion in reserve measures was not associated with strength in bank credit, which in the fourth quarter grew at only about a 3 percent annual rate, well below its earlier pace. The slow expansion in bank credit during the fourth quarter reflected, on the liability side, a sharp reduction in the outstanding amount of borrowing by banks through Euro-dollars, federal funds, and repurchase agreements. January 30, 1980

Federal Reserve (1980, February 18). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_19800219

@misc{wtfs_monetary_policy_report_19800219,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {1980},
  month = {Feb},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_19800219},
  note = {Retrieved via When the Fed Speaks corpus}
}