Monetary Policy Report

.------ Midyear Review of the .Federal Reserve Board - - 1989 ·.. .M ONETARY POLICY . OBJECTIVES July 20, 1989 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 1989 MONETARY POLICY OBJECTIVES Testimony of Alan Greenspan, Chairman Board of Governors of the Federal Reserve System July 20, 1989 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 the In view of the dimensions of the inflation threat, the Federal Reserve tightened policy further early Committee: I appreciate this this year. Additional reserve restraint was applied through open market operations, and the discount opportunity to appear before you in rate was raised ½ percentage point. The determina connection with the Federal Reserve s tion to resist any pickup in inflation also motivated J the decision of the Federal Open Market Committee semiannual Monetary Policy Report at its February meeting to lower the ranges for money and credit growth for 1989. This marked the to Congress. In my prepared remarks third consecutive year in which the target ranges today I will adhere closely to the were reduced, and it underscored our commitment to achieving price stability over time. matter at hand-that is) monetary Reflecting the economy's apparent strength and the tighter stance of policy, interest rates rose during policy and the state of the nation s J the first quarter. Short-term market rates increased economy. around 1 percentage point over the quarter, leaving them up more than 3 points from a year earlier, but long-term rates held relatively steady. The year-long rise in short-term rates had a marked impact on growth of the monetary aggregates, restraining the Economic and Monetary Developments demand for money as funds flowed instead into Thus Far in 1989 higher-yielding market instruments. By the beginning of the second quarter, the Over the course of this year, the contours of the outlook for spending and prices was becoming more broad economic setting have changed. As a conse mixed. Scattered indications of an emerging quence, the stance of monetary policy also has softening in economic activity began to appear, shifted somewhat, although the fundamental prompting market interest rates to pull back. Rates objective of our policy has not. That objective continued to fall as a variety of factors pointed to remains to maximize sustainable economic growth, some lessening of price pressures in the period which in turn requires the achievement of price ahead. In particular, money growth weakened stability over time. further, the underlying trend in inflation appeared Early in the year, the Federal Reserve continued to be less severe than markets had feared, the dollar on the path toward increased restraint upon which it continued to climb, and domestic demand slack had embarked in the spring of 1988. At the time of ened. Against this background, the Federal Reserve our report to Congress in February of this year, I eased reserve conditions, first in early June and characterized the economy as strong, with the risks again in early July. By mid-July, most short-term on the side of a further intensifying of price pres market rates had fallen to a bit below their year-end sures. Labor markets had been tightening notice levels, and long-term interest rates were down as ably, heightening concerns that inflationary much as a full point, to their lowest levels in more pressures might be building. Moreover, increases in than two years. food and crude oil prices were raising the major inflation indexes. 1 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Economic activity apparently grew in the first half than was the case earlier in the expansion. A of this year at a rate somewhat below that of significant moderation in the unit cost of imported potential GNP. This stands in sharp contrast to the materials, likely reflecting the higher value of the performance of the preceding two years during dollar on foreign exchange markets, provided a which growth proceeded at a pace that placed notable offset to these cost pressures. On balance, it increasing pressures on labor and capital resources. appears that firms have continued to experience Job creation has remained the hallmark of the upward pressures on costs. The intensity of these current expansion, however. Even with the more pressures as related to energy inputs may well moderate pace of economic growth in the first half of diminish in coming months, but it remains to be this year, nearly 1 ½ million new jobs were added to seen how other elements of the cost structure will payrolls. And this occurred apparently without evolve. triggering an acceleration in wages. This approach, while helpful in understanding the Prices did accelerate in the first six months of this interaction of prices and costs, does not tell us how year, but most of the increase may be transitory, an inflation cycle begins or why it may persist. related to supply conditions in food and petroleum Short-run inflation impulses can originate from a markets. After a gradual pickup over the preceding variety of sources, on both the demand and the two years, price inflation outside of food and energy supply sides of the economy. But over longer periods held near its 1988 pace. of time, inflation cannot persist without at least Excluding food and energy is one traditional way passive support from the monetary authorities. of estimating the ''underlying'' rate of inflation. The strength of the inflation pressures in 1988 and Although there is some logic in abstracting from into 1989 was, of course, the motive for the progres these prices, which are quite volatile and can be sive tightening of policy that the Federal Reserve dominated over the short run by supply distur undertook over that period. And the outlook for bances, this approach is incomplete. An alternate some reduction in these pressures owes in part to picture of near-term price-setting behavior can be that policy restraint. The associated rise in market gleaned by examining the components of prices, that interest rates, beginning early last year, opened up is, the cost pressures facing firms and the behavior of wide ''opportunity'' costs of holding money assets their profits. Such an analysis reveals that, in and resulted in a sharp slowing of money growth. manufacturing, much of the pickup in inflation thus This was especially the case for liquid deposits, far in 1989 is accounted for by higher unit energy whose rates were adjusted upward only very and labor costs. The runup in world crude oil prices, sluggishly, providing depositors with strong which reflected a series of production accidents this incentives to economize on balances. spring as well as a degree of output restraint on the In addition to the effect of interest rates, several part of some OPEC oil producers, is the main special factors played a role in slowing money reason for the increase in energy costs. growth and boosting velocity-that is, the ratio of In contrast, movements in hourly compensation nominal GNP to money. Probably the most appear to have been quite moderate in the first half important of these was the unexpectedly large size of of this year, and the acceleration in unit labor costs personal tax liabilities in April. Many individuals largely reflected slower growth in productivity. Such evidently were surprised by the size of their liabili a deceleration in productivity is typical as the pace of ties, and drew down their money balances below economic activity slows. But, given the relatively normal levels to make the required payments. As the high levels of resource utilization, it also is possible IRS cashed those checks, M2 registered outright that firms were forced to draw on less skilled workers declines. 2 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis The difficulties of the thrift industry also may Monetary Policy and the Economy into 1990 have affected M2 growth. Late last year, as public Looking ahead at the remainder of 1989 and into attention increasingly focused on the financial 1990, recent developments suggest that the balance condition of the industry and its insurance fund, of risks may have shifted somewhat away from FSLIC-insured institutions began to lose deposits at greater inflation. Even so, inflation remains high a significant rate. These deposit withdrawa_}s were clearly above our objective. Any inflation that particularly strong in the first quarter of this year, persists will hinder the economy's ability to perform and while most of the funds apparently were at peak efficiency and to create jobs. Consequently, repositioned within M2-at commercial banks or monetary policy will need to continue to focus on money funds-this factor likely also had some laying the groundwork for gradual progre~s toward damping effect on that aggregate. price stability. Such an outcome need not i~ply _a More recently, growth of the broader monetary marked downturn in the economy, and policy will aggregates has picked up markedly. The restraint . have to be alert to any emerging indications of a imposed by the earlier rise in market inte~es~ rates ~s cumulative weakening of activity. However, fading, and households appear to be rebmldmg their progress on inflation and optimum growth over time tax-depleted balances. As of May, M2 had risen at also require that our productive resources not be just a 1 percent rate from its fourth-quarter base, under such pressures that their prices continue to but the 6 ¾ percent rate of growth in June lifted the rise without abating. In light of historical patterns of year-to-date increase to around a 2 percent rate, still labor and capital growth and productivity, this somewhat below its 3 to 7 percent annual target progress very likely will be associated with a more cone. M3 rose at a 3 ½ percent rate throughjune, at moderate, and hence sustainable, expansion in the lower end of its range. The latest data on these demand than we experienced in 198 7 and 1988. aggregates suggest that relatively rapid expansion At its meeting earlier this month, the Federal has continued into July. Open Market Committee determined that a Ml, which is the most interest-sensitive of the combination of continued economic growth and monetary aggregates, declined at a 3 ½ percent rate reduced pressures on prices would be promoted by throughjune. The unusual drop in Ml stemmed growth of money and debt in 1989 within the annual from sizable declines in NOW accounts and demand ranges that were set in February. Moreover, it deposits. NOW accounts were reduced both by the tentatively decided to maintain these same ranges large personal tax payments this spring and by the through 1990. high level of interest rates, which drew savings-type The specified ranges, both for this year and next, balances instead toward market instruments or other retain the 4-percentage-point width first instituted types of accounts whose offering rates adjusted for the broader aggregates in 1988. Considerable upward more quickly. The decline in demand uncertainties about the behavior of money and deposits was related in part to a reduction in credit remain, and the greater breadth allows for a balances that businesses are required to hold to range of paths for these aggregates as financial and compensate their banks for various services; for a set economic developments may warrant. Uncertainties amount of services, higher market rates translate about the link between the narrow transactions into lower required balances. aggregate, Ml, and the economy have, if anything, increased, and the Committee once again did not specify a range for this aggregate. 3 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis In view of the apparent variability, particularly Further steps in the resolution of the thrift over the short run, in the relationships between the industry difficulties also have implications for M3. monetary aggregates and the economy, policy will With deposits flowing in again, thrifts will not have continue to be carried out with attention to a wide to rely so heavily on the Federal Home Loan Banks range of economic and financial indicators. The for their funding as they did earlier this year. Partly complex nature of the economy and the chance of as a result, we expect M3 to strengthen from its rate false signals demand that we cast our net broadly of growth over the first half of the year, moving up gathering information on prices, real activity, into the middle of its target range by year-end. financial and foreign exchange markets, and related Our outlook for debt growth foresees little change data. from the pace of the first two quarters. The broad While the monetary aggregates may not be credit measure that we monitor, the debt of domestic preeminent on this list, they always receive careful nonfinancial sectors, has grown at about an 8 consideration in our policy decisions. This is percent rate this year, near the midpoint of its 6 ½ to especially true when they exhibit unusual strength 10 ½ percent range. We have little reason to expect or weakness relative to past patterns and relative to its growth through the end of the year to be very our announced ranges. Thus, the very sluggish different, implying some slowing from the pace of growth in M2 for the year to date was an important 1988. Nevertheless, the expansion of debt is likely to influence in the decision to ease policy in June and exceed nominal GNP growth again this year. again injuly. Velocity may vary considerably over a Growth of money and debt within the 1989 ranges few quarters, but the provision of liquidity, as is expected to be consistent with nominal GNP measured by one or another of the monetary rising this year at a pace not too far from last year's aggregates, is an important factor in the perfor increase, according to the projections of FOMC mance of the economy over the shorter run and over members and other presidents of Reserve Banks. the long run broadly determines the rate of price These projections, however, incorporate somewhat increase. more inflation and less real growth than we experi Although M2 currently remains below its 1989 enced in 1988. The central tendency of the projec target cone, it has picked up substantially. The tions of 2 to 2 ½ percent real GNP growth over the decline in interest rates in recent months, along with four quarters of this year implies continued moder the continued growth of income, should provide ate economic growth throughout the year. For the support for that aggregate over the rest of the year, year as a whole, these projections anticipate that helping to lift it into the lower part of its target growth is likely to be strongest in the investment and range. Growth in M2 likely will be augmented by a export sectors of the economy, with expansion of cessation of the special influences I noted earlier that consumer expenditures and government purchases depressed it in the first half of the year. In particular, rather subdued. we expect households to continue to rebuild their A sectoral pattern of growth such as this would in money balances after the tax-related drawdowns in fact serve the nation's longer-term needs by April and May. Also, deposit withdrawals from contributing to a better external balance. Funda thrift institutions have subsided, and enactment of mentally, improvement in our international legislation that restores full confidence in the payments position requires productivity-enhancing industry would bode well for deposit flows into investment and a higher national saving rate. In this FSLIC-insured institutions. regard the federal government can play a signifi cant, positive role by reducing the budget deficit. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis The outlook for inflation this year, as reflected in The economic projections for 1990 made by the the central tendency of the projections expressed at governors and Reserve Bank presidents center in a the FOMC meeting, is for a 5 to 5 ½ percent range of 1 ½ to 2 percent real GNP growth and 4 ½ increase in the consumer price index. A figure in to 5 percent inflation for next year. Naturally, as I've this range would represent the highest annual already noted, there are considerable uncertainties inflation rate in the United States since 1981; this is surrounding forecasts for 1990. In particular, a source of concern to the Federal Reserve. Yet this developments in the external sector will depend in rate is below that experienced in the first six months. part on economic activity abroad, as well as on the This implies a considerable slowing over the efforts of U.S. firms to become more competitive in remainder of the year, reflecting earlier monetary world markets. Domestically, performance will be policy restraint and a prospective moderation in affected by a large number of influences, including food and energy prices. importantly the budget deficit. Federal Reserve policy is focused on laying the groundwork for more definite progress in reducing Monetary Policy in Perspective inflation pressures in 1990, while continuing support for the economic expansion. The ranges The Federal Reserve is committed to doing its provisionally established for growth of money and utmost to ensure prosperity and rising standards of debt next year are consistent with these intentions. living over the long run. Given the powers and They allow for a noticeable pickup in money growth responsibilities of the central bank, that means most from that likely to prevail this year, should that be importantly maintaining confidence in our currency appropriate. If pressures on prices and in financial by maintaining its purchasing power. The principal markets are less intense than in recent years, role of monetary policy is to provide a stable velocity would not be expected to continue to backdrop against which economic decisions can be increase, and faster money growth, perhaps in the made. A stable, predictable price environment is top half of the range, would be needed for a time to essential to ensure that resources can be put to their support economic growth. Conversely, if price best use and ample investment for the future can be pressures prove intractable, the ranges are low made. enough to permit the needed degree of monetary In the long run, the link between money and restraint. prices is unassailable. That link is central to the Thus, although the 1990 ranges do not represent mission of the Federal Reserve, for it reminds us another step in the gradual, multiyear lowering of that without the acquiesence of the central bank, ranges, the Federal Reserve's intent to make further inflation cannot take root. Ultimately, the monetary progress against inflation remains intact. Uncertain authorities must face the responsibility for lasting ties about the outlook suggested a pause in the price trends. While oil price shocks, droughts, process of reducing the ranges; however, the higher taxes, or new government regulations may Committee recognizes that our goal of price stability boost broad price indexes at one time or another, will require additional downward adjustments in sustained inflation requires at least the forbearance these ranges over time. Of course, as we draw closer of the central bank. Moreover, as many nations have to 1990, the economic and financial conditions learned, inflation can be corrosive. As it accelerates, prevailing will become clearer, allowing us to the signals of the market system lose their value, approach our decisions on the ranges with more financial assets lose their worth, and economic confidence. Hence, the current ranges for money progress becomes impossible. and credit growth in 1990 should be viewed as very preliminary. Digitized for FRASER 5 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Thankfully, this bleak scenario is not one that we The balance that we must strike is to support in the United States are confronting. We do, moderate growth of demand in the near term, while however, face a difficult balancing act. The economy concurrently progressing toward our longer-run has prospered in recent years: the economic goal of a stable price level. Admittedly, the balance expansion has proven exceptionally durable, we are seeking is a delicate one. I wish I could say employment has surpassed all but the most optimis that the business cycle has been repealed. But some tic expectations, and the underlying inflation rate, day, some event will end the extraordinary string of after coming down quickly in the early 1980s, has economic advances that has prevailed since late accelerated only modestly. But now signs of softness 1982. For example, an inadvertent, excess accumu in the economy have shown up. lation of inventories or an external supply shock Accordingly, it is prudent for the Federal Reserve could lead to a significant retrenchment in economic to recognize the risk that such softness conceivably activity. could cumulate and deepen, resulting in a substan Moreover, I cannot rule out a policy mistake as tial downturn in activity. We also recognize, the trigger for a downturn. We at the Federal however, that a degree of slack in labor and product Reserve might fail to restrain a speculative surge in markets will ease the inflationary pressures that have the economy or fail to recognize that we were built up. So our policy, under current circum holding reserves too tight for too long. Given the stances, is not oriented toward avoiding a slowdown lags in the effects of policy, forecasts inevitably are in demand, for a slowing from the unsustainable involved and thus errors inevitably arise. Our job is rates of 1987 and 1988 is probably unavoidable. to keep such errors to an absolute minimum. An Rather what we seek to avoid is an unnecessary and efficient policy is one that doesn't lose its bearings, destructive recession. that homes in on price stability over time, but that copes with and makes allowances for any unforeseen weakness in economic activity. It is such ·a policy that the Federal Reserve will endeavor to pursue. 6 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 1989 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 1989 and 1990 2 Monetary Policy for 1989 and 1990 2 Economic Projections for 1989 and 1990 3 The Performance of the Economy during the First Half of 1989 5 The External Sector 5 The Household Sector 6 The Business Sector 6 The Government Sector 7 Labor Markets 7 Price Developments 8 Monetary Policy and Financial Developments during the First Half of 1989 9 The Implementation of Monetary Policy 9 The Behavior of the Monetary Aggregates 10 Credit Flows 10 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Monetary Policy and the Economic Outlook for 1989 and 1990 As 1989 began, a reduction in inflationary pressures below its target range for the year. Aggregate appeared essential if the ongoing economic expan demand for goods and services moderated, reducing sion was to be sustained. Monetary policy during somewhat the strains on productive resources, espe 1988 had been directed toward reducing the risks of cially in the industrial sector of the economy. The an escalation of inflation and inflationary expecta dollar exhibited considerable strength on the foreign tions, but at the time of the Board's report to the exchange markets, portending a direct reduction in Congress in February of this year, success in that price pressures and slower growth in demands on effort seemed far from assured. domestic production capacity. Although the unem Indeed, among the data reported in the early part ployment rate remained essentially unchanged in the of 1989 were very large increases in the producer neighborhood of 5 ¼ percent-the lowest level since and consumer price indexes, reflecting not only the the early 1970s-trends in wages and total compen effects of run-ups in oil and agricultural commodity sation showed little, if any, further step-up, reflect prices, but also broader inflationary developments, ing at least in part an awareness among workers and including unfavorable trends in unit labor costs over management of the need to contain costs in a highly the preceding year. Under the circumstances, with competitive world economy. Meanwhile, prices of pressures on productive resources still intense, actively traded industrial commodities leveled out, monetary policy was tightened further. Reserve enhancing the prospects of a broader slackening in availability was curtailed through open market oper the pace of inflation. ations, and the discount rate was raised 1/2 percent In this environment, interest rates turned down age point in late February. In response to these during the spring, as financial market participants policy actions, and to expectations that additional responded not only to the better outlook for inflation tightening moves might be needed, market interest but also in anticipation of an easing of monetary rates climbed throughout the first quarter, and restraint by the Federal Reserve. The System began money growth was subdued. to provide reserves slightly more generously through Over the course of the second quarter, a number open market operations at the beginning of June, of indicators suggested the emergence of conditions and took an additional small easing step in early that were more conducive to a future easing of infla July. This helped bring about a further decline in tionary pressures. Growth of the monetary aggregates market rates of interest, which by mid-July generally weakened further, with M2 running noticeably had more than retraced the increases that had occurred earlier in the year. Most short-term interest rates were down about 1/2 percentage point from Foreign Exchange Value of the their December levels, while long-term rates had U.S. Dollar* Index, March 1973 -100 fallen as much as 1 percentage point on balance. Monetary Policy for 1989 and 1990 150 In February, the Federal Open Market Committee (FOMC) specified a range for M2 growth in 1989 125 that was a full percentage point below that of 1988 and ranges for M3 and debt that were 1/2 percent 100 age point below those of the prior year. This was the third consecutive year in which the ranges had been lowered. In February, the Committee had anticipated rela 1983 1984 1985 1986 1987 1988 1989 tively slow money growth over the first half of the *Index of weighted average foreign exchange value of U.S. dollar in terms of cur year, because of the effects of the firming of policy rencies of other G-10 countries plus Switzerland. Weights are 1972-76 global through late 1988 and intr. 1989. In addition to the trade of each of the 10 countries. influence of the higher interest rates on desired hold- 2 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Ranges of Growth for Monetary and that the economic and financial outlook over the Credit Aggregates 1 next year and a half is uncertain; in particular, it is unclear at this juncture whether the velocities of M2 (Percent Change, Fourth Quarter to Fourth Quarter) and M3 are more likely to trend higher or lower Provisional for next year. Although the Committee's initial assess 1988 1989 1990 ment is that growth of money and credit through 1990 within the bounds of the reduced ranges of this M2 4 to 8 3 to 7 3 to 7 year likely would foster the slower inflation and sus tained real economic expansion that it is seeking, it M3 4 to 8 3 ½ to 7 ½ 3 ½ to 7 ½ will reevaluate the ranges next February in light of Debt 7 to 11 6½ to 10½ 6½ to 10½ the unfolding economic and financial situation. The outlook for spending, prices, and financial markets in 1990 should have clarified somewhat by then, as should the influence on monetary expansion of the ings of money, however, several special factors ongoing resolution of thrift industry problems. For including the difficulties of the thrift industry and a the long term, the Committee recognized that ulti drawdown of liquid assets to meet unusually large mate attainment of price stability will require that individual tax payments-appear to have further the ranges for money and credit growth be reduced reduced money balances in the first half. These fac further in future years. tors contributed to a substantial rise in velocity, the ratio of nominal GNP to the stock of money. Economic Projections for 1989 and 1990 By June, money growth had picked up. Nonethe less, M2 ended the quarter just 2 percent at an Members of the Committee and other Reserve Bank annual rate above the fourth quarter of last year, presidents believe that the monetary ranges specified compared with its 3 to 7 percent annual growth are consistent with some progress in reducing infla range. In June, M3 was at the lower end of its 3 ½ tion, which likely will be associated in the near term to 7 ½ percent annual range. The rate of expansion with continuation of a slower pace of economic of domestic nonfinancial sector debt also slowed in growth. The central tendency of the forecasts is for the first half of this year compared with 1988, increases in real GNP of 2 to 2 ½ percent in 1989 though by less than the monetary aggregates; debt and of 1 ½ to 2 percent in 1990. has grown about 8 percent so far this year, near the The expected easing of pressures on resources middle of its 6 ½ to 10 ½ percent monitoring range. should contribute to a damping of inflation in 1990, At its meeting earlier this month, the Committee although the Board members and Reserve Bank agreed to retain the current ranges for growth of presidents also are anticipating some near-term relief money and debt in 1989. The Committee anticipates from the special problems that boosted prices in the that by the fourth quarter all three aggregates will first half of this year. More ample harvests later this be well within those ranges. The more rapid growth year should result in more favorable behavior of in M2 and M3 already evident since mid-May is food prices, and the recent peaking of crude oil expected to extend through the second half. The prices suggests the likelihood of some softening in recent declines in short-term market interest rates consumer energy prices. Thus, retail inflation should have made M2 holdings more attractive, tending to be considerably slower over the remainder of this offset the restraining effects on M2 of previous year, and the central tendency of CPI forecasts for interest rate increases. Domestic nonfinancial debt is 1989 as a whole is 5 to 5 ½ percent-compared with likely to remain in the middle portion of its range the more than 6 percent rate observed through May. through year-end. The forecasts for the CPI in 1990 center on 4 ½ to 5 For 1990, the Committee provisionally decided to percent. use, for all three aggregates, the same growth ranges in force for 1989. The Committee recognized 3 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis In an environment of relatively slow overall exports will depend importantly on economic growth growth, such as is expected by the FOMC members, abroad, which may slow as a result of policy actions some industries and regions are likely to experience taken by some of our major trading partners to off setbacks, but major imbalances that could threaten set mounting inflationary pressures. the continuation of the economic expansion are not A key ingredient in maintaining a healthy pace of anticipated. In the household sector, growth of con economic expansion is further progress in reducing sumer purchases has been sluggish and may remain the federal budget deficit. Taking the actions so for a while. Residential construction activity required to meet the Gramm-Rudman-Hollings tar should pick up some in coming months. gets on schedule will foster confidence in the U.S. The external sector represents an area of consider economy, particularly among financial market par able uncertainty in the economic outlook for the ticipants. At the same time, reduced demands by the next year and a half. Real net exports of goods and federal government for credit will free up the avail services increased earlier this year, but improve able supply to interest-sensitive private sectors, such ments may be more difficult to achieve in the period as housing and business investment. The Committee ahead as the effects of past depreciation of the dollar thus views as highly encouraging the commitments wear off and are offset by those associated with the expressed by the Congress and the Administration to more recent appreciation. In addition, the path of begin soon to address the problems of meeting the fiscal 1991 budget target. Economic Projections for 1989 and 1990 FOMC Members and other FRB Presidents Administration 1989 Range Central Tendency Nominal GNP 5 to 7¾ 6 to 7 7.1 Percent change, fourth quarter to Real GNP 1 ½ to 2¾ 2 to 2½ 2.7 fourth quarter: Consumer price index 4½ to 5¾ 5 to 5½ 4.91 Average level in the fourth quarter, Civilian unemployment rate 5 to 6 Around 5 ½ 5.32 percent: 1990 Range Central Tendency Nominal GNP 4¼ to 7½ 5½ to 6¾ 6.8 Percent change, fourth quarter to Real GNP 1 to 2 ½ 1 ½ to 2 2.6 fourth quarter: Consumer price index 3 to 5¾ 4½ to 5 4.11 Average level in the fourth quarter, Civilian unemployment rate 5 to 6 ½ 5½ to 6 5.42 percent: 1. CPI-W. FOMC forecasts are for CPI-U. 2. Percent of total labor force, including armed forces residing in the United States. 4 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis The Performance of the Economy during the First Half of 1989 After two years of rapid expansion, economic The External Sector activity decelerated substantially in the first half of Developments in foreign exchange markets have 1989. Even so, job creation was considerable played an important role in shaping events in the nearly 1 ½ million between December and June domestic economy in recent years. After depreciat and the civilian unemployment rate, fluctuating ing over most of the period from 1985 to late 1987, around 5 ¼ percent, remained in the lowest range the foreign exchange value of the dollar in terms of since the early 1970s. other G-10 currencies changed little, on net, in 1988 as a decline in the final few months reversed Quarterly much of the increase that had occurred earlier in the Civilian Unemployment Rate average, percent year. In December the dollar began to rebound, and it rose substantially through mid-June before drop ping back somewhat. The appreciation of the dollar 10 through the first half of 1989 was frequently met by concerted intervention sales of dollars by U.S. and foreign monetary authorities. 8 Measured in terms of a trade-weighted average of the other G-10 currencies, the dollar is about 8 per cent higher than in December 1988 and about 12 6 percent higher than in December 1987. After adjust ment for changes in relative price levels, the appreciation of the dollar has been larger, because 1983 1984 1985 1986 1987 1988 1989 U.S. inflation has remained above the average for the other G-10 countries. Meanwhile, the currencies of South Korea and Taiwan have risen moderately Inflation rose in the first half of 1989, but most of against the dollar so far in 1989. the increase appears to have resulted from transitory The U.S. merchandise trade deficit in the first events. In particular, energy prices increased quarter was $110 billion at a seasonally adjusted sharply, as the rise in crude oil prices between annual rate, significantly better than the figure for November 1988 and May 1989 was passed through, the fourth quarter and that for 1988 as a whole. In and food prices surged as the agriculture sector con the first two months of the second quarter, the trade tinued to experience adverse supply developments. deficit was essentially unchanged from the first Outside food and energy, the rate of inflation has, quarter pace. on average, remained at about its 1988 pace, even in the face of relatively high levels of resource Annual rate, utilization. U.S. Real Merchandise Trade billions of 1982 dollars This apparent stability of underlying price trends is attributable in part to the appreciation of the dol 500 lar on exchange markets. So far in 1989, prices of Imports Ql imported goods other than oil have been virtually 400 flat on average, restraining increases in the prices of domestically produced items. In addition, despite the __ .,,,. 300 tightest labor markets in some time, wage trends __, have been fairly stable, helping to limit the accelera ____________ Exports 200 tion in unit labor costs during a period in which productivity has weakened. 1983 1984 1985 1986 1987 1988 1989 5 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Exports have continued to expand this year, Percent of Personal Saving although not so rapidly as in 1988. Export gains disposable income have been broadly based, with notable increases for agricultural goods, industrial supplies, capital goods, 8 and consumer goods. Meanwhile, imports have increased moderately; in fact, average imports of 6 products other than petroleum in April and May Ql were less than 1 percent above their fourth-quarter rate. Notable decreases were recorded in imports of 4 consumer goods and automotive products. So far in 1989, the value of oil imports has risen sharply, as 2 higher prices for petroleum and petroleum products were accompanied by a small increase in physical volume. 1983 1984 1985 1986 1987 1988 1989 The current account deficit widened in the first quarter to $123 billion. The increase from the Residential construction declined over the first fourth-quarter rate was more than accounted for by half in response to the rise in interest rates and to capital losses on assets denominated in foreign cur earlier overbuilding in some markets. rencies resulting from the dollar's appreciation. Set Starts in the single-family sector averaged about ting aside those losses, the current account balance 1 milljon units at an annual rate between March in the first quarter showed a deficit of $108 billion, and May, a period relatively free from the weather an improvement of about $22 billion from the pre related distortions that affected construction in vious quarter. January and February. Meanwhile, multifamily starts fell further in the The Household Sector first half of the year from the already low level Much of the slowing in overall economic growth in recorded in 1988. the first half of 1989 reflected a deceleration in con sumer spending. The slump in demand was fairly The Business Sector broad, encompassing a variety of durable and non In contrast to the household sector, business capital durable goods. spending strengthened in early 1989. In the first The personal saving rate has been on a distinct quarter of 1989, real business fixed investment rose upswing since reaching a forty-year low in mid-1987. at an annual rate of 7 ½ percent, and such spending Several explanations have been propounded for the appears to have increased substantially further in the recent rise, among them the lower level of household second quarter. net worth relative to income since the stock market Particularly noteworthy in the first quarter was a break of 1987, higher costs of consumer credit ( espe sharp rise in outlays for industrial machinery. cially in aftertax terms, because of the phase-down Increases in that area, which includes spending for of interest deductibility), and concerns about a fabricated metal products, engines, turbines, and a potential softening of the economy. Whatever the variety of other types of industrial apparatus, have cause, households appear to have adopted a more been exceptionally strong since mid-1987. Spending cautious spending stance, though it also should be for high-technology equipment also has been robust. noted that the personal saving rate has remained Inventory investment slowed over the first five below the norms of the 1960s and 1970s. months of 1989, as businesses adjusted with appar ent promptness to the more moderate expansion of final demand. 6 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis In the first quarter of 1989, before-tax economic the first half of this year. On the other hand, growth profits of nonfinancial corporations declined, in part has continued in entitlement spending (principally because unit labor costs increased as sales growth Medicare and Social Security) and in net interest slowed and productivity deteriorated. The drop in outlays. profits was spread over most types of businesses; the Federal receipts have grown even more rapidly largest decline was in the manufacturing sector, than outlays, buoyed by increases in employment which had especially strong gains in both 1987 and and income. 1988. Real purchases of goods and services by state and local governments have been on a moderate uptrend this year. Outlays for personnel and construction in Real Business Percent change from end of the education and law enforcement areas have been Fixed Investment previous period, annual rate subject to considerable upward pressure. Some other expenditures have risen because of federal mandates, D Structures l!ill Producers' Durable Equipment especially those in recent health legislation. As in the federal sector, growth of state and local outlays has 40 been tempered by budgetary pressures; excluding retirement trust funds, which are running a large surplus, the sector had a deficit of about $17 billion at an annual rate in the first quarter. 20 Labor Markets Job growth was substantial over the first half of + 1989, though it slowed in the spring. In the first quarter, additions to nonfarm payrolls averaged 264,000 a month, about the same pace seen over the prior two years. By spring, hiring had begun to slow, and payroll employment growth dropped back 1983 1984 1985 1986 1987 1988 1989 to 200,000 per month in the second quarter as a whole. The Government Sector Nonfarm Payroll In the first quarter, real federal purchases of goods Net change, millions Employment and services, the part of federal outlays that is of persons, annual rate counted directly in GNP, were virtually unchanged. D Total fl!!I Manufacturing Such purchases are dominated by defense; nominal 4 spending authority in this area has been virtually [l 8_ [l [l flat since 1985, and procurement of some major new [l: DL ff 2 weapon systems is winding down. + On a unified budget basis, total nominal outlays for the fiscal year through May were more than 2 6 percent above the comparable year-earlier total. Spending related to the thrift institution problem spiked at year-end 1988 and then dropped sharply in 1983 1984 1985 1986 1987 1988 1989 7 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis The moderation in the growth of the demand for Increases in retail food prices were large in the labor in the second quarter did not lead to any first half of 1989, in part reflecting the lingering appreciable reduction in labor market tightness. The effects of last summer's drought and additional dam unemployment rate has fluctuated between 5. 0 and age to some crops this year. From the beginning of 5.4 percent thus far this year; in June it stood at 5.3 the year through May, the rise in the CPI for food percent. was close to 8 percent at an annual rate. Although Average hourly earnings of production and non drought curtailed the winter wheat crop for 1989, supervisory workers accelerated from late 1986 total crop acreage has expanded, and overall produc through mid-1988; since then the rate of increase has tion should rebound this year, if weather conditions flattened out, and in June earnings were up 3 ¾ per are satisfactory. cent from a year earlier. The employment cost index for wages and salaries in the private nonfarm sector, Percent change from end of a broader measure of wages that is available only Consumer Prices* previous period, annual rate through March, indicated some easing of wage trends in the goods-producing sector; however, in the service-producing industries, the trend remained sharply upward. Total compensation per hour wages and salaries plus benefits-was up 4 ½ per cent over that period, in the same range as the 12:-month increases recorded in the preceding three quarters. Productivity performance has deteriorated some what in recent quarters. Price Developments Inflation increased sharply in early 1989, reflecting higher costs for food and energy. The consumer price index for all items, a broad-based measure for finished goods and services, rose at an annual rate more than 6 percent through May, compared with the 4 ½ percent pace in 1987 and 1988. The pro ducer price index for finished goods recorded an 1983 1984 1985 1986 1987 1988 1989 even more pronounced acceleration, owing to the •Consumer Price Index for all urban consumers. greater importance of food and energy in that index. • •Percent change from December 1988 to May 1989. However, the underlying inflation trend has not deteriorated: excluding food and energy, inflation at Excluding food and energy, prices for commodi the retail level has been running at a rate of around ties at the consumer level have risen at a rate 4¾ percent, about the same as in 1988. slightly lower than that recorded for 1988. A marked Energy prices began rising sharply last November, diminution of increases in non-oil import prices after the OPEC nations agreed to limit crude oil associated with the appreciation of the dollar appar production. Subsequently, temporary supply disrup ently has restrained the prices of many goods, tions in Alaska and in the North Sea added to price notably apparel and a variety of household items. In pressures. Energy prices at the producer level contrast, inflation in the service sector has increased, soared, and consumer energy prices rose nearly 25 especially in labor-intensive services, such as medical percent at an annual rate between December and care, entertainment, and public transportation. May. More recently, posted prices of crude oil have remained between $19 and $20 per barrel. 8 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Monetary Policy and Financial Developments during the First Half of 1989 In conducting monetary policy over the first half of Many interest rates began to move off their the year, the Federal Open Market Committee con March highs early in the second quarter as indica tinued its effort to foster long-run price stability, so tions mounted of moderation in the pace of eco as to build a base for sustainable expansion of the nomic activity and in underlying price pressures. economy. In again reducing the ranges for money Market expectations of some additional tightening of and debt growth at its February meeting, the Com monetary policy shifted to anticipations of an easing. mittee recognized that restraint on the expansion of The FOMC eased policy slightly at the beginning money and credit would be needed to promote this of June and again in early July. The federal funds goal. rate moved down about 1/2 percentage point in two Relatively wide monetary ranges-4 percentage steps to around 9 ¼ percent. Evidence that the more points in breadth-were retained, in part to take moderate pace of economic activity was persisting, account of the substantial interest-rate sensitivity of indicators of the behavior of wages and sensitive money demand over horizons of as long as a year prices, and the weakness of the monetary aggregates and of the unpredictable effects on money demand all were consistent with a prospective ebbing of of the resolution of the crisis in the thrift industry. inflationary pressures. Moreover, the dollar was Moreover, in these circumstances, the Committee appreciably above year-end levels, which could be recognized that, in addition to the behavior of the expected to have favorable effects in restraining monetary aggregates, a variety of indicators of infla inflation. While inflation remained a concern, an tionary pressures and the course of economic activity intensification of price pressures did not appear to would have to be taken into account in shaping be a present danger, and the risks of cumulating policy over 1989. weakness in the economy had increased. The Implementation of Monetary Policy M2 Billions of Dollars As noted previously, developments early in 1989 suggested that a worrisome risk remained that infla tion was picking up and could become more deeply 3250 embedded in the economy. Wage and benefit costs had accelerated in 1988, and the readings for the 3150 consumer and producer price indexes were trou bling. Extending the move toward restraint that began almost a year earlier, the Federal Reserve 3050 increased reserve market pressures at the start of this year and again in mid-February. On February 24 the discount rate was raised 1/2 percentage point 2950 to 7 percent. These policy actions were accompanied by marked increases, of about a percentage point, in most 0 N D J F M A M J J A S O N D short-term interest rates. Yields on long-term securi 1988 1989 ties also moved up, but by considerably less than short-term rates. The foreign exchange value of the dollar strengthened as interest rates in the United States rose relative to those abroad. Money growth slowed: M 1 was roughly flat in the first quarter, and M2 and M3 decelerated from already reduced rates in the second half of 1988. Digitized for FRASER 9 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis The Behavior of the Monetary Aggregates however, was heavy reliance by thrift institutions on Federal Home Loan Bank advances and other bor Growth of the monetary aggregates was quite slug rowings, which are not included in the money stock. gish over the first half of 1989, reflecting the effects M3 growth edged down a bit in the second quarter of increases through March in market interest rates with some easing of bank credit demands and strong relative to returns on monetary assets, some deposi growth in government deposits-also not included in tor concern o~~r the problems of the thrift industry, the money stock-resulting from the large volume of and large tax 'payments by individuals. From the tax payments. By June, however, M3 had rebounded fourth quarter of 1988 through June, M2 edged up as tax effects unwound. at an annual rate of only 2 percent, markedly below last year's pace of 5 ¼ percent. M2 velocity rose Credit Flows sharply through the second quarter. Even so, as depositors rebuilt their holdings of monetary assets, The aggregate debt of domestic nonfinancial sectors M2 grew at an annual rate of 6 ¾ percent in June. expanded at an annual rate of close to 8 percent M3 grew at an annual rate of 3 ½ percent from over the first half of this year, near the midpoint of the fourth quarter of last year to June, placing it at its monitoring range and down somewhat from its the lower bound of its target range. In the first 1988 pace. The growth of federal sector debt slowed quarter, expansion of M3 was subject to offsetting as tax receipts surged. Expansion of the debt of non forces. It was bolstered somewhat by bank funding federal sectors also moderated, partly in response to needs generated by strong demand for business higher levels of market interest rates over much of loans. Added demand for commercial and industrial the first half of the year. Household borrowing in loans stemmed both from merger-related financings mortgage markets slowed as increases in lending and from shifts to short-term borrowing by busi rates damped housing demand, while the pace of nesses facing rising long-term interest rates and consumer borrowing slackened along with the investor concerns about '' event risk'' -the possibility deceleration in consumption spending. that a firm's debt obligations would be significantly Mortgage lending by thrift institutions did not downgraded in a corporate buyout or restructuring. appear to be unusually weak in the first few months Acting to damp M3 growth over the first quarter, of 1989, given the prevailing interest rates. These institutions coped with weak deposit flows by run ning off cash and investments and, through the first M3 Billions of Dollars quarter, stepping up borrowing from the Federal Home Loan Banks. Despite signs of a reduction in 4150 mortgage lending activity by these institutions in the second quarter, the overall availability of housing 4050 credit did not appear to be significantly impaired. Total borrowing by nonfinancial businesses in the first half of the year was close to its 1988 pace. 3950 Credit demands continued to be buoyed by sizable merger-related financing in the first quarter, and an 3850 apparent pickup in capital expenditures increased business borrowing in the second quarter even as 3750 credit demands related to mergers and restructur ings, while still strong, eased a bit. 0 N D J F M A M J J A S O N D 1988 1989 10 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Growth of Money and Debt (Percent) Debt of Domestic Mt M2 M.3 N onfinancial Sectors Fourth quarter to 1979 7.7 8.2 10.4 12.3 fourth quarter 1980 7.4 9.0 9.6 9.6 1981 5.2 (2.5)* 9.3 12.3 10.0 1982 8.7 9.1 9.9 9.0 1983 10.2 12.1 9.8 11.3 1984 5.3 7.7 10.5 14.2 1985 12.0 8.9 7.7 13.2 1986 15.6 9.3 9.1 13.4 1987 6.4 4.2 5.7 9.8 1988 4.3 5.2 6.2 8.9 Quarterly growth Q1 -.4 1.9 3.7 8.2 rates 1989 (annual rates) Q2 -5.5 1.3 3.1 7.4e *M1 figure in parentheses is adjusted for shifts to NOW accounts in 1981. e-estimated Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Footnotes 1. Ml is currency held by the public, plus travelers' checks, plus demand deposits, plus other checkable deposits [including negotiable order of withdrawal (NOW and Super NOW) accounts, automatic transfer service (ATS) accounts, and credit union share draft accounts]. M2 is M 1 plus savings and small denomination time deposits, plus Money Market Deposit Accounts, plus shares in money market mutual funds ( other than those restricted to institutional investors), plus overnight repur chase agreements and certain overnight Eurodollar deposits. M.3 is M2 plus large time deposits, plus large denomi nation term repurchase agreements, plus shares in money market mutual funds restricted to institutional investors and certain term Eurodollar deposits. A copy of the full report to Congress is available from Publication Services, Federal Reserve Board, Washington, D.C. 20551 FRB16-48000-0789 12 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis

Federal Reserve (1989, July 19). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_19890720

@misc{wtfs_monetary_policy_report_19890720,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {1989},
  month = {Jul},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_19890720},
  note = {Retrieved via When the Fed Speaks corpus}
}