Monetary Policy Report

Monetary Policy . Objectives for 1987 Midyear Review of the Federal Reserve Board July 21, 1987 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Monetary Policy Objectives for 1987 Testimony of Paul A. Volcker, Chairman, Board of Governors of the Federal Reserve System July 21, 1987 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Testimony of Paul A. Volcker Chairman, Federal Reserve Board I appreciate this, my last) oppor Most interest rates, long- and short-term, have retraced part of the earlier rise. However, long tunity to appear before you as term interest rates and prices of sensitive com modities, some of which had been deeply Chairman of the Federal Reserve depressed, remain well above their levels of earlier Board in connection with the semi this year. The approach of the Federal Reserve toward annual review of monetary policy. the provision of reserves has not changed since May. However, growth in the various monetary You have the official Report of the aggregates slowed further in the second quarter. Board of Governors before you and A reduction in the rate of growth of those aggregates from the relatively high levels of 1986 I will be blessedly brief in touching had been both anticipated and desired by the Fed eral Open Market Committee, as reported to you upon some of the main points. in February. However, it is also true that, with institutional and market developments importantly affecting the relationships between the various measures of money and the variables we ulti As you know, the economy has continued to grow mately care about, judgments about the appropri this year, carrying the expansion well into its fifth ate growth of the aggregates have become both year. At the same time, however, the inflation more difficult and more dependent on prevailing rate has accelerated appreciably relative to the low economic and market circumstances. rate prevailing in 1986. For that reason, the Committee did not set A change in that direction had been widely forth a particular target range for M 1 this year in anticipated in response to the rebound in oil February. That judgment was reaffirmed at the prices and the depreciation of the dollar. meeting earlier this month. M2 is currently run Nevertheless, the size and pervasiveness of the ning below, and M3 around, the lower ends of price increases-which have included many non their 5 ½ to 8 ½ percent ranges established in energy materials as well as services-affected the February. The Committee decided not to change psychology and expectations in financial markets, those ranges for 1987. In doing so, however, particularly in April and early May. Recurrent there was agreement that, depending on further concerns about the dollar internationally also at evidence with respect to emerging trends in eco times affected the mood of domestic markets, and nomic activity, inflation, and domestic and inter interest rates rose rather sharply for a time. national financial markets, actual growth around Through the early part of the year, Federal the lower ends of those ranges may well remain Reserve operations placed minimal pressure on appropriate. bank reserve positions. As reported earlier, how In judging appropriate monetary growth during ever, beginning in late April definite but modest the course of the year, or from year to year, steps were taken to increase reserve pressures account needs to be taken of the apparent somewhat. Perceptions of that action appeared to increase in the sensitivity of demands for money, help calm concerns about the future course of the and for money-like assets, to absolute and relative dollar and inflation. changes in market interest rates. Interest rates administered by institutions, especially those on transactions accounts, tend to lag market rates 2 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis both when interest rates are rising and when they inflationary process. The appropriate range for are falling ( of course, no explicit interest can be 1988 will, of course, again be reviewed with care paid on demand deposits). At the same time, the at the start of the year. cost and effort involved in shifting funds between More broadly, policy has to be judged against types of accounts, or into and out of market progress toward the more basic goals of growth instruments, has greatly diminished. Experience and stability-and it seems to me fatuous to think suggests that, as a result of these factors, demand the first could long be sustained without the lat deposits, NOW accounts, and money market ter. At the same time, now and for some years deposit accounts all tend to grow relatively slowly, ahead, we will need to work to narrow and ulti if at all, when market rates are rising ( as during mately correct the large imbalances in our internal the second quarter) but much faster than nor and external economic positions-adjustments that mally as market rates fall, as during 1985 and necessarily have implications for the policies and 1986. Those differences in growth rates in money prospects of other countries as well. What is at will tend to be reflected in inverse movements in issue is whether we can make those necessary the velocity (that is, the measured rate of turn adjustments while sustaining progress toward the over) of money rather than commensurate broader goals. changes in economic activity or prices. In some areas, developments in the past six That sensitivity of velocity to changes in interest months have been strongly encouraging in that rates makes it more difficult to judge the appro respect. priate rate of monetary growth-particularly over • The evidence by now is pretty clear that, periods as short as a quarter or a year-and in real terms, our trade balance is improv impossible without reference to the stream of ing, even in the face of continuing sluggish available evidence on economic activity, prices, growth, high unemployment and excess and other factors. This year, too, concerns about capacity abroad. the international performance of the dollar have • While growth in domestic consumption has at times had a significant bearing on operational slowed-one essential part of the adjust decisions. Specifically, the tightening of reserve ment process-the expansion of domestic availability in the spring was related in substantial output and employment has been well part to the desirability, in the light of the substan maintained, and unemployment, at close to tial cumulative depreciation over the previous two 6 percent, has dropped to the lowest level years and other economic policy undertakings in this decade. Manufacturing has picked here and abroad, of maintaining reasonable stabil up and prospects for business investment ity in the external value of the dollar. That judg may be improving. ment is, as you know, shared with the Adminis • Helped by some large unanticipated capital tration and the finance ministers and central bank gains tax receipts, this year's budget deficit governors of other leading industrialized countries. will apparently be driven even below Looking ahead to 1988, the Open Market Com earlier expectations, and thus very substan mittee decided tentatively to reduce the target tially below the fiscal 1986 level. ranges for M2 and M3 by 1/2 percent to 5-8 per • Internationally, leading nations are not only cent. While recognizing the inevitable range of agreed upon the desirability of greater uncertainty I referred to earlier, some reduction exchange rate stability but appear to be in the target ranges clearly appeared appropriate working more effectively to that end. in recognition of the importance of assuring that the temporary bulge in price increases foreseen for this year not become a base for a renewed 3 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis • In another area demanding a high level of The already slow growth in other industrialized international cooperation, the basic approach countries appears to have slowed further this year, for dealing with the international debt working against the adjustments needed in trade problems has continued to be implemented and current account positions among Japan, with substantial success despite doubts and Western Europe and the United States. And, in challenges by some. that ·environment the dangers of protectionist trade legislation and a breakdown in the servicing Of central importance, there has been continu of international debts are enlarged. For all those ing evidence of restraint and discipline on costs reasons and more, my very able successor, and and wages in much of American i~dus:ry, _offer the Federal Reserve generally, will have challenge ing the prospect of lower rates of mflation m the aplenty. But, I, as I have spelled o_ut earlier, . months ahead. Over time, that must be an abso would like to think there is somethmg upon which lutely essential element in maintaii:iing our_ inter to build as well. national competitivness as well as m restormg Finally, Mr. Chairman, I would like to acknowl domestic stability after the bulge in prices this edge specifically the usefulness from my stand year. point of these regular semi-annual hearings on At the same time, it would be nonsense for me monetary policy. . to claim that all is safely and securely on path. You and I are both conscious of the special The remaining risks and problems are apparent. position of the Federal Reserve System within the Even the otherwise satisfying fall in the unem overall framework of government. The long terms ployment rate this year implicitly ?as a discou:ag of members of the Board of Governors, the par ing aspect. Outside of manufact~rmg'. the_ statis ticipation of the Regional Federal Reserve Banks tics suggest productivity growth is qmte dismal in the policy process, our budgetary autonomy, so slow, in fact, that I cannot dismiss the thought and the professionalism of our staff are all that the reported statistics may partly reflect designed to provide some insulatio~, in decidi1:g measurement error. upon money creation, against partisan or passmg But no error of measurement can entirely political pressures. . explain away that our private saving, in historical In our system of government, however, msula or in international context, remains so low, or tion cannot be equated to isolation, and particu that our federal deficit remains so large, or that larly isolation from reporting and accountability we, the putative leader of the weste_rn world,. are to the Congress and to the public. These hearings so dependent on other people's capital. De_spite are an important element in that discipline. I the better news on this year's federal deficit, some have welcomed the opportunity they have provided projections of future deficits assuming current pro for us to consult with the Congress, and to grams are being raised rather_ than redu~ed and explain our purposes, our approaches, and our_ the political impasse over domg somethmg about problems in dealing with a complicated, changmg it apparently remains. In the circumstances, th~ economic environment. And I want to express my Gramm-Rudman-Hollings targets are threatenmg appreciation as well for the many courtesies you to become pie in the sky. have extended me personally over these past eight years as we have worked together to foster eco nomic stability and growth. FRB12-48000-0787 4 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Monetary Policy Objectives for 1987 Summary of Report to the Congress on Monetary Policy pursuant to the Full Employment and Balanced Growth Act of 1978. July 21, 1987. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Contents Section Page Monetary Policy in 1987 and 1988 3 Economic and Financial Background 3 Ranges for Money and Credit Growth in 1987 and 1988 5 Economic Projections 6 Economic Performance During the First Half of 1987 9 The External Sector 10 The Household Sector 11 The Business Sector 12 The Government Sector 13 Labor Markets 14 Price Developments 14 Monetary Policy and Financial Markets in the First Half of 1987 15 Money, Credit, and Mondary Policy 16 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Monetary Policy and the Economic Outlook for 1987 and 1988 The economy expanded at a somewhat accelerated reducing our federal budget deficit is essential: a pace in the first half of 1987, and the civilian failure to achieve this often-stated objective could unemployment rate declined over the period to 6.1 only damage confidence in o~r ability to deal with percent in June, the lowest level in this decade. our economic problems and contribute to imbalances Moreover, the pattern of activity has exhibited in financial markets and the economy. In addition, encouraging signs that a turnaround in the trade satisfactory growth in the other major industrialized sector is under way. An improvement in net countries is crucial, as are efforts on all sides to exports, in real terms, appears to be providing a lift maintain and improve the openness of the interna to activity in the industrial sector, offsetting slower tional marketplace. The private sector also must growth of domestic spending and sustaining a play a constructive role, by remaining sensitive to moderate rise in overall domestic production. How wage and price practices that promote the interna ever, the process of restoring balance to the U.S. tional competitiveness of American business. external accounts has involved a sizable increase in the prices paid for imported goods. These price Economic and Financial Background increases have occurred at the same time that a rebound in world oil prices carried inflation rates The economic expansion has now progressed well above last year's modest pace. into its fifth year. Real GNP rose at a 4 ¾ percent Although some of the elements necessary for sus annual rate in the first quarter. However, much of taining economic growth are now beginning to fall the increase in production reflected a rebuilding of into place, the economic outlook continues to be business inventories that had been drawn down late clouded by a number of imbalances, risks, and in 1986, and real GNP appears to have increased at uncertainties. The experience of the first half of an appreciably more moderate pace in the second 198 7 underscored, in particular, the dangers quarter. Nonetheless, growth remained strong associated with a loss of market confidence in the enough to sustain a downtrend in unemployment. dollar and the related potential for a rekindling of inflation expectations. The Federal Reserve, in Ranges of Growth for Monetary and implementing monetary policy, was sensitive to these Debt Aggregates (Percent Change) dangers, while it continued to provide support for sustainable economic growth. During the first part 1987 Tentative for 1988 of the year, growth in money and credit slowed from the rapid pace of 1986, even though pressures 1986 Q4 to 1987 Q4 1987 Q4 to 1988 Q4 on the reserve positions of depository institutions remained mild. Those pressures were increased M2 5½ to 8½ 5 to 8 somewhat in late April and May, however, as the M3 5 ½ to 8½ 5 to 8 dollar fell sharply against other key currencies, infla tion expectations flared up, and long-term interest Debt 8 to 11 7 ½ to 10½ rates jumped to higher levels. In response to these steps, and to complementary policy actions taken abroad, the dollar has stabilized, and interest rates have retreated somewhat from their May highs. If the nation is to achieve an orderly transition to better external balance, one marked by a minimum of financial or inflationary pressures, responsible action by many parties-in addition to the Federal Reserve-will be necessary. Further progress in 3 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Beneath these solid gains in aggregate economic notable restraint on labor costs, has greatly enhanced activity have been welcome improvements in the for the competitiveness of U.S. producers in interna tunes of sectors that have failed to participate in the tional markets. At the same time, though, the increasing prosperity of the past several years. As depreciation has caused prices of imported goods to suggested above, the most significant development increase-sharply in some cases-and exacerbated a has been the emerging improvement in the nation's bulge in prices coming from higher energy costs. trade performance, which has begun to close the gap The rise in consumer prices, averaging more than 5 between the pace of growth in the industrial sector percent at an annual rate over the first five months and the rest of the economy. Indeed, some segments of this year, was a disturbing departure from recent of manufacturing have reached relatively high levels experience. Moreover, as the dollar exhibited con of capacity utilization and strong profitability. Eco tinued weakness in the early spring, and with nomic strains also appear to be easing in other progress toward improvement in the U.S. current troubled sectors. Oil-well drilling, while still at account slower than many had anticipated, concerns depressed levels, has turned up as a consequence of mounted about inflation prospects. This was the firming of world oil prices. Agricultural income reflected for a time in rising prices of precious was quite high last year, although it continued to be metals and other actively traded commodities, an heavily dependent on government support. Farmland event that only served to reinforce the inflation fears values seem to have stabilized, and the amount of that simultaneously were unsettling U.S. securities delinquent farm loans has begun to decline. markets. While the external sector has been strengthening, In these circumstances, and with the economic in real terms, in recent quarters, growth in domestic advance evidencing reasonable momentum, the Fed demand has moderated considerably. To some eral Reserve in late April and May adjusted its open extent, the slower rise in household and business market operations to impose a somewhat greater, purchases in the early months of this year was a but still quite limited, degree of pressure on the reflection of the acceleration that had occurred at the reserve positions of depository institutions. This step end of 1986, motivated by tax considerations. How was reassuring to the markets. Coupled with com ever, consumers, in particular, have shown signs of plementary actions by monetary authorities abroad less exuberance in their expenditure patterns after a and more favorable news on prices and U.S. mer period of several years in which their willingness to chandise trade flows, the firming of money market spend increasing proportions of their income conditions contributed not only to a turnaround in provided considerable thrust to business activity. A the dollar on exchange markets but also to a rally in moderation of domestic spending growth is, of bond prices. On balance, however, short-term interest course, a fundamental ingredient in achieving better rates currently are about one-half percentage point external balance without putting excessive strains on above their levels at the time of the Board's Febru available resources. ary monetary policy report to the Congress, and A key element in the recent trade developments long-term rates· are up about a full percentage point. has been the steep drop in the foreign exchange value of the dollar-almost 40 percent on a trade weighted basis against other G-10 currencies-since early 1985. That decline, in conj unction with 4 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis The rate of growth of the money stock measures, rising interest rates enable banks to earn more on M2 and M3, has been well below that of last year business demand deposits, had a marked effect on and close to, or below, the lower end of the target Ml growth as well, which slowed to a 10 percent ranges adopted in February. This has been viewed .annual rate between the fourth and second quarters as acceptable by the Federal Open Market Commit ( and a 7 ¾ percent rate between the fourth quarter tee (FOMC), given the inflation and exchange rate and June); Ml velocity appears to have changed lit developments, as well as indications of greater than tle in the second quarter, after more than two years anticipated strength in the velocity of money (that of steep decline. is, the ratio of nominal GNP to money). M2 rose at Reflecting in large part the diminution of the fed an annual rate of only 4 percent between the fourth eral deficit and a slowing in state and local govern quarter and June, appreciably below the 5 ½ to 8 ½ ment borrowings, influenced ·by the Tax Reform percent growth range for the year. M3 grew at a Act, aggregate credit expansion in the economy has 5 ¼ percent rate, a shade below the lower bound of slowed noticeably this year. The debt of domestic its identical range. nonfinancial sectors is estimated to have expanded at The marked deceleration of monetary growth, and about a 9 ¾ percent annual rate through June, still the accompanying rise in M2 and M3 velocity after high relative to the growth of nominal GNP, but less two years of decline, reflected a variety of influences. rapid than in the past several years and within the 8 Some unwinding of the buildup in balances that to 11 percent monitoring range specified by the Fed occurred late last year in connection with a huge eral Open Market Committee. volume of tax-related transactions may have been involved; tax reform also may have damped growth Ranges for Money and Credit in money as individuals reduced their additions to Growth in 1987 and 1988 deposit holdings rather than using consumer credit, on which interest is no longer fully tax-deductible. At its meeting earlier this month, the FOMC did Capital constraints on the growth of bank and thrift not change the 1987 ranges for money and credit institution assets may have limited the depositories' growth that it had established in February. As indi efforts to seek funds, an effect likely to express itself cated at that time, operating decisions will continue most fully at the level of M3, which encompasses a to be made not only with due regard to the behavior broad range of depository-institution liabilities. of these aggregates, but also in light of evidence on But it is another factor that appeared most impor emerging trends in economic activity and inflation tant, particularly in the case of M2. Changes in and developments in domestic and international deposit rates have lagged changes in market rates-a financial markets. At this juncture, given the actual behavior exhibited quite consistently in the period growth achieved in the first half, it seems likely that, since most restrictions on deposit rates were absent major movements in interest rates that alter removed. With market rates rising, financial assets, the incentives to hold monetary assets, expansion in other than those included in M2, became relatively M2 and M3 around the lower ends of their 5 ½ to more attractive to the public, the opposite of 8 ½ percent annual ranges may well be appropriate. developments in 1985 and 1986. This same Indeed, should the recent tendency toward a phenomenon, reinforced by the normal downward adjustment of compensating balance requirements as 5 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis strengthening in velocity, which has been particu expected to generate jobs in about sufficient number larly noticeable in the case of M2, persist, or if to match the expansion of the work force. Conse inflationary pressures appear to be mounting, some quently, the civilian unemployment rate is not shortfall from the annual ranges might well be expected to change appreciably from the 6 ¼ percent appropriate. With regard to the domestic debt average of the second quarter, although recent aggregate, the FOMC anticipated that the slower -experience suggests that the projected growth of real pace of debt growth in the first half would continue GNP might lead to somewhat lower unemployment. and that the aggregate would end the year well Real net exports of goods and services are expected within the 8 to 11 percent monitoring range. to strengthen further while the growth of domestic Consistent with the objective of maintaining pro demand remains relatively subdued. The improved gress over time toward general price stability, while competitive position of U.S. producers, resulting in supporting sustainable growth in economic activity, large part from the dollar depreciation of the past the FOMC decided to adopt, on a tentative basis, two years, has only begun to be reflected in trade lower growth ranges for money and credit in 1988. flows, and further improvement in the nation's The target growth ranges for M2 and M3 were external position should be realized in coming reduced 1/2 percentage point, to 5 to 8 percent, quarters. Household spending is expected to grow measured from the fourth quarter of 1987 to the slowly, but stronger increases in business investment, fourth quarter of 1988. At the same time, the especially in equipment, are anticipated as industrial monitoring range for growth of nonfinancial sector firms respond to more favorable sales trends. debt also was tentatively reduced by 1/2 percentage Prices, as measured by the implicit deflator for point, to 7 ½ to 10 ½ percent. GNP, are expected to rise 3 ½ to 4 percent over the The Committee noted that M1 has continued to four quarters of 1987-slightly more than the central exhibit considerable sensitivity to changes in interest tendency range reported to the Congress in Febru rates, among other factors, as illustrated by its sharp ary. For 1988, projections of the increase in the deceleration in the first half of this year. In view of GNP deflator center on 4 percent. Assuming world this, and the still-limited experience with the oil prices are more stable, there should be no repeti behavior of deregulated transactions accounts, the tion of the rebound in domestic energy prices that Committee decided not to set a specific target range raised the general rate of inflation earlier this year. for M1 for the second half of 1987, and no tentative However, the acceleration in prices of non-oil range was adopted for 1988. In its policy delibera imported goods, that is occurring in the wake of the tions over the remainder of the year, the FOMC decline in the foreign exchange value of the dollar, will take account of M 1 growth in light of the likely will continue for a time to provide some impe behavior of its velocity, incoming information about tus to inflation, even if the dollar is more stable over the economy and financial markets, and the degree the period ahead, as assumed. The size of further of emerging price pressures. increases in import prices, resulting from the depre ciation to date, will depend on the aggressiveness with which foreign exporters and U.S. distributors Economic Projections seek to restore profit margins that have been The Committee believes that the monetary objec squeezed in the past two years. The view that infla tives that it has set are consistent with restraint on tion next year will not rise significantly from the inflation in the context of continued moderate pace projected for 1987 is grounded in a belief that growth in economic activity and progress toward a recognition of the potential for losses of market sustainable external position. The central tendency share and job opportunities will continue to of the forecasts of Committee members and other influence wage- and price-setting behavior. Reserve Bank presidents is for growth in real GNP of 2 ½ to 3 percent in 1987 and 1988. Between now and the end of next year, this pace of activity is 6 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis While restraint on inflation is crucial in achieving Finally, the members of the Committee and other an orderly adjustment as our massive external Reserve Bank presidents also view the prospects for imbalance is corrected, so too is continued progress a healthy U.S., and world, economy as depending in reducing the federal budget deficit. Inflows of for significantly on the avoidance of further protectionist eign capital will shrink in step with the reduction in measures here and abroad and on satisfactory eco our current account deficit. In that context, exces nomic growth in other major industrial countries. sive federal borrowing requirements, as they put pressure on financial markets, pose a threat to the ability of our economy to fund necessary private capital formation. Economic Projections for 1987 and 1988 * FOMC Members and other FRB Presidents 1987 Range Central Tendency Nominal GNP 5¾ to 7 ¼ 6¼ to 7 Percent Change, fourth quarter to Real GNP 2 to 3¾ 2½ to 3 fourth quarter: Implicit deflator for GNP 3 to 4¼ 3½ to 4 Average level in the fourth quarter, Civilian Unemployment Rate 6.1 to6.5 6.2 to 6.4 percent: 1988 Range Central Tendency Nominal GNP 5 to 8 5¾ to 7 Percent change, fourth quarter to Real GNP 1 to 3 2½ to 3 fourth quarter: Implicit deflator for GNP 2½ to 5 3¾ to 4¼ Average level in the fourth quarter, Civilian Unemployment Rate 5.9 to 6.8 6 to 6.5 percent: *The Administration has yet to publish its mid-session budget review, but spokesmen have indicated that earlier forecasts will be revised. As a consequence, the customary comparison of FOMC forecasts and Administration economic goals has not been included in this report. 7 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Economic Performance During the First Half of 1987 The economy continued to expand in the first half Industrial Production Index 1977 = 100 of 1987, and, in contrast to the pattern of the preceding four years, the composition of activity 130 appeared to be moving toward a better balance between domestic spending and domestic produc tion. The overall growth in output during the first 120 six months of the year led to a net gain in jobs of around 1 ¼ million, a faster pace of hiring than dur 110 ing 1986. Moreover, the civilian unemployment rate, which had hovered close to 7 percent through 100 out most of last year, moved down to 6.1 percent by June. Inflation picked up early this year, while most 1982 1983 1984 1985 1986 1987 broad indexes of prices increased substantially above those of the past several years. In large part, the acceleration reflected developments in oil markets, Higher inflation rates have been, in part, a conse where prices have retraced part of last year's quence of the ongoing adjustment of the U.S. econ decline. But rising prices for other imported goods omy to a lower foreign exchange value of the dollar. also began to surface at the retail level, and, at the Prices of non-oil imports, particularly for finished producer level, prices paid for raw materials and consumer goods and capital equipment, have been other supplies clearly turned up. Wage trends, how rising at rates in excess of domestic prices in recent ever, have remained stable and restrained. quarters, damping the demand for imported goods. At the same time, goods produced in the United States have become more competitive in world mar Percent change from end Consumer Prices* kets. The volume of exports, which began to pick up of previous period, annual rate noticeably in the second half of 1986, continued to expand in early 1987, although the rebound likely has been limited by slow economic growth abroad. 6 Toward the end of 1986, some manufacturing industries-notably those producing textiles, apparel, steel, chemicals, and paper-began to experience a 4 firming in demand apparently associated with improved trade conditions. In the first six months of 1987, production of office equipment and some other high-tech capital goods as well as several cate gories of industrial machinery also picked up. More over, domestic energy output stabilized, after having been a serious drag on industrial production last 1982 1983 1984 1985 1986 1987 year. On the whole, the pace of activity in the *Consumer Price Index for all urban consumers. ••Percent change from December 1986 to May 1987. goods-producing sector moved back into line with the overall rise in GNP. The index of industrial production increased at a 3 percent annual rate between the third quarter of 1986 and the second quarter of 1987, after little change during the preceding year. 9 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis The External .S ector Annual rate, U.S. Current Account billions of dollars The dollar depreciated further against other major currencies in the first half of 198 7, with most of the adjustment concentrated in one episode early in + January and in another during a period of unsettled 1 · l markets in the early spring. Since mid-May the dol I 50 lar has retraced part of its recent decline, but, on a trade-weighted basis against other G-10 currencies, remains about 6 percent below its average level in 100 December 1986, and almost 40 percent below its I I; peak in February 1985. The underlying downward 150 pressure on the dollar during the first half of 1987 H2 Ql was fueled by perceptions that progress in reducing the U.S. current account deficit had been slow and 1982 1983 1984 1985 1986 1987 prospects for policy adjustments, here and abroad, aimed at restoring better balance in the world econ The U.S. current account deficit stood at just omy, had been disappointing. An offsetting factor under $150 billion in the first quarter of 198 7, little until recently was the widening of interest rate changed, in nominal terms, from the deficit in the differentials between the United States and the other second half of 1986. The volume of merchandise major industrialized countries, as rates rose in the imports, other than oil, was basically unchanged in United States while they declined abroad. recent quarters, after rising steadily for three and one-half years. Demand has leveled off for a wide Foreign Exchange Value of the range of imported industrial materials, consumer .s. U Dollar* Index, March 1973 = 100 goods, and capital equipment. This adjustment, however, occurred as dollar prices for these goods began to pick up, and, thus the value of non-oil 150 imports has continued to edge higher. Demand for imported petroleum products dropped back early this year, but with world oil prices higher, the U.S. 125 oil import bill stayed at approximately its 1986 level. At the same time, the expansion in the volume of merchandise exports that began in mid-1986 100 extended into early 1987. The improvement in for eign sales has been broadly based. In particular, shipments abroad of industrial materials and capital goods, which account for the bulk of U.S. merchan 1982 1983 1984 1985 1986 1987 dise exports, both were up about 10 percent in real •Index of weighted average exchange value of U.S. dollar against currencies of terms in the first quarter from the average in the other G-10 countries plus Switzerland. Weights are 1972-76 global trade of each of the 10 countries. first half_o f 1986. The recent volume of agricultural exports also firmed somewhat as sharply reduced support prices appeared to be combining with the lower dollar to boost foreign demand for some U.S. farm products. 10 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis The adjustment in the U.S. trade position to date Percent change from end of Real GNP has occurred without much impetus from economic previous period, annual rate expansion abroad. Growth of real GNP in other industrial countries averaged less than 2 ½ percent last year; moreover, economic activity began to slow 6 in the second half of the year, and, at least in Europe, the weakness continued into early 1987. Export and import volumes in Europe and Japan 3 have begun to adjust to the exchange rates move IH1 H2 ments of the past two years, cutting into the growth generated by their external sectors. While growth in domestic demand has been maintained above the rate for domestic production, it, too, has slowed and has not taken up the slack from a weak external sector. 1982 1983 1984 1985 1986 1987 Outside of the industrial countries, average growth last year was quite uneven and, on balance, The Household Sector provided only a limited offset to slower economic Consumer spending weakened considerably in the activity in Europe and Japan. Weakness in oil mar first half of 1987, after three years in which real kets held down OPEC growth while the newly gains averaged 3 ¾ percent per annum. In particu industrialized countries in Asia continued to expand lar, households cut back sharply their purchases of strongly. In Latin America, which is an important durable goods as outlays for nondurables flattened market for U.S. exports, output rose close to 4 per out. Spending for services, however, continued to cent for a third year, a marked turnaround from the trend up. Slower sales of new automobiles con 1982-83 period when the onset of external financing tributed importantly to the overall deceleration in difficulties seriously disrupted trade. Internal pres consumer spending. During the first half of 1987, sures to maintain reasonably strong growth persist in sales of new cars averaged 10 million units at an these countries; such growth could be facilitated by annual rate, down from a record 11 ½ million units an improved performance of the industrial econo in 1986. The slackening in demand was most notice mies as a group. able for domestic makes and persisted despite the continuation of special incentive programs on a wide Annual rate, U.S. Real Merchandise Trade billions of 1982 dollars range of models. The deceleration in consumer outlays, especially for durables such as motor vehicles, furniture, and 400 home appliances, followed a period of several years during which a variety of factors were working to encourage households to increase their holdings of 300 big-ticket items: relatively moderate increases, or ..... -- ___________ _, even decreases, in the prices of many home goods; ... ----E-xports ,,- declines in interest rates; and pent-up demands from ..... , 200 the period of economic weakness in the early 1980s. 1982 1983 1984 1985 1986 1987 11 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Consumer Prices Excluding growth of consumer and mortgage debt, some indi Percent change from end Food and Energy* cators suggest that a considerable number of house of previous period, annual rate h?~d_s still are having problems servicing existing lia D Services Less Energy b1ht1es. Although some loan delinquency rates IITl Commodities Less Food and Energy 8 dropped a bit, others rose in the first quarter, as did personal bankruptcies. - - - y_·, .. 6 Spurred by a decline in mortgage interest rates . H2 which reached a nine-year low at the end of Mar~h, 4 - starts of new single-family homes averaged 1 ¼ mil 2 lion. units at_ an annual rate from January through Apnl, the highest level since the late 1970s. Sales of II lll!IIII 11 + singl_e-fam~ly homes, which had been boosted by tax -- i.....--L- cons1derat10ns at the end of 1986, also remained brisk through April. Subsequently, the backup in 1982 1983 1984 1985 1986 1987 mortgage rates to early-1986 levels resulted in some reduction in single-family homebuilding by May, to *Consumer Price Index for all urban consumers. • *Percent change from December 1986 to May 1987. about the pace that prevailed last fall. In the multi ~amily market, the downtrend in activity that began m early 1986 continued through the first half of As those influences dissipated, and with the personal 1987. By May multifamily starts were almost one saving rate reaching an historically low level by late third below last year's peak. Despite the adjustment 1986, consumers apparently became more cautious thus far to overbuilding and the reduced after-tax in their buying patterns. Nonetheless, survey evi profitability of multifamily housing investment, dence still suggested that households' evaluations of rental vacancy rates nationwide are still close to market conditions for major purchases and of their record levels. personal finances remained generally positive. During the first five months of 1987, growth in nominal disposable income picked up from its 1986 The Business Sector pace; but, with consumer prices rising more rapidly, Business spending on plant and equipment fell mcome growth, in real terms, was little different sharply in the first quarter of 1987. For equipment, from the 2 percent pace of the preceding two years. the weakness was concentrated in January, following However, the aggregate balance sheet of the house the effective date of the new tax reform law. In sub hold sector showed further improvement early this sequent months, shipments of nondefense capital year. Asset holdings were bolstered especially by goods recovered, leaving the average level for April gains in the stock prices, while debt accumulation and May, in nominal terms, 1 ¾ percent above the slowed. Growth of mortgage debt dropped back third quarter of last year. New orders for non from the extraordinary pace of late 1986, despite the defense capital goods also dipped at the beginning of popularity of home equity loans, and growth of con the year, but then strengthened noticeably as book sumer credit dropped sharply. To some extent, the ings for aircraft and for office and computing equip deceleration in consumer debt, as well as the slow ment rose sharply. The recent level of orders down in spending on durable goods, may be a con appears consistent with a continuation in the near sequence of the rapid rise in household debt .burdens term of the moderate uptrend in spending on equip during the past several years. In addition, the new ment that has prevailed over the past two years. tax law diminished the incentive to finance expendi According to private survey responses concerning tures with installment credit. Despite the slower business capital spending plans for the year as a whole, firms still intend to direct the bulk of these purchases toward modernization and cost-saving improvements in their production lines. Digitized for FRASER 12 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Changes in Real Business tion of the auto industry. Domestic car makers Annual rate, Inventories billions of dollars boosted production in early 1987 in excess of slack ening sales, leading to a substantial sales backlog of D Nonfarrn Less Autos unsold cars on dealer lots. By June the scaling back lilll Autos of assemblies had stemmed further accumulation, 60 but the industry entered the summer with stocks that were quite large by historical standards. Before-tax profits of nonfinancial corporations, which had slipped a bit relative to GNP since 1984, 30 rose in the first quarter. After-tax profits relative to GNP were up as well, although the rise was damped by increases in corporate tax liabilities associated + with the new tax law. Corporations paid out a slightly larger share of earnings as dividends in the first quarter; nonetheless, internally generated funds remained sizable relative to investment outlays. 1982 1983 1984 1985 1986 1987 The Government Sector In contrast, the environment for expansion of A substantial reduction in the federal budget deficit plant facilities and office space is still generally un for fiscal year 1987 appears in train, with the most favorable. Large amounts of vacant and underused recent estimate from the Congressional Budget Of space in both office buildings and factories began to fice at $161 billion, compared with $221 billion in take a toll on nonresidential construction last year. fiscal 1986. Growth in receipts has been extremely Also, less favorable treatment of commercial struc rapid; this reflects, in large part, a one-time surge in tures under the new tax code reinforced the tenden tax payments this April from individuals who real cies toward a lower level of activity in this sector. As ized capital gains last December, taking advantage a result, spending for commercial and industrial of lower tax rates under the old tax code. But more buildings dropped further in the first quarter of 198 7, fundamental progress in reducing spending growth to a level about 20 percent below a year earlier. The also appears to have been made in the wake of the decline in spending for these types of buildings Gramm-Rudman-Hollings legislation. Total outlays accounted for the overall weakness in nonresidential have been rising at a rate of around 2 percent in the structures early this year, in the face of an upturn in current fiscal year, a marked slowing from 8 percent oil drilling and some increases in other categories. per year during the preceding five years. A sizable swing in business inventories around the Real purchases of goods and services by state and turn of this year was associated with sharp, tax local governments rose at a 4 percent annual rate in induced fluctuations in sales. The surge in consumer the first quarter of 198 7, close to the brisk pace of and business spending at the end of 1986 was met to the past several years. a considerable extent by drawing down stocks, which were then rebuilt at the beginning of this year. This spring, inventory-sales ratios generally were not in dicating serious imbalances, with the notable excep- 13 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Labor Markets Percent change from end of GNP Prices previous period, annual rate Employment accelerated early in 1987, and, despite a slowing in recent months, the average monthly Fixed-weighted Price Index increase in nonfarm payroll employment of just over 200,000 so far this year exceeds the pace of hiring in 4 1986. The improvement in labor demand has been fairly broad based. In manufacturing, a two-year string of cutbacks in durable goods industries ended H2 late last year, and hiring picked up a bit in the non Hl U11 I 2 durable goods sector. As a result, factory employ ii Iii ment, overall, edged higher over the first six months n !I I 11 I of 1987. In addition, the number of jobs in oil and ,1I1 I'I! gas extraction stabilized after the sharp retrenchment ! !II I ! II , i !;! I + in 1986. At the same time, the expansion of jobs in the trade, services, and finance industries, despite some recent slowing, remained sizable. The combination of strong gains in employment and declining numbers of unemployed workers over 1982 1983 1984 1985 1986 1987 the first half of the year lowered the civilian jobless rate to 6 ¼ percent on average in the second quarter Price Developments from just under 7 percent at the end of last year. The rate for adult men (aged 25 years and over), As expected, inflation rates haye been higher so far which remained at around 5 ½ percent from this year, largely reflecting a rebound in energy mid-1984 to late 1986, moved below 5 percent this prices. The GNP fixed-weighted price index, a spring. Further improvement also occurred for adult broad measure of inflation for goods and services women, whose unemployment rate in the past year produced by the United States, increased at about a has moved below that of their male counterparts. 4 percent annual rate in the first quarter; it had risen 2 ½ percent during 1986. Sharper accelerations occurred in the consumer price index, which was up Civilian Unemployment Rate Quarterly at a 5 ½ percent rate over the first five months of average, percent the year, and in the producer price index for fin ished goods, which rose at a 4 ½ percent annual rate over the six months ended in June. 10 The rebound in energy prices began in January when spot prices of crude oil jumped about $3 per barrel in response to the reductions in output. 8 Higher crude oil costs were quickly passed on to end-users, and by May consumer prices for gasoline 6 and fuel oil had risen about 15 percent, retracing half of last year's decline. Spot prices of petroleum products moved up a bit further early in the sum mer as inventories tightened, and these increases 1982 1983 1984 1985 1986 1987 were supported subsequently by the renewal of OPEC's agreement to control production. 14 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Monetary Policy and Financial Markets in the First Half of 1987 The Federal Open Market Committee at its meeting M3 Billions of Dollars in February established 1987 target ranges, meas ured from the fourth quarter _of 1986 to the fourth quarter of 1987, of 5 ½ to 8 ½ percent for both M2 and M3. The FOMC also set a 1987 monitoring range for domestic nonfinancial debt of 8 to 11 per cent. The M2 and M3 ranges represented a 1/2 per centage point reduction from last year's target ranges, and the Committee expected growth to be well within the ranges, especially in the absence of dramatic movements in interest rates. The range for debt was unchanged from 1986 but below the actual outcome in that year and other recent years; thus, the Committee anticipated that debt growth also would slow this year. 0 N D J F M A M J J A S O N D The Committee viewed a substantial slowing in money and credit growth from the rapid pace of 1986 1987 1986 as likely to be consistent with a continuation of sustainable economic expansion and conducive to M 1 over 1986. Instead, the FOM C decided to con further progress over time toward reasonable price tinue evaluating movements in this aggregate in stability. Growth of M 1 also was expected to moder light of the behavior of its velocity, the rate of eco ate considerably this year. However, the Committee nomic expansion, inflationary pressures, and in February elected not to set a target range for Ml developments in financial markets. for 1987 because of the continuing uncertainties Over the first half of 198 7, monetary policy was about the relationship of this aggregate to the econ conducted against a backdrop of heightened con omy. These uncertainties partly reflected the sub cerns about inflation, stimulated in part by substan stantial sensitivity of its velocity to changes in finan tial downward pressure on the dollar in foreign cial conditions that had been evident in recent years, exchange markets. At the same time, growth of capped by a record postwar decline in the velocity of money and credit aggregates moderated considerably and the velocities of the broader aggregates turned up after several y~ars of very rapid money growth M2 Billions of Dollars and falling velocities. Measured from the fourth quarter of 1986, M2 in June was below the lower 3050 end of its target growth range, while M3 was around the lower end of its range. l\1eanwhile, growth in M 1 slowed to a 7 ¾ ·percent pace and debt expansion moderated to a 9 ¾ percent rate. f\s pressures on the dollar and inflation worries intensi fied in April and May, interest rates began to rise substantially, especially in long-term markets. In late April and May, the Federal_R eserve adopted a somewhat less accommodative stance with respect to the provision of reserves through ·open market oper ations. These actions, together with monetary easing 2700 moves by key industrial trading partners, helped to 0 N D J F M A M J J A S O N D stabilize the dollar and calm inflation fears, con tributing to some decline in long-term interest rates 1986 1987 and strengthening of the dollar. 15 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Money, Credit, and :Monetary Policy The effects of these developments also were evi dent in short-term credit markets, where rates rose In its conduct of policy thus far this year, the Fed in April partly in anticipation that monetary policy eral Reserve has given a good deal of weight to a would have to firm to contain pressures on prices number of considerations in addition to the mone and the dollar. In late April and again in May, the tary aggregates. These include recurrent episodes of Federal Reserve did move to tighten the availability heavy downward pressure on the dollar, indications of nonborrowed reserves through open market oper from long-term securities and commodity markets of ations. Short-term interest rates rose about 1/2 to heightened inflationary expectations, and evidence 3/4 percentage point during April and May, and the that the economy continued to advance at a pace prime rate was raised twice, on May 1 and May 15, sufficient to produce rising levels of resource utiliza in 1/4 point increments. The System's firming tion. Under these circumstances, interest rates actions, along with complementary moves abroad, tended to move higher, and the patterns of rapid helped to stabilize the dollar and ameliorate the con money growth and declining velocities of the last cerns about the inflation outlook. several years, when inflation and interest rates were Along with some better price news and evidence moving down, began to be reversed. Growth of the of improvement in our trade deficit, this policy broad aggregates remained around the lower bounds of their growth cones through most of the first half appeared to impart an improved tone to short-term of the year, although M2 dropped well below its and, especially, long-term credit markets over the long-run range later in the period. Growth of both latter part of May and June. Since May, most M2 and M3 was considerably below the pace of short-term rates have posted declines of 1/4 percent recent years, and their velocities increased. Expan age point or more. Longer-term markets generally sion of Ml also slowed markedly, while growth of have registered greater gains, and in early July long domestic nonfinancial sector debt moderated. rates were off 1/2 to 3/4 percentage point from their Long-term interest rates, which had not been May highs. The dollar, meanwhile, has shown more affected very much by the transitory credit demands dramatic improvement, regaining most of the of late 1986, continued to drift down in the early ground it lost in April and May. months of 1987, displaying little short-term volatil Consumer use of installment credit was consider ity. The placid conditions in long-term markets were ably diminished during the first half of the year. To abruptly changed in late March, primarily by some degree, this reflected a shift to mortgage debt developments in the international sphere. Announce in the form of loans taken down under home equity ments of trade sanctions by the United States, per lines of credit. Overall consumer borrowing was sisting weakness of the dollar, and disappointing probably nevertheless damped by reduced deductibil trade figures all raised questions about continuing ity of consumer interest payments under the new tax private demands for dollar assets, prospects for infla code. In addition to credit taken down under home tion, and the response of monetary policy. The dol equity lines, mortgage growth in the first half of the lar dropped sharply in the last three weeks of year was maintained by heavy volumes of new and March, and between late March and late April existing home sales. yields on 30-year government bonds rose about The financial system has continued to evidence 1 percentage point on balance. The exchange and strains in 1987. Indications that the agricultural sec bond markets became highly volatile during this tor is beginning to stabilize have emerged, with loan period, as the dollar continued to drop and inflation delinquencies declining, land prices bottoming out, fears appeared to be intensified by the publication of and export volume firming; the failure rate among adverse price data. Mortgage rates and yields on agricultural banks seems likely to have peaked. mortgage pass-through securities reacted very However, the Farm Credit System, the nation's promptly to the deterioration in the bond markets largest farm lender, lost considerable sums in 1985 and, indeed, rose more than most other long-term and 1986, and many of its units continue to struggle rates as many investors shied away from these with troubled loan portfolios. instruments subject to substantial prepayment risk. 16 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis In addition to difficulties with agricultural loans, record losses this year owing to huge reserve provi commercial banks have been saddled with persisting sions taken by large banks primarily as a conse problems in th_eir energy and developing country quence of developments in the international debt loan portfolios. Although some banks remain highly area. Despite the shrinkage in the book value of profit~ble, 19 percent lost money last year, com-. shareholder equity recognized by these actions, share pared with about 3 percent as the decade began; prices rose at many banks announcing large loan loss provisions were the main cause of the earn increases in loan loss reserves. ings problems. The banking system is likely to post Growth of Money and Credit (Percentage changes at annual rates) Domestic Period M1 M2 M3 N onfinancial Debt Fourth quarter 1986 to 9.9 4.5 5.3 9.8e second quarter 1987 Fourth quarter 1986 7.7 4.0 5.3 9.8e to June 1987 Fourth quarter to 1979 7.9 8.2 10.4 12.2 fourth quarter 1980 7.3 8.9 9.6 9.6 1981 5.1 (2.4)1 9.3 12.3 9.9 1982 8.6 9.1 9.9 8.9 1983 10.2 12.1 9.8 11.5 1984 5.4 7.9 10. 7 13.9 1985 12.1 8.8 7.7 13.4 1986 15.3 8.9 8.8 13.2 Quarterly Q1 8.8 5.3 7.7 15.5 average 1986 Q2 15.5 9.4 8.7 10.2 Q3 16.5 10.6 9.7 12.5 Q4 17 .0 9.2 8.0 12 .1 Quarterly Q1 13.1 6.3 6.3 10.4 average Q2 6.4 2.5 4.1 9.oe 1987 e-estimated 1. M1 figure in parentheses is adjusted for shifts to NOW accounts in 1981. 17 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Footnotes 1. M1 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 Ml 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 Eudodollar 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 inv·estors and certain term Eurodollar deposits. A copy of the full report to Congress is available from Publication Services, Federal Reserve Board, D.q. Washington, 20551 FRB12-48000-0787 18 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis

Federal Reserve (1987, July 20). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_19870721

@misc{wtfs_monetary_policy_report_19870721,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {1987},
  month = {Jul},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_19870721},
  note = {Retrieved via When the Fed Speaks corpus}
}