Monetary Policy Report

Monetary Policy ctives 1986 for _________.;:1~'1--=:,t· Midyear Review of the Federal Reserve Board July 18, 1986 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. July 18, 1986. Contents Section Page Monetary Policy in 1986 and 1987 2 Monetary Policy for 1986 2 Economic Projections 4 Economic Performance: First Half 1986 5 Price Developments 6 The Household Sector 6 The Business Sector 7 The Foreign Sector 7 Money, Credit, and Monetary Policy 8 Monetary Policy • 1986 and 1987 Ill Sharp contrasts among sectors and regions of the Agreement on tax reform also would remove a economy characterized economic developments dur major source of uncertainty that probably has ing the first half of 1986. Because of strong competi inhibited growth in the first half of the year. In tive pressures from abroad a~d large spending cut addition, substantial progress toward eliminating backs in the oil industry in response to sharply federal budget deficits is essential to achieving better declining prices, industrial and investment activity balance in the U.S. and world economies. Overall, were restrained. In contrast, activity continued to prospects for the economy appear to be favorable, expand rather strongly in housing, the financial sec but much will depend on the evolution of policy, tor, and the broad service area of the economy. both in this country and abroad. Although there are substantial uncertainties about the degree and timing of a pickup in overall eco Growth of Money and Debt in 1986 and 1987 nomic activity, a number of positive economic and financial developments have occurred that should The Federal Open Market Committee (FOMC) provide the basis for somewhat faster economic reaffirmed the 1986 target ranges of 6 to 9 percent growth and some reduction in unemployment over that had been established in February for growth in the year ahead. Interest rates have moved lower, the broad money measures-M2 and M3. and, reflecting the decline of the dollar on foreign For 1987, the Committee decided that the target exchange markets, U.S. industry is in a stronger growth ranges for both M2 and M3 would be competitive position internationally. In addition, inflation has remained subdued, reflecting not only declines in the prices of energy and other basic com Ranges of Growth for Monetary and modities but also continued restraint on wages in many sectors. Much of the uncertainty about a Debt Aggregates1 (Percent Change) pickup in growth turns on the strength of economic 1986 Tentative for 1987 performance in other industrialized countries, and there also is some concern over the transitional 1985 Q4 to 1986 Q4 1986 Q4 to 1987 Q4 effects of tax reform legislation. A reduction of the large deficit in the nation's Ml (3 to 8)* (3 to 8)** external accounts is of critical importance over time, and this will be difficult to achieve in an orderly M2 6 to 9 5½ to 8½ way without faster growth in key foreign economies. M3 6 to 9 5½ to 8½ Debt 8 to 11 8 to 11 *While no new range was specified for 1986, growth in excess of the established range would be acceptable. * *Indicative of likely range if more stable velocity behavior shows signs of re-emerging. 2 M2 Billions of Dollars nature of the relationship among Ml, income, and interest rates appears to have been significantly altered by the changed composition of the aggregate Annual Rates of Growth 2800 in recent years, as well as by the prospects for 1985 Q4 to 1986 Q2 greater price stability. The Committee decided that 7 .3 Percent 2750 growth of M 1 in excess of the previously established 1985 Q4 to June 1986 3 to 8 percent range for 1986 would be acceptable 7.8 Percent and growth in that aggregate over the balance of the 2700 year would continue to be evaluated in light of the behavior of the other monetary aggregates. 2650 With respect to 1987, the Committee expressed the preliminary view that the current range for 2600 Ml-3 to 8 percent-should provide for adequate money growth to support continued economic expansion, assuming that greater stability re-emerges 2550 in the link between M 1 and income in a more stable economic, price, and interest rate environment. 0 J F M A M J J A S O N D 1985 1986 lowered by 1/2 percentage point, to 5 ½ to 8 ½ per Mt Billions of Dollars cent, to achieve money growth at a rate consistent Annual Rates of Growth with maintaining reasonable price stability and sus 1985 Q4 to 1986 Q2 tainable economic expansion. 11. 9 Percent The rapid rise in M 1 over the first half of the 660 year underscored the degree of uncertainty sur 1985 Q4 to June 1986 12.8 Percent rounding the behavior of the aggregate and, in par ticular, about its behavior relative to GNP. The 3 ~ 640 .,,,..,,,. .,,,.- .,,,..,,,. .,,,..,,,. .,,,..,,,. .,,,..,,,. M3 .,,,. 620 Billions of Dollars .,,,..,,,. .,,,..,,,. .,,,..,,,. .,,,..,,,. Annual Rates of Growth .,,,..,,,. 1985 Q4 to 1986 Q2 N 7.9 Percent 0 D J F M A M J J A S O N D 3400 1985 1986 1985 Q4 to June 1986 .,"' 7 .8 Percent _,"' ,,,,,,,,,"'"',, 3300 3200 0 N D J F M A M J J A S O N D 1985 1986 3 Economic Projections Progress in reducing the federal deficit is seen as crucial in maintaining financial conditions conducive As is summarized in the table below, the central tendency forecast is for growth of 2 ½ to 3 percent to balanced growth and to an improved pattern of international transactions. in real GNP this year. Such an increase in output A critical element in the expected improvement in would be expected to generate appreciable further economic performance is progress toward reducing gains in employment, but the unemployment rate the size of the merchandise trade deficit. With might not drop below 7 percent before year-end. import prices rising as a result of the depreciation of In 1987, which would be the fifth year of the cur the dollar, the growth in imports is expected to slow, rent expansion, real GNP is projected to increase 3 to 3 ½ percent, and unemployment is expected to and the increased price competitiveness of U.S. goods should bolster export growth. However, a decline moderately. A significant portion of the substantial improvement in our trade performance increase in production next year is expected to come will require satisfactory growth of demand in other from the external sector, with the lower value of the countries. Moreover, it will require open access to dollar expected to restrain the growth of imports and foreign markets, which underscores the critical stimulate exports. However, with energy prices importance of avoiding protectionist measures both leveling off, exchange-rate-related increases in here and abroad. import prices are expected to cause an acceleration in inflation to the 3 to 4 percent range next year. Economic Projections for 1986 and 1987 FOMC Members and other FRB Presidents 1986 Range Central Tendency Nominal GNP 3¾ to 6½ 4¾ to 5¾ Percent change, fourth quarter to Real GNP 2¼ to 3 ½ 2½ to 3 fourth quarter: Implicit deflator for GNP 1 ½ to 3 ¼ 2¼ to 2¾ Average level in the fourth quarter, Civilian Unemployment Rate 6.9 to 7.2 7 percent: 1987 Range Central Tendency Nominal GNP 5 to 8¼ 6 to 7 ½ Percent change, fourth quarter to Real GNP 2 to 4¼ 3 to 3 ½ fourth quarter Implicit deflator for GNP 1 ½ to 4¼ 3 to 4 Average level in the fourth quarter, Civilian Unemployment Rate 6½ to 7 Around 6¾ percent: 4 Economic Performance: First Half 1986 The economy continued to expand in the first half three-month decline since the beginning of 1949. of 1986. Real GNP grew about 2 ½ percent, at an This lower price level has given a substantial boost annual rate, according to preliminary Commerce to consumers' purchasing power and has helped to Department estimates. The overall increase in out support higher levels of spending. Although the vol put during the first six months of the year generated ume of oil imports will rise, the sharper decline in slightly more than one million new jobs, and the price is an aid in reducing the large deficit in our civilian unemployment rate held near 7 percent. At trade accounts. the same time, the dramatic decline in world crude A potentially more significant longer-term influence oil prices caused a substantial slowing in inflation. on our balance of trade is the lower value of the dol The combination of the lingering effects of the lar. The prices of foreign goods are rising in dollar high foreign exchange value of the dollar during terms and should begin to shift expenditures from 1984 and 1985, the slow growth abroad, and the ini imports to domestic products. At the same time, tial impact of lower crude oil prices played a key U.S. goods are more competitive on world markets, role in inhibiting any acceleration in overall eco although we have yet to experience a sustained nomic activity. Industrial output declined noticeably improvement in exports. over the first half, with activity reflecting the con The prospect of lower federal budget deficits in tinuing intense competition from foreign producers the years ahead, coupled with the drop in oil prices, in the manufacturing sector and also the sharp cut encouraged sizable reductions in long-term interest backs in energy-related investment. U.S. agriculture rates at the beginning of 1986, which have begun to confronts growing world supplies of many farm stimulate the interest-sensitive sectors of the econ products, and many farmers continue to be squeezed omy. The most notable result has been in the hous by a heavy debt-servicing burden and falling land ing sector where lower mortgage rates have led to values. The drop in oil prices also has caused sub substantial gains in building activity. Investment in stantial adjustment problems. new plant and equipment has not shown a similarly However, some of the benefits from the drop in positive response to the lower interest rates. Apart oil prices did begin to emerge in the first half. The from the negative effects of the oil drilling decline, lower price of crude oil was reflected fairly quickly business spending has been damped by the existence in the prices of finished energy products, which of a sizable overhang of office and factory space and caused consumer prices to register their largest by continuing uncertainties about sales trends and tax reform. With the decline in energy prices, further progress has been made in reducing the inflation rate. Con Percent change from end of Real GNP previous period, annual rate tinued moderation in wage increases and abundant supplies of agricultural commodities and industrial raw materials also were important factors in restraining price increases in the first half of 1986. These 6 favorable developments worked to offset the infla tionary tendencies associated with the depreciation of the dollar and the continued rapid rise in the prices ii of services. 1981 1983 1985 5 Price Developments Percent of Personal Saving Rate disposable income Falling energy prices were largely responsible for a significant slowing in measures of aggregate inflation during the first half of 1986. A broad measure of 8 prices-the GNP fixed-weighted price index increased at a 2 ¼ percent annual rate in the first 6 half, down from a 3 ½ percent rise in 1985. ~ - Consumer prices actually declined over the February to April period, but they still were up 1 ¾ percent 4 over the twelve-months ended in June. The drop in prices was greater at the wholesale level, where 2 weakness in the industrial sector added to the down ward pressure from energy prices. Outside of the energy area, further progress was 1981 1983 1985 made in reducing the inflation rate during the first half of the year. Retail food prices rose at only a 1 percent annual pace through June, held down by The Household Sector falling meat prices. A small decline in the prices of Consumer expenditures were quite strong in the first consumer goods was responsible for the slowdown in half of 1986, supported in part by rapid income the CPI excluding food and energy to a 3 ½ percent growth. Real disposable personal income increased annual rate of increase from its 4 ½ percent rise dur at about a 7 percent annual rate, boosted by high ing 1985. In contrast, the prices of nonenergy serv levels of farm subsidy payments and the energy ices continued to increase at a 6 percent annual related slowdown in inflation. rate, boosted by rising housing costs and by higher The increase in consumer spending was wide premiums for most types of insurance. spread. Purchases of nondurable goods, such as ap parel, were particularly strong in the first quarter, while outlays for services also grew briskly. The de Percent change from end of mand for new automobiles also remained quite high Consumer Prices* previous period, annual rate after the large sales increase in 1985. Indicators of the financial position of the house hold sector were mixed in the first half of the year. 9 Although the growth in consumer credit slowed from its rapid growth pace in 1985, the ratio of consumer 6 installment debt to disposable income edged up to a I new high. The rallies in the stock and bond markets ffl!El 3 strengthened the asset side of the household sector IJ I I I balance sheet. Many homeowners took the opportu ■ nity presented by the decline in interest rates to ease Hl + their debt-servicing burdens by refinancing mortgage loans. However, increased strains also were evident, as personal bankruptcies rose to record levels and 1981 1983 1985 mortgage delinquency rates remained historically •Consumer Price Index for all urban consumers. high. 6 The Business Sector The Foreign Sector The financial position of the business sector The dollar depreciated further against the currencies improved during the first half of 1986, albeit with of foreign industrial countries during the first half of considerable diversity across industries. Economic 1986. On balance, the trade-weighted ~alue of the profits in the corporate sector rose at an $11 billion dollar has fallen over 30 percent from its February annual rate in the first quarter. Financial conditio:µs 1985 peak, about one-third of which has occurred in agriculture and manufacturing remained weak, this year. Associated with the depreciation was a however. Agriculture continued to be hurt by excess narrowing in inflation-adjusted interest rate differen supply conditions worldwide, and farm loan delin tials between the United States and the other major quencies rose to a postwar high. In manufacturing, industrialized countries, as interest rates declined intense price competition from foreign sources both here and abroad. squeezed profit margins, and with little growth in demand, capacity utilization moved lower. Business spending on plant and equipment was weak in the first half of the year. This poor perfor Exchange Value of the mance partly reflected a "payback" after very U.S. Dollar* Index, March 1971 = 100 strong capital spending in the fourth quarter of 1985. Firms apparently accelerated their spending at the end of last year to take advantage of investment incentives that were targeted for scaling back or elimination under proposed tax reform legislation; expenditures then dropped off in the first quarter of 1986. Much of the change in business inventories in the first half of this year was associated with fluctuations in automobile dealers' stocks. Domestic car produc tion outpaced sales in the first quarter, and this resulted in a substantial build-up of auto inventories. Manufacturers continued to trim their stocks, pre 1981 1983 1985 ferring to keep inventories lean until there was firm •Federal Reserve index of weighted average exchange value of U.S. dollar against evidence of a resurgence in demand. currencies of other G-10 countries plus Switzerland. Weights are 1972-76 global trade of each of the 10 countries. 7 However, exports have been slow to pick up, in Annual rate, U.S. Current Account billions of dollars important part, because of the sluggish pace of for eign economic activity. The volume of U.S. merchandise imports rose It I I I + 1 ½ percent in the first quarter of 1986. The largest increases were in machinery, with smaller advances ............ 40 registered for some consumer goods. The volume of II 11 I merchandise exports was up somewhat in the first 80 quarter, with a 3 ½ percent decline in exports of I agricultural products offset by increased U.S. ■ nonagricultural exports. 120 H2 fili Ql Money, Credit, and Monetary Policy 1981 1983 1985 The Committee emphasized that policy implementa tion would involve a continuing appraisal of trends in all of the money and credit measures, as well as Although a substantial correction has occurred in of indicators of economic activity and prices, and the dollar's value, at least against the currencies of conditions in credit and foreign exchange markets. the major industrialized countries, the nation's cur Within this framework for policy, the Federal rent account deficit was unchanged in the first quar Reserve basically accommodated the demands for ter from the high $135 billion rate of the fourth reserves associated with strong M 1 growth over the quarter of 1985. This lack of improvement was the first half of 1986. result of large increases in nonpetroleum imports In the initial months of 1986, growth of Ml while exports grew more slowly. dropped off sharply from its rapid 1985 pace, and Yet, the decline in the dollar improved the price growth of M2 also slowed substantially, to a rate competitiveness of U.S. goods in foreign markets. below its annual target range. There were signs of some sluggishness in economic activity, and steep declines in oil prices, which were improving the out look for inflation, contributed importantly to a rally U.S. Real Merchandise Trade Billions of 1982 dollars in long-term credit markets that picked up momen tum in mid-February. At the same time, short-term interest rates edged a little lower, but the federal 375 funds rate remained significantly above the Federal Reserve's discount rate. • In this context, a cut in the discount rate would 300 complement the thrust of open-market operations and would accommodate the market tendency toward lower interest rates. However, an important Exports 225 c:...;;; --- consideration in the timing and extent of any rate cut was the risk posed by an excessive reaction in the foreign exchange markets, where the dollar remained under downward pressure during much of 1981 1983 1985 the period. 8 On March 7, the Federal Reserve cut the interest and validate declines that already had taken place in rate charged for discount window borrowings by market rates. Exchange rates and international 1/2 percentage point to 7 percent. The central banks interest rate considerations again played a role, and of Japan, Germany and several other industrial our discount rate cut coincided with a rate cut by nations took similar actions around the same time. the Bank of Japan. On April 18, the Federal Reserve announced With market interest rates falling, price pressures another reduction in the discount rate, to 6 ½ per remaining subdued, and the economies of the cent. This change served primarily to catch up with United States and other industrial countries growing relatively slowly, the Federal Reserve again reduced Growth of Money and Credit (Percentage changes at annual rates) Domestic Period M1 M2 M3 N onfinancial Debt Fourth quarter 1985 to 11.9 7.3 7.9 13.oe second quarter 1986 Fourth quarter 1985 12.8 7.8 7.8 12. 7e to June 1986 Fourth quarter to 1979 7.5 8.1 10.3 12.3 fourth quarter 1980 7.3 9.0 9.6 9.6 1981 5.2 (2.5)1 9.3 12.3 9.8 1982 8.7 9.1 10.0 9.0 1983 10.4 12.2 9.9 11. 2 1984 5.4 8.0 10.5 14.3 1985 11.9 8.6 7.6 14.0 Quarterly Ql 10.1 11. 7 10.2 13.6 average 1985 Q2 10.5 6.3 5.5 12.0 Q3 14.5 9.5 7.6 12.9 Q4 10. 7 6.0 6.5 14.6 Quarterly Ql 7.7 4.3 7.4 16.1 average Q2 15.8 10.3 8.3 9.6t' 1986 e-estimated 1. M 1 figure in parentheses is adjusted for shifts to NOW accounts in 1981. 9 the discount rate by 1/2 percentage point, to 6 per hard hit recently; loan losses at these institutions cent onjuly 11. have soared and their profitability has continued to On balance, since the end of 1985 the dollar has slide. While banks in regions with economies heavily declined more than 10 percent, and short-term rates dependent on energy production were among the about 1 ½ percentage points. Long-term Treasury most strongly capitalized and profitable earlier, their yields fell 2 percentage points, but yields on other financial position has eroded under the pressure of long-term securities fell less; corporate and tax surrounding economic difficulties. Bank failures in exempt bond yields dropped about one point, and the first half of this year continued to run at about fixed-rate mortgages fell just 1/2 percentage point. 1985's rapid pace, with agricultural banks again In contrast to M 1, which grew at a 12 ¾ percent accounting for a disproportionate share. annual rate through June, both M2 and M3 grew At savings and loan associations, overall profit moderately in the first half of the year and in June ability appears to be improving as interest rates have were near the middle of their respective ranges. declined and mortgage origination activity has Some of the more liquid components of the broader surged. However, a substantial number of these monetary aggregates, however, increased very institutions continue to have severe problems owing rapidly, as part of the larger shift in investor port primarily to losses on weak assets, prompting folios toward short-term assets. This shift had much proposals to add to the financial resources of the less effect on M2 or M3 than on M 1, because the FSLIC. reallocation of funds took place largely within these Concern over loans to certain developing countries broader aggregates. In addition to transaction came to the forefront again this year as Mexico deposits, money market deposit accounts, money began to grapple with the additional economic and market mutual funds, and ordinary savings deposits financial problems brought on in large part by dra all expanded strongly during the first half of the matically lower oil prices. Banks have remained cau year, but small time deposits grew only slightly. tious lenders in the face of ongoing concerns about The debt of domestic nonfinancial sectors is esti the economic and financial prospects of these mated to have expanded at a more moderate rate countries. over the first six months of 1986 than it had in some time. Bond issuance had surged in December in advance of the possible effective date of some provi sions of tax-reform legislation, lifting the first Footnotes quarter level of the debt aggregate. Hence, when 1. M1 is currency held by the public, plus travelers' checks, measured from its fourth-quarter-average base, the plus demand deposits, plus other checkable deposits (including growth of domestic nonfinancial sector debt has negotiable order of withdrawal (NOW and Super NOW) remained above its monitoring range, coming in at accounts, automatic transfer service (ATS) accounts, and credit a 12 ¾ percent annual rate through June. Measured union share draft accounts). from its level at the end of December, however, M2 is Ml plus savings and small denomination time deposits, debt grew at an annual rate of 10 ¼ percent through plus Money Market Deposit Accounts, plus shares in money market mutual funds ( other than those restricted to institutional the end of June. investors), plus overnight repurchase agreements and certain The stresses evident in many parts of the econ overnight Eurodollar deposits. omy left their mark on the books of banks and of M3 is M2 plus large time deposits, plus large denomination other financial institutions. Asset quality deteriorated term repurchase agreements, plus shares in money market mutual funds restricted to institutional investors and certain as a consequence of the sharp drop in oil prices and term Eurodollar deposits. associated dislocations in the energy sector, over building in commercial real estate, and the continu ing distress in agriculture. Banks with relatively large amounts of farm loans outstanding, as well as A copy of the full report to Congress is available from other agricultural lenders, have been particularly Publication Services, Federal Reserve Board, Washington, D.C. 20551 FRB 10-48000-0786 10

Federal Reserve (1986, July 17). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_19860718

@misc{wtfs_monetary_policy_report_19860718,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {1986},
  month = {Jul},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_19860718},
  note = {Retrieved via When the Fed Speaks corpus}
}