Monetary Policy Report

LIBRARY .·• of ·c·oi: •. . Board of Governors of the Federal Reserve System . . . . ,gs~ · · . . AUG 2 0 : 0 .:.c: • ,, L.. • ·-1 ~: . . -~~_P.'..· ... -:'~ ..• ~~~ Midyear Monetary Policy Report to Congress Pursuant to the Full Employment and Balanced Growth Act of 1978 July 22, 1980 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., July 22, 1980 THE PRESIDENT OF THE SENATE THE SPEAKER OF THE HOUSE OF REPRESENTATIVES. The Board of Governors is pleased to submit its Midyear Monetary Policy Report to the Congress pursuant to the Full Employment and Balanced Growth Act of 1978. Sincerely, Paul A. Volcker, Chairman TABLE OF CONTEm'S Page Letter of Transmittal Chapter 1. The Outlook for the Economy and Monetary Policy Objectives Section 1. The Outlook for the Economy 1 Section 2. Monetary Policy_Objectives 5 Se~tion 3. Money and Credit Growth in, 1980 and 1981 7 Section 4. The Administration's Short-term Economic Goals and the Relationship of Federal Reserve Objectives to those Goals 16 - Chapter 2. A Review of. Recent Economic and Financial Developments Section 1. Economic Activity During the First Half of 1980 18 Section 2. Labor Markets and Capacity Utilization 30 Section 3. Prices, Wage·s, and Productivity 33 Section 4. Financial Developments During the First Half of 1980 36 CHAPTER 1 THE OUTLOOK FOR THE ECONOMY AND MONETARY POLICY OBJECTIVES SECTION 1. THE OUTLOOK FOR THE ECONOMY The economy moved into recession in the first half of this year. A cyclical downturn had been widely anticipated for some time, but the de cline in spending, output, and employment, once under way, has been steeper than most analysts had foreseen. The second quarter decrease in real gross national product, at an annual rate of about 9 percent according to the Commerce Department's preliminary estimate, was considerably sharper than in the initial quarters of other postwar recessions. The slump in activity has been most pronounced in the housing and auto industries--the latter sector being adversely affected by structural problems as well as by general cyclical pressures. But the decline has not been limited to these sectors. Retail sales excluding autos have dropped considerably since January, and business outlays for equipment and new con struction also have fallen. The very sharp curtailment of spending on houses and consumer goods and services in the current downturn probably is attributable in large part to the cumulative effect of inflation on consumers' financial well-being. Real disposable personal income was virtually flat in 1979 and has declined appre ciably this year. Earlier, consumers had reduced their rate of saving in the face of shortfalls in real income in an effort to maintain consumption standards and in anticipation of inflation. This was accomplished by further rapid growth in installment and mortgage credit in the late stages of the recent expansion, but with the result that debt service burdens--which already were at high levels historically--conttnued to climb. Sharply higher interest rates and generally more stringent credit terms in late 1979 and early 1980 acted as additional deterrents to spending, encouraging households in their efforts to reduce debt and to rebuild savings. -2- The falloff in final sales has caused businessmen to spend more cautiously. This tendency has been reinforced by financial factors as well. The liquidity position of businesses had deteriorated appreciably during the expansion, particularly in the latter stages when there was a surge in short term borrowing; many firms now are making strong efforts to restructure balance sheets. The unexpected rapidity of the current downturn thus far has led analysts to reassess their view of the prospects for economic activity in the period ahead. Significant disagreement has arisen with regard to whether recovery will be prompt and strong, with the recent relaxation of credit mar ket conditions encouraging a resumption of normal spending patterns, or whether the cyclical adjustment will be prolonged and the subsequent upturn possibly sluggish. The experience of the past year or so has demonstrated the hazards of forecasting, and the uncertainties at the present time clearly are sub stantial. Much will depend, for example, on the perceptions of businessmen about the longer-range prospects for demand and the attractiveness of invest ment, the response of consumers to the 1981 model-year automobiles, and the strength of the rebound in housing that may develop in the wake of the recent easing in mortgage market conditions. There are signs that the contraction in some sectors may be nearing an end, but these are far from conclusive. Retail sales in June turned up slightly after four months of sharp decline; in the first ten days of July auto sales were at the strongest pace in three months. Housing starts and sales of new homes strengthened in the most recent.months for which data are available. -l- In reflection of the prevailing uncertainties, there is a consider able range of views among the members of the Federal Open Market Committee re garding the movement of major economic variables over the remainder of the year. Most of the members believe that the recession probably will persist into the fourth quarter, with a cumulative net drop in real GNP less than that in the downslide of 1973-75. Although the decline should slow in the months ahead, employment may ~e cut back further, and the unemployment rate could rise ,, beyond 8-1/2 percent by year-end. The increasing slack in labor markets and in industrial capacity utilization should at the same time help to moderate infla tionary pressures. The table below presents ranges for key economic variables that gen erally encompass the judgments of the individual FOMC members about the prob able performance of the economy this year and in 1981. Actual Projected 1979 1980 1981 Change from fourth quarter to fourth quarter, percent Nominal GNP 9.9 5 to 7-1/2 8-1/2 to 11-1/2 Real GNP LO -5 to -2-1/2 1/2 to 3 Implicit GNP deflator 8.9 9 to 10 7-3/4 to 9-1/2 Average level in fourth quarter Unemployment Rate (percent) 5.9 8-1/2 to 9-1/4 8 to 9-1/4 The outlook for 1981 is especially uncertain at the current time. Economic and financial developments over the next six months should lay the groundwork for the recovery anticipated in 1981. But, in addition, any -4- actions taken in the fiscal arena would have an impact on the path of re covery. The projections presented in the table, which do not assume a tax cut in the next year, indicate a turnaround.in economic activity--although there is a considerable range of views concerning the potential strength of the recovery. On balance, the forecast is for a moderate rebound in real GNP, accompanied by some further slackening in the pace of inflation. Unem ployment, however, is likely to remain high throughout the year. Should there be a tax cut in 1981, the impact on economic perfor mance will, of course, depend on its timing and composition. There is the distinct--and very troubling--possibility that a poorly designed tax reduc tion, or one not coupled with adequate restraint on the expenditure side, might give rise to added inflationary and financial pressures that would in time dissipate the beneficial short-term effects of the fiscal stimulus. Any indication that the Congress and the Administration were moving away from a commitment to rigorous fiscal discipline would run the risk of rein vigorating the inflationary expectations that have played such a major role in the economy's difficulties. The Committee thus feels it important that the question of a tax cut be approached cautiously; if a tax cut ultimately is enacted, it should be carefully structured to enhance the productive potential of our economy and to yield the greatest relief from cost and price pressures over the longer run. -s- SECTION 2. MONETARY POLICY OBJECTIVES The task for monetary policy--and for stabilization policy gener ally--in the current circumstances obviously is a difficult one. Recession naturally summons forth calls for stimulus to aggregate demand. The prevail ing high level of unemployment, and the exceptional weakness apparent in particular industries and sectors of our economy, certainly must be given careful consideration in the formulation of public policy. But caution must be exercised in the application of any broad countercyclical stimulus, espe cially in the present environment of persistent inflationary pressures. Indeed, there is no clearer lesson from the experience of the past decade and a half than that excessive stimulus is detrimental to the objective of achieving and sustaining noninflationary, balanced growth. A primary and continuing goal of monetary policy must be to curb the accelerating inflationary cycle. It now appears that some progress is begin ning to be made in that direction. Price increases have slowed considerably from the pace of early in the year, in part reflecting some relief in the food and energy sectors, but also as a result of the drop in demand pressures. In addition, recent attitudinal surveys point to a reduction in inflationary expectations. The continuation of this trend in expectations will result in a greatly improved economic and financial environment, one more conducive to long-term growth. We already have witnessed one benefit of an easing of inflationary fears: a substantial decline in long-term interest rates from their highs earlier this year and a revitalization of the bond markets. The Federal Reserve's pursuit of a policy of monetary restraint--evidenced this year by a moderation of money growth--has been an important factor in this -6- turn in expectations; a sustained commitment to the -attainment of noninfla-, tionary rates of money and credit growth is essential if this progress is to be extended. Despite the improvement that has occurred, however, inflationary forces are far from subdued. The past years have left a legacy of adverse cost trends that will not be reversed quickly. Moreover, more extreme infla tionary expectations easily could be reignited. In establishing its plans for growth in the monetary aggregates, the Federal Reserve will continue to place high priority on reducing inflation, believing that this is essential to fostering a sound and sustained recovery. Over the long term, a reduction in the underlying rate of inflation is essential for a strong U.S. economy, for encouraging the saving we will need to finance adequate capital investment, and for maintaining the position of the dollar in international markets. But it is clear also that if inflation is to be restrained without undue disruption of economic activity we cannot rely solely on monetary policies. For example, fiscal discipline is essential to ensure that excessive pressure is not placed on the financial and real resources of the economy. The structure of our tax system should be examined with an eye to the incentives i it provides for productivity-expanding research and capital formation. And the full range of governmental policies should be reviewed to ensure that they do not add needlessly to costs and do not stunt innovation and competition. -7- SECTION 3. MONEY AND CREDIT GROWTH IN 1980 AND 1981 In February the Federal Reserve reported to the Congress ranges of growth for the monetary aggregates in 1980 that it believed to be con sistent with the continuing objective of reducing inflationary pressures over time while providing for sustainable growth in the nation's production of goods and services. These ranges anticipated a substantial deceleration in monetary growth in 1980 from the pace of the preceding year. Measured from the fourth quarter of 1979 to the fourth quarter of 1980, the ranges adopted were: for M-lA, 3-1/2 to 6 percent; for M-lB, 4 to 6-1/2 percent; for M-2, 6 to 9 percent; and for M-3, 6-1/2 to 9-1/2 percent. The associated range for bank credit expansion was 6 to 9 percent. During the first half of 1980, growth of the monetary aggregates slowed considerably from the 1979 pace. The deceleration was particularly marked for the narrower aggregates, M-lA and M-lB, which grew at rates below the lower limits of their longer-run ranges--at annual rates of about 1/2 and and 1-3/4 percent, respectively, from the fourth quarter of 1979 to the second quarter of 1980. (M-lA is currency and demand deposits held by the public, while M-lB includes checkable interest-bearing deposits as well.) At the same time, the broader aggregates, M-2 and M-3, grew at annual rates of 6-1/2 and 6-3/4 percent, respectively, which is somewhat above the lower limits of their ranges. In fact, by June, as the accompanying charts show, M-2--which includes money market fund shares and all deposits except large CDs at banks and thrift institutions--was around the midpoint of its longer-run range, and M-3 slightly below, while the narrower aggregates were moving back toward their ranges, following an unusually sharp drop in early spring. -8- Growth Ranges and Actual Monetary Growth M-1A Billions of dollars -Actual ___ Range adopted by FOMC for 1979 04 to 1980 04 6% 390 3½% 380 370 Annual Rate of Growth 360 1978 7.4 Percent 1979 5.0 Percent 1980 H 1 0.4 Percent 350 1979 1980 M-18 Billions of dollars -Actual - __ Range adopted by FOMC for 1979 04 to 1980 04 6½% 410 4% 400 390 380 Annual Rate of Growth 370 1978 8.2 Percent 1979 7.6 Percent 360 1980 H 1 1.8 Percent 1979 1980 LIBRARY -9- Growth Ranges and Actual Monetary Growth M-2 Billions of dollars -- Actual - - - Range adopted by FOMC for 1979 Q4 to 1980 04 1700 9% 6% 1600 1500 Annual Rate of Growth 1978 8.4 Percent 1979 8.9 Percent 1980 H1 6.4 Percent 1979 1980 M-3 Billions of dollars -- Actual - - - Range adopted by FOMC for 1979 Q4 to 1980 Q4 9½% 1900 6½% 1800 Annual Rate of Growth 1978 11.3 Percent 1979 9.8 Percent 1700 1980 H1 6.8 Percent 1979 1980 -10- The contraction in the narrower aggregates during the second quarter was much greater than would be expected on the basis of the historical rela tionships among money, income, and interest rates. This un~~~~l ~~~k~~s~ m~y have reflected exceptional efforts by_~~e public to pare bala~~es, s~ch c~~ as have characterized some other periods following a sharp upward adjustment in market interest rates to new record levels. There may also have been an impact from the surge in debt repayments, especially at banks, after the im position of the credit control program in mid-March, with some of the funds apparently coming out of cash balances. In light of these special circum stances affecting the public's demand for transactions balances, and given the relative strength of the broader aggregates and the usual lags between changes in credit conditions and growth in the narrow aggregates, the FOMC believed it appropriate to fostere_ mo;e--;radual returnlof M-1 growth to the ranges established earlier. In connection with reserve targeting procedures, System open market operations supplied a large volume of nonborrowed reserves over the course of the second quarter. Given the weak demand for money and bank credit, most / of the added nonborrowed reserves were used by banks to repay borrowings from the Federal Reserve discount window. Borrowings fell from a high of $2.8 billion on average in March to minimal levels recently, and the easing of bank reserve positions was reflected in a sharp decline in the federal funds rate. From their peaks of late March or early April, short-term interest rates have declined 7 to 9 percentage points and long-term rates by roughly 2 to 3 per centage points. -11- Expansion in the broader aggregates over the first half of the year reflected the very rapid growth for much of the time in money market mutual fund shares, 6 month money market certificates, and 2-1/2 year small saver certificates, instruments that pay market rates of interest. Late in the period, as short-term market interest rates declined sharply, the contraction in savings deposits at banks and other depository institutions halted, and the outstanding amount.of those deposits began to rise. For part of the period, growth in M-3 was sustained also by continued issuance of large time deposits by commercial banks and thrift institutions, which are included in M-3 but not in M-2; however, large time deposits began to contract in late spring as credit demands weakened substantially. Bank credit growth greatly exceeded the FOMC's range in the first quarter of the year. The second quarter, however, saw a sharp contraction in this measure, and credit growth was well below the FOMC-specified range as of midyear. Demands for bank loans by households and businesses dropped abruptly in the second quarter, while the banks--concerned about the possible erosion of profit margins by high cost funds obtained earlier and seeking to conform to the guidelines of the March 14 special credit restraint program- pursued relatively tight lending policies. Businesses, meanwhile, have met a substantial portion of their credit needs through issuance of commercial paper (which serves as a close substitute for bank credit for many large firms), by borrowing in bond markets, and by reducing holdings of liquid assets. Over the half year, the total of credit advanced by banks and in the private short-term money markets rose at an annual rate of around 7-1/2 percent. -12- Growth Ranges and Actual Bank Credit Growth Bank Credit Billions of doliars -Actual 9% - - - Range adopted by FOMC for 1979 04 to 1980 Q4 1220 6% 1180 1140 1100 Annual Rate of Growth 1978 13.5 Percent 1060 1979 12.3 Percent 1980 H1 4.6 Percent 1979 1980 -13- At its meeting in July, the Federal Open Market Committee reassessed the ranges it had adopted for monetary growth in 1980 and formulated prelim inary goals for 1981. The Committee elected to retain the previously estab lished ranges for the aggregates over the remainder of 1980. This decision by the Committee took into consideration the recent behavior of the money stock measures as well as emerging economic conditions. In this regard it was recognized that, ~f the public continues to economize on cash balances to an unusual degree in the second half of the year, growth in the narrower aggregates would likely fall toward the lower end of the established ranges. With respect to the broader aggregates, growth in the second half is likely to place them nearer the midpoints of their respective ranges, and in the case of M-2 quite possibly in the upper half of its range. Recent trends suggest that a continued substantial expansion in the interest-bearing nontransactions component of M-2 is likely. In the current cyclical environ ment, consumers have begun to reevaluate their financial positions and have reduced their borrowing and adjusted upward their rate of saving. Thus, if the recent lower level of interest rates persists, the outlook is for an augmented flow of funds to depository institutions along with continued, though slower, growth in money market mutual funds. The Committee also noted that the recent sharp contraction in bank credit makes it quite likely that this measure will fall below the 6 to 9 percent growth range specified in February. A resumption of bank credit expansion during the second half is anticipated, but the strength of that move will depend to a considerable extent on patterns of corporate finance. The desire for balance sheet restructuring may well continue to mute business -14- loan demands, although weaker corporate cash flows and a narrowing of the spread of the prime rate over commercial paper rates likely will prompt some borrowing at banks. Mortgage loan demands also should begin to recover as the year progresses, and the runoff in consumer loans is expected to abate. One factor that contributed to the recent weakness in bank lending was the Board's special credit restraint program. As announced earlier, the program is being phased out this month because there is now no evident need for extraordinary measures to hold bank lending within reasonable bounds. In removing the special controls, the Board has emphasized its intention to continue to maintain aggregate growth in money and credit at rates consistent with a reduction in inflationary pressures. With regard to monetary policy over the longer run, the FOMC re iterates its intent to seek reduced rates of monetary expansion over coming years, consistent with a return to price stability. While there is broad agreement in the Committee that it is appropriate to plan for some further progress in 1981 toward reduction of the targeted ranges, most members believe it would be premature at this time to set forth precise ranges for each mone tary aggregate for next year, given the uncertainty of the economic outlook and institutional changes affecting the relationships among the aggregates. The extent and timing of adjustments in the targets will depend upon an appraisal of the outlook at the end of the year. The appropriate money growth in 1981 relative to 1980 of course will depend to some extent on the outcome in this year--that is, on exactly where in the present ranges the various aggregates fall at year-end. -15- In addition, the various measures of money will be affected in 1981 by shifts in the demand for different types of financial assets. The intro duction of NOW accounts on a nationwide basis in January will accelerate the shift from regular demand deposits into interest-earning transactions balances, thereby depressing M-lA growth next year. On the other hand, M-lB probably will be boosted somewhat next year by shifts from savings deposits and other interest-bearing asset~ into NOW accounts. The range for M-lB thus may have to accommodate a period of abnormal growth as the public adjusts to the availability of a new instrument. The experience of the past year and a half with ATS accounts has indicated the difficulty of estimating in advance the public's demand for such balances. Although growth in M-2 and M-3 will not be affected by NOW account movements, these broader aggregates include other relatively new financial instruments, the demand for which is still subject to uncertainty. The behavior of these instruments in coming months will aid the FOMC in determining appropriate growth ranges for the broader aggregates in the 1981 period. -16- SECTION 4. THE ADMINISTRATION'S SHORT-TERM ECONOMIC GOALS AND THE RELATIONSHIP OF FEDERAL RESERVE OBJECTIVES TO THESE GOALS The Administration, in association with its midyear budget review has updated its forecast of the behavior of major economic variables for 1980 and 1981. The revised figures are shown below. The Administration's Forecast 1980 1981 Change from fourth quarter to fourth quarter, percent Nominal GNP 6-3/4 12-1/2 Real GNP -3 2-1/2 Implicit price deflator 10 9-3/4 Average level in fourth quarter Unemployment rate (per~ent) 8-1/2 8-1/2 These estimates, which the Administration has indicated should be viewed as forecasts rather than as goals, show a considerably greater de cline in real activity in 1980 than had been anticipated in the January Economic Report of the President. The outlook for nominal GNP growth through year-end has been lowered by a smaller amount, owing to a somewhat higher anticipated rate of inflation for the four quarters of 1980. The Administra tion's projections for this year fall within the ranges expected by the mem bers of the FOMC. -17- The Administration has projected a resumption of output growth next year that places real GNP near the upper end of the range encompassed by the forecasts of the members of the FOMC. At the same time, the Administration's estimates place the rate of inflation somewhat above the range of the FOMC members' expectations. (Like the FOMC members' projections, the Adminis tration's forecast does not include a tax cut provision for 1981.) As indicated_Jn the preceding section, the Federal Reserve intends to set monetary growth ranges for 1981 that will help to restrain inflationary pressures in the recovery period. As experience this year illustrates, ~01!:" siderable uncertainty attaches to a~y analysis of the relationships over rela tively short periods among money, interest rates, and nominal GNP. However, -------- - --- - ·-- - -- -·- a substantial expansion in demands for goods and services, accompanied by a lack of progress on the inflation front--or worse, an actual increase in inflation or inflationary expectations--would raise the possibility of a con siderable firming of conditions in financial markets. Large and prolonged federal deficits would increase that risk. This highlights the urgency of concerted effort by the public and private sectors to reduce the rate of advance in costs and prices and the need to focus any discussions of fiscal action on approaches that would serve to alleviate cost pressures and bolster productivity. CHAPTER 2 A REVIEW OF RECENT ECONOMIC AND FINANCIAL DEVELOPMENTS SECTION 1. ECONOMIC ACTIVITY DURING THE FIRST HALF OF 1980 Economic activity turned down early this year following almost five years of expansion. Between January and June, industrial production fell 7-1/2 percent, employment declined by about 1-1/4 million, and the unemployment rate jumped 1-1/2 percentage points. Real gross national product is estimated to have fallen at an annual rate of 9.1 percent in the second quarter, with the decline in activity widespread among major sectors of the economy. Retai1 sales have decreased substantially since January, housing starts have dropped to near-record postwar lows, and business out- lays for equipment and new construction have declined. Although businesses were cautious in building inventories during the expansion, the severity of the recent decline in final sales has led to some involuntary stock accumulation; as in past cycles, the resulting efforts to curb inventory growth have played a significant role in the weakening of orders and production. Recent reductions in aggregate demand, coupled with a slower rise of energy prices, meanwhile have brought some moderation in the overall pace of inflation. The producer and consumer price indexes have risen at much less rapid rates in the past few months than they did earlier in the year. Moreover, there are indications from consumer surveys that inflationary expectations have been lowered. Nevertheless, inflation still possesses a strong momentum, with unit labor costs continuing on a steep upward trend. Personal Consumption Expenditures Personal consumption expenditures fell sharply in real terms during the first half. A number of adverse trends had characterized household finances for some time prior to the beginning of 1980. Real disposable income had stag nated after 1978, household liquidity positions had weakened as liabilities -19- Current Indicators of Economic Activity Real GNP and Final Sales Industrial Production Billions of 19 72 dollars Index, 1967=100 1400 150 1350 1300 130 1250 1200 110 1974 1976 1978 1980 1974 1976 1978 1980 Capacity Utilization in Unemployment Rate Manufacturing Percent Percent 9 85 80 7 75 70 5 1974 1976 1978 1980 1974 1976 1978 1980 -20- increased faster than financial assets after late 1976, and a near-record proportion of disposable income had been committed to the servicing of debt. Moreover, consumer confidence. as measured by opinion surveys, had deteri orated to levels last seen in the 1973-75 recession. In the light of these trends, a downward adjustment of consumer outlays might have .been expected last year; the fact that it did not occur appears attributable in part to growing expectations of inflation that fostered a buy-in-advance psychology. Between January and May, retail sales fell 6-1/2 percent in nominal terms and more than 9-1/2 percent in real terms-the sharpest four-month drop in the postwar period. Preliminary estimates for June, however, indicate that sales moved up somewhat. As in past recessions, large decreases in sales this year have occurred for the relatively discretionary items of consumer expendi ture. Automobile sales in June averaged only 7.6 million units at an annual rate, close_ to the May pace, which was the slowest since late 1974. Furniture and appliance sales also are down sharply this year, in part because of the fall in housing sales. But weakness in consumer outlays has not been confined to the durable goods sector. Purchases of nondurables in real terms also have b~en falling since late last year, with sizable declines recorded for clothing and general .-18.erchandise. ,. Since January, real disposable income has decreased substantially as employment and hours worked have fallen and prices have continued upward at a rapid pace; nonetheless, the retrenchment by consumers has lifted the saving rate somewhat above the extraordinarily low level of the fourth quarter of last year. It still remains low ~.Y, historical standards, however, and uncertainty -21- Real Personal Consumption Expenditures and Real Disposable Personal Income Billions of 1972 dollars Disposable Personal income 1000 950 Personal Consumption 900 Expenditures ·1979 1980 Housing ·starts Annual rate, millions of units 1.4 1.0 0.6 0.2 1979 1980 Auto Sales Annual rate, millions of units 14 10 Domestic Models 6 1979 1980 -22- about job and income prospects may well prompt households to enlarge precau tionary savings, thereby contributing further to the weakness in personal consumption expenditures. Residential Construction Homebuilding activity has experienced a severe decline. Housing starts, which averaged nearly 1-3/4 million units at an annual rate during the first nine months of 1979, began to fall sharply last autumn. By December, starts were at a 1-1/2 million unit pace, and by May they had declined almost to a 900,000 rate. June saw a pickup in starts to a 1-1/4 million annual rate. In the single-family sector, starts dropped 45 percent between the third quarter of 1979 and the second quarter of this year. Although demo graphic factors remained quite favorable during this period, the demand for such dwellings was curtailed by the increased cost of homeownership associated with higher house prices and the rapid rise in mortgage interest rates. The monthly cost of interest and principal on an average-priced new home financed with a conventional mortgage rose to $700 in May--a third higher than six months earlier and 50 percent above the same month of 1979. Households prob ably were increasingly reluctant to undertake such heavy financial obligations, especially as income and employment conditions weakened this year. Home sales have dropped almost 40 percent from the pace of last summer. Although production adjustments have reduced the number of unsold new single-family dwellings on the market, these unsold units bulk larger rela tive to the recent slower rate of sales. At the May sales pace, which was up sharply from April, there was almost a nine-month supply of unsold new single family units on the market. The pickup in sales in May is perhaps a sign of -23- some increased interest on the part of homebuyers, prompted by the recent easing in financial markets; however, the still large overhang of unsold homes is likely to discourage a quick resumption of building in many local ities. Multifamily housing starts began declining sharply late last year and in the second quarter were off about 35 percent from the already-reduced pace of the third quarter of 1979. The decline in this sector has been less severe than in the 1973-75 period, as low vacancy rates in many areas and an acceleration in rent increases beginning in late 1979 have given builders an incentive to sustain a significant level of apartment construction in the face of high construction costs and tight financial conditions. In addition, demands for condominiums--a lower-cost alternative to single-family home ownership--have provided support to multiunit activity. Business Spending Business spending on plant and equipment has slowed in recent months as firms have sought to avoid expanding capacity at the onset of a recession. Spending on nonresidential structures, which accounted for much of the gain in investment during 1979, peaked in January and declined substantially in the following months. Business purchases of trucks and automobiles also have been falling since early this year, as have outlays for other capital equipment. Weakness in capital spending in the first half of the year--as well as in forward-looking indicators of investment activity such as surveys, con struction contracts, and equipment orders--probably reflected businessmen's anticipations that sales may remain sluggish for a while. In addition, cor porate cash flows are diminishing,· and with liquidity positions already -24- Contracts and Orders for Plant and Equipment - Annual rate of change, pe-rcent* 1972 dollars - - 20 - - 10 + - 0 - .. - 10 - - 20 - - 30 H1 I I .I I I I I . - 1974 1976 1978 1980 Inventories Relative to Sales Ratio 1972 dollars 1.7 Total Manufacturing and Trade 1.6 1.5 1974 1976 1978 1980 *Annual changes are from 04 to 04; semi-annual change is from 04 to the April-May average. -25- strained in many instances, there may be a reluctance to undertake additional projects requiring external financing. Although interest rates have fallen dramatically from the high levels reached earlier this year, growing excess plant capacity suggests the likelihood of further decreases in real outlays, while firms take advantage of lower long-term rates to restructure their balance sheets. Despite sizable cutbacks in production, some involuntary inventory accumulation appears to have occurred this spring as a consequence of the steep fali in sales. The stock-sales ratio for all manufacturing and trade in real terms rose only moderately during the first quarter, but climbed appreciably in April and May to near the level of late 1974. Since the start of the year, substantial increases in the ratio have been registered in most major industries with especially large rises for primary metals manufacturers, furniture and appliance retailers, and the motor vehicle industry. Auto sales incentive programs and production adjustments in the first quarter of 1980 largely eliminated excessive stocks that had resulted from last summer's gaso line shortages. However, beginning in mid-April, automobile sales plummeted and, despite further curtailments of production, some overhang of stocks at dealers reappeared. Government Spending at all levels of government has been restrained in recent months. Total federal expenditures, which grew rapidly in the early months of the year, moderated in the second quarter largely as a result of the March bud get cuts. Growth in receipts fell off much more, however, as weakness in --26-- Public Sector Expenditures and Receipts Federal Government - Annual rate of change, percent* - NIA Basis D Expenditures - OD Receipts - 20 - - - . H .. 1 - 15 I - -- - - 10 - -· ,- : t-- - . - 5 I I I I I I I 1974 1976 1978 1980 State and Local Governments Annual rate of change, p-ercent* ~ NIA Basis D Expenditures -- 11D Receipts - 16 - - -- - - 12 - - - - - 8 - .H.. 1 - - 4 I I I I I I I 1974 1976 1978 1980 *Annual changes are from 04 to 04: semi-annual changes are from 04 to 02. Data for 1980 H 1 are partially estimated by the Federal Reserve. --27- personal income and pr~fits off~et the impact of additional revenue from the windfall profits tak on oil pr6ducers. As a result, the federal deficit on a nation1.tl incot118 a~~ounts bads prdbably deepened by about $30 billion, at an annual rate, bet~~en the foctrth quarter of 1979 and the second quarter of 1980. However, tht! high-employm~nt budget, a better indicator of the • thrust of discretionary fiscal policy. showed a movement toward restraint during this period. State and local governrfi~nt spending fell in real terms during the first half of 1980, as governmental units -curtailed outlays in response to the slower growth of revenues caused by tax cuts enacted in 1979, the weak ening economy, and the Mac.ch reductions of federal grants-in-aid. The re duced pace of spending was most prono'unc:ed for construction activity because federal funding was cut back and municipal bond issuance was constrained in the first quarter by high interest rates. Despite the downward adjustments of outlays, the aggregate operating deficit of the state and local government sector apparently widened considerably in the spring. International Trade and Payments Real exports of goods and services continued to grow rapidly in the first quarter of 1980, but the rise appears to have slowed somewhat in the second quarter. The d~celeration largely reflected the slowing of economic expansion abroad and th~ fading of the ~mpact of the 1977-78 real depreciation of the dollar. All of the growth in the · first ha~f was concentrated in nonagri cultural expor;ts; agricultural shipments ·were reduced, partly because of the -28- Exp_orts a.Ad Imports of Go·ods end Services Seasonally adjusted, annual rate, billions of 1972 dollars NIA Basis 130 110 90 70 1974 1976 1978 1980 Trade and Current Account Balances Seasonally adjusted, annual rate, billions of dollars Surplus 20 Current Account + 0 Merchandise Trade 20 Deficit 40 1974 1976 1978 1980 Data for 1980 02 Merchandise Trade Balance are partially estimated. -29- embargo on additional grain sales to the Soviet Union imposed by the President in January. The,volume of imports, meanwhile, began to fall off as U.S. economic activity slackened and as higher prices and greater fuel efficiency acted to restrain oil imports. The volume of non-oil imports rose slightly on balance in the first half of 1980, but all of the increase was in the first quarter. The quantity of oil imports fell, apparently reaching its lowest rate in four years in the second quarter. Despite a declining volume of oil imports in the first quarter, higher OPEC prices resulted in a continuation of the rapid growth in the dollar value of oil imports. The oil import bill nearly doubled between the fourth quarter of 1978 and the first quarter of 1980; in the second quarter the value of oil imports changed little as lower volume offset a further rise in import prices. The U.S. merchandise trade deficit increased about $6-1/2 billion, at an annual rate, in the first quarter of this year from the rate in the last quarter of 1979. The current account moved from a deficit of about $7 billion at an annual rate in the fourth quarter, and near balance for the year 1979, to a deficit of about $10 billion in the first quarter of 1980. Higher foreign earnings of U.S. oil companies offset part of the rise in the · merchandise trade deficit. Partial data indicate that the trade and current~ account deficits narrowed in the second quarter. -30- SECTION 2. LABOR MARKETS AND CAPACITY UTILIZATION Labor demand was relatively well-maintained early in the year, but it fell off steeply in the spring as firms responded to the sharp declines in sales by cutting their work forces and shortening workweeks. Between January and June, the number of workers on the payrolls of nonfarm establish ments fell almost 950,000; total employment, as measured by the household survey, fell more than 1-1/4 million. With layoffs rising, the nation's job less rate jumped from 6-1/4 percent in January to 7-3/4 percent in May and June. Much of the cutback in employment occurred in the construction sec tor and in durable goods manufacturing, especially motor vehicle and related industries"". By June, the number of auto workers on indefinite layoff was nearly 250,000 (about 30 percent of total hourly workers in the industry), and substantial layoffs had occurred in the steel and tire industries as well. Construction employment began to drop early in the year, and subsequently sup pliers of building materials also reduced their payrolls. During the spring, however, weakness in labor demand began to spread throughout the economy; employment at trade establishments dropped 190,000 over the second quarter, and in June payrolls in the service-producing sector registered the first monthly decline since 1975. In addition to trimming payrolls, employers have curtailed work schedules in light of the weakening of sales. Since January, the average workweek at manufacturing establishmen·ts has been shortened almost 1-1/4 hours. More ge~erally, :the number of 'workers on part-time schedules for -31- Nonfarm Payroll Employment Annual rate of change, millions of persons* - - r- - 4 . rnn - r- ~ - 2 r- - r- mnn H1 + 0 llllllJ I I J l I I J 1974 1976 1978 1980 Manufacturing Employment Annual rate of change, millions of persons* +° H1 L_J1JU1L--,,rnnr--irmm-Jlllllll___lllJJLIL___JJJ_llll___u..1..1...1...1.7nr-7 1974 1976 1978 1980 unemployment Rates Percent 8 6 Adult Male 4 1974 1976 1978 1980 * Annual changes are from 04 to 04. ·· semi-annual changes are from 04 to 02. --32- economic r..easons rose sharply in the s-econd quarter,. with former full-time ~obholders accounting for most of the increase. The rise in joblessness has been widespread among demographic and occupational groups, with especially large increases reported among adult males. Since December, the jobless rate among men has climbed almost 2-1/2 percentage points, compared with an increase of 3/4 percentage point for adult women, and June marked the first time in two decades that the rate for men was higher than that for women. Unemployment among blue-collar workers rose sharply to an 11-1/2 percent rate in June, the highest since September 1975. In contrast, unemployment rates among white-collar workers have in creased only marginally since the end of 1979. The adjustments in output by firms, especially in the second quar ter, were reflected in a sharp decline in the index of industrial production. Between January and June, industrial production fell nearly 7-1/2 percent. Production declines in auto-related industries and in industries supplying construction materials began early in the year, but by late spring cutbacks were occurring in most other industries as well. Among manufacturing firms, capacity utilization in June dropped to 76 percent, almost 11 percentage points below its 1979 peak. -33- SECTION 3. PRICES, WAGES AND PRODUCTIVITY After exploding upward in the early months of the year, rates of price increase moderated significantly in the second quarter. The improve ment resulted primarily from a stabilizing of energy prices and from declines in the prices of nonferrous metals, after a flurry of speculative activity earlier in the year. Increases in the prices of construction materials and components also slowed noticeably in the second quarter with the decline in activity in the housing sector. In the energy area, retail prices surged in January and February, in large part the result of the hike in OPEC prices that occurred in late 1979, but the pace of increase then slowed noticeably in the spring, as inventories reached near-record levels and demand continued to drop. The increase in energy prices also moderated at the producer level. Nonetheless, indirect effects of earlier increases in the prices of fuels and petroleum feedstocks were still evident through the end of June in items such as plastics and rubber products, industrial chemicals, and household supplies. Moreover, a number of factors--including the latest increases in OPEC prices, the curtailment of gasoline production, and the progressive dec·ontrol of crude oil prices--suggest that further relief in the energy area is not to be expected. Food prices generally have exerted a moderating influence on aggre gate price measures since the beginning of the year. At the producer level, finished food prices fell at about a 4-1/2 percent annual rate between December and June. Steep drops in wholesale prices through May--particularly for live stock--alleviated cost pressures at the retail level, contributing to relatively -34- Prices and Labor Costs Change from year earlier, annual rate, percent 14 Consumer Price Index 10 Gross Domestic Product 6 Fixed Weight Deflater 16 12 8 4 40 30 20 10 14 Unit Labor Costs 10 6 1974 1976 1978 1980 -35- stable retail food prices since the end of last year. However, recent devel opments in the markets for livestock and fresh produce indicate that food prices also are likely to rise more rapidly in the second half of the year. Inflationary pressures have persisted in sectors outside food and energy since the beginning of the year. In the consumer price index, in creases in the homeownership component have been particularly large, as the measures of mortgage rates and home purchase prices both advanced rapidly in the first half of this year; the recent easing of mortgage rates will likely hold down increases in the CPI during the next few months. In the producer price index, prices of capital equipment accelerated in the first half of 1980 from the already rapid pace of 1979. Labor cost pressures remained intense in the first half of 1980, as compensation increases were substantial while productivity declined further. Output per hour in the private nonfarm business sector dropped at about a 1-1/2 percent annual rate in the first quarter, after falling 2 per cent over the preceding year. At the same time, hourly compensation accel- erated to a 10-1/4 percent annual rate, so that the unit labor costs of nonfarm businesses rose at about an 11-3/4 percent rate in the first quarter. Preliminary data for the second quarter suggest that unit labor costs con tinued to rise rapidly, as productivity contracted further. Although cyclical reductions in overtime and the changing employment mix may restrain t;1e growth in total compensation somewhat in coming months, wage demands are likely to remain strong, especially in light of past increases in consumer prices. Thus, upward pressures on unit labor costs will probably remain substantial over the near term. -36- SECTION 4. FINANCIAL DEVELOPMENTS DURING THE FIRST HALF OF 1980 Interest Rates Market rates of interest moved sharply higher in the early months of 1980, exceeding previous record levels and peaking around the end of the first quarter. These increases were largely reversed in the second quarter amid a substantial downslide in economic activity and contracting demands for money and credit. The upward pressure on yields at the turn of the year re sulted from a combination of factors, including a deterioration in inflationary expectations as actual price increases accelerated in January and February, the failure of incoming data to confirm the long-anticipated downturn in activity, and international political developments that raised the likelihood of an in crease in federal deficit spending. In February, moreover, growth in money and credit surged, creating demands for bank reserves well in excess of the provision of nonborrowed reserves consistent with the Federal Reserve's tar- get ranges for growth in the monetary aggregates. In the Treasury bill market, in particular, the resulting rise in short-term interest rates was reinforced by large sales of securities by foreign institutions to finance intervention in foreign exchange markets. On ·March 14, the Board of Governors took actions of a temporary nature designed to reinforce the effectiveness of the measures announced in October 1979 and thus to provide greater assurance that the monetary goals reported to the Congress in February would be met. These actions, some of which were taken under the authority of the Credit Control Act as part of a broad government effort aimed at reducing inflationary pressures, included: -37- lnterest Rates Short-term Percent 20 Prime Rate 16 12 4-6 Month ......- -Prime Commercial Paper 8 3-Month Treasury Bill 4 1974 1976 , 1978 1980 Long-term Percent 16 Home Mortgage Rates 12 Aaa Utility Bond 8 New Issues 4 1974 1976 1978 1980 -38- (1) a special credit restraint program directed toward limiting the growth in loans to U.S. customers by commercial banks and finance companies to ranges consistent with the monetary and credit objectives of the Federal Reserve; (2) a special deposit requirement for all types of lenders on in creases in certain categories of consumer credit; (3) an increase in the marginal reserve requirement on managed liabilities of large member banks and U.S. branches and agencies of large foreign banks; (4) a special deposit requirement on increases in managed liabilities of large nonmember banks; (5) a special deposit requirement on increases in total assets of money market mutual funds; (6) a surcharge of 3 percentage points on frequent borrowing by large member banks from Federal Reserve Banks. These measures hastened the movement toward reduced credit avail abili ty already in train at many lenders, and apparently increased the resolve of consumers to curtail their use of credit. In subsequent weeks, incoming data revealed a substantial slackening in money and credit growth to well within the Federal Reserve's objectives. In light of these developments, the Board amended the special credit program: on May 6 the 3 percentage point sur charge on discount borrowing by large banks was eliminated, and on May 22 special deposit requirements were reduced by half and the special credit re straint guidelines were modified. On July 3 the final phase-out of the pro gram was announced. The rise in most interest rates came to a halt in late March and early April, and yields began to move down as demands for money and credit dropped abruptly in response to developing slack in the economy. Most private short-term rates fell 7 to 9 percentage points, to their lowest levels since -39- the spring of 1978. In long-term securities markets, bond yields retraced most or all of the increases recorded earlier in the year, as market participants appear to have lowered their expectations of inflation. The restraining posture of monetary and fiscal policy, as well as moderating rates of price increase in the cyclical downturn, has contributed to this improved outlook for price changes. Foreign Exchange Markets and the Dollar Movements in U.S. interest rates greatly influenced fluctuations in the foreign exchange value of the dollar over the first half of 1980. The dollar was in strong demand early in the year when U.S. interest rates rose sharply. The growing perception by market participants of accelerating infla tion and worsening payments deficits abroad gave added impetus to the dollar's rise over this period, as did the announcement of credit control measures on March 14. Authorities in a number of foreign countries also moved to tighten monetary conditions, but the resulting increase in foreign interest rates lagged well behind that of U.S. rates. The strengthening in the foreign exchange value of the dollar in February and March was moderated somewhat by substantial inter vention activities by U.S. and foreign monetary authorities. The peaking and subsequent steep decline in U.S. interest rates in early April triggered heavy selling pressure on the dollar in international markets, and its foreign exchange value fell in the April to June period. Foreign and U.S. monetary authorities intervened to moderate this decline by making net purchases of dollars. Even so, by the end of June earlier gains were entirely erased, and the weighted-average exchange value of the dollar at mid year was little changed from its value at the beginning of the year. -40- 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 U.S. CDs 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. -41- Domestic Credit Flows Net funds raised in credit markets by domestic nonfinancial sectors of the U.S. economy totaled a sizable $391 billion at an annual rate in the first quarter of 1980, but contracted sharply to an estimated $193 billion in the second period. This exceptionally large decline in borrowing reflected in large part the recent sudden weakening in production and sales activity; in addition, monetary restraint, supplemented by the special policy actions of mid March, contributed to tauter credit terms and reduced availability of funds at many lenders. In the private sector, the volume of funds raised in the first quarter was greatly enlarged by a surge in borrowing on the part of nonfinan cial business firms. Some of this increased borrowing reflected needs to finance growth in inventories and fixed capital outlays, as the gap between such expenditures and internally generated funds of nonfinancial corporations widened. But fears that unchecked inflation would lead to the imposition of credit controls and a consequent reduction in credit availability apparently led to a burst of anticipatory borrowing by firms as well. As a result, corpo rations added substantially to their holdings of liquid assets in the first quarter and appear.to. have-drawn down these holdings in subsequent· months. As interE:.st rates moved up rapidly early in the year, businesses concentrated their credit demands in short~ and intermediate-term markets, with borrowing at banks and in the commercial ~aper markets especially heavy. Corporate bond financing remained r~latively low as businesses, especially industrial firms, were reluct_ant to issue lo~ng-ternr d~bt at _..h istotfc~lly high -42- Net Funds Raised in Credit Markets By Domestic Nonfinancial Sectors Seasonally adjusted annual rate, billions of dollars 01 400 300 I 02 200 U.S. Government State and Local Governments 100 Households Nonfinancial Business 1973 1974 1975 1976 1977 1978 1979 1980 Source: Federal Reserve Board Flow of Funds Accounts. Data for 1980 02 are partially estimated. -43- yields. This pattern of corporate financing shifted dramatically, however, when interest rates dropped rapidly in the spring. Public offerings of longer term corporate bonds accelerated to unprecedented levels, with the proceeds from many of these issues being used to pay down bank debt. After March, commercial banks--concerned both about pressures on their earnings margins as interest rates dropped and about meeting the loan growth guidelines of the voluntary special credit_r estraint program--tended to discourage business borrowers. In particular, adjustments in the bank prime lending rate lagged substantially behind downward movements in other market rates, greatly increasing the relative cost of this source of financing. As a result of the relatively high cost of bank credit, coupled with a desire of busi nesses to adjust their balance sheets following the heavy reliance on short-term debt in previous months, business loans at banks contracted markedly in the second quarter. Although commercial paper issuance by firms remained very large, total short- and intermediate-term business credit demands in the second quarter moderated appreciably from the first-quarter pace. Late in the second quarter, the prime rate began to move down, narrowing the gap with market rates somewhat; survey data, furthermore, suggest that banks in May were making a large share of short-term business loans at b.elow-prime interest rates. In the household sector, consumers greatly reduced their use of installment credit during the first half. The large growth of con-sumer install ment and mortgage debt in 1979--both in absolute terms and in relation to dis posable income--had produced a marked deterioration in household liquidity. The combination of resulting heavy debt burdens, high interes't ·rates., and, in some states, restrictive usury ceilings acted to slow growth of installment -44- credit in late 1979 and the first quarter of 1980. The volume of outstanding installment credit contracted in the second quarter as consumers curtailed ex penditures and repaid debt against a backdrop of rapidly declining real incomes and rising unemployment. Credit-tightening measures by lenders after the announcement of the credit-control package on March 14 and uncertainty on the part of consumers about the effects of those controls contributed further to the reduction in credit use. Household borrowing in mortgage markets also slowed considerably in the first half. Reduced deposit flows and pressures on earnings margins from rising costs of funds constrained the lending activity of thrift institu tions and pushed mortgage rates to record levels in March. Many would-be homebuyers were deterred by the high cost of mortgage credit. More recently, lower market interest rates have helped to reduce cost pressures for thrift institutions and have contributed to a pickup in deposit flows. Sharp drops in mortgage rates since early April and reports of some easing in nonrate terms suggest that lending institutions have become more active in seeking mortgage loans since early June. But mortgage rates remain high by historical standards, while demands for housing and housing credit continue to be damped by a weak economy and by the liquidity concerns of households; consequently, mortgage commitment activity apparently· has remained relatively sluggish'. The Treasury borrowed heavily in credit markets in the first half to finance the combined deficits of the federal government and off-budget agen cies. Normal seasonal patterns in federal cash flows associated with the timing of tax receipts led to a concentration of the Treasury's borrowing in the first three months of the year. Although the first-quarter deficit was -45- further deepened this year by unusually large tax refunds associated with over withholding in 1979, the Treasury was able to even out its borrowing pattern somewhat by permitting its cash balance to drop over the first quarter and then rebuilding it in the second. In contrast to the federal sector, net borrowing by state and local governments dropped off in the first quarter but accelerated appreciably in the second. Many municipal governments postponed or canceled scheduled bond issues early in the year because of high interest rates; for some governmental units, these actions were necessitated by the rise of interest rates above statutory l~mitations. But the volume of tax-exempt financing picked up considerably in the second quarter when interest rates fell and many previously postponed bond issues were brought to market. The financing needs of state and local uni ts generally increased over the first half in response to slower growth of revenues and a consequent widening of their operating deficits. In addition, the volume of tax-exempt securities issued continued to be boosted by offerings of mortgage revenue bonds, designed to finance single-family housing.

Federal Reserve (1980, July 21). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_19800722

@misc{wtfs_monetary_policy_report_19800722,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {1980},
  month = {Jul},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_19800722},
  note = {Retrieved via When the Fed Speaks corpus}
}