Monetary Policy Report

I I 1 10 a.m., E. D. T. 981 ~ ~ LIBRA V JUL 2 4 198f Board of Governors of the Federal Reserve System I II II //I l 1 Midyear Monetary Policy Report to Congress Pursuant to the Full Employment and Balanced Growth Act of 1978 July 20, 1 981 , 1 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., July 20, 1981 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 CONTENTS Page Chapter 1. Federal Reserve Policy and the Outlook for 1981 and 1982 Section 1. The Objectives of Monetary Policy 1 Section 2. The Growth of Money and Credit 4 Section 3. The Outlook for the Economy 13 Chapter 2. A Review of Recent Economic and Financial Developments Section 1. Economic Activity During the First Half of 1981 17 Section 2. Financial Developments During the First Half of 1981 36 CHAPTER 1 FEDERAL RESERVE POLICY AND THE OUTLOOK FOR 1981 AND 1982 -1- Section 1: The Objectives of Monetary Policy The Federal Reserve reported to the Congress in February that the principal ob_iective for monetary policy in 1981 would be to exert con tinuing resistance to inflationary forces. This goal requires gradual reduc tions over time in the expansion of money and credit to rates consistent with sustainable growth in output at reasonably stable prices. Signs of a deceler ation in broad price measures this year are encouraging. Nonetheless, infla- tionary forces are still well entrenched, and the Federal Reserve must remain firmly committed to a policy of monetary restraint. The persistence of inflation and the extraordinary costs it imposes on the economy have been widely demonstrated in recent years. Deeply embedded expectations of inflation have created serious imbalances in financial markets, distorted spending patterns throughout the economy, and imparted a strong up ward rnomentum to wages and prices. At the same time, productivity growth has slowed markedly and the unemployment rate has remained consistently high by historical standards. Dealing with the inflation problem, with all its diffi culties, is essential if we are to provide a solid base for sustained growth, lower unemployment, and higher productivity, goals central to the Humphrey Hawkins Act. The reduced rate of price increase this year has reflected, in sub stantial part, developments in the food and energy sectors. Sensitive com modity prices, more broadly, have been restrained by the high cost of credit and reduced speculative interest. In short time periods, however, prices in these sectors can be greatly influenced by developments only tangentially related to broader trends in the economy and can be quite volatile. The under lying inflationary tendencies in the economy generally are better captured by -2- trends in labor costs--the largest element in production costs for both goods and services. While there are scattered and tentative indications of some moderation of the rise in unit labor costs, their advance remains rapid. One key element in slowing the rise in costs is avoiding excessive pressures on productive capacity. Restraint on growth of money and credit helps to prevent such pressures. But the process of slowing inflation through monetary restraint can entail strains on particular markets and sectors of the economy, especially when so much of the task of dealing with inflation rests on monetary policy. As long as strong demands for money and credit persist, and inflationary expectations remain intense, restrained monetary growth may be accompanied by high interest rates and considerable financial stress. These financial strains impose particular hardships on industries that depend heavily on credit markets such as construction, con sumer durables, and business equipment. Most obviously, the thrift institu tions are experiencing severe pressures on earnings and reduced inflows of deposits. More generally, the recent infla-tion, combined with a long period of relatively slow growth in activity, has distorted the balance sheets of many businesses and individuals, leaving them more vulnerable to adverse financial and ec_onomic developments. Lasting relief from these financial pressures will be dependent on success in dealing with the inflation that lies at the root of the problem. Monetary stimulus can encourage, at best, only short-lived declines in inter ~st rates and would without question sustain or aggravate underlying infla tionary forces. The only effective way to bring down interest rates and restore financial stability is through the sustained pursuit of anti-inflation policies. The more quickly inflationary forces are defused, the greater the -3- potential for a sustained easing in credit market conditions and a return to more satisfactory production and employment growth. Disciplined money policy is an essential element in the effort to damp inflationary forces. Progress in this direction will be speeded and the near-term hardships minimized if other governmental policies complement the efforts of the monetary authority. As businesses and wage earners become convinced that the government is committed to slowing the rise in prices, expectations of inflation will have a lessening impact on the determination of wages, interest rates, and prices. In this regard, the stance of fiscal policy is of particular importance. Assurance that growth in Federal expendi tures will be limited and that the budget will move toward balance will rein force the effectiveness of monetary restraint and help relieve pressures on financial markets. -4- Section 2: The Growth of Money and Credit The targeted ranges of growth for the monetary aggr egates announced in February anticipated a deceleration in monetary growth. Measured from the fourth quarter of 1980 to the fourth quarter of 1981, and abstracting from the effects of the authorization of NOW accounts nationwide, the ranges adopted were as follows: for Ml-A, 3 to 5-1/2 percent; for Ml-B, 3-1/2 to 6 percent; for M2, 6 to 9 percent; and for M3, 6-1/2 to 9-1/2 percent. The corresponding range for commercial hank credit wa~ 6 t..o 9 percent. The monetary aggregates have shown disparate patterns of growth so far this year. The narrow aggregates, after ad_iusting for the newly author ized NOW accounts, have fallen short of their ranges. At the same time, M2 growth has been at the upper limit of its range, while M3 has exceeded the upper end of its range. The divergent behavior of the aggregates is sympto matic of the rapid structural changes that are underway in financial markets in response to high and volatile interest rates and to an evolving regulatory environment. Recently, the most prominent structural development affecting the measured aggregates has been the introduction at the end of 1980 of NOW accounts nationwide. As expected, there have been maior shifts of funds into NOW accounts from conventional checking accounts included in Ml-A and from interest-earning assets included in M2. Consequently, the Federal Reserve 'is publishing estimates of Ml-A and Ml-B that are adjusted for these shifts in order to facilitate comparisons with earlier years. Through June, these adjustments have had the effect of raising Ml-A by $28 billion and lowering Ml-R by $10 billion. Shifts into NOW accounts were particularly large early in the year, reflecting the rapid response by individuals with -5- Growth Ranges and Actual Monetary Growth M1-A Billions of dollars Annual Rates of Growth Range Adopted by FOMC for 1980 04 to 1981 04 Adjusted Level Adjusted for Impact of Nationwide NOW Accounts o~ 1980 to 1981 02 Actual Level 1.6 Percent ---- 5½% ---- ---- --- 410 1980 04 to 1981 June ---- 0.0 Percent -- ------ -- ---- -- -- - 3% 390 370 1980 1981 M1-B Billions of dollars Annual Rates of Growth Adjusted 1980 04 to 1 981 02 450 2.2 Percent 1980 Q4 to 1981 June .,,,,. .,,,,. - 6% ---- 440 0.7 Percent ---- ----- .,,,,. ---- 3½% ---- .,,,,. 430 .,,,,. ---- .,,,,. -- 420 410 1980 1981 -6- large demand deposit balances. Over the past two months, in contrast, the shift ad_iustments have been negligible, as there have been small outflows from NOW accounts. These outflows probably do not signal the end of the NOW account buildup. The record in New England, where NOW accounts were intro duced some time ago, suggests that the process of adjustment has further to go. Also, a recent survey indicates that individuals are continuing to open NOW accounts, though at a much reduced pace from earlier in the year. Even so, the adjusted and unadjusted data are likely to continue to move much more closely together than in the early months of the year. The shift adjustments published by the Federal Reserve have attempted to correct for one important distorting influence on the narrow aggregates. After taking account of these adiustments, Ml-A and Ml-B have been low relative to their past relationships to income and interest rates, so far this year. For example, despite the rapid ~rowth in nominal income over the first half of 1981, shift-adjusted Ml-B expanded at an annual rate of only 2-1/4 percent from the fourth quarter of 1980 to the second quarter of 1981. This was less than half the rate at which Ml-B grew in 1980 even after allowing for the shift into ATS and related accounts last year. In the first quarter especially, growth in adjusted Ml-B was well below that which would be expected on the basis of average historical relationships among money, income, and interest rateB. Relatively low growth in trans actions balances has occurred on occasion when interest rates have reached new highs, such as happened at the turn of the year. In addition, the intro duction of NOW accounts may have stimulated a general reconsideration of alternative deposit and nondeposit instruments and thereby have intensified the response to the peak in rates. -7- Indeed, at the same time that the narrow aggregates have been unusually weak, the broader aggregates in the first half of 1981 have been at or above the upper limits of their specified ranges. Instruments that offer market-determined yields have continued to grow rapidly, insulating M2 from the damping effects of rising interest rates by encouraging investors to keep their funds in financial intermediaries rather than shifting into open market securities. The growth of money market mutual funds has been particu larly rapid, averaging about 125 percent at an annual rate from December 1980 to June 1981; this growth accounted for 60 percent of the increase in the nontransaction component of M2. ~"hile available data do not permit accurate estimates, the exceptionally rapid growth in these funds, which at least in limited part are used as transactions balances, may have lowered growth in recorded Ml-Ba bit. To the extent that money market mutual funds attracted funds from the open market, the effect was higher M2 and M3. Thus far this year, M3 growth has averaged 11-1/2 percent at an annual rate--about 1-1/4 percentage points faster than last year and 2 _per centage points more than the growth of M2. Large denomination certificates of deposit, which are the main additional instruments included in M3, have been growing strongly, reflecting the need for depository institutions to expand their managed liabilities to offset the weakness in their core deposits. In addition, M3 appears to have been influenced by changing patterns of trans actions between U.S. banks and their foreign branches. Over the first half of 1981, commercial bank credit grew on balance at a rate a bit below the upper limit of its range for 1981. Loan growth was strong early 1n the year but soon tapered off. With the prime rate lagging - 8- Growth Ranges and Actual Monetary and Bank Credit Growth M2 Billions of dollars Annual Rates of Growth -- Range adopted by FOMC for 1980 04 to 1981 04 1980 04 to 1981 02 1800 9.5 Percent • - Actual Level 1980 04 to 1981 June 8.7 Percent 1750 1700 1650 1980 1981 M3 Billions of dollars Annual Rates of Growth ,, 9½% / / 1980 04 to 1981 02 / .,,,,,,.,,,,,,.,,,,,, 2100 11.5 Percent / .,,,,,,.,,,,,,.,,,,,, ------,_.-6½% • 1980 04 to 1981 June .,,,,,,.,,,,,, ---- ---- 2050 11 . 1 Percent .,,,,,,.,,,,,, ---- ---- / .,,,-,,,.-,,,,-,, -/ ---- --,,-,,,,-.,,,, - ,, -/ -- 2000 ----:- . ,,, - / 1950 1980 1981 Bank Credit Billions of dollars Annual Rates of Growth 1 980 04 to 1 981 02 1350 8.9 Percent --------- 9% 1980 04 to 1981 June -------- --___ -6% 1300 8.7 Percent -- -- ---- .- ---.---:::::::-::-:------ 1250 1200 1980 -9- behind the drop in market rates, business loan growth showed a particularly sharp deceleration, as corporations switched much of their borrowing to the commercial paper and bond markets. Later in the spring, however, business loan growth picked up again, as bond rates moved to all-time highs. Real estate loans have shown a more even pattern of growth, sustaining their mod erate 1980 rate of increase, while consumer loans outstanding have continued to edge down this year. Security holdings at banks have grown somewhat faster than loans over the first half of 1981, with the bulk of the increase accounted for by U.S. government obligations. So far this year, bank credit growth has been almost 3 percentage points slower than M3 growth. This divergence between the increase in bank asset portfolios and the expansion in M3--which includes most hank liabilities--mainly reflects the large increase in money market mutual funds; much of the inflow to money funds was channeled into commercial paper and other nonb ank instruments. 1 At its meeting in July, the Federal Open Market Committee reassessed the ranges it had adopted for money growth in 1981 and formulated preliminary objectives for 1982. In the light of all the circumstances, the FOMC elected to retain the previously established ranges for the monetary aggregates over the remainder of 1981. In doing so, the FOMC recognized that the short-fall in Ml-B growth in the first half of the year probably reflected in part some shifting of transactions balances included in Ml-B into other highly liquid assets; in light of that pattern and the desire to moderate growth in money, the FOMC contemplates that growth in the narrow aggregates, adiusted for shifting into NOW accounts, over the year as a whole may be near the lower ends of their annual ranges. Growth in the broader aggregates, on the other hand, has been running at the top or somewhat above the upper ends of their ranges, and given their behavior in the first half of the year, may be toward the upper part of their ranges for the year as a whole. As indicated, the nontransactions components of M2 that offer market-determined rates have been ~rowing vigorously, aoparently partly at the expense of market instruments not included in the aggregates. Moreover, the attractiveness of the small time deposit component of M2 recently was enhanced by the decision effective August 1 to uncap the ceiling on 2-1/2 year or longer "small saver certificates" and to remove ceilings entirely on small time deposits with initial maturities of 4 years or more. In the context of sluggish profits growth and an expanding need for external financing, business loan demands seem likely to remain relatively strong, though a surge in long-term financing could reduce business borrowing at banks if bond rates were to fall. Other components of bank credit are expected to continue recent trends, with real estate loans showing moderate growth and consumer lending remaining weak. While total bank credit is sub ject to considerable short-run fluctuation, the 6 to 9 percent range for its growth in 1981 remains appropriate. Looking ahead to 1982 and beyond, the FOMC remains committed to reducing money growth to a rate consistent with non-inflationary economic growth. The speed with which monetary expansion can be reduced without large short-run effects on production and employment w~ll depend critically on the forces bearing on inflation and credit market demands, including the fiscal position of the government. Also, during a time of rapid institutional change, monetary targets must be chosen with close attention to how such change may affect particular aggregates and the relationships among them. In this regard, regard, looking toward completion of the major shift into NOW accounts, the -11- FOMC now intends to target a single Ml figure in 1982 with the same coverage "Z. as the present Ml-B. Assuming that shifts in.to NOW accounts from nontrans actions balances are small by that time, a separate shift-adjusted figure would not be necessary. Reflecting the intent to reduce growth in money over time, the ~OMC tentatively agreed on an Ml range of 2-1/2 to 5-1/2 percent for 1982. This would involve reductions in the upper and lower ends of the range for Ml-R (as shift adjusted in 1981) of 1/2 and 1 percentage points, respectively. The growth ranges for M2 and M3 would be left unchanged from those in effect for 1981, a specification that would be fully consistent with a reduction in the actual growth of those aggregates in 1982. Thus, the tentative ranges for the broader aggregates in 1982 are as follows: for M2, 6 to 9 percent, and for M3, 6-1/2 to 9-1/2 percent. The associated range for bank credit would remain at 6 to 9 percent. While the level of the range for Ml is a reduction from the Ml-R range for 1981, it also is widened by 1/2 percentage point. Interest-bearing transaction accounts are in the process of becoming a sizable component of Ml-B. To a certain degree, those accounts have a greater savings component for individuals than noninterest-bearing demand accounts. Recause of its changed composition, some time will have to elapse before the behavior of Ml with this component can be related with confidence to changing economic and financial circumstances. Moreover, it is also uncertain when this shift in the composition will end. At present, we are assuming that the great bulk of the growth in NOW accounts will have been completed by the end of 1981, with only a small amount of funds continuing to be shifted from nontransaction balances. A firmer judgment about the transition can be made, of course, in -12- light of added experience when the 1982 targets are re-evaluated early next year. The decision to leave unchanged the ranges for M2 and M3 reflects in part the likelihood that the proportion of credit demand financed through depository institutions rather than market instruments will be modestly increased by the trend towards reduced regulatory constraints. It is expected, though, that actual growth in the broader aggregates may fall somewhat lower in their ranges than this year. -13- Section 3: The Outlook for the Economy The economy entered 1981 on a sharp upward trajectory, but it appears that there has been little further growth in activity since early in the year. Auto sales fell with the termination of price concessions this spring, and real retail sales excluding autos have declined in the second quarter. Housing con struction activity also has slackened appreciably, while business spending for capital goods apparently has edged down after allowing for inflation. Prelimi nary estimates suggest that real ~ross national product showed no increase in the second quarter, and it now appears that economic activity will remain slug gish at least in the near term. In the investment sectors, the weakness in residential construction likely will persist for some time. Declines 1n housing starts, such as occurred in the first half, typically are reflected with a lag in reduced con struction activity. Thus, even if market interest rates should ease soon, homebuilding would tend to be sluggish for a while. Business fixed investment also displays some signs of weakening, although energy rem~in~ a strong sector. Contracts for business construction and orders for new equipment have been on a downtrend in real terms. In addition, the Commerce Department's survey of capital spending intentions indicates that, for the second time this year, firms have scaled back their expected outlays, and at present their spending plans imply almost no growth in real terms for 1981 as a wpole. Consumers also may hold down spending in response to slower growth in real income and to indications that finding or retaining a job may become more difficult as the year progresses. Recent surveys indicate that there has been some retrenchment in anticipated expenditures for consumer goods by households, in part owing to concerns about restrictive credit conditions. -14- The recent appreciation of the dollar, combined with only moderate economic growth abroad, points to a slowing 1n the growth of exports. Over coming quarters, the real volume of exports could well decline a bit. Government expenditures in real terms should rise relatively little. Outside the defense area, spending by the federal government 1s expected to contract in real terms, based on proposed budget cuts for fiscal year 1982. And state and local governments currently are seeking ways to curb expendi tures in response to reduced income from federal grants and to slower growth in tax receipts. Some stimulus to private sector demands would be provided by the reductions in personal and business taxes currently under consider ation by the Congress; however, at this time it seems that most of the impact of the proposed tax cuts would affect.private markets in the second half of 1982. While the near-term outlook suggests a flat economy, it is more difficult to foresee the path of developments in 1982. A crucial element affecting this outlook is the speed with which progress is made in reducing inflation. As noted in the introduction, there has been some slowing in the rate of inflation thus far this year, and the near-term outlook is that prices will continue to rise at a more moderate pace than last year. The recent decline in food prices probably will be reversed in the second half of 1981 in response to tightening supply conditions in some areas. But other factors should work to offset these movements. In particular, the current weakness in world oil markets appears to militate against any substantial rise in petroleum prices over the next few quarters. Also, the increase in the foreign exchange value of the dollar since the end of last year, unless reversed, should further reduce domestic price pressures. -15- The pace of wage increases has abated only a little despite rela tively high levels of unemployment. The rapid increases in consumer prices in 1980 have been a factor in large upward wage adjustments this year, as workers have attempted to recapture losses of real income. Strong produc- tivity gains, such as occurred in the first quarter of this year, can hold down unit labor costs even when nominal wages rise rapidly. But a sluggish pattern of activity, such as is anticipated for the remainder of this year, is likely to be associated with small productivity gains, suggesting rela tively little alleviation of labor cost pressures in the period immediately ahead. The members of the Federal Open Market Committee, in assessing the economic outlook, have formulated projections for economic performance in the current year and in 1982 that fall within the ranges indicated in the table below. In addition to the monetary growth rate targets, the principal assump tions underlying these projections are that there will be a cut in business and personal income taxes, most of which occurs in 1982, and that growth of federal expenditures will slow. FOMC Members' Economic Forecasts Actual Projected 1980 1981 1982 Change from fourth quarter to fourth quarter, percent Nominal GNP 9.4 10 to 11-1/2 9-1/2 to 12-1/4 Real GNP -.3 1 to 1-1/2 1 to 4 Implicit GNP deflater 9.8 7-1/2 to 9 6-1/2 to 8-1/2 Average level in fourth quarter Unemployment rate (percent) 7.5 7-1/2 to 8-1/4 7 to 8-1/2 -16- Most of the members believe that economic growth will remain slug gish in the second half of this year, resulting in some further rise in the un~mployment rate by year-end. The outlook for 1982 reflects the broad range of views among members of the Committee about the pace at which the rate of inflation will be reduced. While most expect growth in nominal GNP to slow somewhat next year, views on how the composition of expenditures will be divided between prices and output are less uniform. The Administration, in association with its midyear budget review, has updated its forecast of the behavior of ma_ior economic variables for 1981 and 1982. The revised figures are shown below. The Administration's Forecast 1981 1982 Change from fourth quarter to fourth quarter, percent Nominal GNP 11.8 12.9 Real GNP 2.5 5.2 Implicit price deflator 9.1 7.3 Average level in fourth quarter Unemployment rate (percent) 7.7 7.0 As compared to the projections of FOMC members, the Administration's forecast for 1982 indicates a greater expansion in nominal GNP. The forecast for the GNP deflator is within the range indicated by Committee members, but real growth is higher. Such an outcome would seem to depend on a substantial rebound in productivity in the wake of the tax and regulatory changes now in prospect, and, relative to historical experience, on a considerable willing ness by the public to economize on cash balances in response to continuing changes in financial technology and other factors. CHAPTER 2 A REVIEW OF RECENT ECONOMIC AND FINANCIAL DEVELOPMENTS -17- Section 1: Economic Activity During the First Half of 1981 The snapback from last year's brief but sharp recession carried into the early part of 1981; however, the economy clearly lost its upward momentum during the first quarter. Over the past several months, activity has been about unchanged on balance. The initial strength of aggregate demand this year was centered in consumer durable outlays and business fixed investment. Spending in these sect~rs began the year on a strong uptrend and was bolstered for a time by the various automobile price concessions. In recent months, however, spending for consumer and business capital goods has flattened out. At the same time, residential construction activity weakened in response to rising mortgage rates, after having been aided this winter by comparative~y moderate weather. Inventories appear to be under good control, except for autos, as high financing costs have reinforced the continuing desire of busi nesses to maintain lean stocks. Unexpectedly favorable developments in volatile food and energy prices played a major role in a noticeable moderation of the broad measures of inflation during the first half. Nonetheless, there also was some limited evidence of a slowing in underlying cost pressures. Unit labor costs advanced less quickly in the first quarter than last year, reflecting a spurt in produc tivit'y growth. The moderation in unit labor costs appears to have continued this spring, as wage increases slowed in a few sectors. The marked apprecia tion of the dollar in exchange markets also began to reduce inflationary pres sures through the lowering of import prices and the associated competitive restraint on domestic prices. - 18- Real GNP Change from end of previous period, annual rate, percent 1972 Dollars 8 H1 1975 1977 1979 1981 GNP Implicit Deflator Change from end of previous period, - annual rate, p-ercent &#45;&#45;&#45; - 12 ... .. . ... ... r~ - >-- 8 ... I I ... I I I I >-- - 4 I I I I i!! I I I I I I 1975 1977 1979 1981-H1 Note: Data for 1981 H1 are partially estimated by the Federal Reserve. -19- Personal Consumption Expenditures Consumer outlays rose sharply early in the year, with strength concentrated in spending for relatively discretionary items such as autos, furniture and appliances, and apparel. This increase in spending was asso ciated with a reduction in the personal saving rate to its lowest level in nearly 30 years. In part, the willingness of consumers to save less and to borrow more may have reflected the reduction in their debt burdens that occurred last year in conjunct ion with the credit restraint program. In addition, the drop in the saving rate undoubtedly was related to the tempo rary opportunity to save on auto purchases afforded by the sizable rebates offered mainly in February and March; auto sales accounted for more than half of the increase in durable goods spending in the first quarter. Once most of the rebate programs ended, however, auto sales dropped sharply and remained at a reduced pace throughout the second quarter. In addition to the cutback in auto demand, spending for furniture and appli ances also weakened in the second quarter. At the same time, outlays for general merchandise increased only moderately, and continuing conservation efforts led to cutbacks in the volume of gasoline purchases. On balance, it appears that consumption expenditures declined slightly in the second quarter after allowing for inflation. In effect, following the first quarter surge in durable goods purchases, consumers retrenched to reestablish a more normal spending pattern; even so, the saving rate remained very low by historical standards. Business Investment Real business fixed investment increased at a 13 percent annual rate in the first quarter, as temporary developments combined to boost - 20- Personal Consumption Expenditures and Disposable Personal Income Annual rate, billions of dollars 1050 Disposable Personal Income 1000 950 900 Personal Consumption Expenditures 1978 1979 1980 1981 Unit Auto Sales Annual rate, millions of units 12 10 8 6 4 1978 1979 1980 1981 -21- spending. In the equipment area, businesses took advantage of the rebates offered on cars and added heavily to their fleets. Nonresidential construc tion also increased vigorously early in the year, aided by the relatively mild weather throughout much of the country. Following this surge, capital spending appears to have declined this spring. Shipments of nondefense capital goods have been little changed on balance, and business purchases of autos dropped sharply following the end of the rebate programs. Nonresidential construction spending also fell in the second quarter, reflecting in part the sustained tautness in financial markets so far this year. In addition, the quickening of activity that typically occurs in the spring was not as strong as usual following the relatively mild winter weather. Business inventories declined in real terms during the first quarter, continuing the liquidation that had been underway over the second half of last year. Early this year manufacturers were rebuilding their stocks at a substantial rate, but this accumulation was more than offset by the liquidation of auto stocks that resulted from the various rebate programs. With the end of the price concessions, however, auto sales weakened appre ciably and dealer stocks rose Quickly during the second quarter. At the end of June, the inventory of U.S. made autos had risen to 87 days supply, only slight1y below the peak reported in May 1980. Thus, with sharp increases in auto inventories and with manufacturers' real inventories showing relatively little change in April and May, overall business inventories probably rose in real terms during the second quarter. Apart from autos, however, business inventories still appeared to be well in line with sales in the second quarter. -22- Nondefense Capital Goods Annual rate, billions of 1972 dollars 3-month moving average 130 125 120 115 1978 1979 1980 1981 Nonresidential Construction Put in Place Annual rate, billions of 1972 dollars 45 40 1978 1979 1980 1981 Manufacturing and Trade Inventories Relative to Sales Ratio 1972 Dollars 2.0 1.8 1.6 1.4 1978 1979 1980 1981 -23- Residential Construction Residential construction activity weakened considerably over the first half of 1981. Housing starts, which had been averaging about 1-1/2 million units at an annual rate in the latter part of 1980, moved down toward a 1 million unit rate over the course of the past six months. Although starts declined early in the year, the value of construction put in place did not begin to fall appreciably until the spring, reflecting in part the favorable winter weather as well as the normal lag between starts and construction activity. In the single-family sector, starts declined 30 percent from December 1980 to June 1981. Sales of new and existing single-family homes also have dropped sharply this year. With conventional mortgage rates again rising to unprecedented levels, sales activity has been supported to some extent by sellers offering concessionary financing. At the same time, some deceleration in house prices has been apparent; existing home prices increased at a 4 percent annual rate during the first 5 months of 1g81 compared with 14 percint last year. After showing a spurt late last year, multifamily starts also have dropped sharply this year. Activity in this sector has increasingly been devoted to the construction of condominiums and cooperatives rather than rental units. First-quarter data indicate that construction of such "for sale" units was up almost a third from a year earlier and accounted for 45 percent of multifamily starts. The popularity of condominiums and cooperatives probably reflects their attractiveness as a lower cost alternative to new single-family homes. - 24- Housing Starts Annual rate, millions of units 2.0 1.5 1.0 .5 1978 1979 1980 1981 -25- Government Expenditures Federal government purchases of goods and services rose at a 15 percent annual rate in real terms in the first quarter and then declined in the second quarter. This volatility was entirely attributable to acquisitions of agricultural inventories by the Commodity Credit Corporation in the first quarter and a runoff of these stocks in the second quarter. Defense spending in real terms was virtually unchanged during the first half of the year, but sustained growth of order backlogs at manufacturers of defense goods indicates continued economic stimulus from this source. Increases on the revenue side of the budget offset this expansionary influence. Large social security tax increases became effective at the beginning of the year, and the rapid growth in GNP at the turn of the year boos te<l other revenues. .On balance, the budget shifted toward restraint. The federal deficit on a national income accounts basis probably shrank by about S26 billion, at an annual rate, between the fourth quarter of 1980 and the second quarter of 1981, while the high-employment budget, which abstracts from the effects of changes in economic activity, became more restrictive by a similar amount as the unemployment rate was little changed over the period. Real purchases by state and local governments edged down over the first six nnnths of the year, following no growth throughout 1980. In gen eral the continued sluggishness in this sector reflected the effects of fiscal limitation measures passed in a number of areas in recent years, as well as reduced growth of federal grants-in-aid. Employment fell slightly in the first half, with job losses greatest in the federally funded public service employment program. Spending for construction was about unchanged. Despite the expenditure cuts, outlays did not decline as rapidly as receipts, and -26- Public Sector Expenditures and Receipts NIA Basis Federal Government Change from end of previous period, annual rate, percent .....- D Expenditures [II] Receipts - ... rn - 20 I I I - 15 I - I "'"" ■ ■ ■ I - .. - 10 ~ I I I I - 5 I I I I !· ! . I I I 1978 1979 1980 1981-H1 State and Local Governments Change from end of previous period, annual rate, percent D Expenditures -[ID Receipts 15 10 5 1978 1979 1980 1981-H1 Note: Data for 1981 H1 are partially estimated by the Federal Reserve. -27- the state and local government sector's operating surplus was almost com pletely erased by spring after having been consistently positive for several years. International trade and payments Real exports of goods and services grew rapidly in the first quarter of 1981, in part because of strong GNP growth in two of our maier trading partners, Canada and Mexico. The growth in real exports moderated somewhat in the second quarter in response to a slowing of economic expansion abroad and the appreciation of the dollar. Increases in both agricultural and nonagricultural exports contributed to the growth of total exports in the first half. The volume of imports also has expanded rapidly so far this year. . Strong domestic demands during the first quarter and the appreciation of the dollar helped boost imports. Oil imports increased from their year-end levels, although the volume continued to be below the average for 1980 as a whole. The U.S. merchandise trade deficit declined from ahout $22 billion at an annual rate in the last quarter of 1980 to roughly SIS billion in the first quarter of 1981. The current account, reflecting this improverl trade performance as well as larger net investment income from abroad, changed from a $6 billion surplus (annual rate) in the fourth quarter of 1980 to a surplus of about $12 billion in the first quarter of this year. But with export growth slowing recently, the trade deficit apparently widened in the second quarter and the current account surplus was reduced. -28- Exports and Imports of Goods and Services. Annual rate, billions of 1972 dollars NIA Basis 170 150 130 110 90 1978 1979 1980 1981 • Trade and Current Account Balances Annual rate, billions of dollars 20 Current Account Surplus + 0 Deficit 20 40 1978 1979 1980 1981 -29- Employment and Labor Markets Employment expanded at a much slower rate during the first half of 1981 than during the second half of 1980; in June nonfarm payroll employment was about 565,000 higher than in December, compared with an increase of 860,000 over the preceding half year. On balance, the increase in employment was barely sufficient to absorb the influx of workers into the labor force, and the unemployment rate hovered around 7.4 percent throughout the first half of the year, iust below its 1980 high of 7.6 percent. Employment has continued to rise at a moderate pace in the services and trade sectors, while the number of manufacturing jobs has expanded slug gishly this year and remains below the previous peak in 1979. Employment in the automotive industry has continued at a depressed level, despite some recalls, with 160,000 auto workers still on indefinite layoff at the end of June. In recent months sharp declines occurred among construction workers, reflecting weak building activity this spring. The number of government jobs also has contracted since February, as federal hiring was curtailed and cut backs in federally funded public service jobs reduced state and local payrolls. Prices and Labor Costs The pace of inflation slowed considerably in the first half of this year, receding from double-digit rates for the first time in two years. The consumer price index rose at an annual rate of about 8-1/2 percent through May compared with a 12-1/2 percent pace over 1980. The relief has been con- centrated in the food and energy areas; however, a considerable slowing of price increases for consumer commodities more generally also has been evident in 1981 compared with the previous year. Inflation in the consumer service 1 -30- Nonfarm Payroll Employment Change from end of previous period, annual rate, millions of persons ·- ■■■■ - 4 ■" ■ ■ -3 -2 ■■■■ ""' ■■ + L--_i..JLLI...L...,_ __ ._...LLL---..L.L.&..&..1L---.-,,-y-....a..■...___. ....... .___ _- ---10 I I 1W I H1 1977 1978 1979 1980 1981 Manufacturing Employment Change from end of previous period, annual rate, millions of persons + L__ _J_JL.LJ...L...,_ _ ...LI...LLL---------y,r,---&..&..&---.JL&.&-------10 H1 1977 1978 1979 1980 1981 Unemployment Rate Percent 8 7 6 1977 1978 1979 1980 1981 -31- sector, on the other hand, has diminished little, owing in large part to the substantial weight that rising labor costs have in this sector. Retail food prices rose at an annual rate of less than 1 percent in the first five months of 1981, in marked contrast to the 10-1/4 percent pace of 1980. The deceleration in food prices in early 1981 was largely confined to sharp declines for meats and related products. More recently, however, the slowdown has been much more widespread. Prices of fruits and fresh vegetables fell sharply in May, and the rise in dairy product prices slowed noticeably. In the energy area, OPEC price increases, coupled with full decon trol of domestic crude petroleum, led to a surge 1n energy prices early in 1981; in the first three months overall retail energy prices rose at just under a 50 percent annual rate. Subsequently, however, the rise in energy costs slowed sharply, reflecting the emergence of relatively abundant sup plies in petroleum markets. Declining demands combined with high levels of production by Saudi Arabia have resulted in price reductions at both the producer and refiner levels in the second quarter. Even so, energy prices did not decline overall, as prices of natural gas--currentlv undergoing decontrol--and electricity continued to rise. Costs of homeownership, as measured in the consumer price index, also have risen more slowly. So far this year, this component has increased at an annual rate near 8 percent, less than half the pace of 1980. The home price measure used in constructing this component has fallen on balance this year, but higher financing costs have more than offset this decline. The CPI measure of home prices is based on a relatively small sample of home sales, and thus, the recent absolute declines in this measure may overstate the degree of -32- Consumer Prices Change from year earlier, percent 12 8 Total Excluding Food, Energy, and Home Ownership 10 6 42 Energy 34 26 18 10 1977 1978 1979 1980 1981 Note: Last point shown is April-May average. -33- softening in housing prices. However, other broader-based indexes indicate there has been a distinct moderation in the rate of increase in home prices this year. Prices of consumer items other than food, energy, and homeowner- ship increased at an 8-1/4 percent annual rate over the first five months of 1981, somewhat below the 10 percent pace over the 12 months of 1980. The moderation in price gains for commodities excluding food has been particularly striking; these items decelerated from a 11-1/2 percent pace over the 12 months of 1980 to 8 percent in the first part of 1981. Prices for consumer services other than home financing and energy, however, have barely edged off from the 10-1/4 percent pace of 1980, as increases in these items tend to follow more closely the underlying trend in labor costs. Movements in labor costs reflected several special factors in the first half in addition to wage and productivity changes. Growth in hourly compensation--which includes employer contributions to social insurance and the costs of fringe benefits--accelerated from a 10 percent pace in 1980 to 11-1/2 percent in the first quarter, owing to an upward adjustment in the tax rate for social security contributions and a rise in the base salary to which the tax rate is applied. On balance, the pace of wage increases in the first half appears to have moderated somewhat. The index of average hourly earnings, which is a measure of wage trends for production and nonsupervisory personnel, increased at a 8-1/2 percent annual rate in the first six months of the year compared with 9-1/2 percent last year. In manufacturing, moreover, wage increases so far this year have been running well below the 11 percent rate posted in 1980, possihly due to the light calendar for new bargaining settlements. ~~ile -34- Unit Cost Indicators Nonfarm Business Sector Change from year earlier, percent 12 Compensation Per Hour 10 8 6 1977 1978 1979 1980 1981 Change from year earlier, percent 4 2 Output Per Hour + t----,.---_..,_~c-----.---:=-------~------.-----1 0 2 1977 1978 1979 1980 1981 Change from ye~r earljer, percent 12 10 8 Unit Labor Costs 6 4 1977 1978 1979 1980 1981 -3.5- wage increases have abated somewhat, the oace of advance remains strong. Some upward pressures have been generated by catchup a<l_iustments in response to the steep rise in consumer prices last year. In addition, the scheduled minimum wage increase in January boosted wage rates in the trade and service sectors early in the year. The sharp rebound in productivity had a moderating influence on the rise in unit labor costs in the first quarter, offsetting some of the sizable increases in wages and other labor expenses. Nonetheless, the cycli cal recovery of productivity since mid-1980 has been sluggish by historical standards, and by 1981-Ql output per hour in the nonfarm business sector was _iust 1 percent above the level a year earlier. Moreover, current estimates of weak output growth suggest that productivitv gains orovided little, if any, offset to wage increases in the second quarter. -36- Section 2: Financial Developments During the First Half of 1981 Interest Rates Short-term market i'nterest rates began the year at, or only a bit below, record highs after having been on an uptrend since mid-1980 as eco nomic activity rebounded and the Federal Reserve sought to restrain monetary expansion. During the opening months of 1981, however, money growth weakened, and the demand for reserves fell relative to the provision of nonborrowed reserves consistent with the FOMC's monetary targets. Short-term rates began to ease, and by the end of the first quarter, the federal funds rate was 6-1/2 percentage points below its January peak, while other short-term rates were down by 2 to 3 percentage points. Early in the second quarter, growth in money accelerated, renewing pressures 1n the reserves market. This along with a 1 percentage point increase on May 5 in both the discount rate and the surcharge rate gave an upward impetus to short-term rates. These rates subsequently declined somewhat as money growth weakened in May and June, but in early July were about at the same levels or a bit higher than .they were at the beginning of the year. Long-term interest rates moved quite differently than short-term rates, particularly during the first quarter. Like many short-term rates, bond rates began the year somewhat below the record highs that had iust been estabiished in December. However, in contrast to the declines in yields on short-term instruments, long-term rates generally rose over the first quarter. Many financial market participants apparently were concerned about underlying inflationary pressures and about the prospects for continuing large budget deficits 1n an environment of strong private credit demands. Such concerns, · 37- lnterest Rates Short-term Percent Bank Prime 20 16 Federal Funds 12 3-month Treasury Bill 8 1978 1979 1980 1981 Long-term Percent 18 Home Mortgage 14 t Aaa Utility Bond Recently Offered 10 Municipal Bond 6 1978 1979 1980 1981 -38- including the growing backlog of potential long-term financing, continued prominent in market sentiment during much of the second quarter, and the rise in short-term rates early in the quarter also helped move most long-term rates well above their previous highs. Since peaking in May, however, long-term rates have retraced some of their earlier gains for the year. This improve ment seems to reflect in part more optimism about the prospects for reduced inflation as encouraging price data were reported, indications appeared that economic growth has slowed, firmness in monetary policy was apparent and con fidence grew that government policy will appropriately restrain federal spending. Foreign Exchange Markets and the Dollar The dollar appreciated strongly during the first half of 1981, rising about 15 percent on a weighted-average basis. Increases against European currencies averaged about 20 percent, while the appreciation against the yen was 10 percent. Over some time intervals, short-run movements in exchange rates paralleled the course of differentials between U.S. and foreign short-term interest rates. But over the first half as a wpol~, the dollar appreciated considerably even though U.S. interest rates fell on balance rela tive to rates in key financial markets abroad, which have risen markedly. A substantial part of the dollar's buoyancy can be associated with the improved outlook for U.S. inflation and the growing consensus that monetary restraint will be applied over an extended horizon. In addition, the continental Euro pean currencies have been weakened by the tensions over Poland and by general political uncertainties in several European countries. -39- Weighted Average Exchange Value of the U.S. Dollar* March 1973=100 110 100 .90 80 1978 1979 1980 1981 3-.month Interest Rates Percent U.S. CDs 18 14 10 Weighted Average of 6 Foreign Interbank Rates* 1978 1979 1980 1981 *Weighted average against or of G-10 countries plus Switzerland using total 1972-76 average trade of these countries. -40- Domestic Credit Flows After rebounding rapidly in the second half of 1980, total funds raised in credit and equity markets by domestic nonfinancial sectors of the U.S. economy leveled off in the first half of 1981, based on preliminary estimates. Firm credit market conditions contributed to some slowing in credit flows to private sectors, especially mortgage flows to households. Borrowing by nonfinancial businesses tapered off in the first four months of the year, but began to pick up in late spring. On a quarterly basis, the pattern of credit flows was greatly affected by the U.S. Treasury, which tapped financial markets for an exceptionally large volume of funds early 1n the year and then did very little net borrowing in the spring. The credit requirements of the U.S. Treasury were substantial in the first quarter, owing to a combined (on- and off-budget) federal deficit that exceeded $38 billion. In addition, redemptions of savings bonds totaled more than $2 billion, further boosting Treasury financing needs. The Treasury met these needs primarily by issuing marketable securities and, to a lesser extent, by a further reduction in cash balances. In the second quarter, when normal seasonal tax receipts moved the combined federal budget to a surplus position, the Treasury used inflows to rebuild its cash balances and to pay down an additional $2 billion of nonrnarketable securities. Borrowing by state and local governments remained heavy in the first quarter of 1981 despite a sharp decline in the issuance of mortgage revenue bonds. The volume of housing-related bonds dropped dramatically after January 1, 1981, when statutory restrictions on these offerings too~ effect. These restrictions, among other things, place limitations on eligible uses of the - 41- Funds Raised by Domestic Nonfinancial Sectors Annual rate, billions of dollars 450 400 Total 350 300 Other 250 200 H1 1977 1978 1979 1980 1981 Note: Data for 1981 H 1 are partially estimated. -42- funds with respect to the value and location of homes and the types of home buyers, the spread between mortgage rates and the original cost of borrowing; alao, the ~olume of imrtgage bonds that can be issued by governmental units is limited. The volume 0f nonhousing issues early in 1981 was buoyed in part by offerings that had been postponed in the fourth quarter, when a large number of mortgage revenue bonds were brought to market in anticipation of regulatory restrictions and yields on municipal bonds rose to then record levels. State and local governments reduced their issuance of long-term debt in the second quarter as interest costs rose again to record highs. However, financing requirements of many municipal units remained substantial in part owing to declines in revenues resulting from cutbacks in grants in aid to state and local governments. In the private sector, nonfinancial .business firms borrowed at a reduced pace early in the year. The falloff in borrowing was concentrated in short-term credit markets, and, in particular, reflected a sharp deceleration in growth of business loans from domestic pffices of U.S. banks. The lag of the banks' prime lending rates behind downward nnvements in open market rates reduced the relative attractiveness to businesses of bank loans early in the year. During the first quarter, some firms' short-term needs were met by borrowing from foreign branches of U.S. banks at rates tied to Euro dollar rates; commercial paper issuance also increased, though not enough to offset the decline in bank borrowing. Near midyear, more favorable rate spreads for bank loans and a bigger gap between cash flow and investment expenditures--largely the result of increased inventory accumulation--encour aged renewed expansion of business loans at commercial banks. Growth of non financial commercial paper also continued robust in the second quarter. -43- State and Local Household Borrowing Government Borrowing Annual rate, billions of dollars Annual rate, billions of dollars 160 36 120 30 80 24 40 18 + 0 12 H1 H1 1977 1978 1979 1980 1981 1977 1978 1979 1980 1981 Funds Raised by Nontlnanclal Corporations Nonflnanclal Business Annual rate, billions of dollars Annual rate, billions of dollars 260 160 Capital Expenditures • • 220 140 180 120 140 100 H1 H1 1977 1978 1979 1980 1981 1977 1978 1979 1980 1981 Note: Data for 1981 H 1 are partially estimated. -44- While short-term borrowing fluctuated, long-term bond issuance by business firms was maintained at a fairly heavy pace over most of the first half. Some companies with major long-range investment programs apparently _have elected to come to the bond markets at regular intervals to reduce their risk of having to finance large amounts at particularly unfavorable rates. Firms tapping the bond markets, meanwhile, sought to hold down bor rowing costs by ad_iusting various terms of their offerings. In ad<lition to shorter maturities, there was an increased volume of convertible debentures and bonds with below-market--or zero--coupons sold at deep discount. A moderate slowing in bond issuance occurred in May when yields on long-term debt reached new highs, and, in June, expectations of near-term rate declines may have led some firms to delay or postpone offerings. But there continued to be indications that_ bond issuance would increase quickly in the event of improved market conditions as many firms would like to reduce their short-term indebtedness. Flow-of-funds estimates for nonfinancial corporations indicate that their aggregate ratio of short-term debt to total debt has risen well above the previous rec9,rd level reached in 1974. Net borrowing by the household sector declined slightly on balance in the first half of the year, as a modest recovery in consumer credit growth only partially offset a reduction in net mortgage formation. Consumer install ment credit growth was bolstered in the first quarter by increases in auto mobile loans, particularly at finance company subsidiaries of the automobile manufacturers. While auto loans slowed in the second quarter in response to slackening car sales, the nonauto consumer goods and personal loan categories of installment credit showed some pickup. Despite the increases in consumer installment debt, the debt position of the household sector continued to -45- improve in the first half of the year. The ratio of consumer installment debt repayments to disposable personal income fell further from 1979 peaks in the first four months of 1981, reflecting strong growth in income. Home mortgage borrowing dropped sharply in the first half. The weakness in mortgage activity was accounted for mostly by reduced lending by thrift institutions. Weak deposit flows and continued erosion of earnings constrained the supply of mortgage funds at thrifts, and rates on new commit ments for conventional home mortgages at savings and loan institutions rose to record levels near 17 percent in late May and remained near this level in June and July. Net mortgage lending at commercial banks also fell, and fewer funds for housing were available from municipal units owing to the aforemen tioned restrictions on issuance of mortgage revenue bonds. The taut mortgage credit conditions have led to increased use of so-called "creative financing" techniques, including wrap-around loans, builder buydown arrangements, and the assumption of low-rate first trusts when house sellers are willing to take back a second mortgage. One effect of such financing arrangements has been to slow the prepayment of old, low-yielding mortgages at the thrift institutions, thus reducing the earnings potential from reinvestment of these funds by these institutions.

Federal Reserve (1981, July 19). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_19810720

@misc{wtfs_monetary_policy_report_19810720,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {1981},
  month = {Jul},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_19810720},
  note = {Retrieved via When the Fed Speaks corpus}
}