Monetary Policy Report

For use at 10:00 a.m., E.S.T. Wednesday February 22, 1995 Board of Governors of the Federal Reserve System . .. .•• ;·c.oV,··. . . . :c5 ;_·• :• . . ..,. .,\ tL;. .1..1: " . . ••• ..L. .RE. .. .• • Monetary Policy Report to the Congress Pursuant to the Full Employment and Balanced Growth Act of 1978 February 21, 1995 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., February 21, 1995 THE PRESIDENT OF THE SENATE THE SPEAKER OF THE HOUSE OF REPRESENTATIVES The Board of Governors is pleased to submit its Monetary Policy Report to the Congress, pursuant to the Full Employment and Balanced Growth Act of 1978. Sincerely, ~ Alan Greenspan, Chairman Table of Contents Page Section 1: Monetary Policy and the Economic Outlook for 1995 1 Section 2: The Performance of the Economy 5 Section 3: Monetary and Financial Developments 19 Section 1: Monetary Policy and the Economic Outlook for 1995 The U.S. economy turned in a strong performance moves. However, a further substantial tightening in in 1994. Real gross domestic product increased November and some tentative signs of moderation in 4 percent over the four quarters of the year. The economic activity around year-end and in early 1995 employment gains associated with this rise in produc appeared to reduce market concerns about increased tion outpaced growth of the labor force by a sizable inflation pressures and additional Federal Reserve margin, and the unemployment rate thus declined policy actions. As a result, long-term rates declined, substantially. Price increases picked up in some sec on net, from mid-November through mid-February. tors of the economy in 1994 as labor and product The foreign exchange value of the dollar in terms markets tightened, but broader measures of price of other G-1 O currencies declined almost 6½ percent change showed inflation holding fairly steady: The last year, even as the economy picked up and interest consumer price index increased about 2¾ percent rates rose. The positive effects on the dollar that over the year, the same as the rise during 1993. Signs would normally have been expected from higher U.S. that growth is moderating have emerged in the past interest rates were offs et in large part by upward month or so, but the bulk of the evidence suggests the movements in long-term interest rates abroad. Indeed, economy continues to advance at an appreciable pace. foreign long-term rates increased as much on average Federal Reserve policy during 1994 and early 1995 as U.S. rates during -1994, owing to much more rapid was aimed at fostering a financial environment condu than expected growth abroad, especial! y in Europe. cive to sustained economic growth. As the economy Concerns about U.S inflation may have contributed to moved back toward high rates of resource utilization, the weakness in the dollar in the middle part of last pursuit of this aim necessitated acting to prevent year, late in the year, the dollar rallied for a time, as a buildup of inflationary pressures. Federal Reserve tighter monetary policy apparently reduced investors' policy had remained very accommodative in 1993 in inflation fears. The dollar weakened again, however, order to offset factors that had been inhibiting eco in early 1995, perhaps reflecting the emerging indica nomic growth. By early 1994, however, the expansion tors of moderating growth in the United States. In clearly had gathered momentum, and maintenance of addition, financial markets were roiled early this year the prevailing stance of policy would eventual! y have by severe financial difficulties in Mexico. A sharp led to rising inflation that, in turn, would have jeopar depreciation of the peso had _adverse effects not only dized economic and financial stability. Taking account in Mexico but also in a number of other countries, and of anticipated lags in the effects of policy changes, the these developments also may have contributed to the Federal Reserve began to firm money market condi weakness of the dollar. tions last February. The Federal Reserve continued to Despite the rise in U.S. interest rates in 1994, tighten policy over the course of the year and into private sector borrowing picked up in support of 1995, as economic growth remained unexpectedly increased spending, abetted in part by more aggres strong, eroding remaining margins of unused re sive lending by intermediaries. The debts of both sources and intensifying price increases at early stages households and businesses grew at their fastest rates of production. Developments in financial markets in five years. The step-up in growth of private debt for example, easier credit availability through banks was accompanied by changes in its composition. and a decline in the foreign exchange value of the Businesses shifted toward short-term funding sources dollar-may have muted the effects of the tightening as bond yields rose, increasing their bank borrowing of monetary policy. and commercial paper issuance, while cutting back Short-term . interest rates have increased about on new bond issues. Similarly, households turned 3 percentage points since the start of 1994, with the increasingly to adjustable-rate mortgages as rates on federal funds rate rising from 3 percent to 6 percent fixed-rate mortgages increased substantially. Banks Other market interest rates have risen between encouraged the shift of households and businesses to 1 ½ percentage points and 3 percentage points, on net, bank borrowing by easing lending standards and not with the largest increases coming at intermediate ma allowing all of the rise in market rates to show turities. Through much of the year, intermediate- and through to loan rates. By contrast, federal borrowing long-term rates were lifted by more rapid actual and was slowed in· 1994 by policies adopted in previous expected economic growth, fears of a pickup in infla years to narrow the federal deficit, as well as by the tion, and market expectations of additional policy effects of the strong economy on tax receipts and Ranges for Growth of Monetary and Debt Aggregates 1 Percent Aggregate 1993 1994 1995 M2 1-5 1-5 1-5 M3 0-4 0-4 0-4 Debt2 4-8 4-8 3-7 1. Change from average for fourth quarter of preceding 2. Monitoring range for debt of domestic nonfinancial year to average for fourth quarter of year indicated. sectors spending. Taken together, the debt of all nonfinancial on a provisional basis last July. The money ranges sectors expanded 5 ¼ percent, about the same as the I percent to 5 percent for M2 and O percent to increase of a year earlier and a figure that was in the 4 percent for M3-are consistent with the Commit middle portion of the 1994 monitoring range of 4 per tee members' expectations of a slowing of nominal cent to 8 percent. income growth ~ the expansion moves to a more sustainable pace, but also rest on the anticipation of Growth in the broad monetary aggregates remained further increases in the velocities of these aggregates. subdued in 1994. M3 expanded about I½ percent, The velocity of M2 is likely to be boosted by lagged well within its O percent to 4 percent target range and effects of the increases in short-term interest rates slightly more than its increase in 1993. M3 was during 1994 and early 1995 and possibly by increased buoyed by growth of more than 7 percent in large flows from M2 deposits into long-term mutual funds time deposits, as banks turned to wholesale markets as investor concerns about capital market volatilit; to fund credit expansion. For the year, M2 rose only recede. The M2 range also provides an indication 1 percent, an increase that was at the lower bound of of the longer-run growth that could be expected its 1 percent to 5 percent target range. In contrast to under conditions of reasonable price stability if that 1992 and 1993, the slow growth in M2, and the aggregate's velocity resumes its historical pattern of resulting further substantial increase in its velocity no long-term trend. M3 velocity has been on a steep (the ratio of nominal GDP to the money stock), was upward path in recent years, but the rate of increase not a consequence of unusually large shifts from M2 might be expected to slow in the near term. Part of deposits to bond and stock mutual funds. Rather, it the increase in M3 velocity in the early 1990s resulted seemed to reflect behavior similar to that in earlier from weak growth of bank credit, in part reflecting periods of rising short-term market interest rates. Dur substantial loan losses and consequent capital impair ing such periods, changes in the rates available on ment, and the contraction of the thrift sector as failed retail deposits usually lag changes in market rates, institutions were liquidated. However, the recent providing an incentive to redirect savings from these strength in bank credit and the end of the contrac deposits to market instruments. These shifts tend to tion in thrift sector credit suggest that M3 growth have an especially marked effect on Ml because could pick up, perhaps appreciably, and its velocity yi~lds on its components either cannot adjust or adjust could begin to level out. The resumption of a more qwte slowly to shifts in market rates. Ml growth last normal relationship between M3 and nominal income year was 2¼ percent; it had been 1O ½ percent in might call for a technical adjustment of the target 1993. Only continued strong growth in currency, range for M3 at mid-year or in 1996. much of which likely reflected increased use abroad, supported Ml. The monitoring range for growth in the debt aggre gate in 1995 is 3 percent to 7 percent. This range is 1 percentage point lower than the monitoring range in Money and Debt Ranges for 1995 1994, reflecting the more moderate path anticipated At its most recent meeting, the Federal Open for expansion in nominal spending and borrowing. Market Committee (FOMC) reaffirmed the 1995 Private sector debt growth will likely remain fairly growth ranges for money and debt that were chosen strong in the coming year, boosted by substantial 2 Economic Projections for 1995 Percent Federal Reserve Governors and Reserve Bank Presidents Administration Central Indicator Range Tendency Change, fourth quarter to fourth quarter1 Nominal GDP 4¾-6½ 5-6 5.4 Real GDP 2-3¼ 2-3 2.4 Consumer price index 2 2¾-3¾ 3-3½ 3.2 Average level, fourth quarter Civilian unemployment rate 5¼-6 About 5½ 5.5-5.83 1. Change from average for fourth quarter of 1994 to aver 2. All urban consumers. age for fourth quarter of 1995. 3. Annual average. capital investment as well as merger and acquisition eral Reserve policy actions and changes in the pace of activity. Credit availability is unlikely to constrain economic growth. Residential building, especially of private sector borrowing, as banks continue to be single-family units, is the part of the economy in eager to lend and as quality spreads in financial mar which those effects are likely to emerge earliest and kets remain relatively narrow. The outlook for the stand out most clearly, but reactions to the higher federal deficit suggests that Treasury borrowing will rates probably will be showing up in other interest be comparable to that in 1994. sensitive sectors as well. The monetary and debt aggregates will continue to Other influences also will be working to moderate be among the variables monitored by the Committee the rate of growth. For example, large increases in to inform its policy deliberations. Given the uncertain real outlays for consumer durables over the past three ties about the behavior of the velocities of the aggre years, partly financed in recent quarters by unsustain gates, however, the Committee will also need to con ably rapid growth in the volume of consumer credit, tinue assessing a wide variety of other financial and probably have exhausted most of the pent-up demand economic indicators. that had accumulated when the economy was sluggish early in the 1990s. Similarly, business investment in new equipment has been rising extremely rapidly for Economic Projections for 1995 some time and has moved to quite a high level; The members of the Board of Governors and the businesses likely will be shifting to more moderate Reserve Bank presidents, all of whom participate in rates of spending growth before too long. Inventory the deliberations of the Federal Open Market Com investment seems likely to moderate as well, as sus mittee, expect the economy to settle into a pattern of tained additions to stocks at the pace of recent quar more moderate expansion in 1995, after a burst of ters would almost surely generate an unwanted growth that has brought rates of resource utilization backup of inventories at some point. to the highest levels since the latter part of the 1980s. In other areas, however, increased strength may be Most of the Board members and Reserve Bank forthcoming. Nonresidential construction, which of presidents expect the rise in real GDP over the four ten tends to lag other sectors of the economy over the quarters of 1995 to be in a range of 2 percent to course of the business cycle, now appears to be pick 3 percent. ing up steam. In addition, net exports may be a less Effects of the past year's increases in interest rates negative factor in corning quarters than they were in probably will show through more strongly in the 1994. Many foreign industrial economies entered the corning year, reflecting the typical lags between Fed- new year with considerable forward momentum; that 3 should keep real exports of goods and services on a The economic prospects anticipated by the gover solid uptrend, even allowing for lower exports to nors and Reserve Bank presidents for 1995 appear to Mexico as a consequence of the peso's devaluation be closely in line with those of the Administration. and the likelihood of little or no growth in that coun The Administration's forecasts of real GDP growth try in 1995. Imports, meanwhile, should begin to slow and inflation are in the middle of the Federal Re as growth of demand in this country eases. serve's central tendency ranges, and the Federal Reserve forecasts of the unemployment rate are cen The Board members and Reserve Bank presidents tered near the low end of the. annual range that was expect that output growth of the magnitude they published in the Economic Report of the President. anticipate will be accompanied by moderate increases in employment and little change in the unemployment Over the coming year, the Federal Reserve will rate. Forecasts of the unemployment rate for the seek to foster continued economic expansion while fourth quarter of 1995 are tightly clustered around avoiding the provision of so much liquidity that the 5½ percent. expected near-term step-up in inflation develops sus tained momentum. Much progress has been made An especially encouraging development in 1994 over the past couple of business cycles in reducing the was that inflation remained relatively quiescent even role that inflation plays in the economic decisions of as the economy moved to high rates of resource households and businesses. Moving ahead, the chal utilization. However, the costs of materials and com lenge will be to preserve and extend this progress, ponents have been rising rapidly, squeezing profit given that the Federal Reserve can best contribute to margins in some sectors, and anecdotal reports of long-run prosperity by establishing an environment of pressures on wages and finished goods prices have effective price stability. proliferated in recent months; increases in average hourly earnings and consumer prices picked up in Economic prospects for the long run will be further January. Assessing the prospects, members of the enhanced if Congress and the Administration succeed Board of Governors and the Reserve Bank presidents in making further progress in reducing the federal think the most likely outcome for this year is that budget deficit. An improved outlook for the federal inflation will run somewhat higher than in 1994. Such deficit over the remainder of this decade and beyond an outcome would be consistent with patterns of price could have significant favorable effects in financial change during earlier periods when the economy was markets, including a shift in long-term interest rates operating at levels of resource utilization like those to a trajectory lower than that which would otherwise seen recently. The central tendency of the Federal prevail. Such a shift in long-term rates would be an Reserve officials' CPI forecasts, ~easured in terms of essential part of a process in which a larger share of the change from the final quarter of 1994 to the final the nation's limited supply of savings would be chan quarter of 1995, spans a range of 3 percent to neled to productivity-improving investment, thereby 3 Y2 percent. boosting growth in output and living standards. 4 Section 2: The Performance of the Economy The economy recorded a third year of strong In contrast to the strength in private expenditures, expansion in 1994. Real GDP grew 4 percent over the government purchases of goods and services edged four quarters of the year, industrial output rose nearly down on net over the four quarters of 1994. Federal 6 percent, and the number of jobs on nonfann purchases of goods and services, which had declined payrolls increased about 3 ½ million, the largest gain sharply in 1993, fell further'in 1994 as a consequence in ten years. Labor and product marlcets tightened of actions taken in recent years to reduce the size of appreciably. Price pressures intensified in the markets the federal deficit. Meanwhile, the real purchases of for materials, but broader measures of price change state and local governments rose only modestly. showed inflation holding steady. Although the expanding economy has provided states and localities with a stronger revenue base, many of these jurisdictions are striving to hold spending in Real GDP Percent change, annual rate check; a number of states have chosen to cut taxes. As in the two previous years, a significant portion of the rise in domestic spending in 1994 went for imports of goods and services, which increased about 15 percent in real terms during the year. Meanwhile, growth of real exports of goods and services picked up noticeably, with gains cumulating to about 10 per cent over the year. Foreign economies strengthened in 1994, and the price competitiveness of this country's products in world marlcets was aided by a subdued rate of rise in production costs and a somewhat lower exchange value of the U.S. dollar. Labor and product markets tightened in 1994. After ......._ __. ..._ _ __. ___ _._ __. ....._ _ __., ___ _.__. 4 ticking up in January of last year in conjunction with 1990 1992 1994 the introduction of a new labor market survey, the civilian unemployment rate fell sharply over the As in 1992 and 1993, the economic advance during remainder of the year, t_o 5.4 percent in December. 1994 was driven mainly by sharp increases in the real The level of the unemployment rate in January of this expenditures of households and businesses. Consumer year-5.7 percent-was a full percentage point below purchases of motor vehicles rose further in 1994, and that of a year earlier. In manufacturing, gains in purchases of other consumer durables increased even production exceeded the growth of capacity by a faster than they had in the two previous years. Resi sizable margin during 1994, and the rate of capacity dential investment posted a small gain, on net, over utilization climbed nearly 3 percentage points. Its the four quarters of the year, despite sharp increases level in recent months has been essential! y in line in mortgage interest rates. Business investment in with the highest level achieved during the economic office and computing equipment slowed from the expansion of the 1980s. spectacular pace of 1993 but continued to rise rapidly nonetheless, and business investment in other types of Inflation pressures picked up in some markets in equipment accelerated. Real outlays for nonresiden 1994. Prices of raw industrial commodities rose even tial construction, which had been a weak sector of the more rapidly than in 1993, and price increases for economy in previous years, picked up in 1994; out intermediate materials accelerated sharply, especially lays for office construction ended a long slide that had after midyear. However, the inflation impulse in these stretched well back into the 1980s. Business invest markets did not carry through with any visible force ment in inventories, which had been quite restrained to the consumer level, probably because unit labor in previous years of the expansion, increased appre costs, which make up by far the largest part of value ciably in 1994. Much of the inventory buildup appar added in production and marketing, continued to rise ently was intentional and reflected the desires of firms at a modest rate. The employment cost index of to stock up in anticipation of continued strength in hourly compensation in private nonfarm industries sales or to build stronger buffers against potential actually slowed noticeably from the pace of 1993, and delays in supply. productivity gains in 1994 held close to the pace of 5 the previous year. As for retail prices, 1994 was the been put off earlier in the 1990s when the economy fourth year in a row in which the rise in the total CPI was sluggish and concerns about job prospects were has been around 3 percent. The CPI excluding food widespread. Real expenditures for motor vehicles and energy rose just 2.8 percent over the four quarters moved up an additional 3 percent over the four quar of 1994, after an increase of 3.1 percent in 1993; the ters of 1994, after gains of about 9 percent in each of rate of rise in this index, which is widely used as an the two preceding years; increases in sales of vehicles indicator of underlying inflation trends, fell by almost in 1994 might have been ~ bit stronger still but for half from 1990 to 1994. capacity constraints and vari.ous supply disruptions that sometimes limited the availability of certain mod els. Real outlays for durable goods other than motor The Household Sector vehicles rose about 11 ½ percent over the four quar Real personal consumption expenditures advanced ters of 1994, a pickup from the already rapid rates of nearly 3½ percent over the four quarters of 1994, expansion of the two previous years. Purchases of about in line with the average pace of the two previ personal computers and other electronic equipment ous years. Support for the rise in spending crune from continued to surge in 1994, and spending on furniture rapid income growth, and, according to surveys, and household appliances moved up further. sharp increases in consumer confidence. Outlays for Consumer expenditures for nondurables and ser durable goods continued to rise especially rapidly, vices exhibited mixed patterns of change in 1994. seemingly little affected by rising interest rates. Nor Real outlays for nondurables increased 3 percent over did spending appear to be much affected, in the the year, a pickup from the subdued rate of growth aggregate, by poor performance of the stock and bond recorded in the previous year and, for this category, a markets, which cut into the real value of household larger than average advance by historical standards. assets. Credit generally was readily available during By contrast, real expenditures for services increased 1994, and growth of consumer installment debt roughly 2¼ percent, a slightly smaller gain than that picked up substantially, to a pace comparable with of 1993; growth of outlays for services was held some of the larger increases that were observed dur down, to some degree, by a decline in real outlays for ing the expansions of the 1970s and 1980s. energy, as warm weather late in 1994 reduced the runount of fuel needed for heating. Income and Consumption Real disposable personal income rose 4¼ percent Percent change, annual rate during 1994. Except for a couple of occasions in previous years when income growth was boosted D Real Disposable Personal Income temporarily by special factors, the rise in real dispos able income in 1994 was the largest increase since the ~ Real Personal Consumption Expenditures 8 1983-84 period. Growth of wages and salaries accel erated in 1994 in conjunction with the step-up of employment growth. Income from capital also rose: 4 Dividends moved up along with corporate profits, and interest income turned back up after three years of decline. By contrast, transfer payments, the growth of + ........- ................ ..._._.._,......_..__,_ ___. .................................. _ 0 which tends to slow as the economy strengthens, registered the smallest annual increase since 1987. The net income of nonfarm proprietors appears to .....,_ ____________________. ........., 4 have about kept pace with the average rate of growth in other types of income. Farm income rose moder 1990 1992 1994 ately on an annual average basis, as an increase in the volume of output more than offset the effects of sharp Real consumer expenditures for durable goods declines in farm output prices that developed over the increased about 8 percent in 1994, bringing the cumu course of the year. lative rise in these outlays over the past three years to near! y 30 percent. The stock of durable goods that Consumers' perceptions of economic and financial households wish to hold apparently continued to rise conditions brightened considerably during 1994. By quite rapidly in 1994, and at least some households year-end, the composite measures of consumer confi probably were still making up for purchases that had dence that are prepared by the Conference Board and 6 the University of Michigan Survey Research Center 17 percent and 8 percent, respectively, in 1992 and had both moved to new highs for the current business 1993. Although starts and sales of single-family expansion. Consumers recame more optimistic over houses fell back from the exceptionally high peaks the year in regard to both current economic conditions that were reached briefly in late 1993, they remained and future economic conditions. Perceptions of em at elevated levels. In total, 1.20 million single-family ployment prospects also improved, with a growing units were started in 1994, topping, very slightly, the proportion of respondents saying that jobs were plen highest annual total of the. 1980s. Sales of existing tiful and a reduced proportion saying that jobs were homes were about the same ~s the previous annual hard to find. Surveys taken early this year indicate peak, set in 1978, and although sales of new homes that confidence remains high. remained well short of previous highs, their annual total was closely in line with the brisk pace of 1993. In contrast to most other indicators for the house Only in the past month or so have indications of a hold sector of the economy, household balance weakening in housing activity started to show up sheets-which had strengthened appreciably in previ more consistently in the incoming data. ous years-showed no further improvement in 1994. According to preliminary data, the aggregate net Private Housing Starts worth of households appears to have recorded a rela Annual rate, millions of units tively small increase in nominal terms over the year, Quarterly average and, in real terms, net worth probably declined slightly. Household assets rose only moderately in nominal terms, and the growth of nominal liabilities 1.5 picked up somewhat, as a result of the sharp increase in use of consumer credit. Early this year, stock and bond prices have risen, on net, giving some renewed lift to household wealth. With personal income growing faster than net 0.5 worth during 1994, the ratio of wealth to income fell over the course of the year. In the past, declines in this ratio sometimes have prompted households to boost ._.__ _ _...._ _ _...._ _ _....__......._ _ __,__ _ __._ _ __.__~ 0 the proportion of current income that is saved, in an 1988 1990 1992 1994 attempt to restore wealth to more desirable levels, and this same tendency may have teen at work, to -some Declines in the starts and sales of single-family extent, in 1994. After dipping in the first quarter of houses in early 1994 basically reversed the huge gains the year to the lowest level of the current expansion, of late 1993. Whatever tendency there may have been the personal saving rate rose a full percentage point for these indicators to exhibit at least a temporary over the remainder of the year, to a fourth-quarter setback after a period of unusual strength was prob level of 4.6 percent Even then, however, the saving ably reinforced by the initial reactions of builders and rate remained quite low by historical standards. Ris homebuyers to increases in mortgage interest rates ing levels of income and employment and increased that had regun in the final quarter of 1993. Exception confidence in the outlook apparently convinced con ally severe winter weather in the Northeast and Mid sumers to push ahead with increases in outlays, most west early in 1994, coming on the heels of favorable notably those on consumer durables. In addition, conditions in late 1993, probably also helped to although improvement in household balance sheets account for the sharpness of the downturn. In any apparently flagged, signs of outright stress in house event, starts of single-family homes ticked back up a hold financial conditions were not much in evidence: bit in the second quarter of the year, sales of existing Delinquency rates on mortgages and other household homes flattened out, and the rate of decline in sales of loans generally remained quite low relative to their new homes slowed. historical ranges. In the second half of the year, the signals were Residential investment held up remarkably well in . mixed: Sales of existing homes trended down at a 1994 in the face of sharp increases in mortgage inter moderate pace during this period; however, single est rates. Preliminary data indicate that, in real terms, family starts and sales of new single-family homes these investment outlays were up about 2 percent, on changed little, on net, from the second quarter to the net, over the four quarters of the year, after gains of fourth quarter. Sizable gains in employment and 7 income and rising optimism about the future of the The Business Sector economy apparently helped to blunt the effects of Robust expansion was evident in 1994 in most of increases in interest rates during the second half of the the economic indicators for the business sector of the year. In addition. the availability of a widening vari economy. Real output of nonfa rm businesses ety of alternative mortgage instruments and, perhaps, increased about 4¼ percent over the four quarters of some easing of loan qualification standards may have the year, nearly matching the large gain of 1993. For permitted some buyers who otherwise would not have a second year, business irtvestment in fixed capital been able to obtain financing to go ahead with their advanced exceptionally rapidly. Inventory invest purchases. ment also picked up appreciably, spurred by large, Late in 1994 and in early 1995, a softer tone seems sustained increases in sales. Business finances to have taken hold in key indicators of single-family remained on a sound footing: Investment expen housing activity. Sales of new homes tailed off toward ditures continued to be financed predominantly with the end of last year, and the ratio of the number of internal funds, and signs of financial stress were unsold homes to the number of sales, which had largely absent. turned up early in 1994, continued to rise. The ratio in Industry entered 1994 with considerable momen December was slightly to the high side of the long tum, and expansion was maintained at a rapid pace run average for this series. Starts of new single-family throughout the year. Industrial production rose nearly houses, which had increased in November and 6 percent over the four quarters of 1994, a rate of December, fell sharply in January, to a level notice expansion exceeded in only one of the past ten years. ably below the lower bound of the range of monthly The production of business equipment advanced espe readings reported during 1994. cially rapidly, buoyed by rising investment in the Various measures of house prices showed small-to domestic economy and further large increases in moderate increases in 1994. The median transactions exports of capital goods. Production of intermediate prices of new and existing homes that were sold in the products-which consist mainly of supplies used in first half of the year were roughly 3½ percent above business and construction-also moved up substan tially during 1994, as did the output of materials, the level of a year earlier, and a similar rise was especially those used as inputs in the production of reported during that period in price indexes that adjust for changes in the quality and regional mix of homes durable goods. The industrial sector also appears to that are sold. After mid-year, the four-quarter changes have had a strong start in 1995, as industrial produc in transactions prices slowed, but the rate of rise in tion rose 0.4 percent in January. the quality-adjusted indexes picked up somewhat. All told, prices have been firmer in the past couple of Industrial Production Index 1987 = 100 years than they were earlier in the 1990s. Jan. After falling to exceptionally low levels in late 1992 and early 1993, construction of multifamily 120 housing units increased throughout 1994. Although the level of activity in this part of the housing sector 115 was not especially high, gains during the year were large in percentage terms: Starts of these units moved up about 65 percent from the fourth quarter of 1993 to 110 the fourth quarter of 1994, at which point they were more than double the lows of a couple years ago. The national average vacancy rate for multifamily rental 105 units remained relatively high in 1994, but markets in some areas of the country had tightened enough to 100 make construction of new multifamily units economi 1990 1992 1994 cally attractive. Reauthorization in August 1993 of a tax credit on low-income housing units also provided The rate of capacity utilization in industry some incentive for new construction The financing of increased about 2V2 percentage points over the twelve multifamily projects was facilitated through more months of 1994. In manufacturing, the operating rate ready availability of credit and increased equity rose about 3 percentage points during the year. By investment r-------..1.!e~ar-~e:nd, utilization rates in some industries had ....... ~ \ i Manufacturing Capacity Utilization Rate profits per unit of output also rose. In the second and Percent third quarters, before-tax profits of nonfinancial cor poration~ amounted to nearly 11 percent of the gross domestic output of those businesses-the highest that 87 this measure of the profit share has been since the late Jan. 1970s. A shift in the capital structure of corporations toward reduced reliance o~ debt, as well as cyclical 84 recovery of the economy, has I:ielped to push the profit share to this high level. In contrast to the experience of nonfinancial corporations, the profits of private 81 financial institutions from their domestic operations fell about 7 percent on net over the first three quarters 78 of the year, as net interest margins narrowed. The decline reversed some of the large rise in profits that these institutions had reported in 1993. 75 1988 1990 1992 1994 Business fixed investment increased 13 percent in real terms over the four quarters of 1994, after a gain of 16 percent during 1993. Outlays for office and moved to exceptionally high levels. Most notably, the computing equipment, which had registered an aston average operating rate among manufacturers engaged ishing gain in 1993, slowed in 1994, but the rise in in primary processing (basically, the producers of these outlays still amounted to nearly 20 percent in materials) had climbed to the highest level since the real terms. Meanwhile, the growth of real expendi end of 1973, surpassing, by small margins, the peaks tures for most other types of business equipment of the late 1970s and late 1980s. picked up. After rising 23 ½ percent over the four quarters of 1993, corporate profits increased another 4 percent Real Business Fixed Investment over the first three quarters of 1994. The profits Percent change, annual rate earned by nonfinancial corporations from their do D mestic operations increased about 7 ½ percent over Structures the first three quarters of 1994, after a gain of 20 ffl] Producers' Durable 21 ½ percent in 1993. Although the 1994 gain in these Equipment profits was partly the result of increased volume, 10 + Before-tax Profit Share of 1--,....µ..J.+,,,....U:.-L.,-..J:o:1.........,.,.--.-f: <1-C=..~L.J...J~...&:.:L.L.a:.:l..L.J~ 0 Gross Domestic Product* Percent 10 Nonfinancial Corporations 20 1990 1992 1994 10 Business investment in motor vehicles rose about 18½ percent over the four quarters of 1994. With the gains of 1994 coming on the heels of big increases in 8 each of the two previous years, annual business out lays for vehicles reached a level about one-third higher than the peak year of the 1980s. Outlays for communications equipment also scored an especially big gain in 1994, more than 25 percent in real terms. 6 1988 1990 1992 1994 Business purchases of industrial equipment advanced • Profits from domestic operations with inventory valuation and about 13 percent during 1994, one of the larger gains capital consufl1)tion adjustments divided by gross domestic product of nonfinarcial corporate sector. of the past two decades. By contrast, commercial 9 aircraft once again was a notable area of weakness; Changes in Real Business Inventories the investment cycle in that sector has been sharply Annual rate, billions of 1987 dollars out of phase with those of most other industries, Nonfarm Businesses owing to persistent excess capacity and poor profit ability in the airline business. 60 Business investment in nonresidential structures rose about 4 percent during 1994, after an increase of 1½ percent in 1993 and declines in each of the three years preceding 1993. Investment in industrial struc tures rose for the first time since 1990, a response, more than likely, to high-and rising-rates of capac ity utilization. Investment in office buildings also turned up in 1994, after a long string of declines that, in total, had brought spending on these structures ......_ __, .__ _ _.__ _. ..__ ___. ______. ....,. 30 down about 60 percent from the peak of the mid- 1980s; declining vacancy rates and a firming of prop 1990 1992 1994 erty values provided additional evidence of improve business sector was only 2 percent larger than it had ment in this sector of the economy in 1994. The been at the start of_the recovery in early 1991. investment data for other types of structures showed a mix of pluses and minuses: Expenditures on commer Circumstances changed in 1994, however. Markets cial structures other than offices moved up further, tightened as demand continued to surge, and supplies after large gains in 1992 and 1993; however, outlays became more difficult to obtain on a timely basis. for drilling declined for a fourth year, to the lowest Anticipation of further growth in demand and level since the early 1970s. increased concern about possible bottlenecks appar ently prompted businesses to begin investing more Because a large share of the growth in business heavily in inventories. Some finns may also have fixed investment in recent years has gone for items been trying to stock up on materials in advance of that depreciate relatively quickly-computers being a anticipated price increases. For the year as a whole, prime example-net additions to the stock of produc accumulation of nonfann inventories was more than tive capital have not been as impressive as the data on twice what it had been in 1993. This additional accu gross investment expenditures might seem to indicate. mulation brought to a halt the previous downtrend in Nonetheless, with the further increase in gross invest the ratio of nonfann inventories to business sales, but ment in 1994, net additions to the capital stock appear the ratio remained quite low by the standards of the to have become more substantial. Still unclear is the past quarter-century. degree to which these increases in the capital stock will ultimately translate into higher rates of increase Inventory accumulation in the farm sector of the in output per worker and faster rates of increase in economy also picked up in 1994. Stocks of farm living standards; as discussed in more detail below, products had been drawn down in 1993, when farm the trend of growth in labor productivity, which is production fell sharply because of floods in the Mid affected by the amount and quality of capital that west and droughts in some other regions of the coun worlcers have available, seems to have picked up in try. However, crop conditions in 1994 were unusually recent years but by a relatively small amount favorable throughout the year, and the output of some major crops climbed to levels considerably above Business investment in inventories picked up previous peaks. With the demand for fann output sharply in 1994. Earlier in the expansion, firms had rising much less rapidly than production, inventories refrained from building stocks, even as the economy of crops increased sharply. Livestock production also strengthened.· Increased reliance on "just-in-time" rose appreciably in 1994; inventories of livestock, systems of inventory control reduced the level of which consist mainly of the cattle and hogs on farms stocks that firms needed to maintain ·their nonnal and ranches, continued to expand. operations, and, with a degree of'slack still present in the economy, businesses usually were able to obtain The Government Sector goods quickly from their suppliers and thus were probably reluctant to hold stocks in house. At the end Federal purchases of goods and services, the part of 1993, the level of real inventories in the nonfann of federal spending that is included in GDP, fell 10 Real Federal Purchases to a cyclical peak of 4.9 percent of nominal GDP. The Percent change, 04 to 04 previous cyclical low in the ratio of the deficit to nominal GDP, 2.9 percent, was reached in fiscal 1989. Since fiscal 1989, defense spending as a share of GDP has dropped appreciably, but this source of deficit reduction has been essentially offset by increased outlays for health and socilli: insurance. Thus, the ratio of total federal outlays to GD~ has changed little, on net; it was about 22 percent in both fiscal 1989 and fiscal 1994. The ratio of federal receipts to nominal GDP was about 19 percent in both of those fiscal years. Federal Unified Budget Deficit Billions of dollars 10 Fiscal years 1990 1992 1994 6.2 percent in real terms over the four quarters of 300 1994. Real outlays for defense remained on a sharp downtrend, and nondefense outlays, which had risen rapidly early in the 1990s, declined moderately for a 200 second year. Total federal outlays, measured in nominal dollars in the unified budget, increased 3.7 percent in fiscal 100 1994, after a rise of 2.0 percent the previous fiscal year. These increases are among the smallest of recent decades. Nominal outlays for defense fell again in 0 fiscal 1994. In addition, the growth of outlays for 1990 1992 1994 income security (a category that includes the expendi The stronger economy of recent years has provided tures on unemployment compensation and welfare state and local governments with a growing revenue benefits) slowed further as the economy continued to base and a broadening set of fiscal options. Some strengthen. Increases in social security outlays also governments have responded to these developments slowed somewhat in fiscal 1994; the rise was about a by cutting taxes, in most cases by small amounts. percentage point less than that of nominal GDP. Out Effective tax rates of state and local governments lays for Medicaid slowed as well, but the rate of rise appear to have edged down a bit, on average, over the in those expenditures continued to exceed the growth four quarters of 1994, and nominal receipts appar of nominal GDP by a large margin. ently rose somewhat less rapidly than nominal GDP Federal receipts were up 9 percent in fiscal 1994, over that period. the largest rise in several years. With rapid expansion Many states and localities also have been trying to of the economy giving a strong boost to almost restrain the growth of expenditures, but success on all types of income, the major categories of federal that score has been difficult to achieve because of receipts all showed sizable gains. Combined receipts increased outlays for entitlements and rising demand from individual income taxes and social insurance for many of the public services that traditionally have taxes increased a bit more than 7 percent in fiscal been provided by state and local governments. Trans 1994, after moving up 5.4 percent in the previous fers of income from state and local governments to fiscal year. Receipts from taxes on corporate profits persons rose about 9 percent in nominal terms over increased nearly 20 percent, slightly more than the the four quarters of 1994, roughly the same as the rise gain of 1993. during 1993 but less than the increases of previous The federal budget deficit declined to $203 billion years; from 1988 to 1992, the average compound rate in fisC<µ 1994, an amount that was equal to 3.1 percent of growth in these transfers was about 15 percent a of nominal GDP. Earlier in the 1990s, when the year. In categories other than transfers, increases in economy was sluggish, the federal deficit had climbed spending have been fairly restrained in recent years; 11 Real State and Local Purchases GDP, the annual surpluses and deficits since World Percent change, 04 to 04 War II have averaged out to a deficit of 0.3 percent. The External Sector When adjusted for differing rates of increase in consumer prices, the trade~weighted average foreign exchange value of the U.S. dollar declined 5½ percent against the currencies of the other G-10 countries in 1994. This depreciation was slightly smaller than the almost 61/2 percent nominal deprecia tion of the dollar, as U.S. inflation exceeded foreign inflation by a small amount. An index of exchange rates that also includes the currencies of several of the major U.S. trading partners in Latin America and East Asia showed about the same degree of real deprecia 1990 1992 1994 tion as did the index for the currencies of the G-10 countries. In the first few weeks of 1995, the dollar has weakened, on balance, in nominal tenns against nominal purchases of goods and services (which the currencies of the G-10 countries, but it has moved account for about 80 percent of the total expenditures up in tenns of the Mexican peso. of state and local governments) have been trending up less rapidly than nominal GDP since the early 1990s. Foreign Exchange Value of the U.S. Dollar * In real tenns, the 1994 rise in purchases of goods Index, March 1973 = 100 and services by state and local governments amounted to just 2 percent. Compensation of employees, which Nominal accounts for about two-thirds of total state and local purchases, increased 1 ½ percent in real tenns over the four quarters of 1994, a gain that was roughly in line with the growth of state and local employment over that period. Construction outlays declined 100 slightly in real tenns during 1994, as gains over the final three quarters of the year were not sufficient to offset a first-quarter plunge. Nonetheless, real outlays for structures remained at high levels; a strong uptrend in construction expenditures over the past ten or twelve years has more than reversed a long contrac tion that began in the latter half of the 1960s and 50 U.....-'----'--...I.--L----'--...1.-----'L----'--.......__, bottomed out in the first half of the 1980s. 1987 1989 1991 1993 1995 * Index of weighted average foreign exchange value of the The deficit in the combined operating and capital U.S. dollar in terms of currencies of other G-10 countries. Weights are based on 1972-76 global trade of each of the accounts of all state and local governments (a mea 10 countries. sure that excludes the surpluses in state and local social insurance funds) amounted to about 0.6 percent Growth of real GDP in the major foreign industrial of nominal GDP in calendar 1994, little changed from countries rebounded sharply during 1994, signifi the corresponding figure for 1993 and down only cantly exceeding the pace of recovery widely ex slightly from a cyclical peak of 0.8 percent in 1991. pected at the start of the year. In the United Kingdom The recent cyclical peak in this measure was larger and Canada, where recovery was already well estab than the peaks reached in recessions of the 1970s and lished, growth continued to be vigorous. In Gennany, 1980s, and declines in the deficit during this expan France, and other continental European countries, sion have not been as large as the declines that where activity had been sluggish during 1993, strong occurred during other recent expansions. Historically, expansion of real GDP resumed and strengthened as the combined operating and capital accounts of state the year progressed. Recovery was evident in Japan and local governments have been in deficit more often as well, but the pace of expansion there remained than they have been in surplus; as a share of nominal somewhat sutx:lued relative to that of the other indus- 12 trial countries. Although most of these economies U.S. Current Account clearly had moved past the troughs of their reces Annual rate, billions of dollars sions, considerable slack remained. As a result, con sumer price inflation remained low and, in some cases, fell further. On average, in the ten major for eign industrial countries, consumer prices rose 2 per cent during the year, even less than the price increase in the United States. - 60 Economic growth in the major developing coun tries in 1994 continued at about the strong pace of 1993. In Asia, the newly industrializing economies - 120 grew rapidly, as e~ternal demand was sustained by lagged effects of depreciation of their currencies against the yen and by recovery in the industrial countries. Growth in China, although still quite rapid, LIL--___JIL-----1IL---...JIL-----JIL.-...---Jl....____,I_ ___ _.I_ _I 180 1988 1990 1992 1994 was somewhat slower than that in 1992-93, as credit conditions were tightened somewhat further and higher interest rates on high and rising U.S. net exter various controls were imposed to damp demand. nal indebtedness. In Mexico, real GDP growth rose markedly during Based on initial estimates for the fourth quarter, the second and third quarters of 1994 from its near exports of goods and services grew 10 percent in real zero rate in 1993, in part because of fiscal stimulus. terms during 1994. Computer exports continued to However, the economic policy program put in place rise rapidly in real terms, about 30 percent for the at the end of the year in response to the peso crisis is year; this gain contributed significantly to the double likely to restrain growth once again in the coming digit growth in total exports. After declining in 1993, year. The Mexican macroeconomic stabilization pro agricultural exports bounced back last year, the much gram is designed to maintain wage restraint, reduce improved harvest of 1994 eased supply constraints government spending and development bank lending, that previously had been limiting shipments of farm and result in significant improvement in the current products. Other categories of merchandise exports account deficit in 1995. The program includes guide averaged more than 8 percent real growth during the lines on increases in wages, guidelines on increases in year, as the pace of activity in the economies of U.S. final energy product prices to consumers and to indus trading partners improved significantly. Geographi try, net cuts in public expenditures, and a reduction of cally, the increase in U.S. merchandise exports was lending by development banks. Mexico has commit accounted for by increased shipments both to devel ted to maintain the current floating exchange rate oping countries in Latin America and Asia and to regime, and the Bank of Mexico has agreed to restrain Canada and Japan. the growth of money. Structural reform measures include continued privatization and lessened restric U.S. Real Merchandise Trade tions on foreign investment Further measures could Annual rate, billions of 1987 dollars be required if inflation and the exchange rate do not respond as projected. The nominal U.S. trade deficit in goods and ser 800 vices increased to about $11 0 billion in 1994, com 04 pared with $75 billion in 1993. Imports grew notice ably faster than exports, as U.S. growth about equaled 600 that of U.S. trading partners and as the lagged effects of dollar appreciation during 1993 continued to be felt. The current account deficit averaged about $150 billion at an annual rate over the first three . 400 quarters. Net investment income moved from a small positive to a moderately negative figure in 1994, reflecting recovery of foreign earnings on direct l.L.-..l--L----1.---L.----------- 200 investment in the United States and the effects of 1988 1990 1992 1994 13 Imports of goods and services rose about 15 per States while U.S. direct investment abroad remained cent in real terms over the four quarters of 1994, at near-record levels. The direct investment inflow reflecting the vigorous growth of U.S. income during was swelled by takeovers of U.S. companies and the year. Imports of computers continued to expand by the revival of profits and reinvested earnings extremely rapidly in real terms. Of the other import reported by affiliates of foreign companies in the categories, imports of machinery and automotive United States. products were particularly buoyant. Import prices rose about 4 percent in 1994, influenced by depreciation of the U.S. dollar, increases in world commodity prices, Labor Markets and a rebound in oil prices, which had declined in Employment rose substantially in 1994. The total 1993 and early 1994. number of jobs in the nonfa rm sector of the econ In the first three quarters of 1994, recorded net omy increased 3.5 million over the twelve months capital inflows were substantially larger than those of ended in December, after a gain of 2.3 million dur 1993, an increase that coincided not only with the ing 1993. 2 About a quarter of a million of the rise in growing current account deficit, but also with a sharp jobs during 1994 was in the government sector, swing in unrecorded transactions in the U.S. interna mostly at the local level. Job growth in the private tional accounts, from a positive figure in 1993 to a nonfarm sector amounted to 3 .2 million, the largest negative one in the first three quarters of 1994.1 gain since 1984. Increases in employment at nonfarm establishments were sizable in each quarter of 1994. Among the recorded capital flows, increases in A further gain in payroll employment, smaller than foreign official assets in the United States were sub the average increase of the past year, was reported in stantial in 1994, but somewhat smaller than in 1993. January of this year, however, total labor input rose In particular, the large reserve accumulations in 1993 considerably faster than employment in January as by certain developing countries in Latin America the workweek lengthened. experiencing massive private capital inflows were not repeated in 1994. Payroll Employment U.S. net purchases of foreign securities, particularly Net change, millions of jobs, annual rate bonds, fell sharply from record 1993 levels. Private Total Nonfarm foreign net purchases of U.S. securities also fell, but only slightly. Rising interest rates on bonds denomi nated in dollars and many other major currencies produced capital losses for U.S. holders of long-term bonds and resulted in flows out of U.S. global bond funds. In the first three quarters of 1994, U.S. inves tors made heavy net purchases of stocks in Japan; Japan alone accounted for more than one-third of all U.S. net foreign stock purchases. In developing coun tries, those that received the largest net equity inflows from U.S. investors in 1993 (Hong Kong, Mexico, Argentina, Brazil, and Singapore) were less favored 3 by investors in 1994, while interest picked up in L..L...--.1..--......1.--...L..--L------L--...L.---1 1989 1991 1993 1995 a wide assortment of other developing countries, including South Korea, Chile, Indonesia, China, Producers of goods boosted employment more than India, and Peru. half a million in 1994. The job count in construction The first three quarters of 1994 also witnessed a increased about 300,000 over the year, employment at revival of foreign direct investment in the United general building contractors rose briskly for a second year, as did the number of jobs at firms involved in 1. In effect, recorded net capital inflows in the first three quarters of 1994 were larger than necessary to balance the rising current account deficit. Moreover, outflows of currency to foreigners, an item that is not reflected in recorded transactions and, therefore, is a 2. The Bureau of Labor Statistics has announced that the level part of unrecorded net inflows in the international accounts, of nonfa rm payroll employment in March 1994 will be raised increased substantially in 1994, suggesting that the other unre 760,0CX) when revised estimates are released this summer. The corded outflows of capital may have been even larger than the revision may lead to larger estimates of job growth in both 1993 published data on errors and omissions indicate. and 1994. 14 special trades related to construction. The number Civilian Unemployment Rate* of jobs in manufacturing increased about 275,()(XJ Percent during 1994, after five years of decline. Producers of durables accounted for most of the rise in manufactur ing employment; among these producers, job gains 8 were widespread. Employment at factories that pro duce nondurables rose slightly in total, as advances in some industries-such as printing and publishing and rubber and plastics-were partly offset by continued secular declines in the number of jobs in industries such as apparel, tobacco, and leather goods. The average workweek in manufacturing, which had 4 stretched out in 1~92 and 1993 when factory employ ment was declining, lengthened further in 1994, rising to new highs for the postwar period. The high fixed ...___..,___ _L --_j,,_ _,l__ _L_..l.,__L__l_j 2 costs that are associated with adding new workers . 1987 . 1989 1991 1993 1995 probably continued to be an important factor in firms' A re~s1gned Sl;Jrvey and revised population estimates were introduced m January 1994; data from that point on are decisions to rely still more heavily on a longer work not directly comparable with those of earlier periods. week as a way to boost labor input. Growth of factory output surpassed the rise in labor input by a sizable a year earlier. 3 Appreciable net declines in unemploy amount in 1994, a reflection of substantial gains in ment rates have been reported over the past year for productivity that were realized in this sector of the nearly all occupational and demographic groups. economy in the most recent year. Data on the reasons why individuals are unem Employment in the private service-producing sec ployed seem to be tracing out patterns fairly similar to tor rose nearly 2¾ million during 1994, after a gain of those seen in previous business cycles. Most notably, 2 million in 1993. The number of jobs in retail trade the number of persons who are unemployed because increased about 800,000 over the year. Auto dealers, they lost their last job has declined sharply, on net, stores that sell building materials, and those that sell over the past year. The number of individuals in this general merchandise were among the retail outlets category had soared earlier in the 1990s, when the that reported impressive gains. Hiring at eating and economy was struggling to gain momentum and many drinking places also moved up briskly; after three large companies were restructuring their operations. years of slow growth around the start of the decade, However, with the more recent decline, the number of hiring at these establishments has increased substan these "job losers," measured as a percentage of the tially in each of the past three years. Employment at labor force, has moved back toward the lows of the firms that supply services to other businesses rose late 1980s. Much of the decline in the number of job about 710,()(XJ in 1994, even more than in 1993. Once losers this past year has been among workers who again, job growth within this category was especially were permanently separated from their previous jobs. rapid at personnel supply firms-those that essen The number of persons unemployed for reasons other tially lease the services of their workers to other than the loss of a job (that is, the sum of "job leavers" employers, often on a temporary basis. Employment and new entrants or re-entrants unable to find work) at businesses that supply health services increased a also has declined over the past year. As in other quarter of a million in 1994, about the same as the business cycles, the number of these individuals, mea gain in 1993; hiring at hospitals has flattened out over sured relative to the size of the labor force, has been the past couple of years, but elsewhere in the health displaying a cyclical pattern considerably more muted sector job growth has continued at a rapid clip. than that of job losers. Strength also was evident in 1994 in data from the monthly survey of households. After ticking up in Janu~ of 1994, when a redesigned household survey 3. Research undertaken by the Bureau of Labor Statistics sug gests that the unemployment rate would have run about two-tenths was implemented and new population estimates were ?f a percen~ge point lower in 1994 but for the changes that were introduced, the civilian unemployment rate turned mtroduced m January of last year. Other series from the household back down in February and declined in most months survey ~o were aff~ted by the introduction of the new survey and the ~ev1~ed population estimates; therefore, data for the period thereafter. The rate increased last month, to 5.7 per startmg m January 1994 are not directly comparable with those for cent, but was still a full percentage point below that of the period ended in December 1993. 15 Growth of the civilian labor force-which consists The rate of increase in hourly compensation moved of the individuals who are employed and those who down another notch in 1994. The employment cost are seeking employment but have not yet found it index for private industry, a measure of hourly labor picked up a bit in the second half of 1994 and in early costs that comprises both wages and benefits, rose 1995. However, even with these increases, the cumu 3 .1 percent during the twelve months ended in lative rise in the labor force in the current business December of 1994, after increases of 3.6 percent in expansion has been relatively small compared with 1993 and 3.5 percent in 1~92. The rise in the wage the gains recorded in other recent expansions; growth component of compensation .was slightly less than of the working-age population has been slower this that of 1993, and the rate of increase in hourly bene decade than it was in the expansions of the 1970s and fits slowed appreciably. Increases in benefits were 1980s, and the share of the population participating in restrained, in large part, by another year of decelera the labor force, which trended up in earlier expan tion in health care costs and a further slowing in sions, has changed little, on net, during this one. workers' compensation insurance costs. The rise in nominal compensation per hour in 1994 was the Output per Hour smallest yearly increase in· the fifteen-year history of Percent change, 04 to 04 the series, the previous low of 3.2 percent having Nonfarm Business Sector come midway through the expansion of the 1980s. Toward the end of that decade, as bidding for labor resources intensified, increases in compensation moved up for a time to around 5 percent a year. 2 I . . I $ I Employment Cost Index* :_!_t.1.'.l.i;l.: (!~ Percent change, 04 to 04 I Total Compensation + 1--'"""""".....__.u.....,__..,.,,,_.....r.:.:. .......- =------'""""----"""'"''--"'""'"':.a........i 0 i - - 6 _ __._ _ ___._ _____ .____.,___.....__.......__ __._ _ _...., 2 ~ 1988 1990 1992 1994 According to preliminary data, output per hour of labor input in the nonfarm business sector increased 1.4 percent over the four quarters of 1994, after a rise of 1.8 percent in 1993 and still larger gains in 1992 and 1991. Over the business cycle, productivity gains typically are largest in the-early years of expansion, and, in that regard, the recent experience does not •Employment cost index for private industry, excluding farm appear to be unusual. Abstracting from cyclical varia and household workers. tion, the trend of productivity growth in recent years Unit labor costs in the nonfarm business sector rose seems to have picked up somewhat from the unusu 2.0 percent over the four quarters of 1994, after an ally sluggish pace that prevailed through much of the increase of just 0.6 percent over the four quarters of 1970s and 1980s, but, at the same time, the pickup 1993. In manufacturing, a sector of the economy in has not been nearly so large as some anecdotal reports might appear to suggest For example, from late 1988 to late 1994, an interval of time that is long enough to not clear. For example, among the many difficult issues that are capture all the phases that productivity goes through involved in the measurement of productivity is the choice of an appropriate set of prices to be used in valuing the output of goods during the business cycle, the average rate of rise in and services. Currently, aggregate output is tallied using the prices output per hour in the nonfarm business sector of 1987, but some major changes in relative prices have taken place amounted to slightly more than 1¼ percent, up only since then, the most notable of which is a huge decline in the price of office and computing equipmenL Using the prices of a more modestly from an average rate of rise of about¾ per recent year to gauge real output would result in less weight being cent during most of the 1970s and 1980s. 4 given to office and computing equipment and, in tum, a smaller contribution from this rapidly growing category to growth of real 4. Whether even this small degree of improvement in the pro output. All else equal, the growth of productivity also would be ductivity trend will stand up through future revisions of the data is negatively affected by switching to the prices of a more recent year. 16 which productivity has advanced quite rapidly in Consumer Prices Excluding Food and Energy * recent years, a rise in output per hour of 4.6 percent Percent change, 04 to 04 during 1994 more than offset a modest increase in hourly compensation, and unit labor costs declined noticeably for a second year. - - 6 Price Developments Although price increases picked up in some parts of the economy in 1994, the broader measures of price change continued to yield readings that were quite favorable. The rise in the total CPI was about 2% percent in 1994, the same as the increase during 1993. The CPI excluding food and energy also rose about 2% percent over the four quarters of 1994, after· increasing slightly more than 3 percent in 1993. The 1988 1990 1992 1994 producer price index for finished goods increased * Consumer price index for all urban consumers. 1 ¼ during 1994, after edging up just ¼ percent dur ing the previous year. As in 1992 and 1993, the past somewhat, influenced by the depreciation in the ex year's increases in all these price indexes were among change value of the dollar, as was true in the domestic the lowest readings of the past quarter-century. economy, the largest price increases for imported Measures of inflation expectations held steady in goods were those for materials. Gains in productivity 1994, but continued to show readings that were apparently enabled manufacturers of finished goods somewhat higher, on average, than the actual rates of to absorb these increases in the costs of domestically price increase. Price data for January of this year produced and imported materials without raising their were less favorable than those of 1994: The total CPI own prices very much. moved up 0.3 percent last month, and the CPI exclud ing food and energy jumped 0.4 percent, the largest Early this year, materials prices continued to surge. monthly rise in that measure since late 1992. The producer price index for crude materials other than food and energy jumped 3 percent in January, to a level about 17 ½ percent above that of a year earlier. Consumer Prices * Percent change, 04 to 04 Further along in the production chain, the PPI for intennediate materials other than food and energy rose 1 percent last month; the index has moved up 6 percent during the past twelve months, the largest 6 such rise since the late 1980s, when the twelve-month rate of increase in intermediate materials prices topped out at slightly more than 7 percent. By con trast, the PPI for finished goods other than food and 4 energy again showed only a modest increase in Janu ary. Since mid-January, the prices of a number of industrial commodities have backed away from ear 2 lier highs, but, given the volatility that these prices sometimes exhibit, the experience of a few weeks may not signal the emergence of a new trend. 0 1988 1990 1992 1994 In the CPI, the prices of commodities other than • Consumer price index for all urban consumers. food and energy rose 1 ½ percent over the four quar ters of 1994, about the same as the rise of 1993. The pickup of price increases last year was con Prices of new cars and new trucks, responding to fined largely to markets for materials. Prices of pri strong demand and, at times, shortages in the supply mary industrial inputs, which had moved up sharply of some models, moved up faster than prices in gen during 1993, continued to surge in 1994, and price eral; prices of used cars rose especially rapidly for a increases for intermediate materials accelerated as the third year. The prices of tobacco products, which had year progressed. Prices of imports also picked up fallen sharply in 1993 when producers made steep 17 one-time price reductions, turned back up in 1994, took a jump toward year-end after Hurricane Gordon rising moderately over the four quarters of the year. had damaged crops in Florida, but the run-up was By contrast, prices of home furnishings changed little partly reversed last month. over the year, and the CPI for apparel fell noticeably. The CPI for energy rose about 1 Y2 percent during In January of 1995, the CPI for goods other than food 1994, after edging down½ percent in 1993. Gasoline and energy jumped 0.4 percent; this rise followed a prices increased 4Y2 percent over the four quarters of string of months in which the index had increased 1994, reversing the decline of the previous year. Much very slowly. of the increase in gasoline prices came in the third The CPI for non-energy services, a category that quarter and followed, with a short lag, a second accounts for about half of the total CPI, rose slightly quarter rise in crude oil prices, which were moving less than 3½ percent over the four quarters of 1994, back up from the low levels of late 1993 and early after an increase of about 3¾ percent in 1993. The 1994. Prices of other energy products exhibited brief increase in these prices in 1994 was just a bit more periods of rapid increase, but sustained upward pres than half the rise that was recorded in 1990, when CPI sures in these prices did not materialize. Fuel oil inflation hit its most recent peak. Prices of medical prices shot up temporarily early in 1994, when stocks services continued to slow in 1994, and airline fares, were pulled down for a time by cold weather in the which have been an especially volatile category in the Midwest and the Northeast; later in the year, however, CPI in recent years, fell appreciably after having risen stocks were replenished and the earlier price increases sharply the previous year. However, auto finance were more than reversed. Natural gas prices followed charges turned up, and the rate of rise in owners' a pattern similar to the price of fuel oil, rising sharply equivalent rent, a category that has a weight of nearly in the first quarter of the year but falling back 20 percent in the total CPI, rose slightly faster over thereafter, to a fourth-quarter level that was about the four quarters of 1994 than it had during the 2¼ percent lower than that of a year earlier. Electric corresponding period of 1993. Like the prices of ity prices rose only slightly during the year. In Janu goods, the CPI for non-energy services accelerated ary of this year, energy prices were up moderately in sharply in January of this year. the CPI. In 1994, for a fourth year, neither food prices nor With the favorable inflation performance of the energy prices provided much impetus to the inflation past year, the average rate of rise in the total CPI since process. The consumer price index for food rose a the business cycle trough in early 1991 has been shade more than 2 ½ percent over the four quarters of 2. 9 percent at an annual rate. Exel uding food and 1994, about the same as the rise of 1993. Food prices energy, the rate of rise has been 3.3 percent at an in 1994 were restrained, in part, by sharp declines in annual rate. Inflation rates lower than these have not the prices of domestically produced farm products, been sustained through the first few years of any which, in turn, were pulled down by the huge business expansion since that of the 1960s, when both increases in crop and Ii vestock production noted pre the CPI and the CPI excluding food and energy viously. With beef and pork prices declining over the showed average rates of increase of less than 1.5 per year, the CPI for meats, poultry, fish, and eggs cent during the first four years after the business cycle changed little in total. Retail prices of dairy products trough of early 1961. Average rates of price increase rose only a small amount. Prices of foods that are during the current expansion have been much smaller more heavily influenced by the costs of nonfarm than those reported during the expansion that began in inputs also showed only small to moderate advances the mid-1970s. They also have been somewhat in 1994: The increase in the CPI for prepared foods smaller than those reported during the first few years amounted to about 2½ percent, slightly less than of the expansion that began in late 1982, a period the previous year's increase, and, for a third year, when price increases were braked in part by unusually the rise in the price index for food away from home steep declines in oil prices. In measuring the progress was less than 2 percent Coffee was the only item in that has been made toward bringing the economy the CPI for food to show sustained price acceleration; closer to the goal of long-run price stability, the freeze damage to the crop in Brazil caused world ratcheting down of the rate of price advance from prices of raw coffee to surge and led to a price rise of cycle to cycle since the 1970s is perhaps an even more than 50 percent at retail over the four quarters of more meaningful indicator than the favorable trends 1994. Fresh vegetable prices, which tend to be espe in the annual price data of recent years. cially sensitive to short-run supply developments, 18 Section 3: Monetary and Financial Developments With the economy generally strong, financial hiked the discount rate on four occasions by a total of markets in 1994 and early 1995 have been character 2¼ percentage points. ized by somewhat more rapid growth in private debt Longer-term rates increased 1 ½ percentage points and by higher interest rates. The increase in interest to 3 percentage points on .balance since January of rates reflected, in part, the policy actions of the Fed 1994, with the largest increase~ posted at intermediate eral Reserve. Concerned about inflationary pressures maturities. In addition to the policy actions, these resulting from rapid economic growth and dwindling rates were boosted through much of 1994 by greater margins of available resources, the Federal Reserve than-expected underlying strength in the economy firmed policy on seven occasions. These actions were and the resulting higher demand for credit, as well as by upward revisions to expectations in financial mar Domestic Interest Rates kets about the policy tightenings that would be Short-Term required to counter an incipient increase in inflation. Percent Since late last fall, however, the extent of Federal Monthly Reserve actions, along with incoming data suggesting some moderation in the pace of expansion, have calmed inflation fears and trimmed estimates of the eventual rise in short-term interest rates. As a conse quence, longer-tenn rates have retraced some of their earlier upward movements. Increases in intermediate- and long-tenn rates over the course of the year caused significant capital losses for some investors. Well-publicized losses at a num ber of investment funds in the first half of the year, along with substantial portfolio reallocations in view of the changed economic and financial outlook, may have contributed to increased financial market volatil ity at that time. On the whole, however, risk premi Long-Term Percent ums remained modest, and volatility ebbed over the course of the year. Late in the year, the tax-exempt Monthly securities market dipped following the bankruptcy of Orange County that resulted from mounting losses in 16 its investment fund, but the effects, beyond those on the fund's investors, proved to be small and short lived. 12 One consequence of the higher and more volatile long-term interest rates was a shift in business bor rowing away from the capital markets and toward 8 shorter-term sources, such as banks. This shift, which reversed the move toward long-term financing that Thirty-year Treasury Bond occurred as bond yields fell in 1992 and 1993, was ________. ___ ______________. ..________ 4 marked by the first annual increase in bank business 1982 1984 1986 1988 1990 1992 1994 loans in several years. Consumer lending also acceler ated in 1994, as the improved economic outlook taken to foster a financial environment more likely to encouraged increased use of consumer credit. Higher be consistent with sustained economic growth and interest rates likely held down household mortgage low inflation. In total, the policy tightenings raised . debt growth, in that the resulting decline in refinanc the federal funds rate by a cumulative 3 percentage ing activity limited the ability of households to "cash points between early February 1994 and early Febru out" some of the equity in their homes. Higher rates ary 1995. Other short-term rates rose by similar also encouraged households to shift to adjustable-rate amounts. Over this span, the Board of Governors mortgages, which offered lower initial interest costs. 19 The debt of all non.financial sectors increased 5¼ per U.S. and Foreign Interest Rates cent in 1994, about the same increase as in 1993, as 3-Month the pickup in business and household borrowing was Percent offset by lower growth in government debt. The Monthly effects of the strong economy on government expen ditures and receipts, policy moves to reduce the fed eral deficit, and retirements of tax-exempt securities that had been advance-refunded all contributed to the 10 slowdown in government borrowing. Banks funded much of the pickup in their loans with nondeposit funds and, in the second half of the year, with sales of securities. As a result, the 6 doubling of loan growth was not reflected in signifi cantly stronger expansion of the monetary aggregates. U.S. Large CD M3, which was boosted by relatively heavy issuance of large CDs, rose 1½ percent, a somewhat larger ......___.____,,._..._....____.____._..,_____.____.__,___,____._~ 2 increase than in 1993. With banks pricing savings and • Trade-weighted average of comparable bank rates in the small time deposits unaggressively as market interest other G-10 countries. rates rose, M2 grew 1 percent over the year, some 10-Year Percent what below its 1% percent pace in 1993. The increase in market interest rates relative to rates on transaction Monthly deposits slowed the growth of Ml to just 2¼ percent from the double-digit increases posted in 1992 and 1993. 12 The foreign exchange value of the dollar declined in terms of the other G-10 currencies last year, even as the U.S. economy expanded briskly and interest rates rose. In part, the weakness was the result of 8 unexpectedly strong growth abroad, especially in Europe, where the recovery in many countries was more rapid than had been anticipated. As a result, long-term interest rates in many of the other G-1 O ..,____.____,,._..._....__.___..__....__,_____.__..._....___._~ 4 countries increased by amounts similar to rates in the 1984 1986 1988 1990 1992 1994 United States. Heightened concerns about inflation • Trade-weighted average of comparable government bond prospects in the United States may also have contrib yields in the other G-10 countries. uted to the weakness of the dollar. Indeed, the dollar extraordinary factors that seemed to be inhibiting rebounded late in the fall when tighter monetary growth. These factors included efforts by households, policy evidently eased those concerns. The dollar firms, and financial intermediaries to repair strained declined, however, in early 1995 amid the signs of balance sheets, business restructuring activities, and slower U.S. growth and concerns about the implica the fiscal contraction associated, in part, with the tions for the United States of turmoil in Mexican downsizing of defense industries. financial markets. During the recovery and expansion, however, con siderable progress had been made by households and The Course of Policy and Interest Rates businesses in decreasing their debt-service burdens, In early 1994, short-term interest rates remained at and lending institutions had succeeded in rebuilding the very low levels reached in late 1992, with the fed their capital positions. By late 1993, the economy was eral funds rate fluctuating around 3 percent-roughly expanding rapidly, and incoming data early last year in line with the rate of inflation. The Federal Reserve suggested that much of that momentum had likely had maintained an accommodative policy stance carried over into 1994. In the circumstances, con throughout 1993. This stance was unusual so far into tinued accommodative policy risked pushing the the expansion phase of a business cycle, but it was demands on productive resources to levels that ulti believed to be necessary because of a number of mately would be associated with increased inflation. 20 Real Federal Funds Rate* would be the first tightening in many years, and some Percent investors would undoubtedly reconsider their port folio s~gies, possibly causing sharp movements in Quarterly 8 bond and stock prices. In addition, a slower initial shift would allow more time to assess the strength of the economy and the effects of the change in policy. 4 In the event, the Committee tightened policy gradu al! y through the winter and early spring. Pressures on reserve positions were increased by relatively small + ~---------1t-1"----1-.....--------~r-#-----t 0 amounts in February, March, and April; once market participants seemed to have made substantial adjust ments to the new direction of policy, a larger tighten ing move was implemented in May. Taken together, 4 the four policy actions raised the federal funds rate about 1 V4 percentage points. The May policy action 1962 1970 1978 1986 1994 was accompanied by an increase of Y2 percentage • Real federal funds rate is the nominal federal funds rate point in the discount rate, voted by the Board of minus the change in the CPI less food and energy over Governors. the last four quarters. Other interest rates moved up between 1 percent Consequently, the FOMC, at its meeting in early age point and 2 percentage points as a result of these February 1994, agreed that policy should be moved to policy moves, with the largest increases coming at a less stimulative stance. intermediate maturities. Besides the effect of the pol icy actions, longer-term rates were boosted by incom The pace at which the adjustment to policy should ing data suggesting continued robust growth, which be made was less clear: A rapid shift in policy stance heightened market concerns about a pickup in infla would minimize the risk of allowing inflation pres tion and expectations of further tightening by the sures to build, while a more gradual move would Federal Reserve. In addition, uncertainty about the allow financial markets time to adjust to the changed timing and magnitude of future policy actions, as well environment. Although many market participants as the capital losses that followed the tightenings, seemed to anticipate a firming move fairly soon, it Selected Treasury Market Rates Percent Daily Close I II 8 I I 7 I I I 1\1 , .' "r,... ,,,-., ~_.J,.>I. " .. ,., t-,!' 1 6 ,;,- :I ,,( r f .' :' ,,,,.,, ~✓ _,~"y-✓: I : ,., ... , : : ,, A ,,,4t-,_."_, ... , 5 I I I , , . , I .1,I'\ ,-,,1•, . I .,_ , ,..! :I ! ,,J,••' ,. -;,'..~onth bill !:::·, 4 ,---1---" : : .,J : : ~-,, ) __ , l l 3 ...._...__.._ . -._.. _ -J__.__ ___ .___......__ _.__ ___ __.._ __. ___ __ .__ __. ....__ _. ..___ __ _,______ 12/31 2/4 3/22 4/18 5/17 7/6 8/16 9/27 11/15 12/20 2/1 FOMC FOMC FOMC FOMC FOMC FOMC FOMC FOMC FOMC • Dotted vertical lines indicate days on which a monetary policy move was announced. 21 Bond Market Volatility * voted by the Board of Governors, was allowed to .-----------------P-ercent show through fully to the federal funds rate. Short term market rates rose following the policy move, End of month while long-term yields declined slightly, perhaps as a result of downward revisions to expectations of future 20 tightening. In advance of the meeting in late September, most market rates increased as incoming economic data 15 were seen in the market as raising the likelihood of higher inflation and the resulting need for tighter reserve conditions. The data suggested that the econ 10 omy had not yet been greatly affected by the tighten ing in monetary policy: Employment was growing strongly, and final sales, especially of consumer ...___.____._...____.____.__.__....____.____._..__.....____.___._. 5 goods, appeared to have firmed. Manufacturing activ 1984 1986 1988 1990 1992 1994 ity had continued to expand rapidly, boosted in part * Expected volatility derived from prices of options on Treasury bond futures. by an increase in motor vehicle production. Given the uncertain duration of lags between changes in mone encouraged investors to shorten the maturity of their tary policy and the resulting effects on the economy, investments and reduce their degree of leverage. The however, it was not clear whether the effects of the resulting portfolio adjustments likely contributed to earlier interest rate increases were smaller than had increased market volatility and may have intensified been expected or were still in train. Another possibil the upward pressure on longer-term interest rates. ity was that the under! ying momentum of the expan Incoming data in the late spring and early summer sion was greater than had been evident earlier. Given suggested that the economy continued to expand these uncertainties, the Committee took no immediate significantly, led by sales of business equipment, a tightening action at its September meeting. As in July, rebound in nonresidential construction following bad however, the Committee agreed to an asymmetric weather earlier in the year, and a pickup in inventory directive suggesting that the likely direction of any investment Inflation was of growing concern, as com move over tre intermeeting period was toward addi modity prices increased rapidly, and measures of slack tional restraint. suggested that the economy was entering a range in Broad measures of inflation remained moderate which pressures on broad price indexes might begin through the fall in spite of continued substantial eco to build. In part reflecting this concern, long-term nomic growth in an economy that was running close rates moved up, and the dollar weakened. Given the to its estimated potential. Nonetheless, strong eco relatively large policy action in May, however, the nomic data and continued upward pressure on prices Committee decided to take no action at the July at earlier stages of production apparently heightened meeting and to wait for more information on the investors' inflation concerns, as well as expectations performance of the economy. The Committee saw the of future policy tightenings. Consequently, most mar possible need for tighter policy, however, and issued ket interest rates rose appreciably between the Sep an asymmetric directive to the Federal Reserve Bank tember and November meetings, with the largest of New York suggesting that policy would respond increases occumng at intermediate maturities. At the promptly to evidence of increased inflation pressures. November meeting, the Committee members agreed In the interval between the Committee meetings in that the stance of policy was not sufficiently re early July and mid-August the economy continued to strained given the clear risks of higher inflation. As a expand robustly, and, coming into the August meet result, they chose a sizable firming of monetary pol ing, it appeared that the markets expected a small icy, tightening reserve conditions in line with the further increase in reserve pressures. At its meeting, increase of ¼ percentage point in the discount rate the Committee agreed that a prompt further tightening approved by the Federal Reserve Board. move was needed to provide greater assurance that inflationary pressures in the economy would remain The yield curve flattened appreciably in response to sutxlued, and tre members chose a tightening action the larger-than-expected policy action. The increase somewhat larger than had been expected by the mar in the federal funds rate pushed up most short-term kets. A rise of½ percentage point in the discount rate, interest rates. Long-term rates increased initially, but 22 in late November and early December these rates est, although anecdotal reports suggested that some more than reversed the earlier increases. Evidently, firms intended to raise prices early in the new year. market participants ultimately interpreted the substan Incoming data on production and employment contin tial policy tightening as demonstrating the Commit ued to be upbeat, with healthy growth reported in tee's intention to take the actions necessary to con virtually all industries and regions. Some indicators, tain inflation at relatively low levels. By contrast, however, raised the possibility of a slowing in the intermediate-term rates increased over the weeks fol pace of the expansion. Nonetheless, output growth in lowing the November meeting as a variety of incom the fourth quarter was the fastest of the year, and the ing data indicated that the economy's growth had Committee felt that, with output and employment at accelerated further in the fourth quarter and additional or even beyond estimates of their sustainable levels, tightenings might be required to slow growth to a the risks of rising inflation were still considerable. As more sustainable pace. By the time of the December a result, the Board of Governors voted an increase of meeting, rates on two-year Treasury notes were only ½ percentage point in the discount rate, and the a little below those on thirty-year Treasury bonds, Committee agreed to allow the increase to be fully although both yields remained well above short-term reflected in the federal funds rate. Because it had rates. been widely anticipated in the financial markets, other interest rates and the foreign exchange value of the Financial markets were focused in early December dollar were little affected by the policy action. Interest on the failure of an investment fund run by Orange rates turned down subsequently, as additional infor County, California, and the subsequent bankruptcy of mation on the economy seemed to reinforce the possi the county itself. The municipal securities market bility that a slowdown was in process. bore the brunt of these developments, with rates ris ing for a time relative to those on comparable Trea At the same meeting, the Committee also formally sury issues. The failure had a substantial effect on the adopted two practices that had been followed on a finances of the municipalities that had invested in the provisional basis during 1994. First, the Committee fund. In addition, investors had to consider the likeli voted to continue to announce any change in the hood of other state and local governments having stance of policy on the day the decision is made. similar investment difficulties. Over the following These announcements, which had followed each of days and weeks, however, only a few other problem the policy tightenings agreed to in 1994, are intended situations emerged, and they were on a much smaller to minimize any confusion and uncertainty about the scale. stance of policy. In addition, a public announcement ensures that all financial market participants have the In the period leading up to the December meeting, same access to information regarding changes in incoming data continued to show robust growth and monetary policy. Second, the Committee agreed to subdued inflation. The Committee felt that the effect continue releasing the transcripts of Committee meet on economic activity of the policy actions during the ings with a five-year delay. The published minutes of year, and especially the substantial tightening moves Committee meetings, which are available soon after in the second half of the year, were not yet visible, the subsequent meeting, provide a relatively complete owing to the lags in the effects of monetary policy on summary of the arguments presented and the reasons the economy. As a result, the Committee decided to for a policy choice. The transcripts provide additional take no further policy action at the meeting, and to information, however, that may be of use to those await additional information on the underlying interested in the details of the policy process. The strength in the economy and the effects of the earlier Committee decided that a five-year delay struck an policy actions. This decision was reinforced by con appropriate balance between the right of interested cerns that the financial markets might be somewhat members of the public to obtain this added detail and unsettled owing both to the usual year-end adjust the Committee's need to debate policy issues openly ments and to uncertainty about the effects and inci and without the sort of restraint that more rapid dis dence of the sizable market losses sustained by some closure might generate. investors over the year. In view of the substantial strength evident in the incoming data, however, the Committee again chose an asymmetric directive Credit and Money Flows in 1994 pointing toward further restraint The debt of all nonfinancial sectors grew In advance of the Committee meeting at the end of 5¼ percent in 1994, somewhat below the middle of January, broad measures of inflation remained mod- its monitoring range of 4 percent to 8 percent, and 23 about the same increase as a year earlier. More rapid rates lagged those in market interest rates. Consumer growth of private sector debt was offset by slower credit may also have been boosted somewhat by the growth of public sector debt As long-term rates rose increased use of credit cards offering rebates or other well above their late 1993 lows, private sector bor incentives. Rising mortgage rates in 1994 greatly rowing shifted toward shorter-term sources of funds. reduced the volume of mortgage refinancings from In part as a result of this shift, financial intermediar the very high levels reached in 1993. The refinancings ies supplied a larger share of new debt than they had had contributed to an in~rease in mortgage debt for several years. Much of the depository credit recause some households ha~ taken the opportunity growth was funded with nondeposit funds, however, afforded by refinancing to cash out a portion of the and growth in the broad monetary aggregates, which equity in their properties. Higher rates on fixed-rate consist primarily of deposits, remained subdued. mortgages also induced many borrowers to shift to adjustable-rate mortgages that carried much lower Debt: Annual Range and Actual Level initial rates. Concessional starting rates and the grow Billions of dollars ing use of adjustable-rate contracts with initial fixed Nonfinancial rate periods lasting several years also may have con 13300 tributed to this shift Over the last few months of the year about half of all new home mortgages were of the adjustable rate variety. The shift to adjustable-rate 13000 mortgages and the sluggish adjustment of consumer loan rates mitigated the effect of higher market inter est rates on household debt-service burdens. 12700 The debt of nonfinancial businesses expanded in 1994 after three years of stagnation. Earlier efforts to 12400 restructure balance sheets by increasing equity capital and refinancing higher-cost credit appeared to leave businesses in a better position to increase debt in 12100 1994, as the sector's debt-service burden had fallen 0 N D J F M A M J J A S O N D about one-third from its peak five years earlier. A 1993 1994 decline in equity issuance, perhaps resulting from the Debt growth both in the federal and in the state and lackluster performance of the stock market, may also local government sectors slowed last year. Growth of have boosted business borrowing. Business financing federal government debt was smaller because of the needs were strengthened by increased spending on narrowing of the federal budget deficit The outstand capital and inventories, as well as merger and acquisi ing volume of state and local government debt actu tion activity. The total value of mergers and acqui al! y declined as bonds that previous! y had been sitions increased substantially last year, and the share refunded in advance of their earliest call date were of such activity requiring cash payments to retired. Much of the bulge in tax-exempt issues in shareholders-rather than swaps of shares-rose 1993 had been for the advance refunding of higher sharply, although it remained below the levels reached cost debt issued in the 1980s. These offerings sub in the late 1980s. sided early in 1994, as the amount of bonds eligible Rising and more volatile long-term interest rates for advance refunding dwindled and borrowing costs encouraged businesses to rely more heavily on short rose. term debt in 1994. This shift was reinforced by Household debt growth increased modestly in changes in supply conditions in various markets. 1994, as an acceleration in consumer credit was partly Capital losses early in the year likely caused some of offset by slower growth in mortgage debt. The pickup those supplying long-term funds to become more in consumer debt reflected, in part, increased demand cautious; for example, some savers backed away from for consumer durables. In addition, responses to Fed bond mutual funds. At the same time, banks were eral Reserve surveys of banks indicated that many loosening terms on business loans as well as easing respondents were more willing to extend credit to their underwriting standards. Banks attributed the eas households last year, which may have led them to ing of loan terms and standards to increased competi ease terms and standards on consumer loans. Indeed, tion for business customers from other banks and also spreads between consumer loan rates and market rates from nonbank lenders. The competitive posture of narrowed significantly last year, as increases in loan banks likely reflected, in part, the high level of profits 24 Changes in Business Lending Standards at credit also likely reflected the shift by households Selected Large Commercial Banks* toward adjustable-rate mortgages. Thrift institutions Percent and banks find holding adjustable-rate mortgages less By Size of Firm Seeking Loan risky than holding fixed-rate mortgages, and so adjustable-rate loans are less likely to be securitized 60 and sold. With bank credit growth -picking up and thrift sec 40 tor credit rising, growth of depository credit in 1994 nearly matched that of total nonfinancial debt Thus, 20 the share of credit provided by these intermediaries stabilized last year after having declined substantially + since 1988. Despite the growth in depository credit, 1-----------3-~~£.._~------~ 0 the broad monetary aggregates continued to expand sluggishly. Domestic banks funded much of their 20 credit expansion from nondeposit sources, such as borrowings from their foreign offices, that are not 1990 1991 1992 1993 1994 included in the monetary aggregates. Funds from these Source. Federal Reserve's Senior Loan Officer Opinion Survey on Bank Lendi~ Practices. sources are not subject to deposit insurance premiums, • Percentage of domestic respondents reporting tightening which may help account for their recent rise. standards over the past three months less the percentage reporting easing standards. M3: Annual Range and Actual Level earned by banks in recent years and the resultant Billions of dollars strengthening of their balance sheets. As a result of 4% these factors, bank business loans increased more than 9 percent, their first annual increase .in several 4400 years. Other sources of short-term business finance, including commercial paper and finance company 4350 loans, also expanded on tre year. The effect of the pickup in business and consumer loans on bank credit growth was partially offset by 4300 slower growth in bank securities holdings. Early in the year, banks purchased a significant volume of 4250 government securities, and reported levels of other securities holdings were boosted by an accounting change.1 Much of this growth was reversed later in .___..__....___.___.__.__.__.__,___,___._.__...._.,__,, 4200 0 N D J F M A M J J A S O N D the year, however, as banks used sales of securities to 1993 1994 fund loan growth. Reported securities growth also was damped by declining securities prices.2 The broadest monetary aggregate, M3, did pick up a In 1994 thrift sector credit expanded for tre first bit as banks turned, in part, to large time deposits to time in several years, as tre Resolution Trust Corpo fund asset growth. M3 expanded about 1 ½ percent, ration virtually completed its liquidation of insolvent well above the lower bound of its O percent to 4 per thrift institutions. In part, the increase in thrift sector . cent annual range and a somewhat larger increase than in 1993. Growth in large time deposits topped 7 percent for the year, marking the first annual 1. New Financial Accounting Standards Board rules, effective at increase in this component since 1989. Much of the the start of the year, limited the ability of banks to net off-balance increase in large time deposits was in senior bank sheet items for reporting purposes. The new rules affected items such as swaps and options, the cash values of which are reported on notes, which are not subject to deposit insurance balance sheets in the other securities category. premiums. 2. A Financial Accounting Standards Board rule implemented at the start of the year required each bank to divide its investment M2 grew 1 percent in 1994-the lower bound of its account securities into those that it intended to hold to maturity, annual range. The slow growth reflected, in part, rela which could be reported at book value, and those that were avail able for sale, which had to be marked to market. tively sluggish upward adjustment of retail deposit 25 M2: Annual Range and Actual Level retail deposits would also require higher advertising, Billions of dollars administrative, and deposit insurance costs. 5% In contrast to the previous several years, M2 behav 3750 ior in 1994 was roughly consistent with its long-run historical relationship with movements in nominal 3700 income and opportunity costs as traditionally defined-that is, the difference between rates on short-tenn instruments (for example, Treasury bills) 3650 and those offered on retail balances. This consistency suggests that, unlike the past few years, the slow 3600 growth in M2 last year was not the result of portfolio shifts toward bond and equity mutual funds. Indeed, 3550 the growth in M2 plus long-term mutual funds ran slightly below the 1 percent pace of M2 growth. Net .....__...._..__.____.____,_____._____._____._____._____.____.__.____.__.__. 3500 sales of equity mutual funds continued at a high level 0 N D J F M A M J J A S O N D in 1994, although the pace of sales slowed somewhat 1993 1994 late in the year. Equity fund sales were partly offset, however, by outflows from bond mutual funds in the rates. Rates on savings accounts and other check last three quarters of the year. Apparently, falling able deposits (OCDs), including NOW accounts, bond prices and greater market uncertainty, and, per responded about as slowly as they have in the past to haps, reports of derivatives losses at some funds, led the increase in market rates, while the response of households to scale back their holdings of bond mu rates on small time deposits was sluggish relative tual funds in favor of investments that posed less risk to historical nonns. Evidently, banks believed that of capital loss. With deposit rates lagging, however, generating increased retail deposits would be more these outflows did not translate into faster M2 growth. expensive than raising wholesale funds given that Some of the withdrawals from bond funds may have higher retail rates would have to be paid on existing been invested direct! y in Treasury securities. Reflect liquid deposits and on time deposits as they were ing such portfolio shifts, net noncompetitive tenders rolled over, as well as on any new deposits. Increasing for Treasury bills, which had been negative in 1993, M2 Velocity and M2 Opportunity Cost Ratio scale Percentage points, ratio scale 13 1.9 11 9 7 1.8 5 1.7 3 1.6 M2 Velocity M2 Opportunity Cost * 1.5 1978 1982 1986 1990 1994 • Two-quarter moving average of 3-month Treasury bill rate less average rate paid on M2 cof'll)Onents. 26 Net Sales of Shares last year, encouraging households to shift funds in Long-Term Mutual Funds* into higher-yielding assets. OCD growth also was Millions of dollars (monthly average) depres~d by the introduction of sweep account pro grams at some large banks. In these programs, the Equity Bond portion of customers' OCD balances in excess of a Period Total funds funds predetermined level are swept into money market deposit accounts at the end _of each day. Year In contrast to transaction -deposits, the currency 1991 10,820 3,821 7,000 component of Ml continued to register strong growth 1992 16,844 7,268 9,576 last year. Currency increased 10V4 percent, the same 1993 23,445 11,832 11,634 rise as 1993 and close to the record increase in 1990. 1994 9,674 11,073 -1,399 As has been the case since 1990, much of the cur rency growth appeared to reflect rapid expansion in Quarter U.S. currency circulating abroad. Informal reports suggest that foreign demand was particularly strong 1994:01 17,438 13,744 3,694 in 1994 in Russia and the other former Soviet 02 10,128 10,935 -808 republics. 03 9,826 11,166 -1,340 04 1,306 8,447 -7,141 M1: Actual Level Billions of dollars Source. Investment Company Institute. * Gross sales of shares less redemptions. 10% totaled more than $16 billion last year, and net non 1220 competitive tenders for Treasury notes also increased substantially. 3 Consistent with its historical behavior, Ml growth 1180 slowed sharply last year in response to widening differentials between market interest rates and those offered on transaction deposits. Ml expanded only 1140 2V4 percent-down substantially from the double digit increases recorded the previous two years. Fol lowing the typical pattern, demand deposits and OCDs were especially responsive to the rise in short 1100 0 N D J F M A M J J A S O N D term interest rates. On balance, demand deposits 1993 1994 edged up only V2 percent, compared with growth of 13V4 percent in 1993, as higher market rates encour aged deposit holders to economize on these non Foreign Exchange Developments interest-earning assets. In addition, the turnaround The trade-weighted foreign exchange value of the reflected the decline in home mortgage refinancing dollar in terms of the other G-1 O currencies declined ~cti vity last year: Demand deposits had been ooosted nearly 6½ percent on balance from December 1993 to in 1993 because prepayments of securitized mort December 1994. After displaying some strength at the gages were held primarily in such deposits for a time start of 1994, the weighted-average foreign exchange before they were distributed. The rates offered on value of the dollar fell about 1O percent from Febru OCD accounts adjusted slowly to higher market rates ary through early November. Although U.S. growth continued to be stronger than expected, market 3. The Treasury permits noncompetitive bids at its auctions to perceptions aoout the strength of economic activity in make it easier for smaller, less sophisticated bidders to participate. the other industrial countries were also revised Those submitting noncompetitive tenders are assured of receiving sharply higher as the year progressed. These changed the security, and the yield on the security they obtain is the average issue rate established at the auction. The level of net noncompeti perceptions led market participants to raise their tive tenders during a period is the dollar volume of securities expectations of market interest rates abroad, which, purchased under noncompetitive tenders less the volume of repay together with increased concerns over potential infla ments of maturing securities that had been purchased under non competitive tenders. tion pressures in the U.S. economy, put downward 27 pressure on the dollar against most foreign cur States. In Japan, where the evidence for a buoyant rencies. The dollar rebounded somewhat at the end recovery remained somewhat mixed, long-term rates of the year as the greater-than-expected tightening rose less. In contrast to long-term rates, foreign short action by the Federal Reserve in November reas term rates were little changed on average and even sured market participants that U.S. inflation risks were declined slightly in several countries, including being addressed. In early 1995, however, with U.S. France and Germany. Major exceptions were Canada, growth appearing to moderate, and the turmoil in where short-term market rates rose about 300 basis Mexican financial markets raising concerns about points, and the United Kingdom, where they rose possible implications for the United States, the dol 100 basis points. In both countries, official lending lar declined on balance, nearly reaching its fall 1994 rates were increased during the year to contain infla low. tion risks in the face of vigorous economic growth. During the first few weeks of this year, foreign long Selected Dollar Exchange Rates term rates on average rose slightly further, but they December 1993= 100 have since retraced most of that rise. Daily During 1994, the dollar depreciated 8 percent in terms of the mark and declined by similar amounts in 105 terms of the other currencies in the exchange rate mechanism (ERM) of the European Monetary Sys 100 tem. The German economy expanded over the year, and the growth of the targeted monetary aggregate, M3, remained above target until the very end of the 95 year. Market participants trimmed their expectations of further declines in official Bundesbank lending Japanese Yen rates, and German long-term interest rates rose. The 90 dollar depreciated by lesser amounts in terms of sterling and the lira, both of which had been with ______. ......___.___.__.____.,___.___,...._.__..._....__. ...... 85 drawn from the ERM in 1992. The persistent strength Weighted Average Foreign Exchange Value of the U.K. recovery raised concerns of renewed of the U.S. Dollar* inflation pressures there, and the political uncertain December 1993= 100 ties in Italy and, to a lesser extent, in the United Daily Kingdom held back market enthusiasm for the two currencies. 100 The dollar also depreciated about 8 percent in terms of the yen during the year. At times, the dollar yen rate fluctuated in response to developments in 96 U.S.-Japanese trade talks. The dollar reached a historic low of 96.11 yen in November and was very weak against the German mark as well, and the Fed eral Reserve joined the U.S. Treasury in intervention 92 purchases of dollars against yen and marks at that time. Subsequently, the dollar rebounded somewhat in terms of the yen and European currencies. In early ,..__....._....__,___.__.___.___.___.___.__.'--.__..._.,__...._......, 88 1995 the dollar weakened further, especially against D J F M A M J J A S O N D J F the mark, in part because that currency attracted funds 1993 1994 1995 from markets upset by the peso crisis. • Index of weighted average foreign excha119e value of the U.S. dollar in terms of currencies of other G-10 countries. Weights are based on 1972-76 global trade of each of the In contrast to its experience in terms of the ERM 10 countries. currencies and the yen, the dollar appreciated in terms Long-term interest rates in major foreign industrial of the Canadian dollar nearly 4½ percent during countries generally rose during the year. On average, 1994. The relative weakness of the Canadian currency yields on foreign government issues with maturities appeared to reflect pressures arising from the of ten years increased 200 basis points in the twelve increases in U.S. short-term rates, concerns over the months to December, about the same as in the United large fiscal deficits of the central government and the 28 provinces and, at times, perceived risks associated port of Mexico's economic reform program, and on with possible secession by Quebec. In the first few January 12, against the background of increased tur weeks of 1995, the Canadian dollar weakened further, bulence in international capital markets, the Clinton as markets apparently became more concerned about Administration, with the support of the bipartisan lead the large outstanding Canadian federal and provincial ership of Congress, announced a proposal to provide debt and the persistent federal government deficit. As $40 billion in guarantees on securities to be issued by a result, market interest rates have risen further, and Mexico in an effort to restore investor confidence. the Bank of Canada has moved up overnight rates Subsequently, the peso weakened further as support several times, including an increase to match the within the Congress for the guarantee proposal upward shift in the U.S. federal funds rate following appeared to decline. The Mexican stock market also the most recent FOMC meeting. In response, the continued to slide, and short-term peso interest rates Canadian dollar strengthened, but more recently, has rose sharply. In late January the peso reached a new given up some of these gains. low of 6.55 pesos to the dollar amid signs that prob The dollar depreciated nearly 5 percent in 1994 lems in Mexico were having effects on financial mar against the currencies of major U.S. trading partners kets in other countries. In particular, equity markets in in Latin America and East Asia when adjusted for Argentina and Brazil had declined in volatile trading. relative changes in consumer prices. The dollar appre More generally, investors appeared to be retreating ciated sharply against the Mexican peso, however, from investments in a variety of emerging market first in March and more significantly during the final economies, some of which have substantial current two weeks of the year and in early 1995. account deficits, while others maintain fixed exchange rates that pose the risk of becoming overvalued. On In response to continuing downward pressures on January 31 the Administration withdrew the request the peso and sizable losses of international reserves for approval of the guarantee program and, with the over the course of 1994, the Bank of Mexico an support of the bipartisan leadership of Congress, nounced on December 20 a 13 percent change in the announced a new plan to provide $20 billion to lower bound of the range that it unilaterally had set support financial stabilization in Mexico using the for the peso-dollar exchange rate. The peso immedi resources of the Exchange Stabilization Fund (ESF) ately fell to the new lower limit, from about 3.5 to and, in the short run, the Federal Reserve. On Febru 4 pesos per dollar, and reserve losses continued. As a ary 1, the Federal Reserve's swap line with the Bank consequence, the Bank of Mexico on December 22 of Mexico was increased further to $6 billion as part permitted the peso to float and activated the North of this package. The package will consist of short American Swap Facility, which provides up to $6 bil term swaps, which will be provided by the Federal lion of short-term funds to the Bank of Mexico, Reserve and the ESF, and swaps with maturities of evenly split between the Federal Reserve and the three to five years and securities guarantees with Treasury, and an additional C$1 billion from the Bank maturities of five to ten years provided by the ESF. of Canada. Repayment will be assured from the proceeds of exports of Mexican oil. Additional multilateral sup During the following days the peso remained vola port for Mexico included an increase from $7.8 bil tile on exchange markets, fluctuating in a range lion to $17 .8 billion in the funds provided by the IMF between 5 and nearly 6 pesos to the dollar. On Janu under a stand-by arrangement that was approved on ary 2, a package was announced totaling $18 billion February 1 and an increase from $5 billion to $1 o bil in international financial support for Mexico, includ lion in the short-term credit supported by the central ing an increase from $6 billion to $9 billion in the banks of a number of major industrial countries acting swap facilities extended by the United States (again through the BIS. split between the Federal Reserve and the Treasury), an additional C$500 million in the swap facility of the The peso rebounded during the week following the Bank of Canada, $5 billion in credit supported by announcement of the January 31 program and, on net, other central banks acting through the Bank for Inter has since held most of that gain in volatile trading. national Settlements (BIS), and $3 billion in credit Through mid-February, the dollar on balance has from commercial banks. On January 6 the IMF began appreciated substantial! y against the peso since talks with Mexico on a stand-by arrangement in sup- December 19, the day before the peso's devaluation. 29 Growth of Money and Debt Percent Domestic Nonfinancial Period M1 M2 M3 Debt Year1 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 11.8 1984 5.5 8.1 10.9 14.4 1985 12.0 8.7 7.6 14.1 1986 15.5 9.3 8.9 13.5 1987 6.3 4.3 5.7 10.2 1988 4.3 5.3 6.3 9.0 1989 .6 4.8 3.8 8.0 1990 4.2 4.0 1.7 6.5 1991 7.9 2.9 1.2 4.6 1992 14.3 2.0 .5 4.7 1993 10.5 1.7 1.0 5.2 1994 2.3 1.0 1.4 5.3 Quarter (annual rate)3 1994:Q1 5.5 1.8 .6 5.3 Q2 2.6 1.7 1.3 5.6 Q3 2.4 .8 2.0 4.4 Q4 -1.2 -.4 1.7 5.5 1. From average for fourth quarter of preceding year to 3. From average for preceding quarter to average for average for fourth quarter of year indicated. quarter indicated. 2. Adjusted for shifts to NOW accounts in 1981. 30

Federal Reserve (1995, February 20). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_19950221

@misc{wtfs_monetary_policy_report_19950221,
  author = {Federal Reserve},
  title = {Monetary Policy Report},
  year = {1995},
  month = {Feb},
  howpublished = {Monetary Policy Reports, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/monetary_policy_report_19950221},
  note = {Retrieved via When the Fed Speaks corpus}
}