Monetary Policy Report

1 9 9 4 M O N E T A R Y P O L I C Y OBJECTIVES Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 1 9 9 4 MONETARY P O L I C Y OBJECTIVES This Executive Summary provides highlights of the Board's Midyear Review to the Congress on the Full Employment and Balanced Growth Act of 1978. JULY 20, 1994 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Contents Section Page Monetary Policy and the Economic Outlook for 1994 and 1995 1 U.S. Economy 1 Economic Projections for 1994 and 1995 5 Money and Debt Ranges for 1994 and 1995 8 Testimony of Alan Greenspan Chairman, Federal Reserve Board 11 Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Monetary Policy and the Economic Outlook for 1994 and 1995 The U.S. Economy Despite disruptions caused by severe winter storms, real gross The favorable performance of the U.S. domestic product (GDP) rose at an economy continued in the first half of annual rate of 3½ percent in the first 1994. Economic activity advanced at a quarter, and available indicators point brisk pace, building on the substantial to another sizable gain in the second gains in late 1993, and broad measures quarter. Business fixed investment has of inflation moved still lower. Unem continued to grow rapidly this year, ployment declined, and industrial capacity utilization rose, substantially reducing the remaining slack in Real GDP resource use. Percent change, annual rate In this context, monetary policy has been directed this year at heading off a buildup of inflationary pressures that could jeopardize the continuation of the economic expansion. To do so, the Federal Reserve has had to move away from its highly accommodative policy stance of recent years. That stance had been adopted to counteract unusual + ----,,,:;;:r-~"""""'"-----'="-----""""'--J"""'--""-""L...l;i;il_--- 0 restraint on domestic spending associated in large part with the efforts of both borrowers and lenders to strengthen their financial condition. Data available in late 1993 and early 1990 1991 1992 1993 1994 1994 suggested that the restraint on spending had dissipated and that the economic expansion had become as firms have sought to improve strong and self-sustaining. Against this efficiency by installing state-of-the-art background, the Federal Reserve has equipment; rising utilization rates firmed money market conditions in have spurred interest in expansion of four steps this year. capacity as well. Consumer outlays have trended higher this year, buoyed by the considerable gains in income and an increased willingness to borrow or use savings; lately, though, Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 1 Private Housing Starts Inflation generally was moderate Annual rate, millions of units during the first half of 1994. Retail food and energy prices changed little, Quarterly average on balance, over this period, holding the rise in the consumer price index Q2* 1.5 (CPI) to 2½ percent at an annual rate. At the same time, prices for a wide range of materials used in manufac turing and construction have been boosted considerably by strong demand and the resulting higher rates of resource utilization. Looking ahead, retail energy prices likely will rise over the summer, pushed up by the rebound in crude oil prices in recent 1988 1990 1992 1994 * April-May average. months; in addition, the decline in the dollar since the beginning of the year, if not reversed, probably will exert spending growth appears to have some upward pressure on prices. moderated somewhat. The rise in long-term interest rates that began last fall has damped the growth of housing Consumer Prices * activity this year, but the effect has Percent change, Dec. to Dec. been relatively mild, in part because homes remain quite affordable by the standards of the past two decades. In the labor market, the employment 6 gains during the first half of this year were substantially more rapid than in ~--------4 1993, and the unemployment rate has continued to move lower. 2 1988 1990 1992 1994 * Consumer price index for all urban consumers. ** Percent change, December 1993 to June 1994. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 2 The Federal Reserve' s policy actions Foreign Exchange Value this year have raised the federal funds of the U.S. Dollar* rate to around 4¼ percent, from Index, March 1973 = 100 3 percent, and have boosted the discount rate to 3½ percent, also from 3 percent. Other market interest rates have risen 1¼ to 1¾ percentage points since the beginning of the year. Increases in intermediate-and long term rates have been unusually large relative to the adjustment of short term rates, reflecting stronger-than anticipated economic growth and market expectations of greater inflationary pressures, as well as actual and expected tightening actions by the 1988 1990 1992 1994 Federal Reserve to contain those ,. Index of weighted average foreign exchange value pressures. On occasion, the declining of U.S. dollar in terms of currencies of other G-10 countries. Weights are based on 1972-76 global value of the dollar also appeared to trade of each of the 10 countries. . contribute to higher yields. Markets have been volatile at times this year as investors have adjusted to a changing Despite the rise in U.S. interest rates, economic and policy outlook. The the dollar has declined considerably uncertain conditions encouraged this year, with its trade-weighted investors to try to reduce their risk foreign exchange value against the exposure, and the associated attempts Group of Ten (G-10) countries falling to make large shifts in portfolios over about 8 percent. Rising long-term short periods seemed to add to the interest rates abroad, associated with upward pressure on long-term rates at brighter prospects for economic times. growth, tended to offset the effect on the dollar of higher U.S. rates. More over, other factors, including dimin ished hopes for a prompt resolution of trade tensions with Japan and market concerns about future inflation in the United States, fostered downward pressure on the dollar. This pressure was especially intense in late April and early May and again in the second half of June and first half of July. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 3 The U.S. Treasury and the Federal Long-Term Interest Rates Reserve made substantial dollar Percent purchase~ on three occasions during these periods to deal with volatile Monthly trading conditions and movements in the dollar judged to be inconsistent with economic fundamentals. Other governments shared the concern of U.S. officials, and the more recent operations were coordinated with the monetary authorities of a large number of other countries, including the other members of the Group of Seven (G -7). Thirty-year Treasury Bond The strength of spending and a 1982 1984 1986 1988 1990 1992 1994 renewed willingness to use and extend credit contributed to a pickup in borrowing by households and busi In contrast to the strength of private nesses _in the second half of last year, borrowing, the growth of federal and this trend extended into the first goveri:unent debt has slowed this year, ~alf of 1994. However, the composi reflecting the subdued growth of ~on o~ borrowing has been affected by expenditures and sharply higher tax finane1al market conditions. Rising and rec~ipts associated with fiscal policy more volatile long-term interest rates actions and the robust economy. As a have encouraged businesses to rely result, the total debt of the domestic more heavily on sources of shorter nonfinancial sectors expanded at about term financing, such as finance a 5¼ percent annual rate from the companies and banks, and have fourth quarter of 1993 through May, prompted households to shift to close to its pace over the second half of adjustable rate mortgages. Banks, last year and well within its monitor which had been hampered by balance ing range of 4 to 8 percent. sheet problems of their own in recent Growth of the broad money years, sought business and household aggregates has not kept pace with that loans more aggressively by continuing ?f nominal GDP again this year. M2 to ease credit standards and the increased at about a 1¼ percent annual nonprice terms of lending. Total rate from the fourth quarter of last commercial bank credit has increased year through June, while M3 fell considerably this year, and thrift slightly, placing these aggregates institution credit, which contracted around the lower bounds of their sharply between 1989 and 1993, respective annual growth ranges. appears to have expanded a bit. Digitized for FRASER https://fraser.stlouisfed.org 4 Federal Reserve Bank of St. Louis In the usual pattern, increases in rates Even with more subdued moves in on retail deposits and on money securities prices since the late spring, market mutual funds have lagged the many small investors have retained a rise in market interest rates, inducing a more cautious view of the possible redirection of savings from M2 into risks and rewards of holding capital market instruments and boosting M2 market instruments, and total inflows velocity. With returns on interest to bond and stock mutual funds have paying checking accounts virtually remained considerably weaker than in unchanged, compensating balance the past few years. The effect of these requirements for demand deposits slower flows on M2 has been offset by reduced by rising rates, and transac shifts into direct holdings of market tions balances also depressed by instruments, such as Treasury bills. several special influences, Ml growth As a consequence, the sum of M2 and this year has slowed to less than half household holdings of bond and stock its rate of advance in 1993; through mutual funds has decelerated sharply June, this aggregate had expanded at this year. about a 4 percent annual rate since the fourth quarter of last year. Owing to Economic Projections the anemic expansion of transactions for 1994 and 1995 deposits, total reserves fell slightly The members of the Board of Gover over the first half of the year. Only nors and the Reserve Bank presidents, continued strong demand for cur all of whom participate in the delibera rency, much of which reflected use tions of the Federal Open Market abroad, has supported growth in Ml Committee, generally anticipate that and the monetary base. the growth of real GDP will moderate In contrast to 1992 and 1993, shifts during the second half of this year and into bond and stock mutual funds into 1995 from the unsustainable pace were not a major factor in the rise in in recent quarters. Employment gains M2 velocity this year. Falling securities through the end of 1995 are expected prices created capital losses for bond roughly to balance the net flow of and equity mutual funds, prompting individuals into the labor force, some fund holders to reevaluate the leaving the unemployment rate about risks and prospective returns of such unchanged from its average level in investments. Bond mutual funds the second quarter of this year. experienced outflows this spring, and Inflation is expected to pick up a little a portion of the proceeds was directed over the next year and one-half. to less-risky money market mutual funds, thus elevating M2 for a time. Digitized for FRASER https://fraser.stlouisfed.org 5 Federal Reserve Bank of St. Louis The forecasts of the Board members rise 3 to 3¼ percent over the four and Reserve Bank presidents for quarters of this year. For 1995, the economic growth in 1994 are quite central tendency of the forecasts close to those made in February. Most is a range of 2½ to 2¾ percent. continue to expect that real GDP will Economic Projections for 1994 and 1995 FOMC Members and Other FRB Presidents Administration Central 1994 Range Tendency Percentage Nominal GDP 5¼ to 6½ 5½ to6 5.8 change, fourth quarter Real GDP 3 to3½ 3 to3¼ 3.0 to fourth quarter Consumer price index 2½ to 3½ 2¾ to3 2.9 Average level in the fourth Civilian unemployment rate 6to6¼ 6 to6¼ 6.2 quarter, percent Central 1995 Range Tendency Percentage Nominal GDP 4½ to 6¼ 5 to5½ 5.6 change, fourth quarter Real GDP 2¼ to 2¾ 2½ to2¾ 2.7 to fourth quarter Consumer price index 2 to4½ 2¾ to3½ 3.2 Average level in the fourth Civilian unemployment rate 5¾ to 6½ 6to6¼ 6.2 quarter, percent Digitized for FRASER https://fraser.stlouisfed.org 6 Federal Reserve Bank of St. Louis Civilian Unemployment Rate * These forecasts envision the next Percent several quarters as a period of transi tion to a more moderate expansion accompanied by reasonably full use of available resources. This transition ----------------8 already is evident in the housing market and, perhaps, in consumer outlays as well. The resulting decelera tion in private domestic spending is expected to be offset, in part, by a smaller decline in net exports than ----------------4 that registered over the past several quarters; this projection for the external sector largely reflects the expectation of stronger economic 1988 1990 1992 1994 * Data after December 1993 are not consistent with expansion abroad. earlier data because of major revisions to the The Board members and Reserve survey from which the series is generated. Bank presidents generally expect the rise in the consumer price index over the four quarters of 1994 to end up in The unemployment rate anticipated in the range of 2¾ to 3 percent. So far this the fourth quarter of 1994 has been year, retail energy prices have been flat revised down about ½ percentage on balance and retail food prices have point from that projected in February.1 moved up only a little, restraining the The forecasts of the unemployment rise in the total CPL However, given rate in the fourth quarter of 1994 are the runup in crude oil prices of late now bunched between 6 and 6¼ per and the unlikely prospect of another cent; this range is also the central large drop in the prices of fruits and tendency of the projections for the vegetables, the rate of inflation fourth quarter of 1995. projected for the next year and one-half is slightly higher than that posted recently. The decline in the I. The unemployment forecast in February was dollar to date, if not reversed, also subject to an unusual degree of uncertainty, as it was made shortly after the introduction of major revisions could exert some mild upward to the survey that generates the unemployment data. pressure on inflation. In February, the revised survey was believed to have boosted the unemployment rate from January 1994 forward by roughly ½ percentage point. Subsequent analysis has indicated that the upward shift caused by the new survey probably was smaller than originally thought. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis 7 The Administration recently Money and Debt Ranges released its mid-year update of for 1994 and 1995 economic and budgetary projections. At its July 1994 meeting, the Federal The projections for nominal and real Open Market Committee (FOMC) GDP growth, inflation, and unemploy reviewed the annual ranges for ment for 1994 and 1995 fall within the money growth for 1994 that it had ranges anticipated by Federal Reserve established in February. In light officials and are essentially consistent of the experience of the first half of with the central tendency of those the year and the likelihood that funds ranges. Thus, it would appear that the would continue to be diverted from monetary ranges set by the FOMC are deposits to higher yielding market compatible with the goals of the instruments, the Committee expected Administration. a substantial increase in the level of Both Federal Reserve policymakers M2 velocity over 1994. M3 velocity and the Administration anticipate also was seen as likely to rise quite further economic expansion accompa sharply, given the funding patterns of nied by relatively low inflation. The depository institutions, which had Federal Reserve can do its part to been favoring sources of funds not prolong and enhance this favorable included in M3, such as capital and performance of the economy b~ . borrowing from overseas offices. continuing to set monetary policy m accord with the long-run objective of price stability. An environment?~ Ranges for Growth of Monetary and stable prices is a necessary condition Credit Aggregates 1 for attaining the maximum sustainable Percent growth of productivity and living standards. However, the outcome for Provisional the economy also will depend on Aggregate 1993 1994 for 1995 government policy in other areas. In this regard, Congress and the M2 1-5 1-5 1-5 Administration can help ensure that the nation's economy reaches its full M3 0-4 0-4 0-4 potential by working to keep the federal budget deficit on a downward Debt2 4----8 4----8 3-7 course, by promoting an open world trading system, and by adopting 1. Change from average for fourth quarter of regulatory policies that preserve the preceding year to average for fourth quarter of year indicated. . flexibility of labor, product, and 2. Monitoring range for debt of domestic financial markets and minimize the nonfinancial sectors. costs imposed on the private sector. Digitized for FRASER https://fraser.stlouisfed.org 8 Federal Reserve Bank of St. Louis As a consequence, the Committee The Committee also decided to continued to expect that money retain its current monitoring range of growth within, though perhaps 4 to 8 percent for growth in the debt toward the lower end, of the ranges of aggregate during 1994. With debt 1 to 5 percent for M2 and O to 4 per expanding at a rate close to that of cent for M3 would be consistent with nominal income, the FOMC' s expecta its broader objective of fostering tion for the growth in nominal GDP financial conditions that would sustain for the year suggested that the debt economic expansion and contain price aggregate would finish the year pressures. It therefore voted to retain comfortably within this range. In 1995, these ranges for 1994. With little however, the Committee expected that information to suggest any new trends macroeconomic performance consis in velocity for 1995, the Committee tent with sustainable expansion would chose simply to carry forward the 1994 involve some slowing in the growth of ranges for M2 and M3 as provisional nominal spending and moderate ranges for those aggregates in 1995. growth in debt; indeed, rapid credit The Committee noted that these growth might suggest the possibility ranges, especially that for M2, pro of a borrow-and-spend psychology vided an indication of the longer-run typical of strengthening inflation. growth that might be expected in this Consequently, the Committee voted to aggregate with the attainment of set provisionally the 1995 monitoring reasonable price stability and a return range for debt growth at 3 to 7 percent, to the past pattern of velocity fluctuat a reduction of 1 percentage point. ing around a constant long-run level. Considerable uncertainty about the behavior of velocity is likely to persist, however, and the FOMC will continue to monitor a broad range of financial and economic indicators in addition to the monetary aggregates, when determining the appropriate stance of policy. Digitized for FRASER https://fraser.stlouisfed.org 9 Federal Reserve Bank of St. Louis Growth of Money and Debt Percent Domestic Period Ml M2 M3 Nonfinancial Debt Annual1 1980 7.4 8.9 9.6 9.1 1981 5.4 (2.5)2 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 5.0 1994 Semiannual H1 4.0 1.6 ---0.1 5.44 (annual rate)3 1994 Ql 6.0 1.8 0.2 5.9 Quarter (annual rate)5 Q2 2.0 1.5 ---0.3 4.74 l. From average for fourth quarter of preced- 4. Second quarter debt aggregate based on ing year to average for quarter of year indicated. data through May. 2. Figure in parentheses is adjusted for shifts 5. From average for preceding quarter to to NOW accounts in 1981. average for quarter indicated. 3. From average for fourth quarter of 1993 to average for second quarter of 1994. Digitized for FRASER https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis Testimony of Alan Greenspan Chairman, Federal Reserve Board Mr. Chairman and members Our actions this year can be under stood by reference to policy over the of the Committee, I appreciate previous several years. Through that this opportunity to discuss period, the Federal Reserve moved toward and then maintained for a with you recent economic considerable time a purposefully developments and the Federal accommodative stance of policy. During 1993, that stance was associ Reserve' s conduct of monetary ated with low levels of real short-term policy. interest rates--around zero. We judged that low interest rates would be The favorable performance necessary for a time to overcome the of the economy continued effects of a number of factors that were restraining the economic expansion, in the first half of 1994. including heavy debt burdens of Economic growth was strong, households and businesses and tighter credit policies of many lenders. By unemployment fell apprecia early this year, however, it became bly, and inflation remained clear that many of these impediments had diminished and that the economy subdued. To sustain the had consequently gained considerable expansion, the Federal Reserve momentum. In these circumstances, it was no longer appropriate to maintain adjusted monetary policy over an accommodative policy. Indeed, recent months so as to contain history strongly suggests that mainte nance of real short-term rates at levels potential inflation pressures. prevailing last year ultimately would have fueled inflationary pressures. Accordingly, the Federal Open Market Committee at its meeting in early February decided to move away from its accommodative posture by tightening reserve market condi tions. Given the level of real short term rates and the evident momentum in the economy, it seemed likely that a substantial cumulative adjust ment of _policy would be needed. Digitized for FRASER 11 https://fraser.stlouisfed.org Federal Reserve Bank of St. Louis However, Committee members With financial markets evidently better recognized that financial markets were prepared to absorb a larger move, the not fully prepared for this action. Federal Reserve could substantially About five years had passed since the complete the removal of the degree of previous episode of monetary firming, monetary accommodation that and a number of market participants prevailed throughout 1993. The Board in designing their investment strate raised the discount rate½ percentage gies seemed to give little weight to the point, a move that was fully passed possibility that interest rates would through to reserve market conditions rise; instead, many apparently by the FOMC. Overall, the federal extrapolated the then-recent, but funds rate increased 1 ¼ percentage highly unusual, extended period of points during the first half of the year, low short-term interest rates, fairly and real short-term rates likely rose a steady capital gains on long-term similar amount. Partly to minimize investments, and relatively stable any market confusion about the extent conditions in financial markets. Many of and rationale for our moves, the Committee members were concerned Federal Reserve has announced each that a marked shift in the stance of action and, in relevant instances, policy, while necessary, could precipi provided an explanation. At its tate an exaggerated reaction in meeting in early July, the FOMC faced financial markets. considerable uncertainty about the With this in mind, we initially pace of expansion and pressures on tightened reserve conditions only prices going forward, and it made no slightly-just enough to raise the further adjustment in its policy stance. federal funds rate¼ percentage point. Nonetheless, it is an open question And the financial markets did indeed whether our actions to date have been react sharply, with substantial sufficient to head off inflationary increases in longer-term interest rates pressures and thus maintain favorable and declines in stock prices. Markets trends in the economy. Labor demand remained unsettled for several has been quite strong, pointing to months, and we continued to move robust growth in production and cautiously in March and April incomes. To be sure, some hints of in the process of moving away from moderation in the growth of domestic our accommodative stance. By final demand have appeared, and the mid-May, however, a considerable recent indications of accelerating portion of the adjustment in port inventory accumulation may suggest folios to the new rate environment an unwanted backing up of stocks. appeared to have taken place. Digitized for FRASER https://fraser.stlouisfed.org 12 Federal Reserve Bank of St. Louis Conversely, the inventory accumula The economic figures that have tion may reflect pressures on firms formed the backdrop for our policy who had brought inventories down to actions so far this year confirm that a suboptimal levels and now need to rapid expansion has been in progress. replenish them. In the latter case, Following growth at an annual rate of stock-building may continue at an 7 percent in the fourth quarter of last above-normal rate, supporting year, real gross domestic product rose production for quite some time. at nearly a 3½ percent rate in the first Moreover, the improving economic quarter. A conceptually equivalent conditions of our trading partners measure of aggregate output, gross should add impetus to aggregate domestic income, exhibited even larger demand from the external sector. gains in the fourth and first quarters. How these forces balance out in the At this stage, available data leave coming months could be critical in some uncertainty regarding the pace of determining whether inflation will economic activity over the past three remain in check, for the amount of months. Nonetheless, the evidence in slack in the economy, while difficult to hand makes it reasonably clear that judge, appears to have become growth remained appreciably above relatively small. Concerns that its longer-run trend. The robust productive capacity could come under expansion over the first half of 1994 pressure and prices accelerate are has been reflected in substantial already evident in commodity and increases in employment. Since last financial markets, including the December, nonfarm payrolls have foreign exchange market. An increase risen by 1¾ million workers, bringing of inflation would come at consider the gain in jobs since the expansion got able cost: We would lose hard-won underway to 5 million. Reflecting this ground in the fight against inflation hiring, the civilian unemployment rate expectations-ground that would be has fallen to 6 percent. difficult to recapture later; our Although labor markets have long-run economic performance tightened considerably in recent would be impaired by the inefficien months, aggregate measures of wage cies associated with higher inflation if and compensation rates have not yet it persisted; and harsher policy actions evidenced persuasive signs of accelera would eventually be necessary to tion. Similarly, the increases in the reverse the upsurge in inflationary consumer price index excluding instabilities. We are determined to food and energy, at about a 3 percent prevent such an outcome, and cur rate over the last six months, have rently are monitoring economic and remained near last year's pace, financial data carefully to assess while the overall CPI has risen at whether additional adjustments are a reduced rate of about 2½ percent. appropriate. Digitized for FRASER https://fraser.stlouisfed.org 13 Federal Reserve Bank of St. Louis To be sure, price pressures have been One of the effects of the extended manifest at earlier stages of processing: market rallies of recent years was to Costs of many commodities and promote a rather complacent view materials have been climbing, in some among investors about the risks of cases reflecting the tightening of holding long-term assets. In response, industrial capacity utilization, which is they gradually increased the propor now at its highest level in five years. tions of their portfolios devoted to But these pressures have been offset stocks and bonds, driving up their by favorable trends in unit labor costs prices still further and narrowing risk resulting from marked improvements spreads. But when developments in productivity-especially in earlier this year surprised investors manufacturing-in recent years. and diminished their confidence in The accumulating evidence of predicting future market conditions, stronger-than-expected economic they pulled back from long positions growth here and abroad, combined in securities until returns rose to with changing expectations of policy compensate them for the additional actions by the Federal Reserve as well price risk. as other central banks, prompted The recent weakness in bond prices considerable increases in long-term was not limited to the United States, interest rates in occasionally volatile but was accompanied by a surge in markets over the first half of the year. foreign interest rates. This surge was Market participants concluded that, particularly informative; ordinarily with aggregate demand stronger, one would expect that as interest rates higher real rates would be necessary to go up in one country, they would not hold growth to a sustainable pace. increase to the same extent in others Inflation expectations may also have because exchange rates also would be been revised higher, as the perfor expected to adjust. The initial jump in mance of the economy seemed to foreign interest rates was a sign of the make further near-term progress extraordinary increase in uncertainty against inflation less likely and raised as, evidently, investors attempted to questions about whether price reduce their price-sensitive long pressures might intensify. positions by selling stocks and bonds To a degree, the very volatility of regardless of currency denomination markets probably augmented the or economic conditions in the country backup in long-term interest rates. of issuance. Roughly concurrently, moreover, signs that the slump in some foreign industrial economies was ending also were becoming apparent. Digitized for FRASER https://fraser.stlouisfed.org 14 Federal Reserve Bank of St. Louis As a result, market participants Rising interest rates and consider anticipated stronger credit demands able volatility in financial markets do abroad and a reduced likelihood of not seem to have slowed overall credit further easing by some foreign central flows this year. At about a 5¼ percent banks, and intermediate-and longer annual rate through May, domestic term rates in many of our trading nonfinancial sector debt has increased partners rose as much as or more than within its 4-to-8 percent monitoring in the United States. range. The composition of debt Rising foreign interest rates, growth, however, has differed from concerns in markets about the pros the patterns of the previous few years. pects for reduced trade tensions and Expansion of federal debt has slowed about U.S. inflation contributed to as the actions of the Congress and the considerable activity directed at Administration as well as cyclical rebalancing international investment forces have narrowed the budget portfolios. One effect of this activity deficit considerably. The total debt of appears to have been a substantial businesses, households, and state and decline of the foreign exchange value local governments, by contrast, has of the dollar on net over the past six risen this year at a brisker pace, months. Foreign exchange rates are though growth has remained quite key prices in the American economy, moderate in comparison with the with significant implications for the average experience of recent decades. volumes of exports and imports as The pickup this year indicates both well as for the prices of imports and that private borrowers have become domestically produced items that less cautious about taking on debt and compete with imports. The foreign that lenders have become more exchange value of the dollar also can comfortable lending to them. provide useful insights into inflation Although household debt-income expectations. If we conduct an ratios remain high, debt-service appropriate monetary policy-and burdens have fallen appreciably, appropriate economic policies more partly reflecting the refinancing of generally-we shall achieve our goals mortgages at lower interest rates. The of solid economic growth and price lower debt burdens evidently have stability, and such economic results fostered a more favorable attitude will ensure that dollar-denominated toward credit among households, and assets remain attractive to global consumer installment borrowing has investors, which is essential to the accelerated, with strong growth of dollar's continuing role as the world's consumer loans at banks. Banks have principal reserve currency. been increasingly willing to extend credit, easing their terms and stan dards on business loans considerably. Digitized for FRASER https://fraser.stlouisfed.org 15 Federal Reserve Bank of St. Louis In addition, some firms have turned to The increases in market rates this banks for financing because of the year have exerted a particular drag on turbulence in bond and stock markets the narrower monetary aggregates, as this spring. Total bank lending has well as on the closely related reserves strengthened materially and, with and monetary base measures. Ml has continued acquisitions of securities, expanded at only a 4 percent rate so total bank credit has picked up as well. far this year, compared with 10½ per Nonetheless, growth of the monetary cent increases in each of the previous aggregates remains damped, as banks two years. Ml's velocity has continued have relied heavily on non-deposit to fluctuate sharply, limiting its sources of funds to finance loan usefulness in formulating and inter growth. preting monetary policy. The growth Expansion of M2 has been quite of Ml this year would have been even slow this year, leaving this aggregate lower were it not for continued heavy near the lower end of its 1-to-5 percent demands for U.S. currency abroad. annual range. M3 actually has edged Flows of currency overseas have an down, and thus is just below its even greater effect proportionately on 0-to-4 percent range for 1994. The the monetary base, which has growth weakness in the broader aggregates rapidly this year despite declines in has not been reflected in the growth of the reserves of depository institutions. income again this year, representing a In reviewing its ranges for money continuation of the substantial growth in 1994, the FOMC noted that increases in velocity that we have further increases in velocity of M2 and experienced over the past few years. M3 were likely. Although yields on The factors behind this behavior, deposits will probably continue to rise however, have changed somewhat. further in lagged response to increases The diversion of savings funds from in market rates, the wider rate disad deposits to bond and stock mutual vantage of deposits is likely to persist, funds, which sharply depressed and savers will continue to redirect money growth in past years, seems to flows into market instruments. As a have slowed substantially; the experi result, growth of both aggregates near ence with capital losses this spring the lower bounds of their 1994 ranges apparently has heightened some is considered to be consistent with investors' appreciation of the risks of achieving our objectives for economic such instruments. On the other hand, performance, and the ranges were left rising short-term market interest rates, unchanged. combined with the usual lag in the adjustment of deposit rates, have been a significant restraint on growth of the aggregates this year, in contrast to 1992 and 1993. Digitized for FRASER https://fraser.stlouisfed.org 16 Federal Reserve Bank of St. Louis The Committee also decided on a As usual, we shall review carefully all provisional basis to carry forward the of the provisional ranges for 1995 in current ranges fdr the monetary February. aggregates to 1995. We were not Given the rapid pace of financial confident that we could predict with change, considerable uncertainties sufficient accuracy the money-income continue to attend the relationships relationships that were likely to of all of the aggregates to the perfor prevail next year: to modify the ranges. mance of the economy and inflation, Moreover, further permanent reduc and we do not expect in the near term tions of the monetary ranges did not to increase the weight accorded in seem necessary, as those ranges are policy formulation to these measures. already low enough to be consistent However, the processes of portfolio with the goal of price stability and reallocation that have generated these maximum sustainable economic recent shifts may be slowing. We shall growth, assuming an eventual return continue to monitor monetary growth, to more stable velocity behavior. From and financial flows more generally, for that point of view, we felt that information about the course of the maintenance of the current monetary economy and prices in coming to ranges would give the clearest decisions regarding adjustments indication of the long-run intentions to the stance of monetary policy. of policy. We expect that expansion of money Regarding domestic nonfinancial and credit within the ranges we have sector debt, we made no adjustment to established will be consistent with this year's monitoring range, but continuation of good economic elected to set a provisional monitoring performance. With appropriate range for 1995 of 3 to 7 percent, a monetary policies, the Board members percentage point lower than this and Reserve Bank Presidents see the year's. A lower range would conform economy settling into more moderate with some deceleration in nominal rates of growth over the next six income, in the process of containing quarters and inflation remaining inflation and ultimately making relatively subdued. Specifically, progress toward price stability. The the central tendencies of our fore reduction is not intended to signal an casts are for real GDP to expand increased emphasis on the debt 3 to 3¼ percent over 1994 and measure, but it is supported by our 2½ to 2¾ percent next year. The view that rapid debt growth, if consumer price index is projected sustained, can eventually lead to to increase 2¾ to 3 percent this year. significant imbalances that are inimical to stable, noninflationary growth. Digitized for FRASER https://fraser.stlouisfed.org 17 Federal Reserve Bank of St. Louis In 1995, inflation may be about the The Administration, for example, same as in 1994 or slightly higher; the projected in its most recent forecast recent depreciation in the dollar is that the economy will expand at a likely to put upward pressure on 2.5 percent rate in the second half of inflation over the next year if it is not the 1990s and unemployment will reversed. With the pace of hiring likely average 6.1 percent. These projections to about match that of labor force are consistent with common estimates growth, the unemployment rate is of the economy's potential growth rate expected to remain close to its recent and fall within the range of typical level. estimates of the so-called "natural Mr. Chairman, you also asked for rate" of unemployment. economic projections for 1996. I fully Uncertainties around these estimates appreciate your purpose in requesting arise because identifying economic this information. However, my relationships is always difficult, partly colleagues and I don't think we can owing to limitations of the data. But best communicate our policy inten more fundamentally, all policymakers tions through additional numerical recognize that notions of potential forecasts. Rather, we believe our GDP growth and the natural rate of intentions are best conveyed in terms unemployment are considerable of our declared objective of fostering simplifications, useful in conceptual as much growth of output and models but subject to a variety of employment as can be achieved real-world complications. Our econ without placing destabilizing inflation omy is a complex, dynamic system, ary pressures on productive resources. comprising countless and diverse There is considerable uncertainty households, firms, services, products, about what that goal implies for the and prices, interacting in a multitude expansion of GDP and rates of of markets. Estimates of macroeco unemployment. nomic relationships, as best we can That said, it may be useful to note make them, are useful starting points that the assumptions underlying the for analysis-but they are just starting medium-term projections provided points. to you by the Administration and the Given questions about the aggregate Congressional Budget Office (CBO) relationships, policymakers need to are within the mainstream of think look below the surface, in markets ing among academics and private themselves; for evidence of tightness business economists. These projec that might indicate whether inflation tions do not attempt to anticipate ary pressures are indeed building. cyclical movements, but instead represent estimates of the likely performance of the economy in the neighborhood of its potential. Digitized for FRASER https://fraser.stlouisfed.org 18 Federal Reserve Bank of St. Louis One important source of such evidence we would also expect to see increas is the reports we receive from our ingly frequent signs of shortages of Reserve Banks through their extensive goods as well as labor. Businesses contacts in their communities. These might have difficulty in obtaining reports are released to the public in the certain materials. Vendor performance "beige book" and are updated would deteriorate, and lead times frequently on the basis of confidential on deliveries of new orders would information from individual firms and increase. Pressures on supplies of financial institutions-by the Reserve materials and commodities would be Bank officials at our meetings and reflected in rising prices of these items. through normal intermeeting commu Of course, we would not expect to nications. Another source of useful see these phenomena occur simulta information is individual industries neously throughout the economy and trade groups, which provide quite the contrary. And, to a degree, many timely indicators that are these symptoms occur in a few sectors sensitive to supply-demand condi even in noninflationary economies. But tions in particular sectors. a noticeable step-up in their incidence If the economy were nearing could constitute evidence of an capacity, we would expect to see incipient inflationary process. certain patterns in the statistical and In recent months, we have seen anecdotal information with increasing some of these signs. There are reports frequency and intensity. Reports of of shortages of some types of labor shortages of skilled labor, strikes, and construction workers and truck instances of difficulties in finding drivers, for instance. Indexes of workers in specific regions all would vendor performance have deteriorated be more likely. To attract additional considerably, and manufacturers are workers, employers would presum paying higher prices for materials ably step up their use of want-ads and used in their production processes. might begin to use nonstandard As yet, these sorts of indications do techniques, such as signing or recruit not seem to be widespread across the ing bonuses. More firms might choose economy. Nonetheless, we shall need to bring on less skilled workers and to be particularly alert to these emerg train them on the job. All of these ing signs in considering further adjust steps in themselves could add ments to policy in the period ahead. to costs and suggest developing inflationary imbalances. As firms experienced difficulty in expanding production to meet rising demand, Digitized for FRASER https://fraser.stlouisfed.org 19 Federal Reserve Bank of St. Louis Financial flows may also impart A more significant issue for eco useful warnings of price pressures. For nomic policymakers than the precise example, persistent unsustainably low values of such estimates is what can be real interest rates might prompt very done to maximize sustainable employ rapid credit growth, as expectations of ment and economic growth. We need, price increases led households and for example, to give careful attention firms to accelerate purchases of to the problem of unemployment, as durable goods and equipment and noted by the G-7 leaders at their recent finance these expenditures by stepping summit. We could raise output and up the pace of borrowing. Although living standards around the world consumer borrowing has accelerated and at the same time ease many social considerably of late, overall debt problems if more people were work growth has so far remained moderate. ing. Here at home, nearly eight million In light of the uncertainties about Americans are looking for work. aggregate measures of our economic At this stage of the business cycle potential, the Federal Reserve cannot having experienced almost forty rely heavily on any one estimate of months of expansion and particularly either the natural rate of unemploy strong growth recently-most of this ment or potential GDP growth. Most unemployment probably is not due important, we have no intention of to a shortfall in aggregate demand. setting artificial limits on employment Rather, a good deal of it is likely or growth. Indeed, the Federal Reserve ''frictional,'' reflecting the ordinary would be pleased to see more rapid process of workers moving between output growth and lower unemploy jobs, or "structural," resulting from ment than projected by forecasters longer-term mismatches between such as the CBO and the workers and available jobs. Monetary Administration-provided they were policy, which works mainly by sustainable and consistent with influencing aggregate demand, is not approaching price stability. I should suited to addressing such problems. note, however, that most Federal But we ought to be encouraging other Reserve policymakers would not measures to increase the flexibility of regard the inflation projections of our workforce and labor markets. these other forecasters, which gener Improving education and training ally do not foresee further progress and facilitating better and more rapid toward price stability over the matching of workers with jobs are medium term, as a desirable outcome. essential elements in making more effective use of the U.S. labor force. Digitized for FRASER https://fraser.stlouisfed.org 20 Federal Reserve Bank of St. Louis Just as important, Congress should As I have emphasized many times, avoid enacting policies that create the Federal Reserve also can contribute impediments to the efficient move to the achievement of our overriding ment of individuals across regions, goal-maximum sustainable economic industries, and occupations, or that growth-by pursuing and ultimately unduly discourage the hiring of those achieving a stable price level. Without seeking work. Competitive markets the uncertainties engendered by have shown a remarkable ability to inflation, households and firms are create rising standards of living when better able to plan for the future. And left free to function. firms focus on maximizing profitabil Congress and the Administration ity by holding down costs and also can continue to contribute to the increasing productivity rather than by growth of our economy's capital and using inflationary conditions to productivity through a sound fiscal support price increases. There is some policy. The extension of the spending evidence to suggest that the stronger caps in last year's budget agreement trend of productivity growth we have was a significant step in putting fiscal witnessed over the recent past is due policy on a more sustainable long-run at least partly to the beneficial effects path. Budget deficit reduction has of low rates of inflation. proved to be particularly timely, by Our nation has made considerable reducing the government's claim on progress in putting the economy on a savings just as households and firms sound footing in the past few years. are seeking more capital to finance To preserve and extend these investments. But under current law, advances, our monetary and fiscal the deficit as a percent of GDP will policies will need to remain disci begin to expand again as we move plined and focused on our long-term into the next century, with unaccept objectives; we would be foolish to able consequences for financial squander our recent gains for near stability and economic growth. The term benefits that would prove primary cause of this increase will be ephemeral. Indeed, by fostering federal outlays, which will almost progress toward price stability, surely again be rising at a pace that achieving lower federal budget will exceed the growth of our tax deficits, and encouraging competitive base. Only by reducing the growth markets both here and abroad, we will in spending is ultimate balance help ensure the continued vitality of achievable. our nation's economy now and for many years into the future. FRBl-46000-0794 Digitized for FRASER https://fraser.stlouisfed.org 21 Federal Reserve Bank of St. Louis

Federal Reserve (1994, July 19). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_19940720

@misc{wtfs_monetary_policy_report_19940720,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {1994},
  month = {Jul},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_19940720},
  note = {Retrieved via When the Fed Speaks corpus}
}