Monetary Policy Report

1988 MONETARY POLICY OBJECTIVES Midyear Review of the Federal Reserve Board July 13, 1988 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 1988 MONETARY POLICY OBJECTIVES This Executive Summary provides highlights of the Board's Midyear Review to the Congress on Monetary Policy pursuant to the Full Employment and Balanced Growth Act of 1978. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Contents Section Page Monetary Policy and the Economic Outlook for 1988 and 1989 2 Monetary Plans for the Remainder of 1988 and for 1989 2 Economic Projections 4 The Performance of the Economy during the First Half of 1988 6 The External Sector 7 The Household Sector 7 The Business Sector 8 The Government Sector 9 Labor Markets 9 Price Developments 10 Monetary Policy and Financial Markets during the First Half of 1988. 11 Behavior of Money and Credit 11 Implementation of Monetary Policy 12 The Stock Market 14 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Monetary Policy and the Economic Outlook for 1988 and 1989 The economy continued to expand rapidly in the tic demand, which would allow the economy to first half of 1988, displaying impressive resilience in accommodate rising external demands on U.S. the wake of last fall's stock market break. Especially producers without generating overall inflationary encouraging has been the fact that the expansion in pressures. Consistent with continued external adjust activity this year has been propelled largely by rising ment and with its commitment to achieving price exports and business investment, which bodes well stability over time, the Federal Open Market Com for the restoration of better balance in the economy. mittee (FOMC) in February lowered its 1988 target With the industrial sector continuing to enjoy growth ranges for the broader measures of money greater growth, capacity utilization rates have crept M2 and M3-to 4 to 8 percent. higher. At the same time, the civilian unemployment Monetary Plans for the Quarterly Remainder of 1988 and for 1989 Civilian Unemployment Rate average, percent At its meeting last month, the Federal Open Market Committee agreed to retain the 4 to 8 percent target growth ranges for M2 and M3, measured from the 10 fourth quarter of 198 7 to the fourth quarter of 1988. In addition, the Committee retained the 7 to 11 per cent monitoring range for the debt of domestic non 8 financial sectors and again set no range for M 1, the narrowest measure of money. Recognizing the varia 6 bility of the relationship of these measures to the performance of the economy, the Committee agreed Q2 that operating decisions would continue to be made not only in light of the behavior of the monetary 1983 1984 1985 1986 1987 1988 aggregates, but also with due regard to develop ments in the economy and financial markets, includ ing attention to the sources and extent of price pres rate has declined since year-end, and the average of 5 ½ percent in the second quarter was the lowest in sures and to the performance of the dollar in foreign exchange markets. nearly 15 years. Despite the tightening of labor markets, wage increases to date have been notably restrained, on balance, helping to contain cost pres Ranges of Growth for Monetary and sures in many sectors. Most measures of price infla Credit Aggregates (Percent Change) tion among finished goods and services also have shown little if any pickup, although basic commodity Provisional prices have risen considerably, most recently reflect 1987 1988 for 1989 ing the effects of drought on agricultural markets. During the first half of the year, the Federal M2 5 ½ to8½ 4 to 8 3 to 7 Reserve continued to direct its policies toward providing monetary and financial conditions that M3 5 ½ to 8½ 4 to 8 3 ½ to 7 ½ would foster price stability over time, promote sus Debt 8 to 11 7 to 11 6½ to 10½ tainable economic growth, and contribute to an improved pattern of international transactions. It was recognized that progress toward these goals in 1988 would require relatively slow growth of domes- 2 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis In the absence of any significant economic and tive to inflationary risks. An acceleration of inflation financial disturbances, the Committee expected could undermine the sustainability of the economic growth in M2 to moderate over the remainder of the expansion and the international competitive position year, placing the aggregate around the middle of its of U.S. producers. The lower ranges tentatively target range at year-end. Growth in M3 this year is adopted for 1989 were believed consistent with a expected to exceed that of M2 but to remain com monetary policy that would curb any tendency for fortably within its range, on the assumption that inflation to worsen and would contribute over time asset expansion at depository institutions would to the restoration of price stability. However, the remain fairly robust in the second half. The debt of Committee also noted that developments over the domestic nonfinancial sectors is expected to remain next half year could alter substantially the rates of near the middle of its monitoring range, which money growth needed to foster satisfactory economic would put its growth for the year around the slowest performance in 1989 and beyond. Consequently, it annual pace registered in the past decade. stressed the provisional nature of its decision and the For 1989, the Committee set, on a tentative basis, possibility that the ranges for 1989 might need to be target growth ranges of 3 to 7 percent for M2 and adjusted when they are reviewed early next year. 3 ½ to 7 ½ percent for M3, measured from the The Committee again decided not to set a range fourth quarter of 1988 to the fourth quarter of 1989; for M 1, given the sharp swings in its velocity in re the monitoring range over the same period for domes cent years, resulting in part from its increased sensi tic debt was set at 6 ½ to 10 ½ percent. Although tivity to movements in market interest rates since uncertain about how strong the economy might be deposits were deregulated. In considering narrow over the coming year or so, the Committee recog monetary measures, the Committee also has dis nized that, given the current high levels of resource cussed whether the monetary base could play a use utilization, it was necessary to be particularly atten- ful role in the conduct of policy. This measure com prises the major monetary liabilities of the Federal Reserve System-currency in the hands of the pub Percent change from end of GNP Prices lic and reserves of depository institutions-and previous period, annual rate represents, in a sense, the "base" of the broader Fixed-weighted Price Index monetary aggregates. The Committee decided against establishing a range for the monetary base, because it seemed unlikely to provide a more reli 4 able guide for policy than the aggregates for which ranges already are established. Although the base has been less variable in relation to economic ac tivity and prices than M 1, its velocity nonetheless 2 has fluctuated appreciably and rather unpredictably from year to year. 1983 1984 1985 1986 1987 1988 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Economic Projections Continued improvement in the external sector is expected to provide the main impetus to U.S. eco As indicated in the table, the central tendency of the nomic growth over the next 18 months. Real exports forecasts of Committee members and nonvoting of goods should remain on a strong upward path, Reserve Bank presidents is for growth in real GNP reflecting the improved competitive position of U.S. of 2 ¾ to 3 percent in 1988, with a modest slowing producers. At the same time, the growth of real of expansion in 1989. Such a pace of growth likely imports is likely to be restrained, owing to the would generate employment gains sufficient to hold lagged effects of the depreciation of the dollar the civilian unemployment rate close to its average through the end of last year. This continued shrink second-quarter level of 5 ½ percent. Prices, as meas age of the real trade deficit is expected to be suffi ured by the implicit deflator for GNP, are generally cient to generate some reduction in the nation's defi expected to rise 3 to 3 ¾ percent over the four cit on current account during 1988 and a further quarters of 1988, similar to last year's rate of decline in 1989. advance. For 1989, projections of the increase in the In contrast to the boost provided by the external GNP deflator are of course more uncertain, and the sector, domestic demand is projected to remain rela central-tendency range widens to 3 to 4 ½ percent. tively subdued. Consumer spending, in particular, has been on a sluggish growth trend since late 1986, Economic Projections for 1988 and 1989 FOMC Members and other FRB Presidents Administration 1988 Range Central Tendency Nominal GNP 4 to 7 5¾ to 6¾ 6.6 Percent Change, fourth quarter to Real GNP 1 to 3 ¼ 2¾ to 3 3.0 fourth quarter: Implicit deflator for GNP 2¾ to 4 3 to 3¾ 3.5 Average level in the fourth quarter, Civilian Unemployment Rate 5 ¼ to 6 ½ 5¼ to 5¾ 5.5 percent: 1989 Range Central Tendency Nominal GNP 4 to 7 ½ 5 to 7 7 .1 Percent change, fourth quarter to Real GNP 1 to 3 2 to 2 ½ 3.3 fourth quarter: Implicit deflator for GNP 2 to 5 3 to 4½ 3.7 Average level in the fourth quarter, Civilian Unemployment Rate 5 to 7 5½ to 6 5.3 percent: 4 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis and that pattern seems likely to persist. Moreover, level; assuming that world oil prices remain fairly in an environment of more moderate growth of stable, domestic energy prices should not be a sig overall activity, economy-wide spending on new nificant inflationary force in 1988-89. Labor markets plant and equipment may not rise as swiftly as it have tightened considerably since last year, however, has on average over the past year. Even so, within and most measures of wage and compensation rates manufacturing, improved profitability and higher have firmed. Although the overall rate of industrial capacity utilization have stimulated a healthy pickup capacity utilization is not high by historical stan in capital spending, which should continue for some dards, plants are being used very intensively in time. some materials-producing sectors; sharply rising The performance of the interest-sensitive sectors, materials prices have raised costs for manufacturers most notably homebuilding and business investment, generally. Food prices also have been a less favor will be influenced considerably by the extent to able element in the inflation picture recently, and which the federal government is competing for avail are likely to experience some further acceleration as able supplies of credit. Accordingly, continued fiscal a consequence of drought conditions; however, it is restraint is essential if we are to free up resources to important to recognize the temporary nature of this support private investment. In this regard, the phenomenon, which should have no lasting effect on budget summit agreement reached last December overall inflation so long as it does not become was a favorable first step, and the members of the embedded in wage trends. Federal Open Market Committee and other Reserve For 1989, the FOMC central-tendency range for Bank presidents have assumed that the necessary the GNP deflator widens on the upper end, suggest legislative action will be taken to implement the ing the possibility of a pickup in inflation from the agreement. There is a clear need for further initia pace this year. However, this apparent acceleration tives to deal with the out-year deficits, which remain of prices largely reflects the arithmetic implication of distressingly large; financial events later this year an eccentric movement in the deflator for GNP in and in 1989 could be substantially affected by the the first quarter of this year. Shifts in the composi developments in the fiscal arena. tion of output caused the deflator to rise at less than Although little change is expected in the overall a 1 ½ percent annual rate during that quarter; these pace of inflation this year, as compared with 1987, shifts are not expected to be so noticeable in coming the sources of actual and potential price pressures quarters. appear to have changed. In 1987, a rebound in oil prices was a major factor boosting the general price 5 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis The Performance of the Economy during the First Half of 1988 The economy continued to expand briskly in the Industrial Production Index 1977 = 100 first part of 1988. Activity was boosted by strength in capital spending and growth in foreign demand May 130 for U.S. goods. The rise in overall output during the first six months of this year supported the addi tion of about 1 ¾ million jobs to nonfarm payrolls, 120 and the civilian unemployment rate, which had trended down throughout 1987, has dropped some 110 what further since the beginning of the year to an average level of 5 ½ percent in the second quarter. 100 Despite the greater tightness in labor markets and the higher rates of capacity utilization now prevail ing in some industries, tendencies toward additional 1983 1984 1985 1986 1987 1988 inflation have been limited. Prices of materials and components have risen sharply, but for finished goods there are only hints of price acceleration out The continued resurgence of manufacturing has side the food sector. Wages, on the whole, have con been one of the most notable economic develop tinued to be fairly well behaved, suggesting a recog ments this year. During the first five months of nition on the parts of labor and management of the 1988, industrial production expanded at nearly a 4 need to maintain competitive cost structures. percent annual rate, and the rate of capacity utiliza tion for total manufacturing rose 1/2 percentage Percent change from end of point between December and May to just over Real GNP previous period, annual rate 83 percent, the highest level during the 1980s. Owing to these advances in production, manufac turers have embarked on substantial programs to invest in plant and equipment, pacing an economy wide pickup in the rate of capital spending. The bet ter balance of expansion also has been visible in agriculture, although the upturn in that sector has been jeopardized by recent drought conditions. The improvements in manufacturing and agricul ture are, in part, reflections of a broader adjustment of the U.S. external position. The combination of a lower dollar and domestic cost containment has translated into a marked turnaround in real net 1983 1984 1985 1986 1987 1988 exports. That process also has been aided by stronger economic growth in other large industrial countries. 6 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis The External Sector Annual rate, U.S. Real Merchandise Trade billions of 1982 dollars After having trended down for nearly three years, the dollar appreciated substantially over the first half of 1988 against most major foreign currencies. The Ql 400 dollar rose sharply at the beginning of the year, responding in part to coordinated central bank inter 300 vention. In recent months, sentiment toward the Expor~ __ ,, -------------------------- dollar appears to have improved, owing largely to 200 the release of better-than-expected trade reports and to firming actions by the Federal Reserve. The U.S. merchandise trade deficit for the first quarter was $144 billion at a seasonally adjusted 1983 1984 1985 1986 1987 1988 annual rate, substantially below the figures for the fourth quarter and for 1987 as a whole. In April, The Household Sector Consumer spending showed some vigor in early Foreign Exchange Value of the 1988, after declining in the fourth quarter of last U .s. Dollar* Index, March 1973 = 100 year. Real outlays increased at a 3 ¾ percent annual rate in the first quarter, as purchases of motor vehi cles bounced back with the expansion of manufac turers' incentive programs, outlays for other durable 150 goods were strong, and expenditures on services continued to post appreciable gains. Data for April 125 and May suggest, however, that the growth of con sumer spending slowed from the rapid first-quarter rate. 100 The buoyancy of consumer spending early this year can be traced to robust income growth. Real disposable personal income rose at a 5 percent 1983 1984 1985 1986 1987 1988 •Index of weighted average foreign exchange value of U.S. dollar in terms of cur- Percent of Personal Saving Rate rencies of other G-10 countries plus Switzerland. Weights are 1972-76 global disposable income trade of each of the 10 countries. 8 the trade deficit narrowed further. Exports have con tinued to expand rapidly, while import growth has slowed considerably. The strong growth of exports I\ - 'v\ /\ /\ 6 can be attributed primarily to the increased price V" competitiveness of U.S. goods, which reflects the /Ql 4 decline of the dollar in recent years and the tight control over production costs exercised by domestic 2 firms. This growth of exports continues to be broadly based, and foreign sales have been particu larly strong for industrial machinery and for com 1983 1984 1985 1986 1987 1988 puting equipment. 7 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis annual rate, on average, during the fourth quarter The Business Sector of 1987 and the first quarter of 1988, substantially Business fixed investment advanced sharply in the above the 2 percent rate posted for 1987 as a whole. first quarter of 1988, owing to a large increase in However, disposable income growth appears to have purchases of equipment. In recent months, spending slowed considerably in the second quarter, as a appears to have remained near the high first-quarter result of a spurt in nonwithheld tax payments and a level. Surveys of capital spending plans, taken this slower pace of employment gains. spring, point to appreciable growth in investment Although the pace of consumer spending thus far outlays over the second half of 1988. this year has been stronger than many expected, the stock market break probably did exert some restrain ing effect. This is evident in the personal saving Changes in Real Business Annual rate, rate, which has averaged 4 ½ percent for the seven Inventories billions of 1982 dollars months after October-one percentage point above the average level during the first three quarters of 0 Nonfarm Less Autos lill1 Autos 1987. While most households experienced little 60 direct loss of wealth from the stock market decline, the startling dimensions of the event obviously affected consumer sentiment last fall. With each H2 30 passing month, however, confidence has grown and Hl helped to sustain the growth of spending. Residential construction was weak during the first + half of 1988. Total housing starts averaged about 1 ½ million units at an annual rate through May, almost 9 percent below the 1987 total. In the multi family sector, building declined from the already 1983 1984 1985 1986 1987 1988 depressed 1987 level. Starts in this sector have been falling since the end of 1985, as near-record vacancy Real outlays for computing equipment jumped at rates and changes in the tax laws have reduced the more than a 90 percent annual rate in the first quar incentive to build new units. In the single-family ter, but fell back considerably in subsequent months. sector, building has fluctuated from month to Smoothing through this volatility, it appears that de month, influenced by movements in interest rates mand for such equipment has emerged from the lull and perhaps by weather; on balance, the average that prevailed during 1986 and the first half of 198 7, level of starts through May was roughly 6 percent when excess computing capacity-as well as con below the 198 7 pace. cerns about the usefulness of available software limited purchases. Outlays for other types of equip ment also have been strong, on balance, since the turn of the year, largely reflecting the buoyancy of overall economic activity. In particular, with utiliza tion rates now at elevated levels in many manufac turing industries, equipment investments have been an attractive way of removing bottlenecks and achieving a relatively rapid improvement in effective capacity. 8 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Real Business The Government Sector Percent change from end of Fixed Investment previous period, annual rate In real terms, federal government purchases of goods and services-which add directly to GNP and D Structures lilll Producers' Durable Equipment account for about one-third of total federal expenditures-fell during the first quarter and 40 appear to have remained relatively weak in recent months. This dropoff reflects the winding down of Ql some major defense procurement programs, restraint on domestic discretionary spending, and net reduc 20 tions in farm inventories held by the Commodity H2 Credit Corporation. However, on a budget basis, total outlays have been growing rapidly, owing to continued increases in entitlements, greater demands + on deposit insurance agencies, and increasing net interest payments. Meanwhile, growth of federal government revenue has slowed compared with the sharp increase in FY1987. Although tax receipts have been pushed up 1983 1984 1985 1986 1987 1988 by the robust gains in income and by an increase in the payroll tax rate, this upward impetus to revenue The pace of business inventory investment moder has been tempered by the final reductions in income ated somewhat during the first four months of 1988, tax rates from the reforms enacted in 1986. In con reducing the concern about excessive stocks that had trast to its effects this year, tax reform had provided arisen earlier this year. This concern had focused on a substantial boost to revenues in FY1987. On bal the retail sector, where inventories at auto dealers ance, it is quite possible that the budget deficit this and at certain outlets for nondurable goods (primar year will exceed the $150 billion shortfall recorded ily general merchandise and apparel stores) appeared last year. high relative to sales at year-end. By cutting produc tion early in the year and offering a variety of sales Labor Markets incentives, automakers have been able to bring their inventories into better alignment with sales. In con Early in the year, incoming data seemed to signal trast, inventory-to-sales ratios for nondurable retail some weakening of labor demand. Initial claims for goods continue to hover at levels that are high by unemployment insurance, which had trended up historical standards. At the manufacturing level, during the final months of 1987, rose even further inventory positions through May appeared fairly just after the turn of the year. Moreover, the first lean in general, given the pace of shipments. Much report on nonfarm payroll employment for January of the recent building of factory stocks has been in showed the smallest monthly increase since mid-1986. industries where market demand has been robust, Taken together, these indicators conveyed a picture of deterioration in the labor market. However, as such as aircraft, machinery, chemicals, and paper. subsequent data were released, it became clear that the underlying pattern of labor demand had, in fact, remained healthy. Claims for unemployment insur ance dropped back to relatively low levels and the anemic employment gains for January were revised up substantially. Moreover, since January, nonfarm payroll employment has advanced more than 300,000 at a monthly rate, somewhat above the average increase in 1987. Although the gains have 9 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis been concentrated in the service-producing sector, indicators for commodities and intermediate goods, manufacturing has posted an average monthly which have posted sharp increases. The consumer increase of about 30,000 jobs thus far this year, with price index-a measure of inflation for finished the largest advances in the machinery and metals goods and services-showed no acceleration during industries. the first five months of 1988, rising at the 4 ½ per The combination of strong gains in employment cent annual rate registered for 1987 as a whole. and slower growth of the labor force over the first In the agricultural sector, tighter crop inventories half of 1988 lowered the civilian jobless rate to 5. 3 and stronger grain exports pushed up farm-level percent in June from 5.8 percent at the end of last prices early in 1988. In addition, prices for grains year. Jobless rates fell for a broad spectrum of and soybeans recently have surged in commodity demographic groups over the first half of the year, markets, owing to the drought in major growing and the June rate of unemployment represents the regions. It now appears likely that retail food prices lowest monthly figure since mid-1974. The June will accelerate in coming months and exert some level, however, may be artificially low, owing to the upward pressure on aggregate consumer price difficulty of adjusting for seasonal swings in employ inflation. ment at the end of the school year. At earlier stages of processing, inflation appears to have picked up for a wide range of items. On com modity markets, prices of crude industrial materials Price Developments have remained on an upward course this year, Upward pressures on prices appear to have grown although the price hikes have been less pervasive stronger this year, reflecting the lagged effects of the than in 1987. Reflecting, in part, these develop earlier depreciation of the dollar, as well as tighter ments, the producer price index for intermediate markets for labor, industrial materials, and farm materials other than food and energy rose at nearly output. Energy prices, in contrast, have been an 8 percent annual rate over the first five months restrained this year, on balance, and have provided of this year, up from the 5 percent pace registered some offset to these pressures. For the most part, last year. Price increases have been especially large signs of higher inflation have been confined to price for materials used by producers of metals, chemicals, paper, and plastic, where output has been strong or capacity utilization rates high. Percent change from end of Consumer Prices* previous period, annual rate The upward movement of intermediate goods prices relative to finished goods prices at the pro Hl ducer level has been quite substantial. Although divergences in the two series, such as the one that has arisen over the past year, are not unprecedented, disparities typically have not persisted for long. Historical evidence indicates that higher materials costs, on average, pass through rather quickly into finished goods prices. In the recent period, the effect of the sharp rise in materials prices may have been cushioned by restraint on unit labor costs, by the spreading of overhead costs over larger sales + volumes, and, perhaps, by efforts to save on or sub stitute away from higher cost materials. Nonetheless, past experience suggests that, even if there may not be a significant delayed pass-through in coming months, the risks of an acceleration in finished 1983 1984 1985 1986 1987 1988 goods prices would be considerable if the pressures *Consumer Price Index for all urban consumers. on materials prices do not ease soon. **Percent change from December 1987 to May 1988. 10 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Monetary Policy and Financial M arkets during the First Half of 1988 The Federal Open Market Committee has sought M3 Billions of Dollars monetary and financial conditions that promote price stability over time, support sustainable eco nomic growth, and contribute to an improved pat tern of international transactions. To this end, the Committee at its February meeting established tar get ranges, measured as growth rates from the fourth quarter of 1987 to the fourth quarter of 1988, of 4 to 8 percent for both M2 and M3. It also set a monitoring range of 7 to 11 percent for the growth of domestic nonfinancial debt and chose, once again, not to stipulate a range for Ml growth. The 1988 3360 target ranges for M2 and M3 represented reductions from last year's ranges of 5 ½ to 8 ½ percent for both aggregates and resulted in a lowering of the 0 N D J F M A M J J A S O N D midpoint of the target ranges by one full percentage 1987 1988 point. During the first part of 1988, monetary policy was As information suggesting greater economic conducted against a backdrop of data suggesting strength and an increased potential for a build-up of some weakness in the economic expansion. Reflect inflationary pressures became available in March ing concern about the outlook for economic growth, and in subsequent months, and with M2 and M3 the Committee moved in January to ease slightly the running near the upper ends of their growth ranges, degree of pressure on reserve positions. On balance, the Committee moved, in several steps, to tighten interest rates fell during January and February, reserve pressures. Owing to the force of credit which, in conjunction with rate declines that fol demands and the Federal Reserve's less accommoda lowed the stock market drop in October, contributed tive posture, interest rates rose on balance over to a pickup in M2 and M3 growth over the first those months. Late in the second quarter, growth in quarter of the year. the aggregates moderated, leaving both well within their target ranges as the first half of 1988 ended. M2 Billions of Dollars Behavior of Money and Credit 3200 8% 3150 From the fourth quarter of 198 7 through June 1988, M2 increased at about a 7 percent annual rate, a 3100 noticeable increase over its 1987 rate of 4 percent. 3050 The faster growth can be attributed primarily to the lagged reaction of the public's demand for M2 3000 balances to decreases in market interest rates relative 2950 to deposit rates that occurred in late 1987 and early 2900 1988. In the second quarter of 1988, however, the "opportunity cost" of holding M2 reversed its 2850 downward trend, and growth in M2 moderated 2800 toward the end of the period. 0 N D J F M A M J J A S O N D M3 growth increased in the first half of 1988 to a 7 percent rate, following a 5 ½ percent increase in 1987 1988 1987. Credit expansion at banks and thrift institu tions, which heavily influences the overall behavior of M3, remained at roughly the same pace as last 11 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis year, but it was financed to a greater extent over the Short-term Interest Rates Percent first half of the year by liabilities included in M3. In particular, inflows to banks from their foreign branches and borrowings by savings and loans from Federal Home Loan Banks; which are not included 16 in M3, dropped off sharply compared with 1987. Federal Funds M 1 grew at a 5 percent rate during the first half of the year, which although below the 6 ¼ percent 12 rate for all of 1987, was higher than its growth in the second half of last year. The sluggish growth of Ml, especially in comparison to that of M2 and M3, owed entirely to weakness in demand deposits, 8 which have been declining over the past 18 months. \--- - In contrast, growth in currency and other checkable 3-month Treasury Bill \_, _,..,-;\ /, deposits was robust. 4 Domestic nonfinancial debt grew at a 8 ½ percent rate from the fourth quarter of 1987 to June, according to estimates based on partial data. Debt growth in the first half represented a slowdown from last year's 9 ½ percent rate and a substantial decline 1980 1982 1984 1986 1988 from the 13 ¼ percent rate of expansion in 1985 and 1986. Nonetheless, debt continued to grow faster than nominal GNP. Reflecting the effects of smaller of the modification was to permit greater flexibility federal deficits during the calendar year, growth in in System operations in light of the volatility and federal debt slowed from last year's pace and fragility characterizing financial markets at that remained at a rate well below that recorded over time. During this period, it was considered impor most of the 1980s. N onfederal debt also expanded at tant to assure the markets of the System's intention a somewhat slower rate, as the growth of the debt of to provide adequate liquidity, and it was feared that households and state and local governments declined modestly. Long-term Interest Rates Percent Implementation of Monetary Policy In conducting monetary policy, the Federal Reserve directed its operations during the first three months 17 of 1988 at either maintaining or easing slightly the Home Mortgage Fixed Rate degree of reserve pressure that had prevailed since 14 the October stock market collapse. Thereafter, the System moved in several steps to firm reserve positions. 11 In the aftermath of the stock market crash last V October, the System's procedures were modified by 30-year Treasury Bond placing greater emphasis on money market condi 8 tions and less on bank reserve positions in carrying out day-to-day open market operations. In doing so, it was neither the Committee's intention to alter its operating procedures permanently nor to ignore 1980 1982 1984 1986 1988 bank reserve positions completely. Rather, the thrust Note: Last observation is for June 1988. 12 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis significant variation in money market conditions placing greater emphasis on reserve positions in con could add to the unusual uncertainties already in the ducting System operations, allowing money markets markets. to respond more sensitively to changing economic As markets exhibited signs of increased stability circumstances. The transition back to the pre this year, the Committee responded by gradually October approach was completed in the spring. Growth of Money and Credit (Percentage changes at annual rates) Domestic Period Mt M2 M3 N onfinancial Debt Fourth quarter 1987 to 5.0 7.4 7 .1 8.5 second quarter 1988e Fourth quarter 198 7 5.1 7 .1 7.0 8.5 to June 1988e Fourth quarter to 1979 7.7 8.2 10.4 12.3 fourth quarter 1980 7.5 8.9 9.5 9.6 1981 5.2 (2.5t 9.3 12.3 10.0 1982 8.7 9.1 9.9 8.9 1983 10.2 12.1 9.8 11.3 1984 5.3 7.6 10.4 14.2 1985 12.0 8.9 7.7 13.3 1986 15.6 9.4 9.1 13.3 1987 6.2 4.0 5.4 9.6 Quarterly Ql 13.2 6.5 6.5 10.5 average 1987 Q2 6.6 2.7 4.6 8.6 Q3 0.8 2.8 4.5 7.9 Q4 3.9 3.9 5.4 10.1 Quarterly Ql 3.8 6.7 7.0 8.4 average Q2e 6.1 7.9 7 .1 8.3 1988 e-estimated *Ml figure in parentheses is adjusted for shifts to NOW accounts in 1981. 13 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis The Stock Market Definitions The collapse of equity prices last October heightened 1. M1 is currency held by the public, plus travelers' public concerns about the volatility_ of stock prices checks, plus demand deposits, plu.s other, ch,eckable and the fragility of financial institutions, and mar deposits [in~ltid~ng negotiable ord-e/ o~ withdrawal (NOW kets. These concerns became the subject of studies and Super NOW) accounts, automatic· transfer service by a Presidential commission, governmental agen (ATS) accounts, and credit union share draft accounts]. M2 is M 1 plus savings and small denomination time cies, and the securities industry. Recommendations deposits, plus Money Market Deposit Accounts, plus from these groups and from a follow-up Presidential shares in moriey market mutual funds ( other than those working group focused on ways to avoid excessive restricted to institutional investors), plus overnight repur stock price volatility and to strengthen the ability of chase agreements and certain overnight Eurodollar markets and related systems to deal with large price deposits. movements. Progress has been made in this regard, M3 is M2 plus large time deposits, plus large denomi with steps having been taken by market participants nation term repurchase agreements, plus shares in money to address some of the problems revealed by the market mutual funds restricted to institutional investors market break in clearing and settlement systems. and certain term Eurodollar deposits. Additional steps have been taken to coordinate trad ing halts triggered ~y extreme price moves and to ·strengthen capital positions of specialists and other market makers. In considering the possibility of future regulatory action in this sphere, it is noteworthy that the stock market break has not been followed by any major aftershocks. In part, this reflects the basic resilience in this period of the economy and financial markets. In addition, it attests to the general adequacy of the current regulatory framework and monetary policy institutions in cushioning financial disturbances, so that they do not spread to the economy as a whole. Thus, while the additional steps initiated by private entities to strengthen market mechanisms certainly are desirable, a major extension of the governmental regulatory apparatus does not seem necessary. A copy of the full report to Congress, including an appendix on the monetary base, is available from Publication Services, Federal Reserve Board, Washington, D.C. 20551 FRB 14-48000-0788 14 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 1988 MONETARY POLICY OBJECTIVES Testimony of Alan Greenspan, Chairman, Board of Governors of the Federal Reserve System July 13, 1988 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Testimony of Alan Greenspan Chairman, Federal Reserve Board Mr. Chairman) and members of In the event, the economy proved remarkably I resilient to the loss of stock market wealth. Eco the Committee) I appreciate this nomic growth remained vigorous through the first half of the year. Continuing brisk advances in opportunity to review with you exports, together with moderating growth in imports, supported expansion in output, especially recent and prospective monetary in manufacturing. Some strengthening also was evi policy and the economic outlook. I dent in business outlays for equipment, especially computers, and consumer purchases of durables, would also like to provide a including autos. · Financial markets also returned to more normal broader perspective by discussing in functioning. Although trading volumes did not regain pre-crash levels in many markets, price vola some detail our nation )s longer tility diminished somewhat and quality differentials term economic objectives) the overall stayed considerably narrower than in the immediate aftermath of the stock market plunge. In response, strategy for fiscal and monetary the Federal Reserve gradually was able to restore its standard procedure of gearing open market opera policies needed to reach those objec tions to the intended pressure on reserve positions of depository institutions. We thereby discontinued tives) and the appropriate tactics the procedure of reacting primarily to day-to-day variations in money market interest rates that had for implementing monetary policy been adopted right after the stock market break. within that strategic framework. As the risks of faltering economic expansion and further financial market disruptions diminished, the dangers of intensified inflationary pressures reemerged. Utilization of labor and capital reached the highest levels in many years, and hints of The Ecom>mic Setting and Monetary acceleration began to crop up in wage and price Policy So Far in 1988 data. Strong gains in payroll employment that con tinued through the spring combined with slower The macroeconomic setting for monetary policy has growth in the labor force to lower the unemploy changed in some notable respects since I testified ment rate by about 1/4 percentage point, even last February. At that time, the full after-effects of before the strong labor market report for June; the the stock market plunge on spending and financial industrial capacity utilization rate moved up as well. markets were still unclear. While most Federal In ·part reflecting the payroll tax increase, broad Open Market Committee members were forecasting measures of hourly compensation picked up some moderate growth, in view of rapid inventory build what in the first quarter. Prices for a wide range of ing and some signs of a weakening of labor domestic and imported industrial materials and sup demand, the possibility of a decline in economic plies rose even more steeply than last year. Finished activity could not be ruled out. To guard against goods price inflation has not reflected this step-up in this outcome, in the context of a firmer dollar on price increases for intermediate goods, in part as exchange markets, the Federal Reserve undertook a productivity gains kept unit labor costs under con further modest easing of reserve pressures in late trol. Even so, continued increases in materials prices January, which augmented the more substantial eas at the recent pace were seen as pointing to a poten ing following October 19. Short-term interest rates tial intensification in inflation more generally, since came down another notch, and with a delay helped based on historical experience, such increases have to push the monetary aggregates higher within their tended to show through to finished good prices. targeted annual ranges. 2 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis In these circumstances, the Federal Reserve was international trade position should continue to pro well aware that it should not fall behind in estab vide a major stimulus to real GNP growth through lishing enough monetary restraint to effectively next year, reflecting the lagged effects of the decline resist these inflationary tendencies. The System took in the exchange value of the dollar through the end a succession of restraining steps from late March of last year. Although the month-to-month pattern through late June. The shortest-term interest rates in our trade deficit can be expected to be erratic, gradually rose to levels now around highs reached the improvement in the external sector on balance last fall. Responding as well to the unwinding of a over time is expected to replace much of the tax-related buildup in liquid balances, M2 and M3 reduced expansion in domestic final demands from growth slowed noticeably. our consumer, business, and government sectors. In contrast to the shortest-maturity interest rates, Employment growth is anticipated to be substan long-term bond and mortgage rates, though also tial, though some updrift in the unemployment rate above February lows, still remain well below last may occur over the next year and a half. Capacity fall's peaks. The timely tightening of monetary utilization could well top out soon, as growth in policy this spring, along with perceptions of better demands for manufactured goods slows to match prospects for the dollar in foreign exchange markets that of capacity. in light of the narrowing in our trade deficit, Considering the already limited slack in available seemed to improve market confidence that inflation labor and capital resources, a leveling of the unem ary excesses would be avoided. Both bond prices ployment and capacity utilization rates is essential if and the dollar rallied in June despite increases in more intense inflationary pressures are to be interest rates in several major foreign countries and avoided in the period ahead. Otherwise, aggregate jumps in some agricultural prices resulting from the demand would continue growing at an unsustain drought in important growing areas. able pace and would soon begin to create a destabilizing inflationary climate. Supply conditions for materials and labor would tighten further and The Economic Outlook and Monetary costs would start to rise more rapidly; businesses Policy through 1989 would attempt to recoup profit margins with further The monetary actions of the first half of the year price hikes on final goods and services. These faster were undertaken so that economic expansion could price rises would, in turn, foster an inflationary psy be maintained, recognizing that to do so, additional chology, cut into workers' real purchasing power, price pressures could not be permitted to build and and prompt an attempted further catchup of wages, progress toward external balance had to be sus setting in motion a dynamic process in which tained. The projections of FOMC members and neither workers nor businesses would benefit. The nonvoting presidents indicate that they do expect hard-won gains in our international competitiveness economic growth to continue, and inflation to be would be eroded, with feedback effects depressing contained. the exchange value of the dollar. Excessive domestic The 2 ¾ to 3 percent central tendency of FOMC demands and inflation pressures in this country, members' expectations for real GNP growth over with its sizable external deficit, would be disruptive the four quarters of this year implies a deceleration to the ongoing international adjustment of trade and over the rest of the year to a pace more in line with payments imbalances. their expected 2 to 2 ½ percent real growth over Not only the reduced slack in the economy but 1989 and with the long-run potential of the econ also several prospective adjustments in relative omy. The drought will reduce farm output for a prices have accentuated inflation dangers. One is time, and it is important that nonfarm inventory the upward movement of import prices relative to accumulation slow before long, if we are to avoid a domestic prices, which is a necessary part of the troublesome imbalance. Still, further gains in our process of adjustment to large imbalances in inter national trade and payments. Another is the recent Digitized for FRASER 3 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis I drought-related increases in grain and soybean dropped sharply since the 1982 base year used for prices. It is essential that we keep these processes constructing the deflator. Indeed, if the deflator confined to a one-time adjustment in the level of were indexed with a 1987 base year, it would have prices and not let them spill over to a sustained risen appreciably faster in the first quarter. higher rate of increase in wages and prices. Elevated Another understatement of inflation in the defla import and farm prices must be prevented from tor this year arises from its exclusion of imported engendering expectations of higher general inflation, goods, which are not directly encompassed because with feedback effects on labor costs. A more serious they are produced abroad. In part because import long-run threat to price stability could come from prices have continued to rise significantly faster than government actions that introduced structural rigidi prices of domestically produced goods, consumer ties and increased costs of production. Protectionist price indexes have increased more than the GNP legislation, inordinate hikes in the minimum wage, deflator. and other mandated programs that would impose The FOMC believes that efforts to contain infla costs on U.S. producers would adversely affect their tion pressures and sustain the economic expansion efficiency and international competitiveness. would be fostered by growth of the monetary The costs to our economy and society of allowing aggregates over 1988 well within their reaffirmed a more intense inflationary process to become 4 to 8 percent annual ranges, followed by some entrenched are serious. As the experience in the slowing in money growth over the course of next past two decades has clearly shown, accelerating year. M2 should move close to the midpoint of its wages and prices would have to be countered later range by late 1988, if depositors react as expected to by quite restrictive policies, with unavoidably the greater attractiveness of market instruments adverse implications for production and employ compared with liquid money balances that was ment. The financial health of many individual and brought about by recent increases in short-term business debtors, as well as of some of their credi market rates relative to deposit rates. M3 could end tors, then would be threatened. The long-run costs the year somewhat above its midpoint, though com of a return to higher inflation and the risks of this fortably within its range, if depository institutions occurring under current circumstances are suffi retain their recent share of overall credit expansion. ciently great, that Federal Reserve policy at this The debt of nonfinancial sectors, which so far this juncture might be well advised to err more on the year has been near the midpoint of its reaffirmed 7 side of restrictiveness rather than of stimulus. to 11 percent monitoring range, is anticipated to We believe that monetary policy actions to date, post similar growth through year-end. together with the fiscal restraint embodied in last For 1989, the FOMC has underscored its inten fall's agreement between the Congress and the tion to encourage progress toward price stability administration, have set the stage for containing over time by lowering its tentative ranges for money inflation through next year. The central tendency of and debt. We have preliminarily reduced the growth FOMC members' expectations for inflation in the range for M2 by 1 full percentage point, to 3 to 7 GNP deflator ranges from 3 to 3 ¾ percent over this percent; last February, the FOMC also had reduced year and 3 to 4 % percent next year. But in one the midpoint of the 1988 range for M2 by 1 per sense the GNP deflator understates this year's rate centage point from that for 1987. We have adjusted of inflation, and the comparison with next year the tentative 1989 range for M3 downward by 1/2 overstates the pick-up. The deflator represents the percentage point, to 3 ½ to 7 ½ percent. This con average price of final goods and services produced figuration is consistent with the observed tendency in the United States, or equivalently domestic value for M3 velocity over time to fall relative to the added, using current quantity weights. This meas velocity of M2; over the last decade, the Federal ure was artificially held down in the first quarter by Reserve's ranges frequently allowed for faster a shift in the composition of output, especially by growth of M3 than of M2. The monitoring range the surge in sales of computers whose prices have for domestic nonfinancial debt for 1989 also has 4 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis been lowered 1/2 percentage point to a tentative 6 ½ assets, or both. To be sure, such changes in market to 10 ½ percent. incentives would have self-correcting effects over The specific ranges chosen for 1989 are, as usual, time in reducing the imbalance between our domes provisional, and the FOMC will review them care tic spending and income. Higher real interest rates fully next February, in light of intervening develop would curtail domestic investment and other spend ments. Anticipating today how the outlook for the ing. A lower real value of the dol1ar would make economy in 1989 will appear next February i diffi U.S. goods and services relatively less expensive to cult, and a major reassessment of that outlook both U.S. and foreign residents, damping our would have implications for appropriate money spending on imports out of U.S. income and boost growth ranges for that year. Unexpectedly strong or ing our exports. weak economic expansion or inflation pressures over But simply sitting back and allowing such a self the next six months also could have implications for correction to take place is not a workable policy the behavior of interest rates and their prospects for alternative. Trying to foUow such a course could 1989. The sensitivity of the monetary aggregates to have severe drawbacks now that our economy is movements in market interest rates means that the operating close to effective capacity and potential appropriate growth next year in M2, M3, and debt inflationary pressures are on the horizon. The time could seem different next February than now, neces is hardly propitious to discourage investment in sitating a revision in the annual growth ranges. As needed plant and equipment, to add further the aggregates have become more responsive to impulses for import price hikes on top of the interest rate_c hanges in the 1980s, judgments about upward tendencies already in the making, or to possible ranges for the next year necessarily have push our export industries as '"'ell as import become even more tentative and subject to revision. competing industries to their capacity limits. Fortunately, we have a better choice for righting the imbalance between domestic spending and The Persistent U.S. External and income- one over which we have direct control. Fiscal Imbalances That is to resume reducing substantially the still Despite the changes in the economic setting over the massive federal budget deficit, which remains the last six months, other features of the macroeconomic most important source of dissaving in our economy. landscape remain much the same. Most notable are The fall in the dollar we have already experienced the continuing massive deficits in our external pay over the last few years, even allowing for the dol ments and internal fiscal accounts. As a nation, we lar's appreciation from the lows reached at the end still are living well beyond our means; we consume of last year, has set in motion forces that should much more of the world's goods and services each continue to narrow our trade and current account year than we produce. Our current account deficit deficits in the years ahead. The associated loss of indicates how much more deeply in debt to the rest foreign-funded domestic investment is likely to of the world we are sliding each year. adversely affect overall investment unless it can be The consequence of this external imbalance will replaced by greater domestic investment financed by be a steady expansion in our external debt burden domestic saving. A sharp contraction in the federal in the years ahead. No household or business can deficit appears to be the only assured source of aug expect to have an inexhaustible credit line with bor mented domestic net saving. Such a fiscal cutback rowing terms that stay the same as its debt mounts should help counter future tendencies for further relative to its wealth and income. Nor can we as a increases in U.S. interest rates and declines in the nation expect our foreign indebtedness to grow dollar, partly by instilling confidence on the part of indefinitely relative to our servicing capacity without international investors in the resolve of the United additional inducements to foreigners to acquire dol States to address its economic problems. lar assets-either higher real interest returns, or a Fiscal restraint in the years ahead would assist in cheaper real foreign exchange value for dollar making room for the needed diversion of more of Digitized for FRASER 5 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis I our productive resources to meeting demands from a sustainable external position and above all stable abroad. Domestic demands will have to continue pnces. growing more slowly than our productive capacity, High employment is consistent with steadily rising as seems to have been the case so far this year, if nominal wages and real wages growing in line with net exports are to expand further without resulting productivity gains. Some frictional unemployment in an inflationary overheating of the economy. will exist in a dynamic labor market, reflecting the Absent this fiscal restraint, higher interest rates process of matching available workers with available would become the only channel for damping domes jobs. But every effort should be made to minimize tic demands if they were becoming excessive. If a both impediments that contribute to structural renewed decline in the dollar were adding further unemployment and deviations of real economic inflationary stimulus at the same time, upward pres growth from the economy's potential that cause sures on interest rates would be even more likely. cyclical unemployment. The restrictive impact would be felt most by the By a sustainable external position, I am referring interest-sensitive sectors-homebuilding, business to a situation in which our foreign indebtedness is fixed investment, and consumer durables. not persistently growing faster than our capacity to In terms of federal deficit reduction, the schedule service it out of national income. Our international under the Gramm-Rudman-Hollings law is a good payments need not be in exact balance from one baseline for a multi-year strategy, and I trust the year to the next, and the exchange value of the dol Congress will stick with it. But we should go fur lar need not be perfectly stable, but wide swings in ther. Ideally, we should be aiming ultimately at a the dollar, and boom and bust cycles in our export federal budget surplus, so that government saving and import-competing industries, should be avoided. could supplement private domestic saving in financ By price stability, I mean a situation in which ing additional domestic investment. Historically, the households and businesses in making their saving United States was not a low saving, low investing and investment decisions can safely ignore the possi economy. From the post-Civil War period through bility of sustained, generalized price increases or the 1920s, the United States consistently saved more decreases. Prices of individual goods and services, of as a fraction of GNP than Japan and Germany, and course, would still vary to equilibrate the various we saved much more as a share of GNP then than markets in our complex national and world econ we have since the end of World War II. A turn omy, and particular price indexes could still show around in our current domestic saving performance transitory movements. A small persistent rise in is essential to a smooth reduction in our dependence some of the indexes would be tolerable, given the on foreign saving, and the federal government inadequate adjustment for trends in quality should take the lead. improvement and the tendency for spending to shift It is also apparent that redressing our external toward goods that have become relatively cheap. imbalances must encompass cooperative policies But essentially the average of all prices would with our trading partners. These include both the exhibit no trend over time. Price movements in established industrial powers, the newly industrial these circumstances would reflect relative scarcities ized economies, and the developing countries, whose of goods, and private decision-makers could focus debt problems must be worked through as part of their concerns on adjusting production and con the international adjustment process. sumption patterns appropriately to changing This is the strategy that U.S. fiscal policy as well individual prices, without being misled by general as economic policies abroad should follow in most ized inflationary or deflationary price movements. effectively promoting our shared economic objec The strategy for monetary policy needs to be cen tives. The strategic role of U.S. monetary policy is tered on making further progress toward and ulti implied by a clear statement of what those ultimate mately reaching stable prices. Price stability is a objectives are. We should not be satisfied unless the prerequisite for achieving the maximum economic U.S. economy is operating at high employment with expansion consistent with a sustainable external bal- Digitized for FRASER 6 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis ance at high employment. Price stability reduces growth rates in the monetary aggregates provide uncertainty and risk in a critical area of economic useful checks on the thrust of monetary policy over decisionmaking by households and businesses. In time. It is clear to all observers that the monetary the process of fostering price stability, monetary ranges will have to be brought down further in the policy also would have to bear much of the burden future if price stability is to be achieved and then for countering any pronounced cyclical instability in maintained. the economy, especially if fiscal policy is following a But, in a shorter-run countercyclical context, program for multi-year reductions in the federal monetary aggregates have drawbacks as rigid guides budget deficit. While recognizing the self-correcting to monetary policy implementation. As I discussed nature of some macroeconomic disturbances, mone in some detail in my February testimony, financial tary policy does have a role to play over time in innovation and deregulation in the 1980s have guiding aggregate demand into line with the econ altered the structure of deposits, lessened the pre omy's potential to produce. This may involve dictability of the demands for the aggregates, and providing a counterweight to major, sustained cycli made the velocities of M 1 and probably M2 over cal tendencies in private spending, though we can periods of a year or so more sensitive to movements not be overconfident in our ability to identify such in market interest rates. Movements in short-term tendencies. and to determine exactly the appropriate market rates relative to sluggishly adjusting deposit policy response. In this regard, it seems worthwhile rates can result in large percentage changes in the for me to offer some thoughts on the approach the opportunity costs of holding liquid monetary assets. Federal Reserve should take in implementing this Depositor responses can induce divergent growth longer-term strategy for monetary policy. between money and nominal GNP for a time. I might add that it was partly these considerations that led the FOMC to retain the wider four percent The Appropriate Tactics for Monetary Policy age point ranges for money and credit growth for For better or worse, our economy is enormously this year and next. complex, the relationships among macroeconomic Nonetheless, the demonstrated long-run connec variables are imperfectly understood, and as a con tion of money and prices overshadows the problems sequence economic forecasting is an uncertain of interpreting shorter-run swings in money growth. endeavor. Nonetheless, the forecasting exercise can I certainly don't want to leave the impression that aid policymaking by helping to refine the bound the aggregates have little utility in implementing aries of the likely economic consequences of our policy monetary policy. They have an important role, and stance. But forecasts will often go astray to a greater it is quite possible that their importance will grow or lesser degree and monetary policy has to remain in the years ahead. Currently, the FOMC keeps M2 flexible to respond to unexpected developments. and M3 under careful scrutiny, and judges their A perfectly flexible monetary policy, however, actual movements relative to assessments of their without any guideposts to steer by, can risk losing appropriate growth at any particular time. In this sight of the ultimate goal of price stability. In this context, these aggregates are among the indicators connection, the requirement under the Humphrey influencing adjustments to the stance of policy, both Hawkins Act for the Federal Reserve to announce at regular FOMC meetings and between meetings, its objectives and plans for growth of money and as the FOMC 's directive to the Federal Reserve credit aggregates is a very useful device for calibrat Bank of New York's Trading Desk indicates. The ing prospective monetary policy. The announcement FOMC also regularly monitors a variety of other of ranges for the monetary aggregates represents a monetary aggregates. At times in recent years, we way for the Federal Reserve to communicate its have intensively examined the properties of several policy intentions to the Congress and the public. alternative measures, and reported the results to the And the undisputed long-run relation between Congress. These measures have included Ml, Ml-A money growth and inflation means that trend (Ml less NOW accounts), monetary indexes, and most recently the monetary base. 7 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis An analysis of the monetary base appears as an Judgments about the balance of various risks to I appendix to the Board's Humphrey-Hawkins the economic outlook need to adapt over time to the report. This aggregate, essentially the sum of cur shifting weight of incoming evidence; this point is rency and reserves, did not escape the sharp veloc well exemplified so far this year, as noted earlier. ity declines of other money measures earlier in the The Federal Reserve must be willing to adjust its 1980s. Its velocity behavior stemmed from relatively instruments fairly flexibly as these judgments evolve; strong growth in transactions deposits compared we must not hesitate to reverse course occasionally with GNP, which was mirrored in the reserve com if warranted by new developments. To be sure, we ponent of the base. In this sense, some of the prob should not overreact to every bit of new informa lems plaguing M 1 also have shown through to the tion, because the frequent observations for a variety base, though in somewhat muted form. Moreover, of economic statistics are subject to considerable the three-quarters share of currency in the base transitory "noise" . But we need to be willing to raises some question about the reliability of its link respond to indications of changing underlying eco to spending. The high level of currency holdings nomic trends, without losing sight of the ultimate $825 per man, woman and child living in the policy objectives. United States-suggests that vast, indeterminate To the extent that the underlying economic trends amounts of U.S. currency circulate or are hoarded are judged to be deviating from a path consistent beyond our borders. Indeed, over the last year and with reaching the ultimate objectives, the Federal one half, currency has grown noticeably faster than Reserve would need to make "mid-course" policy would have been expected from its historical rela corrections. Such deviations from the appropriate tionships with U.S. spending and interest rates. direction for the economy will be inevitable, given Although the monetary base has exhibited some the delayed and imperfectly predictable nature of useful properties over the last three decades as a the effects of previous policy actions. Numerous whole, the FOMC's view is that its behavior has unforeseen forces not related to monetary policy will not consistently added to the information provided continue to buffet the economy. The limits of mone by the broader aggregates, M2 and M3. The Com tary policy in short-run stabilization need to be mittee accordingly has decided not to establish a borne in mind. The business cycle cannot be range for this aggregate, although it has requested repealed, but I believe it can be significantly staff to intensify research into the ability of various damped by appropriate policy action. Price stability monetary measures to indicate long-run price trends. cannot be· dictated by fiat, but governmental Because the Federal Reserve cannot reliably take decision-makers can establish the conditions needed its cue for shorter-run operations solely from the to approach this goal over the next several y"ears. signals being given by any or all of the monetary aggregates, we have little alternative but to interpret the behavior of a variety of economic and financial indicators. They can suggest the likely future course of the economy given the current stance of mone tary policy. 8 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis

Federal Reserve (1988, July 12). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_19880713

@misc{wtfs_monetary_policy_report_19880713,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {1988},
  month = {Jul},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_19880713},
  note = {Retrieved via When the Fed Speaks corpus}
}