Monetary Policy Report

1 9 9 4 M O N E T A R Y P O L I C Y , OBJECTIVES 1 9 9 4 MONETARY P O L I C Y OBJECTIVES This Executive Summary provides highlights of the Board's Report to the Congress on the Full Employment and Balanced Growth Act of 1978. FEBRUARY 22, 1994 Contents Section Page Monetary Policy and the Economic Outlook for 1994 1 Economic Projections for 1994 1 Money and Debt Ranges for 1994 3 Monetary and Financial Developments in 1993 5 Testimony of Alan Greenspan Chairman, Federal Reserve Board 10 Monetary Policy and the Economic Outlook for 1994 Economic Projections for 1994 market slack over the four quarters of the year. Forecasts of the unemploy In general, the governors and Reserve ment rate in the fourth quarter of 1994 Bank presidents anticipate that 1994 span a range of 6½ percent to 6¾ per will be another year of progress for the cent. Because of changes in survey economy, with low inflation and design, a comparable rate for the financi~l market_conditions continuing fourth quarter of last year is not to provide a setting conducive to available; however, the Bureau of sustaining moderate economic growth Labor Statistics has estimated that the and rising employment opportunities. fourth-quarter rate would have The Federal Reserve officials' exceeded 7 percent on the new basis. forecasts of real GDP growth over the The sectoral composition of growth four quarters of 1994 span a range of in 1994 may well resemble that of 2½ percent to 3¾ percent, with the 1993. The financial adjustments of central tendency of the forecasts being recent years have left households 3 to 3¼ percent. The governors and better positioned and more willing to Reserve Bank presidents anticipate boost spending. Moreover, with that the rise in real GDP will be employment rising, real income accompanied by a further increase in growth should be supportive of labor productivity. Nonetheless, increased consumer expenditures in employment gains are expected to be the coming year, despite the higher sufficient to bring about some further taxes confronting some households. reduction in the degree of labor Economic Projections of FOMC Members and Other FRB Presidents for 1994 Percent Item Range Central tendency Change, Nominal GDP 4¾-7½ 5½-6 fourth quarter to fourth Real GDP 2½-3¾ 3-3¼ quarter: 1 Consumer price index 2 2¼-4 About3 Average level in Unemployment rate3 6½-6¾ 6½-6¾ the fourth quarter: l. C~ange from average for fourth quarter of 2. All urban consumers. precedmg year to average for fourth quarter of 3. Civilian labor force. year indicated. 1 Business investment seems likely to be Consumer Prices* pushed ahead by ongoing efforts to Percent change, Q4 to Q4 modernize and by further declines in computer prices. By contrast, further cuts in federal outlays for defense r-------- 6 likely will continue to be a restraining factor on the growth of aggregate demand. With the passage of time, the more accommodative monetary policies now in place in a number of countries, together with the moderate fiscal stimulus in Japan, are likely to lead to a gradual pickup in the rates of growth of foreign industrial countries and U.S. exports. However, U.S. 1987 1989 1991 1993 imports from abroad will likely *Consumer price index for all urban consumers. continue to move up at a brisk pace. Net exports of goods and services thus The majority of the governors and may decline somewhat further, albeit Bank presidents expect inflation in at a slower rate than they have over 1994 to run a shade higher than in the past year. 1993. Most of their forecasts for the rise in the consumer price index are close to 3 percent, although the full U.S. Real Merchandise Trade range of forecasts extends from a low Annual rate, billions of 1987 dollars of 2¼ percent to a high of 4 percent. Several developments are likely to work against better inflation perfor mance in 1994. In agriculture, a poor harvest in 1993 has left some crops in very tight supply, and the risk of unfavorable food price developments is greater than it has been in recent years. In addition, although the future course of energy prices is uncertain, a repeat of last year's declines, which helped to hold down the overall CPI, cannot be counted on. 1987 1989 1991 1993 2 More fundamentally, the recent In the area of trade policy, the nation's narrowing of the degree of slack in the long-standing support of an open labor and product markets suggests world trading system was reaffirmed that competitive pressures damping this past year in the form of passage of wage and price increases will be less the North American Free Trade strong and less pervasive than they Agreement and the agreement in the have been recently. Uruguay Round-actions that will The central tendencies of the yield important benefits over time not forecasts of GDP growth, unemploy only to the United States but also to its ment, and inflation are quite similar to trading partners. Nonetheless, serious the projections put forth by the obstacles to free trade still remain. On Administration in its recent reports. a wide range of regulatory issues, the Moreover, insofar as the Administra Congress and the Administration face tion's numbers were predicated, in decisions that have the potential to part, on the assumption that short promote-or to damage-the flexibil term interest rates would rise mod ity in labor and product markets and estly in 1994, the recent tightening the processes of innovation and action by the Federal Reserve does not investment that are so critical to appear to be inconsistent with the long-run economic progress. In the Administration's outlook. area of monetary policy, the challenge Prospects for sustained growth over is to build on the favorable price the longer run have been bolstered by performance of late in a situation in policy actions on a number of fronts. which the economy will likely be Considerable work remains to be operating closer to full capacity than it done, however. Although recent fiscal has in recent years. With success in measures have been helpful in keeping the economy on course bringing about declines in the federal toward the long-run goal of price budget deficit, the Congress and the stability, the prospects for sustained Administration still must deal with expansion will be greatly enhanced. some difficult issues to ensure that the deficit is kept on a downward Money and Debt Ranges for 1994 course through the latter part of the At its July 1993 meeting, the Commit 1990s and into the next century. tee had provisionally chosen the same ranges for 1994 as it had established for 1993-1 to 5 percent for M2 and 0 to 4 percent for M3 and a moni toring range of 4 to 8 percent for the domestic nonfinancial debt aggregate. 3 At that time, the Committee noted that Additionally, firms, having strength disturbances to the historical relation ened their financial positions, may feel ships between the aggregates and more comfortable taking on shorter spending required that the actual term obligations and, so, may direct determination of these ranges for 1994, more of their business to depositories. in February of this year, be made in Banks, which are better capitalized light of additional experience and and more liquid, should be in a strong analysis. position to meet those needs. Still, capital markets will provide attractive alternatives to the depository sector, Ranges for Growth of Monetary and suggesting that the forces tending to Debt Aggregates 1 divert funds from depositories-and Percent to raise the velocities of the monetary aggregates-will continue to be 1992 1993 1994 important. However, the strength of these forces, and whether or how M2 2½-6½ 1-5 1-5 quickly they might be abating, remains difficult to judge. M3 1-5 0--4 0--4 Against this background, the Federal Open Market Committee at its Debt2 4½-8½ 4-8 4-8 most recent meeting reaffirmed the annual growth ranges for the money 1. Change from average for fourth quarter of and credit aggregates that had been preceding year to average for fourth quarter of year indicated. Ranges for monetary aggregates chosen provisionally last July. The are targets; range for debt is a monitoring range. annual ranges appear to be sufficiently 2. Domestic nonfinancial sector. wide to encompass growth of M2 and M3 consistent with Committee members' expectations for nominal As noted above, the velocities of M2 income under a variety of alternatives and M3 increased further in 1993, but for the behavior of the velocities of the at a slower rate than in the previous aggregates. If the forces depressing the year. This deceleration might indicate demand for money relative to income that the forces that had distorted the were to persist unabated in 1994, aggregates over the past few years, while still potent, were beginning to wane. The yield curve, although quite steep, now offers investors less inducement to move outside M2 in the search for better returns than at any time in the past three years. 4 M2 and M3 might be in the lower Healthier balance sheets, lighter debt portion of their cones; should M2 and service burdens, heavier capital M3 move closer to their former spending, and more eager lenders alignments with spending-buoying should all act to boost the expansion of the demands for those aggregates and nonfederal debt. Overall, the debt of depressing their velocities-then the nonfinancial sectors is expected to outcomes in the upper portion of the grow again at about the pace of ranges would be expected. The nominal income. Committee will watch the monetary aggregates closely during the course of Monetary and Financial the year for evidence on unfolding Developments in 1993 economic and financial conditions. Nineteen ninety-three turned out to be But, given uncertainties about velocity a favorable year for the U.S. economy, behavior, that information will with notable gains in real output, necessarily be assessed in combination declines in joblessness, and a further with a variety of other financial and small drop in the rate of inflation. economic indicators as the Committee Financial conditions conducive to formulates policy. Through 1994, as growth prevailed throughout 1993 and was true last year, the Committee's gave considerable impetus to activity. primary concern will be to foster With the Federal Reserve keeping financial conditions that help to reserve market pressures unchanged, contain price pressures and to sustain short-term interest rates held steady economic expansion, and it will have during the year at unusually low to assess the rates of money growth consistent with these objectives as the year goes on. Long-Term Interest Rates Debt growth, which has moved in Percent closer alignment with nominal income over the past few years than have the Monthly monetary aggregates, will again be monitored in light of a 4 to 8 percent annual range. With the federal sector's demands on the pool of saving diminishing, the Committee envisions that an unchanged range would be associated with some pickup in borrowing by the private sector. Thirty-year Treasury Bond 1983 1985 1987 1989 1991 1993 Last observation is for January 1994. 5 levels, especially when measured employment moved up at a moderate relative to inflation or inflation pace, and the unemployment rate expectations. In addition, long-term dropped almost a percentage point rates declined further, partly in over the year. As measured by the response to actions taken by the consumer price index, the rate of Congress and the Administration to inflation edged lower last year, as put the federal deficit on a more unfavorable reports in the first few favorable trend. months of 1993 gave way to more Against this backdrop, households subdued readings thereafter. The and businesses were able to take performance of the U.S. economy further steps to reduce the burden of stood in sharp contrast to the contin servicing debt, and more expansive ued sluggish growth in many of the attitudes toward spending and the use other industrial countries and helped of credit seemed to take hold. Spend to buoy the trade-weighted value of ing in the interest-sensitive sectors of the dollar on foreign exchange the economy surged ahead, with markets. particularly large advances in residen tial investment, business outlays for fixed capital, and consumer durables. Foreign Exchange Value The growth of real GDP picked up of the U.S. Dollar* sharply in the second half, and the Index, March 1973 = 100 increases for all of 1993 cumulated to about 2¾ percent according to initial estimates. In the labor market, Real GDP Percent change, annual rate 1987 1989 1991 1993 *Index of wei~hted average foreign exchange value + of U.S. dollar m terms of currencies of other -----""'. .........." "--J"""--~.......,,..,---=.__._....._......._.=-=-......._._.___ 0 G-10 countries. Weights are based on 1972-76 global trade of each of the 10 countries. 1989 1990 1991 1992 1993 6 In conducting policy through 1993, Earlier this month, the Federal the Federal Open Market Committee Reserve concluded that the weight of recognized that it was maintaining a the evidence indicated that undimin very accommodative stance in reserve ished monetary stimulus posed the markets. Reserve conditions had been threat that capacity pressures would eased to this degree over the prior four build in the foreseeable future to the years to counter the effect of some point where imbalances would unusual factors restraining aggregate develop and inflation would begin to demand. The Committee recognized pick up. At its February 1994 meeting, that, as these forces abated, short-term the Federal Open Market Committee interest rates would likely have to rise determined that it was time to move to to forestall inflationary pressures that a slightly less accommodative stance. would eventually undermine the While the discount rate remained at expansion. 3 percent, the federal funds rate edged Toward the end of 1993 and into up to trade around 3¼ percent, a little early 1994, incoming data on the above the prevailing rate of inflation. economy and credit flows have Strength in spending last year was increasingly conveyed a picture of supported by increased borrowing by considerable underlying strength. The both households and businesses. marked speedup of growth in the Continuing declines in a number of economy has been reducing spare interest rates, which sparked consider capacity, as is evident in the recent able refinancing of existing obligations, declines in unemployment and helped to trim debt service burdens for increases in capacity utilization rates both sectors, undoubtedly facilitating in industry. Moreover, while move the pickup in borrowing and spend ments in broadly based price indexes ing. Indicators of financial stress, have remained relatively favorable, including loan default rates and there also have been undercurrents bankruptcy filings, took a decided tum suggesting that the process of disin for the better in 1993. Borrowing by flation might be stalling out. In par households was robust enough to raise ticular, after slowing considerably in the ratio of debt to disposable income; 1992, nominal increases in hourly business debt, held down in part by compensation----comprising wages and equity issuance, declined relative to benefits-fell no further in 1993, and income. The debt of all nonfinancial long-term inflation expectations sectors is estimated to have grown remain stubbornly above recent about 5 percent last year, the same as inflation rates. Also, commodity prices in 1992, as a diminution in the net generally have firmed in recent funding needs of the federal govern months. ment was about offset by the pickup in private demands. This growth placed the debt aggregate in the lower half of its 4 to 8 percent monitoring range. 7 The growth of M2 slowed in 1993, This continuing redirection of credit albeit considerably less than the flows has rendered the movements of deceleration in nominal GDP. For the the broad monetary aggregates less year, M2 advanced 1½ percent, representative of the pace of nominal placing it a little above the lower spending than was evident in the bound of its 1 to 5 percent annual longer historical record. In 1993, growth cone. M3 expanded ½ percent, nominal GDP grew a shade more than the same pace as in 1992, and a bit 5 percent, or 3¾ percentage points above the lower bound of its O to above the rate of expansion of M2 and 4 percent annual range. The ranges 4½ percentage points above that of had been adjusted down by the M3. Federal Open Market Committee Most of the increase in the broad during 1993. The adjustments were aggregates was recorded in their Ml technical in nature and reflected the component, which grew 10½ percent Committee's judgment as to the extent in 1993, as low money market and of the ongoing distortions of financial deposit interest rates provided little flows relative to historical patterns, reason to forgo the liquidity of transac and of consequent increases in tion deposits. At times during the velocities-that is, the ratios of year, declines in longer-term market nominal GDP to money. rates produced waves of mortgage The special factors shaping the refinancing, an activity that is associ growth of the monetary aggregates ated with temporary flows through the included a marked preference by transaction deposits that are counted borrowers for capital market financing, in Ml. In addition, the currency rather than bank loans, and a con component expanded at about the figuration of market returns that same rate as the Ml total, spurred by enticed investors away from the tradi considerable demands from abroad. tional financial products offered by The double-digit expansion in Ml depositories. Bond and stock mutual deposits pushed reserves up at a funds were the primary beneficiaries 12½ percent rate in 1993, while the of this shift, with inflows into such monetary base, which includes funds in 1993 setting a new record. reserves and currency, increased 10½ percent, the same rate that was posted in the previous year. 8 Growth of Money and Debt Percent Domestic Ml M2 M3 Nonfinancial Debt Annual, 1980 7.4 8.9 9.6 9.1 Fourth quarter to fourth quarter 1 19812 5.4 (2.5) 9.3 12.4 9.9 1982 8.8 9.2 9.9 9.6 1983 10.4 12.2 9.9 12.0 1984 5.5 8.1 10.9 14.0 1985 12.0 8.7 7.6 14.2 1986 15.5 9.3 8.9 13.4 1987 6.3 4.3 5.7 10.3 1988 4.3 5.3 6.3 9.0 1989 0.6 4.8 3.8 7.8 1990 4.2 4.0 1.7 6.6 1991 7.9 2.9 1.2 4.6 1992 14.3 1.9 0.5 5.0 1993 10.5 1.4 0.6 4.9 1993 Ql 8.3 -1.3 -3.2 4.0 Quarter (annual rate) 3 Q2 10.7 2.2 2.1 . 4.5 Q3 12.0 2.6 1.1 5.7 Q4 9.4 2.1 2.4 5.2 1. From average for fourth quarter of preced- 3. From average for preceding quarter to ing year to average for quarter of year indicated. average for quarter indicated. 2. Ml adjusted for shifts to NOW accounts in 1981. 9 Testimony of Alan Greenspan Chairman, Federal Reserve Board Mr. Chairman and members In the seven months since I gave the previous Humphrey-Hawkins of the Subcommittee, I am testimony, the performance of the U.S. pleased to appear today to economy has improved appreciably. Private-sector spending has surged, present the Federal Reserve' s boosted in large part by very favorable semiannual monetary policy financial conditions. With mortgage rates at the lowest level in a quarter report to the Congress. century, housing construction soared in the latter part of 1993. Consumer spending, especially on autos and other durables, has exhibited consider able strength. Business fixed invest ment has maintained its previous rapid growth. Important components of GDP growth in the second half of last year represented one-time upward adjustments to the level of activity in certain key sectors, and, with output in these areas unlikely to continue to climb as steeply, significant slowing in the rate of growth this year is widely expected. In addition, the Southern California earthquake and severe winter weather may have dulled the force of the favorable trends in spending in January and February. Nonetheless, as best we can judge, the economy's forward momentum remains intact. The strengthening of demand has been accompanied by favorable developments in labor markets. In the second half of the year, employment continued to post moderate gains, and the unemployment rate fell further, bringing its decrease over the full year to nearly 1 percentage point. The unemployment rate in January apparently declined again on both the old and new survey bases. 10 On the inflation front, the deteriora Wages do not seem to be accelerating tion evident in some indicators in the despite scattered reports of some first half of 1993 proved transitory. For skilled-worker shortages, and the year as a whole, the Consumer advances in productivity early this Price Index rose 2¾ percent, the year are holding down unit labor smallest increase since the big drop in costs. Moreover, while private oil prices in 1986. Broader inflation borrowing has picked up, broad measures covering purchases by money-to be sure a highly imperfect businesses as well as consumers rose indicator of inflation in recent years even less. While declining oil prices has continued to grow slowly. contributed to last year's good Nonetheless, markets appear to be readings, inflation measured by the concerned that a strengthening CPI excluding food and energy also economy is sowing the seeds of an diminished slightly further, to just acceleration of prices later this year by over a 3 percent rate for the whole rapidly eliminating the remaining year. In January the CPI remained slack in resource utilization. Such quite well behaved on the whole. Not concerns were reinforced by forecasts all signs have been equally favorable, that recent data suggest that revised however. For example, a number of estimates of fourth-quarter GDP to be commodity prices have firmed released next week will show upward noticeably in recent months. And revisions from the preliminary indications that such increases may be 5.9 percent annual rate of growth. broadening engendered a back-up in Rapid expansion late last year, it is long-term interest rates in recent days. apparently feared, may carry over into In particular, the Philadelphia Federal a much smaller deceleration of activity Reserve Bank's survey showing a in 1994 than many had previously marked increase in prices paid by expected. manufacturers early this year was But it is too early to judge the degree taken as evidence of a more general of underlying economic strength in the emergence of inflation pressures. early months of 1994. Anecdotal It is important to note, however, that evidence does indicate continued in the past such price data have often underlying strength in manufacturers' been an indication more of strength new orders and production, but we in new orders and activity than a will have a better reading on new precursor of rising inflation through orders on Thursday when preliminary out the economy. In the current data for January are released. period, overall cost and price pres sures still appear to remain damped. 11 The labor markets are signalling a not to lower unemployment, but to somewhat less buoyant degree of higher unemployment, as destabilizing activity as initial claims for unemploy forces and uncertainties associated ment insurance in recent weeks have with accelerating inflation induced moved up a notch. Clearly, the Federal economic contraction. Over the longer Reserve will have to monitor carefully run, no tradeoff is evident between ongoing developments for indications inflation and unemployment. Experi of potential inflation or a strengthen ence both here and abroad suggests ing in inflation expectations. As I have that lower levels of inflation are often noted, if the Federal Reserve is to conducive to the achievement of promote long-term growth, we must greater productivity and efficiency contribute, as best we can, to keeping and, therefore, higher standards of inflation pressures contained. living. In this regard, a clear lesson we have In fact, lower inflation historically learned over the decades since World has been associated not just with War II is the key role of inflation higher levels of productivity, but with expectations in the inflation process faster growth of productivity as well. and in the overall performance of the Why inflation and productivity macroeconomy. As I indicated in my growth are linked this way empirically testimony before the Joint Economic is not clear. To some extent higher Committee last month, until the late productivity growth may help to 1960s, economists often paid inade damp inflation for a time by lessening quate attention to expectations as a increases in unit labor costs. But the key determinant of inflation. Unem process of cause and effect in all likeli ployment and inflation were consid hood runs the other way as well. ered simple tradeoffs. A lower rate of Lower inflation and inflation expecta unemployment was thought to be tions reduce uncertainty in economic associated with a higher, though planning and diminish risk premiums constant, rate of inflation; conversely, for capital investment. They also a higher rate of unemployment was clarify the signals from movements in associated with a lower rate of relative prices, and they encourage inflation. effort and resources to be devoted to But the experience of the past three wealth creation rather than wealth decades has demonstrated that what preservation. Many people do not appears to be a tradeoff between have the knowledge of, or access to, unemployment and inflation is quite ways of preserving wealth against ephemeral and misleading. Attempts inflation; for them, low inflation to force-feed the economy beyond avoids an inequitable erosion of living its potential have led in the past to standards. rising inflation as expectations ratcheted higher and, ultimately, 12 The reduced inflation expectations the federal government will be of recent years have been accompanied competing less vigorously for private by lower bond and mortgage interest saving in the years ahead. Concerns rates, slower actual inflation, falling that the deficit is out of control have unemployment, and faster trend diminished. In the extreme, explosive productivity growth. The implication federal debt growth makes an eventual is clear: when it comes to inflation resort to the printing press and expectations, the nearer zero, the inflationary finance difficult to resist. better. By shrinking any perceived risk of this It follows that price stability, with outcome, the deficit reduction package inflation expectations essentially apparently had a salutary effect on negligible, should be a long-run goal longer-term inflation expectations. of macroeconomic policy. We will be The Federal Reserve' s policies in at price stability when households and recent years also have helped to damp businesses need not factor expecta inflation and inflation expectations. tions of changes in the average level of We were able to do so, even while prices into their decisions. How those adopting an increasingly accommoda expectations form is not always easy to tive policy stance. By placing our discern, and they can for periods of actions in the context of a thorough time appear to be at variance with analysis of the prevailing situation and underlying economic forces. But of a longer-term underlying strategy, history tells us that it is economic and our move to greater accommodation financial forces and their consequences could be seen as what it was-a for realized inflation that ultimately deliberate effort to counter the various shape inflation expectations. "headwinds" that were retarding the Fiscal and monetary policy are advance of the economy rather than a important among those forces and series of short-term actions taken have contributed to the decline in without consideration for potential inflation expectations in recent years inflation consequences over time. along with decreases in long-term As I discussed with this Subcom interest rates. The actions taken last mittee last July, this longer-run year to reduce the federal budget strategy implies that the Federal deficit have been instrumental in this Reserve must take care not to overstay regard. Although we may not all agree an accommodative stance as the on the specifics of the deficit reduction headwinds abate. But determining measures, the financial markets are when a policy stance is becoming too apparently inferring that, on balance, accommodative is not an easy matter. 13 Unfortunately, although subdued providing there were a sufficiently inflation is the hallmark of a successful broad and active market for them. monetary policy, current broad In addition, the price of gold, which inflation readings are actually of has been especially sensitive to limited use as a guide to the appropri inflation concerns, the exchange rate, ateness of current instrument settings. and the term structure of interest rates Patently, price measurements over can give important clues about short time spans are subject to transi changing expectations. tory special factors. More important, Of course, a number of factors in monetary policy affects inflation only addition to inflation expectations affect with a significant lag. That a policy all of these indicators to a degree. stance is overly stimulative will not Short-and long-term rates, for become clear in the price indexes for example, tend to be highly correlated perhaps a year or more. Accordingly, through time, in part because they are if the Federal Reserve waits until responding to the same business cycle actual inflation worsens before taking pressures. Thus, when the Federal countermeasures, it would have Reserve tightens reserve market waited far too long. At that point, conditions, it is not surprising to see modest corrective steps would no some upward movement in long-term longer be enough to contain emerging rates, as an aspect of the process that economic imbalances and to avoid a counters the imbalances tending to build-up of inflation expectations and surface in the expansionary phase of a significant back-up of long-term the business cycle. The test of success interest rates. Instead, more wrenching ful monetary policy in such a business measures would be need~d, with cycle phase is our ability to limit the unavoidable adverse side effects on upward movement of long-term rates near-term economic activity. from what it would otherwise have Inflation expectations likely have been with less effective policy. more of a forward-looking character Moderate to low long-term rates, than do measures of inflation itself, with rare exceptions, are an essential and, in principle, could be used as a ingredient of sustainable long-term direct guide to policy. But available economic growth. When we take surveys have limited coverage and credible steps to head off inflation are subject to sampling error. As I before it can begin to intensify, the have testified previously, price effects on long-term rates are muted. indexed bonds of various maturities, By contrast, when Federal Reserve which would indicate underlying action is seen as lagging behind the market inflation expectations, would need to counter a buildup of inflation be a useful adjunct to our information pressures, long rates have tended base for making monetary policy, to move sharply higher, as even- tually happened in the late 1970s. 14 This suggests an important conclusion: That level, of course, is difficult to Failure to tighten in a timely manner discern and, obviously, is not a fixed will lead to higher than necessary number but moves with developments nominal long-term rates as inflation within the economy and financial expectations intensify. Ultimately, markets. short-term rates will be higher as well Over a period of several years if policy initiatives lag behind inflation starting in 1989, the Federal Reserve pressures. The higher short-term rates progressively eased its policy stance, are required not only to take account in the process reducing real short-term of rising inflation expectations, but interest rates to around zero by the also to provide the additional restraint autumn of 1992. We undertook those on real rates necessary to reverse the easing actions in response to evidence destabilizing inflation process. of a variety of unusual restraints on For decades, the monetary aggre spending. Households and nonfinan gates, especially M2, provided cial businesses on the borrowing side generally reliable early warning and many lenders, including deposi signals of emerging inflationary tory institutions, were suffering from imbalances. But, as I have discussed in balance-sheet strains. These difficulties detail in previous testimonies and will stemmed from previous overleverag touch on later in this statement, the ing combined with reductions in net signals they have sent in recent years worth from impairments to asset have been effectively jammed by quality, through, for example, falling structural changes in financial markets values of commercial real estate. and the unusual nature of the current Corporate restructuring and defense business cycle. cutbacks compounded the problems of Our monetary policy strategy must the economy by reducing job opportu continue to rest, then, on ongoing nities and fostering a more general assessments of the totality of incoming sense of insecurity about employment information and appraisals of the prospects. probable outcomes and risks associ The deliberate maintenance of low ated with alternative policies. Our short-term rates for a considerable purpose over the longer run is to period was intended to decrease the help the economy grow at its greatest drag on the economy created by these potential over time. To do so, we headwinds. Households and busi must move toward a posture of nesses could refinance outstanding policy neutrality-that is, a level debt at much reduced interest cost. of real short-term rates consistent In addition, lower rates and improved with sustained economic growth performance by borrowers would at the economy's potential. take the pressure off of depository institutions, helping them recapitalize. 15 Low interest rates, along with reduced The projections of the FOMC financial strains, would encourage members suggest a continuation of private spending to pick up the slack good economic performance in 1994, left by defense cutbacks. Once finan with reasonable growth and subdued cial positions were well on the road to inflation. The central tendencies of the recovery, and employment and economic forecasts made by governors confidence began to recover, it was and Bank presidents imply expecta believed that the economic expansion tions that economic growth this year would gain self-sustaining momen likely will be 3 percent or slightly tum. At that point abnormally low real higher. With this kind of growth, a short-term real rates should no longer further edging down of the unemploy be needed. ment rate from its January reading is As the Federal Open Market Com viewed as a distinct possibility. mittee (FOMC) surveyed the evidence Inflation, as measured by the overall at its February 4 meeting, a consensus CPI, is seen as rising only a little developed that the balance of risks compared with 1993, even though last had, in fact, shifted. Debt repayment year's benefit from falling oil and burdens had been lowered enough to tobacco prices may not be repeated, unleash strong aggregate demand in and last year's crop losses could buoy the economy. Real short rates close to food prices in 1994. zero appeared to pose an unacceptable There are, of course, considerable risk of engendering future problems. risks to this generally favorable We concluded that our policy stance outlook. Some observers have pointed could be made slightly less accommo to downside risks to economic activity dative without threatening either the associated with fiscal restraint and continued improvement in balance weak foreign economies; I believe sheet structures or, ultimately, the these factors will have some effects, achievement of solid economic but they are likely to be less than growth. Indeed, the firming in reserve feared. As for fiscal restraint, a good market pressures was undertaken portion of the negative impact of last to preserve and protect the ongoing year's budget bill may already be economic expansion by forestalling behind us, as some households and a future destabilizing buildup of businesses have adjusted their inflationary pressures, which in our behavior to the new structure of taxes judgment would eventually surface and to curtailments in defense and if the level of policy accommodation other budget programs. that prevailed throughout 1993 were continued indefinitely. We viewed our move as low-cost insurance. 16 The concern about weak foreign I cannot, however, tell you at this time economies relates to the strength of when any such rise would occur; I foreign demand for U.S. exports going would hope that part of any increase forward. Many of our major trading in real short-term rates ultimately partners have been experiencing would be accomplished through economic difficulties. But some further declines in inflation expecta already appear to be pulling out of tions rather than through higher recession and a number of others seem nominal short-term rates. to have improved prospects. More In assessing our policy stance, we over, containing inflation will keep will continue to monitor developments increases in production costs of traded in money and credit, but in 1994 as in goods made in the United States 1993 the FOMC is unlikely to be able subdued, so that our products will to put a great deal of weight on the remain competitive in world markets. behavior of these aggregates relative to With competitive goods and an their ranges. We have set the ranges as improving world economy, the growth best we can in an evolving financial of U.S. exports should strengthen this situation to be consistent with our year, lessening the drag from the objectives for sustained growth and external sector on our output growth. low inflation. There are upside risks as well. Based on our experience in 1993 and Inventories have reached a low level expectations about financial relation relative to sales, suggesting the ships for 1994, the FOMC judges that possibility of a boost to production the growth of money and credit this from inventory rebuilding beyond that year will stay within the annual ranges currently anticipated. In addition, with set provisionally last July, which were both borrowers and lenders in reaffirmed at its meeting early this stronger financial condition, low month. Specifically, these ranges call interest rates have proven a powerful for growth of 1 to 5 percent for M2, stimulant to spending. While we were 0 to 4 percent for M3, and 4 to 8 per reasonably convinced at the last cent for domestic nonfinancial sector FOMC meeting that a zero real federal debt. The ranges are the same as the funds rate put real short rates below a final specifications established last July "neutral" level, we cannot tell this for 1993. Subcommittee, with assurance, The final specifications for last year precisely where the level of neutrality had gone through two rounds of tech currently resides. To promote sustain nical downward adjustment after they able growth, history suggests that real were first set provisionally in July 1992. short-term rates are more likely to have to rise than fall from here. 17 These downward revisions reflected of savings from retail deposits and the FOMC' s recognition that the money funds toward bond and stock relationship between spending and mutual funds may lessen, as house money holdings was departing hold portfolios more fully complete markedly from historical norms. the adjustment to the latter's height Financial intermediation was moving ened availability. Now that banks have away from past patterns, as flows of achieved healthier capitalization, they funds were increasingly being rechan may more readily issue large time neled away from banks toward deposits instead of equity and subordi securities markets, notably via bond nated debt to support stepped-up loan and stock mutual funds. Also, banks growth. Just how far these develop were relying more heavily on non ments will go, however, is difficult to deposit funding sources, such as predict, so the prospective relationship equity and subordinated debt, as they between spending and broad money strengthened their capital positions. remains highly uncertain. The FOMC In the event, growth of M2 and M3 will continue to monitor the behavior last year came in above the lower of money supply measures for bounds of their reduced ranges with evidence about underlying economic only ½percentage point to spare. M2 and financial developments more grew at 1½ percent and M3 at ½ per generally, but it will still have to base cent over the year as a whole. Even so, its assessments regarding appropriate nominal GDP advanced more than policy actions on a wide variety of 5 percent over the year, extending economic indicators. rapid increases in the velocities of Among those indicators, the Federal broad money through another year. Reserve will again pay attention to The discrepancy between the growth credit market developments, especially rates of nominal GDP and broad for any light they can shed on the money diminished some from that of strength of household and corporate 1992, but was still unusual in the face balance sheets and spending propensi of steady short-term interest rates. ties. The overall debt aggregate put in Somewhat faster growth of M2 and a repeat performance last year, again M3 this year than last year may be in growing by around 5 percent, even as prospect. The governors' and presi the advance of nominal GDP moder dents' outlook calls for a small stepup ated to a similar pace. But this steady in nominal spending, and the factors debt growth incorporated an upturn in depressing growth of the broader private borrowing, as the borrowing of aggregates relative to the expansion of the federal government slackened. spending could well abate to some degree. In particular, the diversion 18 Households in particular showed a In conclusion, the Federal Reserve heightened willingness to take on debt has welcomed both the strengthening to help finance strong purchases of in activity and the generally subdued homes and consumer durables. At the price trends, because the intent of our same time, massive mortgage refinanc monetary policy in recent years has ings at much reduced interest rates been to foster precisely this kind of contributed to further reductions in healthy economic performance. household debt-service burdens Looking forward, our policy approach relative to income to a level last seen will be to endeavor to select on a in the mid-1980s. For businesses as continuing basis the monetary well, the bite taken out of cash flow by instrument settings that will minimize interest payments was shrunk to a size economic instabilities and maximize last observed in the mid-1980s, partly living standards over time. The through the refinancing of higher-cost outlook, as a result of subdued debt and continued equity issuance. inflation and still low long-term Although business borrowing firmed a interest rates, is the best we have seen little, it remained subdued, as enough in decades. It is important that we do internal funds were available to everything we can to tum that finance the bulk of hefty capital favorable outlook into reality. expenditures. Looking ahead, federal borrowing is scheduled to diminish further this year, partly reflecting deficit reduction measures. Borrowing by nonfederal sectors should continue to strengthen, prodded by the anticipated pickup in nominal GDP and the healthier financial condition already attained by households and businesses. FRBl-44000--0294 19

Federal Reserve (1994, February 21). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_19940222

@misc{wtfs_monetary_policy_report_19940222,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {1994},
  month = {Feb},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_19940222},
  note = {Retrieved via When the Fed Speaks corpus}
}