Monetary Policy Report

Monetary Policy Objectives for 1986 Summary of Report to the Congress on Monetary Policy pursuant to the Full Employment and Balanced Growth Act of 1978. February 19, 1986. Contents Section Page Monetary Policy and the Economic Outlook for 1986 2 Monetary Policy for 1986 2 Economic Projections 3 Monetary Policy and the Performance of the Economy in 1985 5 Monetary Policy in 1985 5 Economic Performance in 1985 8 Monetary Policy and the Economic Outlook for 1986 While there are unusual uncertainties surrounding Ranges of Monetary Growth 19861 prospects for prices and economic activity in Measured from fourth quarter 1985 to fourth quarter 1986 1986-stemming in part from questions about the timing and dimension of domestic adjustments to the Ml 3 to 8 percent weaker dollar on exchange markets, oil price declines, and the process of fiscal restraint-the over M2 6 to 9 percent all economic outlook for the year appears generally favorable. Real economic growth probably will pick M3 6 to 9 percent up somewhat from last year's pace, and inflationary pressures should remain contained. The recent weak Total Domestic Nonfinancial Debt 8 to 11 percent ness in oil prices, though it has the potential for causing dislocations in energy markets and adding to the strains on some heavily indebted oil-producing countries, should enhance real growth and work to shown above. These ranges are the same as those for offset the upward impact on the price level this year 1986 tentatively set last July, except that the M 1 from the drop in the dollar on exchange markets. range has been widened to reflect the uncertainties Over the course of the year, the prospective move affecting the behavior of that aggregate. ment toward fiscal restraint, and also the more com In particular, the availability of interest-bearing petitive exchange rate, should help correct imbalances checking accounts that serve both transaction and that in recent years have threatened the sustainability savings functions may have increased the sensitivity of economic expansion and affected domestic and of M 1 to changes in market rates as well as to other international financial markets. factors influencing the public's allocation of its sav ings among various financial assets. While the range Monetary Policy for 1986 for M 1 is wide enough to allow for some variation in behavior of the aggregate's income velocity in At its February meeting, the Federal Open Market response to changing conditions, the range was set on Committee framed its monetary policy plans for 1986 the assumption that there would not be a large drop in light of the fundamental objectives of maintaining in velocity, such as occurred in 1985. In that connec sustainable growth of economic activity, making con tion the Committee will evaluate behavior of M 1 in tinued progress over time toward price stability, and ligh; of its consistency with the other monetary working toward better balance in the nation's external aggregates, economic and financial developments, transactions. Ranges set by the FOMC for the mone and the potential for inflationary pressures. In sum, tary aggregates and a monitoring range for debt are policy implementation will involve continuing appraisal of the relationships among the various measures of money and credit, their velocity trends, indicators of economic activity and prices, as well as conditions in domestic credit and foreign exchange markets. The growth of the broader aggregates in 1986 is not expected to be far different from last year, when 2 their velocities declined somewhat. Last year's veloc good many uncertainties and risks in the present ity experience was closer to the norm for these environment-for instance, the actual outcome for aggregates than was the case for M 1. The final the budget, the behavior of the dollar, and oil phase of deposit deregulation this year-the removal prices-the Committee members and other Reserve of minimum balance requirements on money market Bank Presidents generally believe that prospects for deposit accounts at the beginning of the year and the economy in the year ahead are reasonably favor the elimination of ceiling rates on savings and regu able, and their projections are indicated in the table lar NOW accounts at the end of March-is expected below. to have only minimal effects on the broad aggregates The expanding job opportunities associated with as well as on Ml. the increase in output are expected to lower the The Committee for some years has had a unemployment rate gradually, although sluggish monitoring range for the total debt of domestic non productivity performance, if it should continue, financial sectors. Historically, debt has expanded would limit the nation's growth potential. about as rapidly as GNP, but in recent years debt Two key factors in the positive economic outlook has grown more rapidly than the economy, raising are the recent developments in energy and financial some concern about the increasing debt burden. The markets. The decline in energy prices should raise growth of debt is expected to moderate somewhat in the growth of real disposable income and bolster 1986. While the federal deficit is expected to remain consumer spending in the months ahead. The marked at a high level for much of 1986, it should begin increase in household financial wealth associated declining in the course of the year as greater fiscal with the substantial rise in stock and bond prices restraint takes hold and helps to curb the rate of also should provide the basis for continued gains in increase in U.S. government debt. consumer outlays. This should work to offset the restraint in spending that could be exerted by the runup in household indebtedness and the associated Economic .Projections decline in the personal saving rate during the past The FOMC felt that its monetary objectives were consistent with expectations for continued growth in output, further reductions in unemployment, and muted inflation in 1986. While there clearly are a Economic Projections for 1986 (percent) FOMC members and other FRB Presidents Administration CBO Range Central Tendency Nominal GNP 5 to 8½ 6½ to 7 ¼ 8.0 7.6 Change, fourth quarter to fourth Real GNP 2¾ to 4¼ 3 to 3½ 4.0 3.6 quarter: Implicit deflator for GNP 2 ½ to 4½ 3 to 4 3.8 3.9 Average level in Unemployment Rate 6¼ to 6¾ About 6½ 6.7 6.7* the fourth quarter: *Civilian unemployment rate. 3 year. Notwithstanding the increase in household the strategies firms pursue with respect to the poten wealth, the level of consumer debt remains a risk to tial trade-off between profit margin and market the outlook for consumer spending. share. Perhaps more important in the short run, our The rise in stock prices and decline in interest trade and current account positions also will depend rates has improved prospects for domestic invest on the pace of economic growth abroad; if growth in ment in plant, equipment, and housing. While the other countries is relatively slow, that would tend to federal deficit is not likely to drop significantly for limit near-term improvement. some months, greater fiscal restraint, as it develops, With regard to the outlook for inflaton, wages in should enhance the availability of domestic savings the aggregate have shown no tendency toward accel for private investment and reduce the need to rely eration and recent settlements in major collective on foreign saving. Mortgage rates are currently at bargaining agreements indicate wage gains in their lowest levels since 1979, and the greater afford manufacturing, construction, and transportation are ability of housing can be expected to buoy residen likely to continue at the moderate pace registered in tial construction in the face of some evident over recent years, even though the unemployment rate is building in the multifamily sector. Similar! y, lower declining. Disappointing productivity performance costs of capital-along with some improvement in does raise questions about pressures from the labor the competitiveness of U.S. industry owing to the cost side, although some pickup in productivity dollar's decline-help to support business investment improvement is assumed this year. A decline in oil despite likely weakness in the energy and office prices also should be a constructive influence. building sectors. In the near term, the leanness of Nevertheless, it was recognized that a weaker dollar manufacturers' inventories suggests the likelihood of poses a clear risk of greater inflationary pressures. some pickup in the rate of inventory accumulation. The outlook for the external sector is quite uncer tain. The response of U.S. industry, as well as for eign producers, to the decline in the dollar will take place only over time and will depend on a number of factors, such as the extent to which it is believed the exchange rate change is "permanent" and on 4 Monetary Policy and the Performance of the Economy in 1985 Monetary Policy in 1985 M1 Billions of dollars In July, the FOMC reaffirmed the ranges set in February for M2, M3, and debt, but established a Annual Rate of Growth 1985 Q2 to 1985 Q4 new M 1 growth range of 3 to 8 percent, measured at an annual rate, from the second to the fourth 12. 7 Percent quarter of the year. The M 1 objective anticipated a considerable slowing of money growth in the second 590 half of the year, on the assumption that more nor mal historical behavior in the velocity of M 1 would re-emerge. Continued uncertainty about the behavior 570 of the aggregate, however, was signaled in widening the Ml range by 2 percentage points. The unusual pattern of M 1 behavior in fact per 550 sisted over the second half of the year; growth in the aggregate did not slow, and its velocity registered an even steeper decline. At the same time, the broader OND.J FMAMJ J AS OND monetary aggregates were growing generally within 1984 1985 their ranges, while economic growth had slowed to well below the pace of the year before and upward price pressures remain.ed .rp.uted. In the fall, the tions were varied in a narrow range over the year, FOMC determined that, under these circumstances, and the discount rate was reduced once, by one-half growth in M 1 above its range for the second half of percentage point. Much of the unusually strong the year would be acceptable. growth in M 1 in 1985 and the accompanying de In general, the FOMC last year emphasized the cline in velocity seemed to be attributable to lower need to evaluate growth in all the aggregates in light interest rates, though expansion in the aggregate was of developments in the economy and prices, as well stronger, particularly in the second half of the year, as conditions in financial and foreign exchange mar than historical evidence on its relationship to income kets. Throughout the year, monetary policy and interest rates would have suggested. The remained generally accommodative to emerging demands for money. Pressures on bank reserve posi- Growth of Aggregates 1985 2 1985 Range 1985 Actual 1985 Q4 Levels• Ml 3 to 8 percent*• 12. 7 percent*• 620.1 M2 6 to 9 percent 8.6 percent 2550.5 M3 6 to 9 ½ percent 7 .4 percent 3176.5 Total Domestic N onfinancial Debt 9-12 percent 13.5 percent 6637 .5 *Billions of dollars seasonally adjusted ••Annual rate QII to QIV 1985 5 behavior of this aggregate may have become more M3 Billions of dollars sensitive to changes in market rates in recent years owing to the deregulation of certain transaction Rate of Growth 9.5% accounts. By reducing the opportunity cost of hold 1984 Q4 to 1985 Q4 3200 ing transaction balances, the creation of NOW and 7.4 percent Super NOW accounts has made Ml a much more attractive savings vehicle for households. Moreover, with the rates on NOW accounts fixed and those on Super NOW s being adjusted sluggishly to changing conditions, falling interest rates have led to relatively 3000 substantial reductions in incentives to economize on Ml balances, with accompanying declines in veloc 2900 ity. However, considerable uncertainty about the response of M 1 to variations in interest rates or income unavoidably persists, as both money holders ONDJ FMAMJ J AS ONO and depository institutions adapt to the elimination 1984 1985 of important regulatory constraints. In 1985, the interaction of lower market interest rates with deregulated transaction deposit rates offering rates on these deposits and interest rates on seemed to induce especially heavy inflows to time deposits and market instruments, low by the interest-bearing checkable accounts. Spreads between standards of recent decades, apparently diminished the incentives to keep savings in longer-term instru ments, as well as to separate savings from transac M2 tion balances. Demand deposits also contributed to Billions of dollars the increase in M 1 last year, registering unusually Rate of Growth 9% rapid growth, especially in the second half. Business 1984 Q4 to 1985 Q4 2550 demand balances paced the rise, likely reflecting the 8.6 Percent cumulative effect of lower interest rates on incentives to economize on demand deposits and on compen 2500 sating balance requirements, as well as generally more cautious cash management practices, possibly 2450 in part because banks and corporations sought to re duce risk in response to financial problems that had 2400 developed in certain areas of the market. 2350 0 J F M A M J J A s 0 N D 1985 6 Financial Markets long-term rates, and simultaneous surge in stock ~~~ke_t prices, was fueled in part by legislative At mid-year most market interest rates had fallen m1t1at1ves to mandate reductions in the federal about 3 to 4 percentage points below their mid-1984 deficit and pare the government's demands on credit levels. On balance over the second half of 1985 markets. mos_t short-term interest rates were little changed, Early in the year, privately insured savings and endmg the year just slightly above their midyear loans in Ohio, and then in Maryland, were closed lows and about a percentage point below their levels or li~ited to small withdrawals following depositor when 1985 began. However, on exchange markets runs m both states. As the difficulties emerged, the the dollar declined more than 15 percent over the ' Federal Reserve advanced funds at the discount win second half, impelled in large part by the G-5 dow to the affected institutions to bolster their an??uncement in September indicating the desir liquidity. Such lending-whose expansive reserve ability of some appreciation of other currencies rela effect was offset through open market operations tive to the dollar and by the ensuing coordinated has been repaid in Ohio, where the troubled institu ~nterve1:1tion by the United States and other key tions _have been restructured and reopened, but mdustnal countries. ~em_am~ outstanding at a number of Maryland thrift In long-term debt markets, interest rates generally mst1tut10ns. fell a percentage point or more on balance over the The thrift industry as a whole showed some second half, with most of the decline occurring dur improvement in earnings and capital positions last ing the fourth-quarter rally that accelerated as the year drew to a close. The downward movement in Growth of Money and Credit (Percentage changes)3 Domestic Period M1 M2 M3 Nonfinancial Debt Fourth quarter to 1979 7.5 8.1 10.3 12.4 fourth quarter 1980 7.3 9.0 9.6 9.6 1981 5.2 (2.5)4 9.3 12.3 9.8 1982 8.7 9.1 10.0 9.1 1983 10.4 12.2 9.9 11.2 1984 5.4 8.0 10.5 14.1 1985 11.9 8.6 7.4 13.5 Quarterly Q1 10.1 11. 7 10.1 13.5 growth rates 1985 Q2 10.5 6.3 5.6 11.9 Q3 14.5 9.5 7.6 12.2 Q4 10.6 5.9 5.7 13. 7 7 year, although many institutions remained heavily temporary special seasonal program aimed at mak burdened with low quality or low yielding assets. ing liquidity available to agricultural banks that Lower interest rates lifted profits from their might experience strong loan demand. Although depressed 1984 levels by reducing the cost of funds total seasonal borrowing fell short of the unusually and generating capital gains on asset sales. The high level in 1984, evidence suggests that these profitability of commercial banks also appears to actions increased access to seasonal credit, boosting have increased in 1985, breaking the downtrend of borrowing somewhat above what would otherwise recent years. Asset quality remained a concern for have been expected given money market conditions some institutions, however, and was a major factor and overall slack loan demand by farmers. In early in the sharp increase in the number of bank failures. 1986, the Federal Reserve renewed the temporary Banks apparently again increased the rates at which seasonal program to assure that agricultural banks they charged off bad loans and added to loan-loss would not face liquidity constraints in accommodat reserves, reflecting continued financial strains in ing the needs of their farm borrowers this year. such industries as agriculture, energy and real estate. Higher profits along with the rallies in stock Economic Performance in 1985 and bond markets helped many banks improve their capital positions in 1985, facilitating efforts to com The economy completed a third successive year of ply with more stringent capital adequacy guidelines. expansion in 1985, with real gross national product As part of its efforts to ensure the continued safety increasing 2 ½ percent over the year. The rise in and soundness of the financial system, the Federal economic activity was sufficient to create 3 million Reserve also initiated a program to strengthen new payroll jobs, and the unemployment rate edged supervision of commercial banking operations. down; with a further strong increase in employment Agricultural finances drew special attention last in January of this year, the jobless rate for civilians year. Farm income remained depressed, and falling reached a six year low of 6. 7 percent. Most broad prices for agricultural products left many farmers measures of price increase indicate that inflation unable to meet their debt-servicing requirements. slowed to about a 3 ½ to 3 ¾ percent rate in 1985, Moreover, declining land prices eroded the value of somewhat less than the pace registered over the collateral behind many agricultural loans. Conse previous two years. quently, failures of banks with relatively high proportions of agricultural loans in their portfolios Real GNP Percent change, Q4 to Q4 rose to 68 in 1985, from 32 in 1984 and an average of just 6 in each of the preceding three years. To ease possible constraints on the availability of credit _at agricultural banks over the 1985 growing season, the Federal Reserve in March liberalized its regular seasonal borrowing program and initiated a 8 Quarterly and abundant harvests pushed prices sharply lower. Civilian Unemployment Rate average, percent As a result, farmers continued to face mounting difficulties in servicing the large volume of debt 10 accumulated in the 1970s. To a considerable extent, these imbalances and stresses are related to fundamental disequilibria in 9 the nation's finances: the continuing huge federal budget deficit and the growing deterioration in the 8 U.S. current account. During the past year, how ever, policymakers took important steps to address 7 these problems. The Balanced Budget and Emer gency Deficit Control Act was passed, establishing a mechanism for deficit reduction and signaling the 1981 1983 1985 resolve of Congress and the Administration to achieve meaningful progress on this front. And the financial authorities of the G-5 nations agreed that Though output and employment continued to exchange rates should better reflect underlying eco grow in 1985, the rate of expansion was slower than nomic relationships, which could enhance the some had anticipated, raising concern about the prospects for some improvement in our external sustainability of the recovery. Furthermore, the pat balance. tern of developments in the past year had some dis The federal budget deficit was of record magni turbing aspects: domestic and foreign demands con tude in fiscal year 1985. The large federal deficit not tinued to be diverted away from goods and services only absorbed a significant portion of the savings produced in the United States, draining income from our households and businesses and exacerbat ing an inventory correction by U.S. firms as their Federal Government Deficit Billions of dollars sales lagged. Consumers continued to increase their Fiscal Years spending at a substantial clip, but only by borrow ing at a pace that pushed household debt burdens 200 to still higher levels. i Ii Serious sectoral imbalances that had emerged II earlier during the recovery became more apparent 150 when gains in activity moderated. Industrial output ii II I grew slowly in 1985, and manufacturing and min ing employment posted outright declines during 100 much of the year. The agricultural sector remained ----l!I=!~, .,..._-I~~J- ----1 under acute pressure, as shrinking export markets Ii i i 1981 1983 1985 9 Percent change, has failed to provide strong markets for U.S. ex Consumer Price Index December to December ports. The net result has been that domestic de mands have increased more rapidly than domestic production throughout the course of the expansion. An important achievement of the current recovery has been the sustained expansion of economic ac tivity with no relinquishment of the progress made toward the goal of price stability. The containment of inflation has been aided by the high exchange value of the dollar and excess world supplies of many basic materials, which have left prices un changed or lower for a wide range of imported goods, industrial commodities, agricultural products and petroleum. More fundamentally, wage increases 1981 1983 1985 in the aggregate have been restrained, limiting up ward pressures on costs. available to the domestic economy, but also continued to be a source of concern to investors with respect to The Household Sector longer-range potential for inflationary pressures. Not sur prisingly, the prospect for some reduction in the deficit Spending in the household sector remained strong, contributed to the downward trend in interest rates late despite a sharp slowing in income growth. Growth last year. in real disposable income rose about 1 ½ percent in The importance of international economic develop 1985, much less than the 4 percent increase of the ments for the performance of the U.S. economy has be previous year. Income growth was limited as wage come increasingly apparent during the current economic and salary gains decelerated, interest income expansion. Although the foreign exchange value of the dollar declined over most of the year-encouraged at Personal Saving Rate Percent of disposable income times by coordinated official intervention activity changes in spending patterns, which typically lag move ments in exchange rates, were not yet evident, and im ports made further inroads into domestic markets. Slow growth, on average, in much of the rest of the world 0 1981 1983 1985 10 weakened and farm income plummetted. Real per less, the growth in business fixed investment was sonal consumption expenditures advanced 3 percent well below the extraordinary pace of the preceding last year-only a little less than in 1984-buoyed by two years. continued high levels of borrowing. As a result, the Businesses accumulated inventories at a much personal saving rate fell to an average of about 4 ½ reduced pace in 1985, particularly in the manufac percent last year, well below historical norms. turing sector. In real terms, nonfarm business inven Recent trends in consumer balance sheets con tories rose $10 billion last year, following the sharp tinued last year. Consumer installment debt, which $56 billion investment that occurred in 1984. In the had climbed sharply in 1984, did so again in 1985, manufacturing sector, sluggish orders and stable or and the ratio of debt to disposable income reached a falling prices have induced businesses to adopt a record high. Growth in financial assets of households cautious approach to inventory accumulation. has, however, more than kept pace with the rapid rise in debt over the past two years. In particular, The Foreign Sector the strong gains posted by the stock and bond mar After registering particularly sharp gains toward the kets in 1985 provided a substantial boost to house end of 1984 and in the first two months of 1985, the hold weal th. dollar generally fell in international currency trading Inqications of debt-servicing difficulties in the throughout the remainder of 1985. By the end of household sector have mounted. Delinquency rates 1985 the trade-weighted foreign exchange value of on consumer installment loans have been on the rise the dollar had fallen nearly 25 percent from its peak since mid-1984, and for some categories-such as in February. This decline occurred against the back bank credit cards-have reached relatively high drop of a narrowing of the differential between levels. Moreover, mortgage loan delinquencies per inflation-adjusted long-term interest rates in the sist at the historically high levels that have prevailed since the 1981-82 recession. However, surveys of households continue to show favorable readings on Exchange Value of the attitudes concerning financial positions, suggesting U.S. Dollar Index, March 1973 = 100 these financial strains are currently limited to a small part of the population. The Business Sector Economic conditions in the business sector also were 5 mixed last year. After-tax economic profits of non financial corporations as a group increased sharply for a third consecutive year and as a percent of GNP stood at their highest level since the late 1960s. Many firms in manufacturing and mining industries, however, have encountered significant difficulties brought about by the high value of the ■-----198-1 -------19-83 -------198-5 - dollar. In addition to the influence of the exchange rate, downward pressures on prices and profits in the agricultural and energy sectors have been exacerbated by ample supplies in world markets. Business spending for equipment and structures advanced 6 percent in real terms in 1985. N everthe- 11 U.S. Real Merchandise Trade development banks, working with the International Billions of 1982 dollars Monetary Fund, to provide the assurance that ade quate external financing would be available to sup port such programs during the next several years. The initial response to these proposals has been 300 positive; all parties generally accept that they repre sent a constructive framework for dealing with individual countries' international debt problems 250 and for promoting the growth and stability of the Exports _...--...,. ____ , 200 •w orld economy. ------ ---- Price Developments ~fost broad measures of prices indicate that inflation 1981 1983 1985 was unchanged or perhaps moved a bit lower in 1985, even as the economy was passing through a United States and other industrial countries, which third year of expanding activity. Progress toward at least in part reflected the slowing of economic price stability has been sustained by several factors, growth in the United States relative to growth the most important of which have been subdued abroad. inflation expectations, moderate wage increases, and It will take some time before the effects of the dol the influence of the high value of the dollar on the lar's depreciation manifest themselves in the external prices of imports and goods that compete with position of the United States, which continued to imports. In addition, developments in the food and deteriorate last year. The widening gap between energy markets continued to restrain the overall rate imports and exports boosted the current account def of inflation in 1985. icit to about $120 billion, up from $107 billion in 1984. U.S. Current Account The Secretary of the Treasury in October urged Billions of dollars the borrowing countries to undertake comprehensive programs of economic adjustment designed to pro + mote efficiency and economic growth. At the same II I II time, he called upon the international banking com munity, the World Bank and the other multilateral 40 I 80 120 1981 1983 1985 •Estimated. 12 Footnotes 1. Mt is currency held by the public, plus travelers' checks, plus demand deposits, plus other checkable deposits (including negotiable order of withdrawal (NOW and Super NOW) accounts, automatic transfer service (ATS) accounts, and credit union share draft accounts). M2 is M 1 plus savings and small denomination time deposits, plus Money Market Deposit Accounts, plus shares in money market mutual funds ( other than those restricted to institutional investors), plus overnight repur chase agreements and certain overnight Eurodollar deposits. M3 is M2 plus large time deposits, plus large denomi nation term repurchase agreements, plus shares in money market mutual funds restricted to institutional investors and certain term Eurodollar deposits. Total Domestic Nonfinancial Sector Debt is outstand ing debt of domestic governmental units (federal, state and local), households, and nonfinancial businesses. 2. Except for M 1, growth rates and actual figures are measured fourth quarter to fourth quarter; M 1 , measured fourth quarter to fourth quarter, is 11. 9 percent. 3. M 1, M2, and M3 incorporate effects of benchmark and seasonal adjustment revisions made in February 1986. 4. M 1 figure in parentheses is adjusted for shifts to NOW accounts in 1981. A copy of the full report to Congress is available from Publication Services, Federal Reserve Board, Washington, D.C. 20551 FRB9-55000-0286 13

Federal Reserve (1986, February 18). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_19860219

@misc{wtfs_monetary_policy_report_19860219,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {1986},
  month = {Feb},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_19860219},
  note = {Retrieved via When the Fed Speaks corpus}
}