Monetary Policy Report

1991 MONETARY POLICY OBJECTIVES Summary Report of the Federal Reserve Board February 20, 1991 1991 MONETARY POLICY OBJECTIVES This Executive Summary provides highlights of the Board's Review to the Congress on the Full Employment and Balanced Growth Act of 1978. February 20, 1991 Contents Section Page Monetary Policy and the Economic Outlook for 1991 3 Monetary Policy for 1991 4 Economic Projections for 1991 5 The Performance of the Economy 1n 1990 7 Price Developments 8 The Household Sector 9 The Business Sector 10 The Government Sector 11 The External Sector 12 Labor Markets 12 Monetary and Financial Developments during 1990 14 The Implementation of Monetary Policy 14 Behavior of Money and Credit 16 Monetary Policy and the Economic Outlook for 1991 When it reported to Congress last July, the Federal coupled with the drop in oil prices since mid-autumn, Reserve was anticipating that the economy would have given the Federal Reserve greater latitude in continue to grow in the second half of 1990. recent months to focus on steps that will aid in Although the first half had been far from robust, bringing about economic recovery, without jeopardiz with problems clearly evident in some industries and ing continued progress toward price stability. regions, the economy still was expanding and was In fact, as it became clear that the inflationary afflicted with neither the inventory imbalances nor spillover of the oil shock was being effectively con the escalating inflationary pressures that had tained, and that an appreciable economic contraction preceded past cyclical downturns. Indeed, it seemed posed the greater risk, the Federal Reserve did ease at midyear that the goal of achieving a reduction of policy markedly. Earlier in the second half, policy inflation in the context of continued expansion might already had moved to a slightly more accommoda well be attainable. tive stance, first in July, to offset the effects on the But in August the economy was jolted off course economy of apparent restraint in private credit sup by the Iraqi invasion of Kuwait. The surge in oil plies, and again in October, when prospective reduc prices that followed the invasion gave additional tions in federal budget deficits enabled interest rates impetus to inflation, and it also portended a weaken to decline. Over the balance of the year and into ing of activity as the price increases cut sharply into 1991, money market rates were reduced substantially domestic purchasing power. Uncertainties about the further through open market operations and two course of the economy were heightened enormously, half-point decreases in the discount rate. In total, and household and business sentiment plummeted most short-term rates have fallen nearly 2 percent almost overnight, a response that perhaps grew in age points since mid-1990, with most of the decrease part out of memories of the difficult adjustments occurring during the last few months, and long-term that had followed previous oil shocks in the 1970s. rates are about a half percentage point lower than At the time of the invasion, and on into the they were at midyear. Falling interest rates have autumn, sentiment also was being affected by the contributed to an appreciable decline in the dollar considerable uncertainty that existed regarding the since mid-1990. course of fiscal policy. The behavior of the monetary aggregates and Actual production and spending held up for a credit was an important consideration in the Federal time after the oil shock, but started to decline in Reserve's decisions to ease policy over recent months. early autumn. The production cuts reduced real M2 and M3 ended 1990 within the ranges set by incomes still further and added to the cumulating the Federal Open Market Committee (FOMC), but forces of contraction, which included a continued they were in the lower parts of those ranges, and shift toward greater caution by lenders. The econ their expansion over the fourth quarter and into omy thus fell into recession in the latter part of 1990, early 1991 has been quite sluggish. The sluggishness and, given the further declines in employment and of the aggregates during this period was worrisome production that were seen in January, that recession because it suggested that the economy was weaker clearly has continued into the early part of 1991. than anticipated and because it indicated the possi The secondary wage-price pressures that many bility of some undesirable restraint on future spend had expected to see after the oil shock have not been ing through constricted credit intermediation by much in evidence, probably because those pressures depository institutions. In particular, the thrift have been countered by the softening of aggregate industry has been contracting, and banks, concerned demand. The underlying rate of increase in prices about the credit quality of borrowers and facing began to drop back over the last few months of pressures on capital positions, have become increas 1990. In addition, the rate of increase in nominal ingly reluctant to lend, raising interest margins and wages and benefits, which already had started to tightening nonprice terms. To bolster lending incen slow in the third quarter, decelerated further in the tives, the Federal Reserve in December eliminated fourth quarter. These wage and price developments, the reserve requirements on nonpersonal time deposits and net Eurocurrency liabilities. 3 To a significant extent, however, overall credit Ranges for Growth of Monetary and flows have been sustained by sources outside deposi Credit Aggregates1 tories; thus, debt of the domestic nonfinancial sectors (Percentage Change, Fourth Quarter to Fourth Quarter) grew 7 percent in 1990 and ended in the middle of the FOMC's monitoring range for this aggregate. 1989 1990 1991 The effective substitution of non-depository credit for depository credit made it possible to achieve a M2 3 to 7 3 to 7 2 ½ to 6 ½ greater amount of nominal income and expenditure M3 3 ½ to 7 ½ 1 to 5 1 to 5 growth for a given expansion of the money stock. One facet of this process was a shifting by the public Debt 6 ½ to 10½ 5 to 9 4½ to 8 ½ out of assets that are included in the monetary aggregates and into holdings of Treasury issues and other securities. Velocity, the ratio of nominal gross Taking account of these effects, the Committee national product (GNP) to the money stock, decided that the ranges for 1991 that were chosen on exhibited surprising strength: M2 velocity was about a provisional basis last July remain appropriate for unchanged in 1990, even though declines in interest achieving its objectives. The ranges for M2 and debt rates ordinarily are associated with falling velocity, are a half percentage point below those for 1990-a and M3 velocity registered an unusually large further step to ensuring that longer-run trends in mcrease. money and credit growth are moving toward con sistency with the achievement of price stability. At Monetary Policy for 1991 the same time, they allow for money and credit In considering its plans for monetary policy for growth sufficient to support a rebound in the 1991, the Federal Open Market Committee focused economy this year; moreover, the ranges should on two objectives, consistent with the goals of the provide ample room for any policy adjustment that Full Employment and Balanced Growth Act: One may be required by unanticipated developments in was to foster an upturn in activity and thus higher the economy or the financial sector as the year levels of employment and real income; the other was progresses. to contain and reduce inflation over time, to max The M2 range for 1991 is 2 ½ to 6 ½ percent. imize the efficiency of resource allocation and long Growth in this aggregate is expected to strengthen range growth and to minimize the capricious and from the sluggish pace of recent months, partly in inequitable effects of inflation on the wealth of lagged response to the substantial easing of money savers. The translation of these objectives into market conditions over the past few months. While specific ranges for money and debt was complicated acknowledging some uncertainty about developing by the effects of the ongoing restructuring of credit velocity relationships, Committee members stressed flows. Again this year, a number of insolvent thrift that M2 expansion noticeably above the lower end institutions are likely to be closed, with many of of the range likely would be needed to foster a satis their assets ending up at the Resolution Trust Cor factory performance of the economy in 1991. poration (RTC) or disbursed to a wide variety of The 1 to 5 percent range for M3 was not reduced investors; at other thrifts and at banks, restraints on from that for 1990. That range was already at an lending may moderate a bit, but growth in deposi unusually low level in recognition of the accelerated tory credit is likely to continue to be constrained by pace of the restructuring of the thrift industry. pressures on capital positions. The rechanneling of credit outside of depository institutions is expected to continue to distort the relationship of money to income, buoying the velocities of both M2 and M3. 4 Credit growth in 1991 is expected to be moderate Economic Projections for 1991 and to occur largely outside of depositories. Conse The economic outlook is unusually difficult to assess quently, total funding needs of depositories are at this time, owing not only to the obvious uncer expected to be damped, keeping the growth of M3 tainties associated with the war in the Gulf, but also quite low and raising its velocity furth:r. to some unresolved problems in the economy. How The monitoring range for nonfinanc1al sector debt ever, the members of the Board of Governors and for 1991 was set at 4 ½ to 8 ½ percent. Federal bor the presidents of the Reserve Banks, all of who~ rowing is expected to be robust, owing in part to the participate in the discussions of the FOMC, believe_ R TC and also to the effect of the weak economy on that the most likely outcome is that the economy will the f~deral budget deficit. By contrast, borrowing by swing back into expansion later this _year .. At t~e domestic nonfederal sectors is likely to be slow, same time, they also anticipate that mflat10n will be though still consistent with a rebound in the economy. much lower in 1991 than it was in 1990. On the demand side of the credit market, house With regard to real gross national product, the holds and businesses appear to be returning to central tendency of the FOMC participants' fore sounder financial practices, seeking a healthier bal casts is for a gain over the four quarters of 199_1 of ance between debt and the income available to ser 3/4 to 1 ½ percent. This is in line with the projec vice it. At the same time, restraints on the supply of tion of the Administration, which anticipates an out credit also may continue to play a role, with some put gain of 0.9 percent. With these GNP forecasts private borrowers facing higher interest rates and so similar, the forecasts of unemployment also are tighter nonprice terms on credit, in part because of about the same: the Committee's central tendency the stresses faced by many intermediaries. In that projections fall in a range of 6 ½ to 7 percent in the regard, the Federal Reserve is working with other fourth quarter of 1991 , a range that brackets the federal regulatory agencies to ensure that bank Administration's forecast. On the other hand, the supervisory practices, while prudent and_ fair, do not Board members and Bank presidents are more unduly impede the flow of funds to creditworthy optimistic on average than is the Admini~trati?n borrowers. with regard to the prospects for reduced mflat10n. Economic Projections for 1991 Measure 1990 Actual FOMC Members and other FRB Presidents Administration Range Central Tendency Nominal GNP 4.3 3 ½ to 5 ½ 3 ¾ to 5 ¼ 5.3 Percentage change, fourth quarter to Real GNP .3 - ½ to 1 ½ ¾ to 1 ½ .9 fourth quarter: 1 Consumer price index 2 6.3 3 to 4½ 3¼ to 4 4.3 Average level in the fourth quarter, Unemployment rate 5.9 6¼ to 7 ½ 6 ½ to 7 6.6 percent: 3 1. Average for the fourth quarter of the preceding year to the average for the fourth _quarter of the year indicated. . A t 1 d FOMC forecasts are for all urban consumers; Administration forecast 1s for urban wage earners an~ clerical workers. . . ~: P;r~:nt:;e of the labor force. Actual and FOMC forecasts are for the civilian labor force; Administration forecast 1s for the total labor force, mcludmg armed forces residing in the United States. 5 The central tendency range for the consumer price Meanwhile, the prospects for exports, and for our index (CPI) increase this year-3 ¼ to 4 percent overall trade and current account balances, continue compares with an Administration projection of to look favorable, given the improved competitive 4.3 percent. The Administration's forecast for nomi ness of U.S. producers. And, any pickup in final nal GNP is at the upper end of the FOMC central demand, whether from domestic buyers or from tendency range, and thus also would be compatible abroad, should translate fairly quickly into increased with the FOMC's monetary ranges. production, in view of the success that businesses In discussing their projections, the Board members seem to have had in preventing a buildup of inven and Bank presidents stressed that the war introduces tories in recent months. a major imponderable into an outlook that, even As stated earlier, the Board members and Reserve before, had been subject to considerable uncertainty. Bank presidents project a marked slowing of infla The demands of the war on the economy are not tion in 1991. A key assumption underlying these fully clear at this point. Nor is it possible to forecast forecasts is that oil prices will hold in their recent with any precision how household and business con range, at a much lower level than prevailed through fidence will respond to the course of events in the the autumn of 1990. The pass-through of these Gulf. Among the significant unresolved economic lower oil prices to consumers is expected to result in and financial problems elsewhere in the economy are a sharp decline in retail energy prices. In addition, those in the real estate markets; commercial con increases in wages and benefits seem likely to be struction, in particular, still is plagued by a large more moderate this year, reducing the pressures of overhang of vacant space that will severely limit new labor costs on profit margins and prices. To be sure, construction for some time to come. On the finan there are some near-term negatives in the inflation cial side, the overexuberance and loose lending prac picture: labor expenses are being boosted by legis tices of the 1980s have given way to large losses and lated increases in employers' contributions for social extreme caution among some lenders, who may not security and by a further rise in the minimum wage, be able or willing at present to shift quickly back and prices are being affected by a rise in postal rates toward more normal lending behavior. Because of and increases in various excise taxes. All told, how these problems, the Board members and Bank presi ever, the coming year appears likely to be one in dents perceive that, in the near term, the risks to which overall price increases will be considerably the economy may be skewed to the downside. smaller than in 1990 and in which the downward tilt On the other hand, some of the potential under of the underlying inflation trend should begin to pinnings of recovery also are evident. For example, stand out more clearly. with the further decline in oil prices since the start of 1991, much of the surge that followed the Iraqi invasion of Kuwait now has been retraced; in a reversal of the effects seen earlier, this drop in oil prices is taking pressure off inflation, and it also is augmenting real purchasing power, which will help to bolster spending. Also working in the direction of supporting spending is the decline in interest rates since the spring of 1989. In contrast to past business cycles, when declines in rates usually did not come until the economy was softening, this decline began far in advance of the peak in activity and its effects on spending should begin to be felt, especially in sectors like housing, where affordability has been considerably enhanced over the last year and a half. 6 The Performance of the Economy • 1990 Ill When 1990 began, the economy was in its eighth Real GNP Percentage change, Q4 to Q4 year of expansion, and it remained on a positive course into the summer. During this period, prob lems were evident in some sectors of the economy, notably construction, where activity was being damped by the persistence of high vacancy rates, 4 and finance, where a significant number of institu tions were encountering difficulties that reduced their ability or willingness to provide credit. Overall, however, production and spending still were on a course of expansion at midyear, and while the rate 2 of price increase had not yet started to abate, there were indications that the groundwork for achieve ment of slower inflation was coming into place with out major disruption to the economy. + Then, in early August, the Iraqi invasion of Kuwait set off a chain of events that gave further impetus to inflation and tilted the economy from a path of slow growth to one of contraction. Declines in output and employment were widespread during the remainder of 1990. Real gross national product 1985 1986 1987 1988 1989 1990 fell at an annual rate of about 2 percent in the fourth quarter, and the gain over the four quarters of the year amounted to only 0.3 percent. The While surging energy prices accounted for much civilian unemployment rate, which had held around of the acceleration in inflation in 1990, they were by 5 ¼ percent through the first half of the year, moved no means the only source of upward price pressure. up steadily in the second half, to 6.1 percent in The year-to-year rate of increase in the CPI exclud December. In January of this year, the rate edged ing food and energy-a rough indicator of basic up further, to 6.2 percent. The consumer price inflation trends-maintained a gradual upward tilt index rose 6 .1 percent from December of 1989 to through the first three quarters of 1990, peaking at a December of 1990, the largest annual increase in rate of 5.5 percent in August and September; a nearly a decade. slight easing of price pressures over the balance of 1990 brought that rate back down to 5.2 percent by year-end. The year-to-year rate of increase in nomi nal labor compensation, as measured by the employ ment cost index, also moved up in the first half of 1990; after mid-year, however, wage pressures moderated, and the rise in nominal compensation over the year ended up at 4.6 percent, slightly less than the increases recorded in each of the two previ ous years. 7 Support for growth of real activity continued to The CPI for energy rose 18 percent from Decem come from the external sector in 1990, as the real ber of 1989 to December of 1990. Over the year, exports of goods and services rose 5 percent over the fuel oil prices increased about 30 percent at the con four quarters of the year; this gain, however, was sumer level, and gasoline prices were up almost considerably smaller than the increases seen in each 37 percent. By contrast, increases over the year of the four previous years. Gross domestic purchases, in the prices of the service fuels ( natural gas and the broadest indicator of domestic demand, fell electricity) were quite small-in the range of about 1/4 percentage point, on net, over the four 1 ½ to 2 percent. quarters of 1990; within this category an increase in The consumer price index for food rose 5. 3 per government purchases was more than offset by cent in 1990; this increase was about the same as weakness in consumption, homebuilding, and busi those seen in 1988 and 1989. Over the preceding ness fixed investment and a swing in inventories few years, food price increases had tended to run from moderate accumulation late in 1989 to more in the 3 to 4 percent range. decumulation in the fourth quarter of 1990. The CPI for nonenergy services (which accounts for more than half of the total CPI) rose 6 percent Price Developments during 1990, after an increase of 5. 3 percent in 1989. The prices of medical services, which have All of the major price indexes-the consumer price been rising rapidly for many years, were up 9.9 per index, the producer price index, and the GNP price cent in 1990. Airlines, which were hit hard by the indexes-rose faster in 1990 than they had in 1989. surge in energy costs, raised their fares almost In general, the increases seen in 1990 also were the 23 percent over the year. largest since those of the early 1980s. In all of the The CPI for commodities excluding food and measures, the pickup in the rate of price increase in energy rose 3. 4 percent in 1990, after increasing 1990 basically reflected the effects of the oil shock in 2. 7 percent in 1989. Within this category, tobacco a situation in which underlying inflation pressures prices again registered a particularly large increase, already were well entrenched. about 11 percent over the course of the year. The CPI for apparel was up 5 percent in 1990; apparel Consumer Energy Prices* Percentage change, Q4 to Q4 prices had changed little over the course of 1989, and the 1990 rise may therefore have been, in part, an effort to restore margins. New car prices con tinued to rise, even as sales declined; by contrast, I! 15 the prices of used cars were down a bit for a second 111l tlttiti!! tt---- year. The prices of many household appliances fell 11 llli 1111'1 in 19 . 9 0, exte . nding the gradual downward trends 111.111 seen m previous years. 111!11 + Apart from energy, increases in producer prices were comparatively moderate in 1990. The producer price index for finished goods excluding food and 15 energy rose 3.5 percent over the year, about 3/4 percentage point less than in either of the preceding two years. In manufacturing, the pres sures from rising wages and soaring energy costs 1985 1986 1987 1988 1989 1990 were partly damped by continued rapid gains in *Consumer Price Index for all urban consumers. productivity and softening demand. 8 Consumer Prices* Real Income and Percentage change, Q4 to Q4 --------------------- Consumption Percentage change, Q4 to Q4 ITIII Real Disposable Personal Income D Real Personal Consumption Expenditures 6 3 + 1985 1986 1987 1988 1989 1990 Patterns of change in the various categories of 1985 1986 1987 1988 1989 1990 consumer spending were mixed in 1990. Real out *Consumer Price Index for all urban consumers. lays for services continued to trend up over the year, but at a slower pace than during most years of the The Household Sector expansion. Real outlays for nondurables fell 2 ¼ per cent over the course of the year, an unusually large In mid-summer, consumer spending still was on an decline by historical standards. The drop presumably uptrend, and it edged up a little further after the oil was brought on in large part by the downturn in shock, peaking in September. But with real incomes real income over the four quarters of 1990, the first being dragged down by slumping employment and such decline since 1974. The real outlays for con soaring energy prices, the rise in spending eventu sumer durables fell 3/4 percent over the four quarters ally ran out of steam. Real outlays fell at an annual of 1990; they had fallen about 1 ½ percent in 1989. rate of 3 percent in the fourth quarter. The drop in 1990 was accounted for by a second The declines in real income and spending in the year of decline in the purchases of motor vehicles. latter part of the year essentially reversed the moder Outlays for the other durables-furniture, household ate gains made earlier. Over the year, after-tax equipment, and the like-were up about 1/2 percent income was down about 1/2 percent in real terms; on net over the four quarters of 1990, after having real consumption spending was up over the four grown at a moderate pace in 1989. quarters of 1990, but only fractionally. The personal Spending for residential construction got a transi saving rate rose over the first half of the year, but tory boost from good weather in the first quarter of then dropped about 1 percentage point in the last 1990, but then fell sharply in each of the three sub two quarters. sequent quarters. Over the year as a whole, residen tial investment outlays declined 8 ¾ percent in real terms; they had dropped 7 percent in 1989. 9 The Business Sector Annual rate, millions of units, Private Housing Starts -------------------qua-rter-ly a-ver-age The business sector began 1990 on a rather shaky note. Profits had declined during 1989, and over hangs of business inventories had developed in the second half of that year in some markets, notably autos. In manufacturing, production growth had been restrained late in 1989, and output dropped 1.6 sharply in January of 1990, led by a steep cutback in auto assemblies. But conditions improved over the next few months. Industrial production rose fairly briskly, in fact, from January into mid summer, and the drop in business profits was halted for a time . . 8 From August on, the business climate was domi nated by the oil shock and its attendant uncertain ties. After peaking in September, industrial produc tion plummeted over the last three months of 1990, and it closed out the year about 1 ½ percent below the level of a year earlier. The operating rate in industry also fell sharply over the latter part of the 1985 1986 1987 1988 1989 1990 year, back to where it had been in early 1987, before capacity pressures started developing in that year. This slump in homebuilding reflected a variety of influences, most of which appeared to enter on the Industrial Production Index, 1987 = 100 demand side of the equation. The downshifting of real income growth after the start of 1989 may have led households to view their longer-run prospects in a more cautious light and to hold back from housing investments that they might otherwise have under taken. In addition, the unwinding in some regions of the country of real estate booms seen in the 1980s 110 tarnished the attractiveness of housing as a longer term investment. Builders cut back sharply on new construction in 1990. The annual starts of single-family units fell 11 percent from their 1989 level, and starts of multi family units declined by almost 20 percent, from an 100 already low level. However, these reductions in starts still were not large enough to balance the market. The supply of unsold new homes, measured relative to the pace of sales, jumped sharply in the first part of 1990 and then remained high over the rest of the year; the vacancy rate on multifamily rental units dipped temporarily in the spring, but later bounced 1985 1986 1987 1988 1989 1990 back up to the high levels seen over most of the period after 1986. 10 Serious overhangs of business inventories were not Nonresidential construction declined 5 percent apparent when the oil shock hit in August, and over the four quarters of 1990. Weakness was con prompt production adjustments that followed the centrated mainly in the outlays for offices and other shock forestalled stockbuilding in the ensuing commercial structures ( which together account for months. Indeed, real manufacturing and trade about one-third of the total). An excess supply of inventories fell slightly on net between the end of these structures developed in many cities during the July and the end of November. Over 1990 as a building boom of the mid-1980s, and despite sharp whole, the level of real business inventories declined cutbacks in construction after 1985, vacancy rates about $3 billion, according to preliminary estimates. remained high through 1990. The rapid reductions of nonfarm inventories that were seen in the fourth quarter of 1990 accounted The Government Sector for all of that quarter's drop in real GNP. In the government sector, budgetary pressures inten After registering relatively strong gains in each sified in 1990. At the federal level, the rate of year from 1987 to 1989, business outlays for fixed growth of receipts slowed to 4 .1 percent in fiscal investment rose only 1 percent in real terms over year 1990, less than half the rate of increase in the the four quarters of 1990. Spending was affected by previous fiscal year and more than a percentage the squeeze on profits, the easing of pressures on point below the rate of growth in nominal GNP. capacity, and the heightened uncertainties regarding Meanwhile, spending jumped 9.4 percent in fiscal the business outlook. The outlays for equipment 1990, and the federal budget deficit increased to were up 2.8 percent over the year, about half the $220 billion, up $67 billion from the 1989 fiscal year gain that was seen in 1989. and well above the target for 1990 that had been laid out in the Gramm-Rudman-Hollings legisla Changes in Real tion. Finding a way to get back on track toward Annual rate, Business Inventories deficit reduction occupied Congress and the billions of 1982 dollars Administration through much of 1990; an agreement that was reached in October prescribed new targets Total Nonfarm and new procedures for the five-year period starting in the 1991 fiscal year. 45 The deficit in the combined operating and capital accounts of state and local governments ( excluding social insurance funds) averaged $30 billion at an annual rate over the first three quarters of 1990, and it appears to have widened considerably further in + the fourth quarter as the recession cut into tax receipts. 1985 1986 1987 1988 1989 1990 11 The External Sector Measured in terms of the other Group of Ten (G-10) currencies, the foreign exchange value of the The merchandise trade deficit narrowed from $115 bil U.S. dollar depreciated about 12 percent from lion in 1989 to a bit less than $110 billion in 1990, December 1989 to December 1990. This depreciation a degree of improvement that was smaller than seen extended a decline that began in mid-1989 and more in either of the two preceeding years. A surge in the than reversed the earlier appreciation. price of oil imports in the second half of the year led to a jump in the value of imports. In addition, trade Labor Markets flows during the year were influenced to some extent by lagged effects of the firming of dollar exchange Payroll employment increased in each month in the rates that had taken place in the first half of 1989. first half of 1990 and fell in each month of the sec The current account balance averaged $93 billion, at ond half. The declines of July and August, however, an annual rate, during the first three quarters of reflected layoffs of federal workers who had been 1990, down from a total of $110 billion in 1989; the hired temporarily to conduct the 1990 Census. In improvement in this account was greater than that the private nonfarm sector, employment continued in the trade account owing to a strengthening of net to edge up into August and did not turn down deci receipts from service transactions, those involving sively until October. More than half a million jobs such things as travel, education, and finance. were lost over the final three months of the year. U.S. merchandise exports grew 7 ½ percent in Over the year as a whole (December to December), real terms over the four quarters of 1990, after the number of jobs in the private nonfarm sector rising about 12 percent in 1989. Merchandise increased about 250,000 on net, but much of that imports excluding oil grew only 2 percent in real small gain was wiped out by the further drop in terms during 1990, less than half the pace recorded employment in January of this year. in 1989. The deceleration in imports reflected the Growth in the supply of labor was quite subdued net decline in total domestic demand in the United in 1990. The civilian labor force increased only States during the year. 0.5 percent on a December-to-December basis, the smallest annual gain in almost thirty years. Part of Annual rate, the explanation for this slow labor force growth is U.S. Real Merchandise Trade billions oi' 1982 dollars that the working-age population has not been grow ing very rapidly in recent years. In addition, the share of the working-age population that chose to Q4 participate in the work force declined in 1990, by 500 _ enough to cut labor force growth to about half of Q4 what it would have been had the participation rate __, ; remained unchanged. ,,,- 400 / ..-,_; / 300 Expor-t-s- / -- --- --- .,,,,,,. ---- 1985 1986 1987 1988 1989 1990 12 After rising about 3 ¼ percent in both 1986 and Quarterly Civilian Unemployment Rate average, percent 1987, the employment cost index (ECI) for compen sation (which includes the cost of workers' benefits, as well as wages and salaries) moved up about 4¾ percent in both 1988 and 1989; and in the first half of 1990, the year-to-year rate of increase in this measure of compensation rose still further, to 5 ¼ percent. A marked slowing of wage pressures emerged in the second half of 1990, and the year-to-year rate of 5 increase in the ECI dropped back to 4.6 percent by the end of the year. Although workers' real incomes were battered by the surge in energy prices during this period, attempts to regain those income losses appear to have been overwhelmed by the increase in labor market slack and associated concerns about 1985 1986 1987 1988 1989 1990 job security. The efforts of management to contain costs in a time of declining profits probably also were a factor helping to limit wage increases during this period. 13 Monetary and Financial Developments during 1990 Monetary policy has been progressively eased since The invasion of Kuwait at the beginning of mid-1990, resuming the trend begun in 1989. The August fundamentally altered the environment for Federal Reserve has acted against the backdrop of a monetary policy. World oil prices soared, and a con weakening economy, sluggish money growth, siderable measure of uncertainty was added to the improved inflation prospects, greater fiscal restraint, outlook for the economy, complicating the formula and indications of tightening credit to private bor tion of monetary policy. rowers. In response to the System's actions and to Late in the year, indications accumulated that developments in economic activity and prices, short inflationary pressures, apart from those closely con term interest rates, as of mid-February, were nearly nected to the surge in energy prices, were easing. As 2 percentage points below those prevailing at the the economy softened and wage pressures also time of the Board's July report to Congress, and diminished, it seemed more likely that the effects of long-term rates were down about a half percentage higher oil prices would not be built into ongoing point. ., inflation trends. Market interest rates declined across In the formulation of policy in 1990, the Federal the maturity spectrum, although these declines were Reserve continued to examine a variety of informa most pronounced for government obligations owing tion bearing on developments relating to economic to heightened concerns about credit quality, which activity and prices. Over the year, certain develop drew investors toward high-grade assets. ments in financial markets took on special signifi Financial strains were experienced by more and cance for the economy and monetary policy. The more lending institutions, as problems emerged in cost and availability of credit was monitored in light many real estate portfolios and as a growing number of indications that tightening credit supplies were of highly leveraged firms ran into trouble. Efforts by constraining output to a greater degree than was banks and other lenders to protect or improve their desirable. In addition, considerable attention was capital positions as their loan portfolios deteriorated paid to money stock movements, especially in the were reflected in widespread signs of cutbacks in the latter part of 1990 and into 1991, when money availability of credit and increases in its cost, espe growth virtually stalled. The Federal Reserve recog cially to less-than-prime borrowers lacking access to nized that the relation of the monetary aggregates to securities markets. While much of the tightening of broad measures of economic performance remained lending standards was welcome from the standpoint subject to considerable uncertainty, but the marked of safety and soundness, it exerted a contractionary sluggishness of money growth was seen as suggesting influence on the economy and was reflected in the both weak contemporaneous growth of income and slow growth in bank credit and the broad monetary spending and the existence of constraints on the aggregates. availability of credit through depository institutions Against this backdrop, the Federal Reserve under that could adversely affect spending in the future. took additional actions designed to support the econ omy and to counter the tightening in credit terms. The Implementation of Monetary Policy In mid-November, the FOMC moved to lower money market rates through open market operations, During the first half of 1990, the Federal Reserve and in early December, the Board eliminated the took no actions in reserve markets designed to pro 3 percent reserve requirement on nonpersonal time duce changes in money market interest rates. Fed deposits and net Eurocurrency liabilities. This action eral funds-overnight interbank loans of immedi was taken in response to the increased restraint on ately available funds-traded around the 8 ¼ percent lending by commercial banks; lower reserve require level that had been established in December 1989, ments reduce funding costs to depository institutions, and other short-term rates were little changed as encouraging them to expand lending. Ultimately, the well. Throughout this period economic activity con lower funding costs are passed through as a combi tinued to grow, the unemployment rate held steady, nation of lower rates for borrowers and higher rates and there were no clear signs of abatement in offered to depositors. inflation. 14 Following the reduction in reserve requirements, from its mid-1990 level and about 3 ½ percentage further actions were taken in reserve markets to points from its most recent peak in mid-1989. bring down short-term interest rates. These actions Under the impetus of the easing of monetary included additional steps toward a more accom policy and the softening of the economy, other short modative supply of nonborrowed reserves through term rates also fell significantly below mid-1990 open market operations and two reductions in the levels by mid-February. The drop in yields on discount rate-of a half point in December and of a Treasury bills roughly paralleled that in the federal like amount in January 1991. All of these moves funds rate. Banks reduced their prime rates in two were made in light of further declines in economic 1/2 percentage point steps in early 1991, but, as a activity, sluggish money and credit growth, and evi consequence of the tightening in credit supplies, dence of ebbing inflation pressures. In total, the fed prime rates remained higher than usual relative to eral funds rate has fallen about 2 percentage points rates on federal funds and other sources of funds. Growth of Money and Debt (Percentage change) Debt of Domestic Mt M2 M3 N onfinancial Sectors Fourth quarter to 1980 7.4 8.9 9.5 9.4 fourth quarter 1981 5.4 (2.5)* 9.3 12.3 10.1 1982 8.8 9.1 9.9 9.1 1983 10.4 12.2 9.8 11.1 1984 5.4 8.0 10.7 14.2 1985 12.0 8.7 7.6 13.1 1986 15.5 9.2 9.0 13.2 1987 6.3 4.3 5.8 9.7 1988 4.2 5.2 6.3 9.2 1989 0.6 4.7 3.6 7.7 1990 4.2 3.9 1.8 6.9 Quarterly growth Ql 5.2 6.2 2.9 6.1 rates 1990 (annual rates) Q2 4.2 3.9 1.3 6.9 Q3 3.7 3.0 1.6 7.4 Q4 3.4 2.2 1.3 6.4 *Figure in parentheses is adjusted for shifts to NOW accounts in 1981. 15 Rates on commercial paper and CDs also fell less and the sudden plunge in real income· consumer t~an those on federal funds or Treasury bills, drop credit growth was especially slow in the fourth ping about 1 ¼ percentage points from mid-1990 quarter. levels. M3 grew 1 ¾ percent in 1990, somewhat less than ~ad_ been anticipated early in the year. Roughly Behavior of Money and Credit similar to the quarterly pattern of M2, M3 growth fell off noticeably after the first quarter and ended M2 grew unexpectedly slowly in 1990, about 4 per the year somewhat above the lower bound of its tar cent for the year, well down in the lower half of the get range. That range itself had been lowered at FOMC's range. After a robust first-quarter, M2 midyear by 1 ½ percentage points amid evidence growth weakened markedly over the balance of the tha: the drop in thrift assets was proceeding more year. The expansion of this aggregate was well rapidly than had been expected and that credit flows below what the historical relationships based on :-ver~ b~ing directed away from depository income and interest rates would suggest. mstitut10ns. The shortfall of money growth, relative to histori . Banks by and large are sound and well capital c~! patterns, probably reflected the shifting of finan ~zed, ?ut concerns about the strength of the industry cial flows associated with the contraction of the thrift intensified throughout 1990. The General Account industry ~nd the increased reluctance or inability of ~ng Office and the Congressional Budget Office commercial banks to expand their balance sheets. issued reports questioning the financial health of Indeed, the_ slowdown of M2 growth emerged at some large banks and exploring the implications of about the time that RTC activity picked up. The possible difficulties with those banks for the Bank drop in depository credit, which had its primary Insurance Fund. Banks had to make large provisions effect on the ~3 aggregate, also may have damped for loan losses as delinquency and loss rates rose on M2 by lessening the need of commercial banks and most major categories of loans, but especially on real thrifts to bid for retail deposits. One indication is estate loans. By mid-September, rates on the subor the apparent cutback in advertising for these ?in~ted_ debt obl~gations of some major banking deposits during the year. And, a result of the mst1tut10ns had Jumped appreciably as investors diminished need for retail deposits, deposit rates reevaluated the health of these organizations. Several were held down relative to returns available on 1:1-ajor bank_ holding companies chose to redeem por market instruments. tions of their outstanding auction-rate preferred Nevertheless, even taking account of these factors stock rather than pay sharply higher rates. Spreads affecting the relative attractiveness of yields on M2 b~tween bank and Treasury obligations widened sig assets, M2 growth remained much slower than seemed mficantly, and bank stock prices tumbled. These explainable, indicating an underlying reevaluation price movements began to be reversed subsequently. of, and shift away from, M2 assets. One factor Partly under the influence of lower interest rates behind such a shift may have been concerns gener bank ~tock prices have risen substantially in 1991, ated by the publicity about S&L failures and about reversing much, though not all, of the declines since credit quality problems at banks. To the extent that the summer; spreads on subordinated and other ho~seholds moved assets to money market funds, bank obligations have narrowed over the last few which grew rapidly in the second half of the year, months, but remain well above their levels of last M2 would not be affected; however, direct purchases summer. of market instruments would reduce M2. For exam Not surprisingly, banks tightened standards and ple, noncompetitive tenders at Treasury auctions raised lendin~ margins in response to the rising costs have been unusually strong, suggesting a shift of funds, capital shortages, and perceptions of toward holding these assets directly. In addition, greater risk o_f default. In the wake of highly lever ~10useholds_ may have chosen to deplete liquid assets ~ge~ transaction (HLT) disclosure guidelines, banks ~nst~ad of increasing borrowing to maintain spend mst1tuted management-imposed caps on their mg m the face of higher prices for energy products 16 exposure to HLTs. Banks with low capital have cut the ebbing of borrowing demand as the economy back lending, while adequately capitalized banks turned down, the growth of bank assets slowed in though maintaining substantial credit growth 1990, especially in the fourth quarter. Total loan appeared to be unwilling to step into the breach and growth fell to roughly half its 1989 rate, with slow increase their lending pace. Survey responses and ing evident in business, real estate, and consumer other information on lending terms suggest espe lending. There was, however, a strong regional dis cially severe constraints on credit for real estate parity in the slowdown of bank lending, a disparity development and commercial mortgages, but also that was visible in total bank loans as well as each some cutbacks for business lending more generally. loan category. Some of these business borrowers have limited The slowdown in bank credit growth in 1990 alternative sources, and so the restriction of credit occurred despite a pickup in bank holdings of by banks probably has reduced their access to funds. government securities early in the year and the large As a result of the tightening of credit standards transfers of deposits from failed thrifts. Thrift credit and lending terms, but also owing importantly to shrank rapidly during the year as the R TC resolved Growth of Domestic N onfinancial Sector Debt and Depository Credit Percent Four-quarter moving average 16 Domestic Non financial Debt 14 12 10 8 \ I ti\ I 6 I \ \ Depository Credit 4 \ \ 2 \ + 1961 1966 1971 1976 1981 1986 17 insolvent thrifts, acquiring the bulk of those institu Footnotes tions' assets in the process, and as many viable 1. Mt is currency held by the public, plus travelers' thrifts shed assets in an effort to meet the new capi checks, plus demand deposits, plus other checkable tal guidelines. The credit contraction at depository deposits [including negotiable order of withdrawal (NOW institutions probably reduced total credit to some and Super NOW) accounts, automatic transfer service extent, but by far less than one for one. Both the (ATS) accounts, and credit union share draft accounts]. secondary market in mortgages and the securitiza M2 is M 1 plus savings and small denomination time tion of consumer loans substituted to a large extent deposits, plus Money Market Deposit Accounts, plus for bank and thrift intermediation in those sectors. shares in money market mutual funds ( other than those restricted to institutional investors), plus overnight repur Securitization alone is estimated to have removed chase agreements and certain overnight Eurodollar more than $40 billion in consumer loans from bank deposits. balance sheets during 1990 as banks pared their M3 is M2 plus large time deposits, plus large denomi asset totals to improve capital ratios. Overall, the nation term repurchase agreements, plus shares in money markets for home mortgages and consumer credit market mutual funds restricted to institutional investors showed little indication that supply conditions were a and certain term Eurodollar deposits. significant factor restraining growth of these types of credit. Spreads on both asset-backed and mortgage backed securities did widen a bit in the fourth quarter, but remained well within historical ranges and appeared to have little impact on the cost of funds to consumers. Sluggish expansion of both consumer credit and residential mortgage borrowing in 1990 seemed to reflect ebbing demands associated with slumping markets for housing and consumer durable goods. With credit extensions outside banks and thrifts picking up, growth of total debt of the domestic nonfinancial sectors slowed only moderately to 7 percent, in the middle of the FOMC's monitoring range for this measure. Its growth was boosted last year by the federal government which borrowed, in part, to fund acquisitions of thrift assets by the R TC. The growth of debt has slowed over recent years, but, even abstracting from the effects of RTC activity, remained well in excess of last year's expan sion of nominal income. A copy of the full report to Congress is available from Publication Services, Federal Reserve Board, Washington, D.C. 20551 FRB19-48000-0291 18

Federal Reserve (1991, February 19). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_19910220

@misc{wtfs_monetary_policy_report_19910220,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {1991},
  month = {Feb},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_19910220},
  note = {Retrieved via When the Fed Speaks corpus}
}