Monetary Policy Report

Monetary Policy Objectives for 1986 Testimony of Paul A. Volcker, Chairman, Board of Governors of the Federal Reserve System July 23, 1986 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Testimony of Paul A. Volcker, Chairman, Federal Reserve Board I appreciate the opportunity to report unemployment rate has remained generally at a once again on the conduct of monetary little over 7 percent and, relative to the size of the working age population, more people are policy. I would first like to place that employed than ever before recorded. In Europe, matter in the larger context of the per- unemployment has also remained relatively steady, but at much higher levels. formance of the United States and the After more than three years of economic expan world economy. sion, the process of disinflation has continued, reinforced for the time being by sharply lower As you know) there have been prices of oil, by far the most important com marked contrasts in the economic perfor modity. With industrial prices steady, the average mance of different sectors and regions of level of wholesale prices has been declining here, and even faster in key countries abroad whose this country. Consumption has been currencies have been sharply appreciating relative strongly maintained) and there have to the dollar. Interest rates here and abroad have also declined appreciably, reflecting both the sense been large increases in employment in of progress against inflation and the fact that the broad servz"ce sector. Housing is growth has been proceeding well within capacity being built at a high rate. But restraints. The large decline in U.S. interest rates and the industrial activity and business invest sharply higher stock market over the past year ment) which had leveled off last year) suggest the cost of capital has declined. The fall in oil prices has helped bolster the real income of have declined over the last six months) consumers. Meanwhile, the substantial deprecia and the agricultural and energy tion of the dollar has placed our industry in a decidedly better competitive position vis-a-vis industries are under strong pressure. As other industrial countries. As many have sug a consequence) activity in some areas of gested, these underlying forces should help sustain the country has advanced rather strongly) an economic expansion that has already lasted longer than most. while severe adjustments are taking But I would be remiss in failing to emphasize place in the energy and agricultural belts. much less satisfactory aspects of the U.S. and world economic situation. There can be no evading the fact that some fundamental economic adjustments must be made within our economy in the months and years ahead. The net result is that the overall economic growth The clear challenge is to find the ways and rate in the United States moderated to about 3 means to work through those adjustments in a percent through 1985 and early 1986, and context of sustained growth while also con apparently slackened further in the second quarter solidating and retaining the progress toward price of this year. Moreover, growth in other major stability. The conduct of U.S. monetary policy is industrialized countries remained slower than in obviously relevant to that process. But that single the U.S. during 1985 and the early part of this policy instrument cannot itself provide the year. Throughout this period, sizable increases in employment have continued in this country; the 1 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis answer. Complementary approaches in the fiscal, in the face of the massive and growing federal trode and other policies of this country, and in deficit. Consequently, private investment and con the approaches of ot.ber countries, will be required struction could expand. At the same time, the as welt The hard fact is that, while the need for competitive pressure from imports encouraged complementary actions to achieve the necessary strong cost-cutting and productivity efforts in the adjustments in the United States and world industrial sector. That has been one powerful fac eoonomy seems to be more widely recognized, tor accounting for the near stability of prices of progress in coordinating action toward those aims manufactured goods over the past year or more. has been limited. We cannot, however, build a lasting foundation for sustained growth and stability on massive international dis-equilibrium-huge and rising Disequilibrium in the Industrial World trade deficits in the United States and counterpart Some obvious imbalances have developed in the surpluses abroad. Nor can we count on satisfying economies of the industrialized world. That is evi indefinitely so much of our own needs for capital dent most of all in the enormous deficit in our by drawing so heavily on the savings generated external trade and current accounts, and in the elsewhere in the world-savings that have been so counterpart surpluses of a few other countries. freely available in part only because internal Unless dealt with effectively and constructively, growth in Europe and Japan has been relatively growing market and political pressures will, slow. sooner or later, inevitably have much more Today the imbalances and strains are clearly disturbing consequences. showing. The forward momentum of our The problem first clearly emerged some time economy has been sustained almost entirely by ago. The powerful thrust of the strong U.S. consumer spending and housing construction, economic expansion in 1983 and 1984 had spilled both of which have been accompanied by unsus out abroad in the form of sharply rising imports, tainably heavy borrowing. Savings meanwhile aided and abetted by the exceptional strength of have remained at a relatively low level, even by the dollar internationally. There were, for awhile, past U.S. standards. For more than a year, benefits on all sides. At a time of slack demand at industrial production in the United States has not home, exports to us helped Europe and Japan to grown appreciably, and there has been some restore and maintain their growth. The United decline in 1986. The pace of business investment States also absorbed a disproportionate share of has slackened. the necessary external adjustment efforts by the Some of the relative weakness in industrial out heavily indebted countries of Latin America. put and investment over the past six months can Those countries have sharply curtailed their be attributed to temporary factors and to imports since 1982, and they have become more developments peculiar to the United States. For competitive in markets for manufactured goods. instance, some investment orders were speeded up At the same time, the United States began to late last year in anticipation of tax reform, and be the recipient of a growing flow of capital from the debate on the nature of that reform has abroad. That inflow, which pushed the dollar so apparently led to some deferral of ordering this high in the exchange markets until early 1985, year. The boom in spending for computers has had the practical effect of relieving potential subsided and commercial construction, in pressures on our internal financial markets even response to large and growing vacancies of office space, is predictably declining. Probably much more important in recent months have been very sharp cutbacks in domestic oil exploration and investment, driving energy producing states into 2 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis recession-like conditions and affecting production tion as to the buoyancy of the markets for our of steel and equipment elsewhere as well. exports and of their own growth prospects. But a large part of the difficulty stems from the You are well aware that the present imbalance continuing imbalances in the world economy. On among industrial countries is reflected in strong the average, growth rates in major European protectionist pressures in the United States. Yet, economies and Japan were about 3/4 percent less as the President has so strongly emphasized, to than the reduced growth path of the United States abandon our tradition of relatively open markets during 1985 and the first quarter of 1986. How would surely be to invite an unravelling of the ever, the more disturbing contrast lies in the international trading order. We would then have source of that growth. less trade and more inflation. With that, prospects In the United States, the rate of growth in for sustained growth both here and abroad would domestic demand, while slowing in the third year clearly be placed in jeopardy. of expansion, continued to average about 3 ¾ per I know of the complaints about "unfair" trading cent through that period. Domestic demand growth practices of other countries. We need to deal with in the industrialized countries of Europe and them energetically. But I also know the clear Japan was significantly less-about 2 ½ percent. lesson of experience is that a protectionist retreat In the early part of this year, when their exports by the United States, the world's leading economic slackened, those countries grew not at all. power, would invite recrimination and escalation. The plain implication is that our overall GNP Certainly, the most effective and promising ave growth rate was reduced by continuing deteriora nue for dealing with the trade complaints on all tion in our trade and current account balances. sides will be in the planned round of multilateral With our current account deficit reaching a record trade negotiations rather than in a tit-for-tat pro $135 billion annual rate in the first quarter of this cess of mutual retaliation. year, industrial production and investment were Moreover, I believe it is demonstrable that, as restrained. Meanwhile, foreign surpluses con a matter of relative importance, much more fun tinued to build through much of the period, and damental imbalances in the world economy than as their exports have slowed, internal demand has unfair trading practices are responsible for the not yet, in most of those countries, picked up the present pattern of trade deficits and surpluses. slack. Those underlying imbalances can only be dealt Prospects for investment and for manufacturing with by complementary economic policies, not activity in the United States are heavily depen protectionism. dent on an improved trade outlook. The sharp Quite clearly it is in no one's interest-not the decline in the dollar since its peak in early 1985 United States or other countries-that we seek should help set the stage for such an improve better balance in our external accounts by ment. There is evidence that U.S. producers find deliberately restraining further our own growth themselves in a stronger competitive position. rate. But it is also true that as things now stand, However, the deterioration in actual trade in stronger domestically generated growth in the United manufactured goods has slowed little. States will not reduce the international imbalances. The decline in the dollar is both relatively Taken alone, it would aggravate our trade deficit recent and from a very high level so the absence further, posing an even more difficult adjustment of a stronger response in trade so far is not problem later. entirely surprising. What is of concern is that the domestic markets of our major industrial com petitors have remained so sluggish, raising a ques- 3 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis As I suggested, the recent exchange rate Put another way, in a growing economy, reduc changes can help us to. escape that dilemma-they tions in the federal deficit will be necessary to should work to improve our trade position and release the real and financial resources· necessary reduce the surpluses of others. In fact, faced with to improve our trading position in a way consis a comb_ination of appreciating currencies and tent with rising investment. slower growth in overseas -markets, exporters in In a few foreign countries, such as Germany, both Japan and some European countries are some signs of stronger internal growth have experiencing reduced profits and more sluggish appeared in recent months. But such signs are far orders from abroad. However, in the absence of from uniform among key countries abroad, and offsetting internal sources of expansion, those most projections of their growth for this year have same pressures could dampen their own prospects been lowered, not raised, as exports have slowed. for growth. With rising currencies and falling oil prices, That is one of several reasons we should not some of those countries after years of effort have rely on exchange rate changes alone to produce the now successfully achieved virtual stability in con needed international adjustments in the world sumer prices. Moreover, their wholesale prices economy. Over a number of years, we in the have declined sharply and are appreciably lower United States will certainly need to shift more of than a year ago. our resources into exports, and into recovering All of us-and certainly this central banker domestic markets where import penetration has can appreciate the importance of maintaining a been so high. That, very broadly, implies broad framework of stability and appropriate relatively more growth in manufacturing; financial disciplines to sustain that progress. What relatively less growth in services, in governmental is at issue for some countries is their ability to spending, or in other sectors; and more savings achieve and maintain vigorous internal growth at and less borrowing. For some of the rest of the a time of high unemployment and ample resources world, the opposite shift will need to be at as external stimulus fades away, as it must if work-less reliance on exports, and more on international equilibrium is to be restored. The domestic sources of growth. appreciation of their currencies and the strong Much still needs to be done to ease the way for deflationary influences of low oil and other com those adjustments. For one thing, we in the modity prices would appear to offer a prime United States are not prepared for a really large opportunity for reconciling those goals of domestic improvement in our trade balance. Our financial growth and stability. markets remain dependent on the large capital inflows from abroad that are a necessary counter The International. Debt Problem part of our trade and current account deficits. Moreover, taken by itself, depreciation of our Four years after the international debt problem currency in an effort to redress the trade deficit broke into our collective consciousness in 1982, poses a risk of renewed inflation. when Mexico abruptly lost access to international Only as our huge federal deficit is cut can we credit markets, that threat to our mutual pros comfortably contemplate less borrowing abroad perity remains. The renewed difficulties of the oil and provide assurance against renewed inflation. producing countries today should not, however,. obscure the progress that has been made. Collec tively, the heavily indebted countries of .Latin America and elsewhere have made an enormous effort to adjust their external accounts; in fact, m 1984 and 1985, they were in rough current 4 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis account balance, in contrast to an aggregate defi government earlier this week. In cooperation with cit of about $50 billion in 1982. the IMF and the World Bank, Mexico is under To be sure, that effort for a time was accom taking a wide range of efforts to deal with both its panied by sharply lower imports, recession, and short- and longer-range economic problems. To lower standards of living as they brought their my mind, their efforts, in the midst of crisis, to spending more in line with their internal resources. move toward a more open, competitive economy, But it is also true that many of those countries are particularly encouraging. They have joined are again growing, in some cases with vigor, as is GATT, import restrictions are being rationalized the case with the largest single debtor, Brazil. and liberalized, a good many state-owned enter Helped by the reduction in world interest rates, prises are being made available for sale (or, if too external interest burdens have been reduced inefficient, shut down), subsidies are being appreciably in some countries relative to exports reduced and eliminated, and procedures for or other measures of capacity to pay. A number approving foreign investment eased. If carried of Latin American countries have also made strik through effectively, those measures promise to ing progress in dealing with ingrained inflation work toward fundamental improvement in the for the first time in many years, in the process efficiency, competitiveness, and creditworthiness gaining political support. There has been con of the Mexican economy, thereby enhancing pros siderable, if uneven, progress toward liberalizing pects for longer-term growth. their economic structures in ways that should Today, that country is in recession. But the encourage more growth and productivity over time. program clearly contemplates economic recovery In the midst of this progress, the sharp decline in 1987 and 1988. Certainly, sizable amounts of in oil prices over the past six months has had an financing from abroad will be required to support enormous adverse impact on the oil-exporting that effort. About half of that can be committed heavily indebted countries-Venezuela, Nigeria, by the IMF, the World Bank, and the Inter Ecuador and Mexico. At current oil prices, for American Development Bank. But Mexico is call instance, Mexico would lose about a third of its ing upon commercial banks, with so much 1985 exports, perhaps as much as 15 percent of already at stake, to play a large role as well. its government revenues, and the equivalent of In assessing that situation, I would note that some 5 percent of its GNP. Inevitably, that situa the Mexican exposure of commercial banks appears tion poses a new and severe challenge for Mexico-a not to have increased for some 18 months. challenge that will require strong new efforts to Indeed, there has been little net new lending to make the necessary economic adjustments and to Latin America as a whole over the past year. improve the structure of their economy. There is Taking the entire period since mid-1982, the no large cushion of external reserves to buffer the exposure of American banks to the heavily shock. Consequently, a large amount of financial indebted countries of Latin America relative to resources will have to be marshalled from abroad their capital has declined appreciably. That ratio to help ease the transition, to maintain continuity fell from about 120 percent of the capital of lend- in debt service, and to provide a solid base for renewed growth. That combination of adjustment, structural change, and appropriate financing is, indeed, the essence of the approach announced by the Mexican 5 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis ing banks to less than. 75 percent at the end of tions, most of the borrowers can look toward last year, a decline of 38 percent. No doubt, there more balanced expansion in their imports and has been a further reduction by now. exports as they grow-among other things, pro Those exposures, in relative terms, are actually viding renewed opportunities for American considerably less than in 1977 when the data were exporters. first collected. For some time, the pace of lending But I must also emphasize one essential ingre has, in fact, been well below that contemplated by dient for success beyond the capacity of the Secretary Baker when he set out a framework for indebted countries to manage. Only a stable, a growth-oriented approach toward the interna growing world economy, with markets open to the tional debt problem at the IMF meetings last developing world, can provide an environment autumn. conducive to economic expansion, more normal That initiative-essentially contemplating a interest rates, and orderly debt service by the bor combination of strong adjustment efforts and rowers. That ingredient is plainly the respon structural reform by the indebted countries with sibility of the industrialized world alone. It is one reasonably assured financing by international of the reasons why we must collectively deal with institutions and private banks-is now being the obvious imbalances among us. tested. It is being tested in difficult circumstances not foreseen at the time-the sharp break in oil Monetary Policy in 1986 prices. But the basic community of interests among borrowers and lenders-and the world at These larger issues were the background against large-in a coherent, cooperative approach is as which the Federal Reserve has conducted strong as ever. monetary policy in 1986 and reviewed its objec The debtor countries themselves have an enor tives for growth in money and credit this year mous stake in maintaining their creditworthiness and next. The results of the review by the Federal and in seeking solutions in the framework of Open Market Committee of target ranges for open, competitive markets. We all have a strong money and credit for 1986 and tentative ranges interest in international financial order-all the for 1987 were discussed in the Humphrey-Hawkins more when there are other points of strain in the Report published and sent to the Committee at banking system. And, of course, relationships the end of last week. That report also sets out beyond the purely economic are at stake, for the projections for real activity and prices of FOMC United States most of all. members and Reserve Bank presidents. The challenge is large, but with cooperation, As indicated in the Report, the posture of also manageable. Indeed, the same oil price monetary policy remained broadly accommodative decline that has undermined the budgetary and over the past six months. The discount rate has trading position of Mexico and other large oil been reduced in three steps this year by 1 ½ per exporters has relieved the pressure on those cent, in part responding to and in part facilitating importing oil. Interest rates have declined. A declines in short-term interest rates of similar number of borrowing countries will require magnitude. Long-term interest rates also moved significantly less, rather than more, financing than lower, extending the sharper drops in the second was contemplated a year ago. Given the enor half of last year. The general structure of interest mous progress made in adjusting external posi- rates is now as low as at any time since 1977. The reductions in interest rates in 1985 and 1986 have clearly helped support the more interest-sensitive sectors of the economy, reflected in part in the highest level of housing starts since the late 1970s. The declines have also helped ease 6 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis the debt servicing costs of businesses, farmers, remained well within their respective target ranges developing countries and the U.S. Government of 6-9 percent, ending the second quarter close to itself. their mid-points. That and other evidence sug On the other side of the ledger, as interest rates gested that much of the growth of Ml reflected a have declined, the rate of growth in debt has shifting of the composition of liquid assets rather remained at disturbingly high levels, although than excessive, and potentially highly inflationary, there are at least faint signs of a slackening in the money creation. That judgment was, of course, rate of debt creation after a burst around the turn reinforced by the moderate rate of growth for the of the year. The declines in interest rates also economy overall, the absence of indications of a clearly helped induce the general public to strong acceleration as the year progressed, increase its holdings of its most liquid assets, evidence of greater stability in prices of manufac including demand deposits and NOW accounts tured goods, and declining commodity prices. included in the narrow measure of the money In looking ahead, the Committee decided to supply, Ml. That reaction was undoubtedly retain the existing ranges of 6-9 percent for M2 amplified by the fact that interest is paid on and M3 this year. The range of 3-8 percent set NOW accounts, which are now the favored form for M 1 early in the year was not recalibrated in which transaction balances are held by because of the uncertainties as to the behavior of individuals. With interest rate spreads currently that aggregate at present. Certainly the infla quite narrow between NOW accounts and other tionary potential of excessive money growth liquid assets, those accounts no doubt have served remains a matter of concern. But in current cir increasingly as a repository for liquid savings as cumstances, the Committee decided that the well as for money held for transactions purposes. significance of changes in M 1 could only be Similarly, there are some indications of a judged in the context of movements in the greater willingness of businesses to hold demand broader aggregates, and against the background deposits at a time of lower interest rates, partly of movements in interest rates and the economy because, with interest rates down, a larger bal generally. Taking account of those factors, growth ance is necessary to compensate banks for a given in excess of the target established at the start of amount of services. To some extent, an environ the year will be acceptable. ment of more stable prices may also be encourag In circumstances of greater economic, price, ing larger money holdings. and interest rate stability, more predictable rela None of that was predictable with any preci tionships between Ml and the economy may sion, and the rate of growth in Ml, which ran at re-emerge over time, although the trend of Ml almost 13 percent over the first half of the year, velocity-the ratio between GNP and Ml-will was far above the FOMC's target range. Action likely be different than earlier in the postwar to restrain that growth within the target range period. However, a firm conclusion concerning which would have required reducing the provision the nature and stability of future velocity of reserves and a significant increase in pressures characteristics may take years of experience in the on bank reserve positions-was not deemed desir new institutional and economic setting. For the able in the light of other important considerations. time being, in looking to next year, the Commit One of those considerations was that growth in tee set out a highly tentative range of Ml growth the broader measures of money-M2 and M3- of 3-8 percent on the assumption that velocity changes will be within the range of most postwar experience. However, that judgment-and indeed 7 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis the weight to be given any Ml range for 1987-will as the economy grows more strongly and as a be carefully reviewed at the start of next year. large amount of resources are shifted back to The tentative 1987 ranges for M2 and M3 were manufacturing industries as our trade balance lowered by one-half percentage point to 5 ½ -8 ½ improves. Without such assurance, there would percent. That modest reduction, consistent with be no firm basis for expecting the level of interest the long-term objective of achieving a rate of rates to remain for long at lower levels or to monetary growth compatible with price stability, decline further. is judged to be entirely compatible with a In looking toward growth in the 3-3 ½ percent somewhat greater rate of economic growth next range next year, considerable emphasis was year, provided that growth is not accompanied by placed by Committee members on the potential a marked increase in inflationary pressures. contribution to that growth of a stronger trade The actual price statistics for some months balance. As I emphasized earlier, that shift, if it is have, of course, reflected the precipitous drop in to take place in the context of sustained and the price of oil, and consumer prices have drop stronger world growth, will require appropriately ped slightly this year. But equally clearly, the complementary policies here and abroad. Signifi price of oil will not continue falling so fast, and at cant progress toward dealing with our own budget some point could well rise again. More predict deficit seems to me a key ingredient in that ably, the large depreciation of the dollar will overall policy "mix." bring in its wake an increase in import prices of The timing of another important domestic manufactured goods. That impact has been mod policy instrument-discount rate cuts-has been erated so far by the narrowing of the earlier wide influenced by international financial and exchange profit margins of many of those exporting to us rate considerations. A substantial realignment of and by the availability of imports from developing the excessively strong dollar exchange rate has countries, few of which have had any appreciable been a necessary and constructive part of achiev appreciation of their currencies vis-a-vis the ing the necessary adjustment in external trade. dollar. But there are clear dangers in placing excessive The rate of increase in costs of housing and of weight on that approach. many services, which account for a large propor History demonstrates all too clearly that a kind tion of the economy, has decelerated little if at all of self-reinforcing cascading depreciation of a in recent years. With demand strong, measured nation's currency, undermining confidence and productivity gains limited, and compensation or carrying values below equilibrium levels, is not in increases in service occupations continuing to that nation's interest or that of its trading part average 4 ½ percent or more, those areas continue ners. Among other things, such a movement of to lend a chronic inflationary bias to the general the dollar now could transmit strong inflationary price level. pressures to the United States and inhibit the free Those underlying forces are reflected in the flow of capital from abroad at reasonable interest projection of FOMC members and Reserve Bank rates. Moreover, other countries would find it presidents that the overall inflation rate is likely to more difficult to sustain their forward momentum. be somewhat higher next year. That prospect In the light of all these considerations, the dis underscores the need for vigilance in the conduct count rate reductions in March and April were of monetary policy. We want to assure mainte timed to coincide with similar changes by one or nance of the remarkable progress toward stability more other key countries, minimizing any impact on the exchange markets and consistent with the desirability of some reduction in interest rates in the industrialized world generally. 8 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Some Lessons of Recent Experience cumstances. But it is equally true that that single, broad-brush policy instrument cannot, at one and Experience over the first half of 1986 underscored the same time, be called upon to stimulate the the difficulty-I would say the impossibility-of economy, protect the dollar, restrain excessive conducting monetary policy in current circum debt creation, and shift resources away from con stances according to one or two simple, pre-set sumption and back into investment, manufactur criteria. For instance, the rapid growth of debt ing and exports-as desirable and important as all and M 1 clearly bear watching because of the those goals may be. potential for aggravating the vulnerability of the Events of recent years have also heavily financial structure to adversity and because of the underscored how cumbersome fiscal policy can be, inflationary potential. However, the weight of the and the difficulties of achieving political consensus evidence strongly suggests that M 1 alone during on such matters as tax reform and the appropriate this period of economic and institutional transition legislative framework for financial institutions. On is not today a reliable measure of future price an international scale, achieving consensus on pressures (or indeed a good short-term "leading appropriate action can be still more difficult. indicator" of business activity). The more We have nonetheless come a long way toward restrained performance of the broader aggregates, restoring growth and stability in this decade. But as well as the performance of the economy and my sense is that all that progress is in growing prices themselves, point in a different direction. At the same time, pressures on the oil industry, jeopardy unless we act-we in the United States, we in the industrialized world, and we in the agriculture, and parts of manufacturing and the world as a whole-in mutually supportive ways. more general disinflationary process are reflected The main directions of that effort seem to me in strains on some depository institutions. Those clear enough. The Gramm-Rudman-Hollings strains emphasize the importance of dealing with legislation is an expression of the sense of urgency factors more directly under the control of lenders themselves: excessive leveraging of borrowers and surrounding our budgetary effort in the United States. The rest of the industrial world needs to loose credit standards. A broad array of approaches achieve and maintain a momentum of "home by the supervisory and regulatory authorities has been necessary to deal with the particular points grown" expansion. With strong national and of pressure in a manner consistent with the international leadership-and with the cooperation stability of the entire fabric of financial institu of private and public lenders-a constructive resolution of the economic crisis in Mexico can tions and markets. The present situation certainly makes all the point the way to a wider resolution of the debt problem in a context of growth. more pointed the need to provide a stronger sense Hard as it may be to carry through on those of legislative direction about the evolution of the financial system over time. There are also urgent efforts, that is what needs to be done if the imbalances in the eco~omy are to be effectively specific pieces of legislation before you to permit the FDIC and the Federal Reserve to facilitate addressed. Then we will have a really solid base interstate acquisitions of failed or failing banks for sustaining the momentum of growth and the progress toward stability in the years ahead. Cer and to supplement the resources of the FSLIC. The difficulties of some financial institutions are tainly, the Federal Reserve will play its part in that effort. one specific example of economic problems that cannot be effectively dealt with by monetary policy alone. It is indeed a strength of monetary policy that it can respond flexibly to changing cir- FRB 10-48000-0786 9 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 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. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 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 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Monetary Policy • 1986 and 1987 In 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 M1 (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 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis M2 nature of the relationship among Ml, income, and Billions of Dollars 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 growth of M 1 in excess of the previously established 3 to 8 percent range for 1986 would be acceptable 1985 Q4 to June 1986 7.8 Percent and growth in that aggregate over the balance of the 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 Billions of Dollars .,., 620 .,., _., .,., Annual Rates of Growth .,., 1985 Q4 to 1986 Q2 0 N D J F M A M J J A S O N D 7.9 Percent 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 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis E conomic Projections Progress in reducing the federal deficit is seen as crucial in maintaining fina ncial 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 p rogress 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 res uit of the depreciation of In 1987, which would be the fifth year of the cur- the dollar, the growth in im ports 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 co mpetitiveness 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 grow th 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 unde rscores the critical stimulate exports. However, with energy prices importance of avoiding prote ctionist 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 3½ 2½ to 3 fourth quarter: Implicit deflator for GNP 1 ½ to 3¼ 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 7½ Percent change, fourth quarter to Real GNP 2 to 4¼ 3 to 3½ 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 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 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 tinued moderation in wage increases and abundant previous period, annual rate 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 3 of services. + 1981 1983 1985 5 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 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 new high. The rallies in the stock and bond markets 3 strengthened the asset side of the household sector balance sheet. Many homeowners took the opportu nity presented by the decline in interest rates to ease + 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 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 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 t~e first half of considerable diversity across industries. Economic 1986. On balance, the trade-weighted value 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 conditions 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 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 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 + 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 merchandise exports was up somewhat in the first 80 quarter, with a 3 ½ percent decline in exports of agricultural products offset by increased U.S. nonagricultural exports. 120 H2 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 improveme~t was the first half of 1986. result of large increases in nonpetroleum imports In the initial months of 1986, growth of M1 while exports grew more slowly. . dropped off sharply from its rapid 1985 pace, and Yet the decline in the dollar improved the pnce ' growth of M2 also slowed substantially, to ~ 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 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 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 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 Nonfinancial 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)' 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 9.6<' 1986 e-estimated 1. M 1 figure in parentheses is adjusted for shifts to NOW accounts in 1981. 9 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis the discount rate by 1/2 percentage point, to 6 per hard hit recently; loan losses at these institutions cent on July 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. Ml 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, plus Money Market Deposit Accounts, plus shares in money debt grew at an annual rate of 10 ¼ percent through 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 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis

Federal Reserve (1986, July 22). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_19860723

@misc{wtfs_monetary_policy_report_19860723,
  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_19860723},
  note = {Retrieved via When the Fed Speaks corpus}
}