Monetary Policy Report

Febrmrry 22, 1995 SUMMARY REPORT OFTHE FEDERAL RESERVE BOARD 1995 MONETARY POLICY OBJECTIVES February 22, 1995 This Executive Summary provides highlights of the Board's Report to Congress on the Full Employment and Balanced Growth Act of 1978. 1995 MONETARY POLICY OBJECTIVES Contents Section Page Monetary Policy and the Economic Outlook for 1995 1 Economic Projections for 1995 3 Money and Debt Ranges for 1995 7 lfe stimony of Alan Greenspan thairman, Federal Reserve Board 10 I Monetary Policy and the Economic Outlook for 1995 The U.S. economy turned in a strong Federal Reserve policy during 1994 performance in 1994. Real gross and early 1995 was aimed at fostering domestic product increased 4 percent a financial environment conducive to over the four quarters of the year. The sustained economic growth. As the employment gains associated with this economy moved back toward high rise in production outpaced growth rates of resource utilization, pursuit of of the labor force by a sizable margin, this aim necessitated acting to prevent and the unemployment rate thus a buildup of inflationary pressures. declined substantially. Price increases picked up in some sectors of the economy in 1994 as labor and product Real GDP markets tightened, but broader mea Percent change, annual rate sures of price change showed inflation holding fairly steady: The consumer price index increased about 2¾ per cent over the year, the same as the rise during 1993. Signs that growth is moderating have emerged in the past month or so, but the bulk of the evi dence suggests the economy continues o+ _ ...........- ---=----=-~-_.....~. ........................." '-"'-'. ......... __ to advance at an appreciable pace. Consumer Prices * Percent change, Q4 to Q4 1989 1990 1991 1992 1993 1994 ________ Federal Reserve policy had remained 6 very accommodative in 1993 in order to offset factors that had been inhibit ------- ing economic growth. By early 1994, 4 however, the expansion clearly had gathered momentum, and mainte- nance of the prevailing stance of policy 2 would eventually have led to rising inflation that, in turn, would have jeopardized economic and financial 1988 1990 1992 1994 stability. Taking account of anticipated * Consumer price index for all urban consumers. lags in the effects of policy changes, 1 the Federal Reserve began to firm Foreign Exchange Value money market conditions last Febru of the U.S. Dollar * ary. The Federal Reserve continued to Index, March 1973 = 100 tighten policy over the course of the Nominal year and into 1995, as economic growth remained unexpectedly strong, eroding remaining margins of unused resources and intensifying price increases at early stages of production. Developments in financial markets for example, easier credit availability through banks and a decline in the foreign exchange value of the dollar may have muted the effects of the tightening of monetary policy. Short-term interest rates have 1986 1988 1990 1992 1994 increased about 3 percentage points ,. Index of weighted average foreign exchange value since the start of 1994, with the federal of the U.S. dollar in terms of currencies of other G-10 countries. Weights are based on 1972-76 global trade funds rate rising from 3 percent to of each of the 10 countries. 6 percent. Other market interest rates have risen between 1½ percentage points and 3 percentage points, on net, The foreign exchange value of the with the largest increases coming at dollar in terms of other G-10 curren intermediate maturities. Through cies declined almost 6½ percent last much of the year, intermediate-and year, even as the economy picked up long-term rates were lifted by more and interest rates rose. The positive rapid actual and expected economic effects on the dollar that would growth, fears of a pickup in inflation, normally have been expected from and market expectations of additional higher U.S. interest rates were offset policy moves. However, a further in large part by upward movements substantial tightening in November in long-term interest rates abroad. and some tentative signs of modera Indeed, foreign long-term rates tion in economic activity around increased as much on average as U.S. year-end and in early 1995 appeared rates during 1994, owing to much to reduce market concerns about more rapid than expected growth increased inflation pressures and abroad, especially in Europe. Concerns additional Federal Reserve policy about U.S inflation may have contrib actions. As a result, long-term rates uted to the weakness in the dollar in declined, on net, from mid-November the middle part of last year; late in the through mid-February. year, the dollar rallied for a time, 2 as tighter monetary policy apparently Long-Term Interest Rates reduced investors' inflation fears. The Percent dollar weakened again, however, in early 1995, perhaps reflecting the Monthly emerging indicators of moderating growth in the United States. In addi tion, financial markets were roiled early this year by severe financial difficulties in Mexico. A sharp depre ciation of the peso had adverse effects not only in Mexico but also in a number of other countries, and these developments also may have contrib uted to the weakness of the dollar. · Thirty-year Treasury Bond Despite the rise in U.S. interest rates 1982 1984 1986 1988 1990 1992 1994 in 1994, private sector borrowing picked up in support of increased spending, abetted in part by more the federal deficit, as well as by the aggressive lending by intermediaries. effects of the strong economy on tax The debts of both households and receipts and spending. Taken together, businesses grew at their fastest rates the debt of all nonfinancial sectors in five years. The step-up in growth expanded 5¼ percent, about the same of private debt was accompanied by as the increase of a year earlier and a changes in its composition. Businesses figure that was in the middle portion shifted toward short-term funding of the 1994 monitoring range of sources as bond yields rose, increasing 4 percent to 8 percent. their bank borrowing and commercial paper issuance, while cutting back Economic Projections for 1995 on new bond issues. Similarly, households turned increasingly to The members of the Board of Gover adjustable-rate mortgages as rates nors and the Reserve Bank presidents, on fixed-rate mortgages increased all of whom participate in the delibera substantially. Banks encouraged the tions of the Federal Open Market shift of households and businesses to Committee, expect the economy to bank borrowing by easing lending settle into a pattern of more moderate standards and not allowing all of the expansion in 1995, after a burst of rise in market rates to show through to growth that has brought rates of loan rates. By contrast, federal borrow resource utilization to the highest ing was slowed in 1994 by policies levels since the latter part of the 1980s. adopted in previous years to narrow 3 Most of the Board members and Other influences also will be work Reserve Bank presidents expect the ing to moderate the rate of growth. For rise in real GDP over the four quarters example, large increases in real outlays of 1995 to be in a range of 2 percent for consumer durables over the past to 3 percent. three years, partly financed in recent Effects of the past year's increases quarters by unsustainably rapid in interest rates probably will show growth in the volume of consumer through more strongly in the coming credit, probably have exhausted most year, reflecting the typical lags of the pent-up demand that had between Federal Reserve policy accumulated when the economy was actions and changes in the pace of sluggish early in the 1990s. Similarly, economic growth. Residential build business investment in new equipment ing, especially of single-family units, has been rising extremely rapidly for is the part of the economy in which some time and has moved to quite a those effects are likely to emerge high level; businesses likely will be earliest and stand out most clearly, shifting to more moderate rates of but reactions to the higher rates prob spending growth before too long. ably will be showing up in other Inventory investment seems likely to interest-sensitive sectors as well. moderate as well, as sustained Economic Projections for 1995 Percent Federal Reserve Governors and Reserve Bank Presidents Administration Central Indicator Range Tendency Change, Nominal GDP 4¾--6½ 5--6 5.4 fourth quarter to fourth Real GDP 2-3¼ 2-3 2.4 quarter: 1 Consumer price index 2 2¾-3¾ 3-3½ 3.2 Average level in Civilian unemployment rate 5¼--6 About5½ 5.5-5.83 the fourth quarter: 1. Change from average for fourth quarter of 2. All urban consumers. 1994 to average for fourth quarter of 1995. 3. Annual average. 4 additions to stocks at the pace of should begin to slow as growth of recent quarters would almost surely demand in this country eases. generate an unwanted backup of The Board members and Reserve inventories at some point. Bank presidents expect that output growth of the magnitude they anticipate will be accompanied by U.S. Real Merchandise Trade moderate increases in employment Annual rate, billions of 1987 dollars and little change in the unemployment rate. Forecasts of the unemployment rate for the fourth quarter of 1995 are tightly clustered around 5½ percent. --------------- 800 Civilian Unemployment Rate * Percent --------------- 8 1988 1990 1992 1994 ' 6\_ --~--------"- 6 Jan. In other areas, however, increased --------------- 4 strength may be forthcoming. Nonresi dential construction, which often tends to lag other sectors of the economy over the course of the business cycle, 1988 1990 _19,92 1994 now appears to be picking up steam. * A redesigned survey .µid revised population estimates were introduced in January 1994; data In addition, net exports may be a less from that point on are not directly comparable negative factor in corning quarters with those of earlier periods. than they were in 1994. Many foreign industrial economies entered the new year with considerable forward · An especially encouraging devel momentum; that should keep real opment in 1994 was that inflation exports of goods and services on a remained relatively quiescent even as solid uptrend, even allowing for lower the economy moved to high rates of exports to Mexico as a consequence of resource utilization. Ho~ever, the the peso's devaluation and the likeli costs of materials and components hood of little or no growth in that have been rising rapidly, squeezing country in 1995. Imports, meanwhile, profit margins in some sectors, and 5 anecdotal reports of pressures on Manufacturing Capacity wages and finished goods prices Utilization Rate have proliferated in recent months; Percent increases in average hourly earnings and consumer prices picked up in January. Assessing the prospects, -------------- 87 members of the Board of Governors and the Reserve Bank presidents think the most likely outcome for this year is that inflation will run somewhat higher than in 1994. Such an outcome would be consistent with patterns of price change during earlier periods when the economy was operating at levels of resource utilization like those seen recently. The central tendency 1988 1990 1992 1994 of the Federal Reserve officials' CPI forecasts, measured in terms of the change from the final quarter of 1994 inflation develops sustained momen to the final quarter of 1995, spans a tum. Much progress has been made range of 3 percent to 3½ percent. over the past couple of business cycles The economic prospects anticipated in reducing the role that inflation plays by the governors and Reserve Bank in the economic decisions of house presidents for 1995 appear to be holds and businesses. Moving ahead, closely in line with those of the the challenge will be to preserve and Administration. The Administration's extend this progress, given that the forecasts of real GDP growth and Federal Reserve can best contribute to inflation are in the middle of the long-run prosperity by establishing an Federal Reserve' s central tendency environment of effective price stability. ranges, and the Federal Reserve Economic prospects for the long run forecasts of the unemployment rate will be further enhanced if Congress are centered near the low end of the and the Administration succeed in annual range that was published in making further progress in reducing the Economic Report of the President. the federal budget deficit. An Over the coming year, the Federal improved outlook for the federal Reserve will seek to foster continued deficit over the remainder of this economic expansion while avoiding decade and beyond could have sig the provision of so much liquidity that nificant favorable effects in financial the expected near-term step-up in markets, including a shift in long-term interest rates to a trajectory lower than that which would otherwise prevail. 6 Such a shift in long-term rates would Net Sales of Shares be an essential part of a process in in Long-Term Mutual Funds1 which a larger share of the nation's Millions of dollars (monthly average) limited supply of savings would be Equity Bond channeled to productivity-improving Period Total Funds Funds investment, thereby boosting growth in output and living standards. Year Money and Debt Ranges for 1995 1991 10,820 3,821 7,000 At its most recent meeting, the Federal 1992 16,844 7,268 9,576 Open Market Committee (FOMC) 1993 23,445 11,832 11,634 reaffirmed the 1995 growth ranges for money and debt that were chosen on a 1994 9,674 11,073 -1,399 provisional basis last July. The money ranges-1 percent to 5 percent for M2 Quarter and O percent to 4 percent for M3- 1994: Ql 17,438 13,744 3,694 are consistent with the Committee members' expectations of a slowing Q2 10,128 10,935 -808 of nominal income growth as the Q3 9,826 11,166 -1,340 expansion moves to a more sustainable pace, but also rest on the anticipation Q4 1,306 8,447 -7,141 of further increases in the velocities-of these aggregates. The velocity of M2 SoURCE. Investment Company Institute. 1. Gross sales of shares less redemptions. Ranges for Growth of Monetary and is likely to be boosted by lagged effects Debt Aggregates 1 of the increases in short-term interest Percent rates during 1994 and early 1995 and possibly by increased flows from M2 Aggregate 1993 1994 1995 deposits into long-term mutual funds, as investor concerns about capital M2 1-5 1-5 1-5 market volatility recede. The M2 range also provides an indication of the M3 0--4 0--4 0--4 longer-run growth that could be expected under conditions of reason Debt2 4-8 4-8 3--7 able price stability if that aggregate's velocity resumes its historical pattern 1. Change from average for fourth quarter of preceding year to average for fourth quarter of of no long-term trend. M3 velocity has year indicated. been on a steep upward path in recent 2. Monitoring range for debt of domestic years, but the rate of increase might be nonfinancial sectors. 7 expected to slow in the near term. Part nominal spending and borrowing. of the increase in M3 velocity in the Private sector debt growth will likely early 1990s resulted from weak growth remain fairly strong in the coming of bank credit, in part reflecting sub year, boosted by substantial capital stantial loan losses and consequent investment as well as merger and capital impairment, and the contrac acquisition activity. Credit availability tion of the thrift sector as failed insti is unlikely to constrain private sector tutions were liquidated. However, the borrowing, as banks continue to be recent strength in bank credit and the eager to lend and as quality spreads end of the contraction in thrift sector in financial markets remain relatively credit suggest that M3 growth could narrow. The outlook for the federal pick up, perhaps appreciably, and its deficit suggests that Treasury borrow velocity could begin to level out. The ing will be comparable to that in 1994. resumption of a more normal relation The monetary and debt aggregates ship between M3 and nominal income will continue to be among the vari might call for a technical adjustment of ables monitored by the Committee to the target range for M3 at mid-year or inform its policy deliberations. Given in 1996. the uncertainties about the behavior The monitoring range for growth in of the velocities of the aggregates, the debt aggregate in 1995 is 3 percent however, the Committee will also need to 7 percent. This range is 1 percentage to continue assessing a wide variety of point lower than the monitoring range other financial and economic in 1994, reflecting the more moderate indicators. path anticipated for expansion in ,y nk 8 Growth of Money and Debt Percent Domestic Period Ml M2 M3 Nonfinancial 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 0.6 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 0.5 4.7 1993 10.5 1.7 1.0 5.2 1994 2.3 1.0 1.4 5.3 1994 QI 5.5 1.8 0.6 5.3 Quarter (annual rate)3 Q2 2.6 1.7 1.3 5.6 Q3 2.4 0.8 2.0 4.4 Q4 -1.2 -0.4 1.7 5.5 1. From average for fourth quarter of preced- 3. From average for preceding quarter to ing year to average for fourth quarter of year average for quarter indicated. indicated. 2. Adjusted for shifts to NOW accounts in 1981. 9 Testimony of Alan Greenspan Chairman, Federal Reserve Board Mr. Chairman and other Recent Developments members of the Committee, I Nineteen-ninety-four was a good year for the American economy. Economic appreciate this opportunity to growth quickened, with real gross discuss the Federal Reserve' s domestic product expanding 4 percent over the four quarters of the year. In conduct of monetary policy. manufacturing, industrial production As required by law, we have advanced nearly 6 percent. We now have enjoyed over three years of already delivered to the relatively brisk advance in the nation's Congress our formal report output of goods and services, and this economic progress has been shared detailing the performance of by many Americans. Payrolls swelled the economy and the imple 3½ million last year, and the unem ployment rate closed 1994 at 5½ per mentation of policy. In my cent, more than a percentage point remarks this morning, I will below its level one year ago. And workers were producing more on summarize that discussion average: Output per hour in the and expand further on some nonfarm sector increased about 1½ percent over the four quarters of the key factors bearing on of last year, suggesting some tilting monetary policy. up to the underlying trend of labor productivity that promises sustained and substantial benefits in the coming years. The data that have been published in the first weeks of 1995 have offered some indications that the expansion may finally be slowing from its torrid and unsustainable pace of late 1994. While hours of work lengthened in January, employment growth slowed from its average of recent quarters and the unemployment rate rose. Moreover, recent readings on retail The prospects in this regard are sales suggest a more moderate rate of fundamentally good, but there are increase, and housing activity has reasons for some concern, at least with shown some softness. Nonetheless, respect to the nearer term. Those the economy has continued to grow, concerns relate primarily to the fact without seeming to develop the types that resource utilization rates have of imbalances that in the past have already risen to high levels by recent undermined ongoing expansion. historical standards. The current Of crucial importance to the unemployment rate, for example, is sustainability of the gains over the last only a bit above the average of the late few years, they have been achieved 1980s, when wages and prices acceler without a deterioration in the overall ated appreciably. The same holds true inflation rate. The Consumer Price of the capacity utilization rate in the Index rose 2.7 percent last year, the industrial sector. same as in 1993. Inflation at the retail Clearly, one factor in judging the level, as measured by the CPI, has inflationary risks in the economy is the been a bit less than 3 percent for three potential for expansion of our produc years running now-the first time that tive capacity. If "potential GDP" is has occurred since the early 1960s. growing rapidly, actual output can This is a signal accomplishment, for it also continue to grow rapidly without marks a move toward a more stable intensifying pressures on resources. economic environment in which In this regard, many commentators, households, businesses, and govern myself included, have remarked that mental units can plan with greater there might well be something of a confidence and operate with greater more-than-cyclical character to the efficiency. evident improvement of America's As I have stated many times in competitive capabilities in recent Congressional testimony, I believe years. Our dominance in computer firmly that a key ingredient in achiev software, for example, has moved us ing the highest possible levels of back to a position of clear leadership productivity, real incomes, and in advanced technology after some living standards is the achievement of faltering in the 1970s. But, while most price stability. Thus, I see it as crucial analysts have increased their estimates that we extend the period of low of America's long-term productivity inflation, hopefully returning it to a growth, it is still too soon to judge downward trend in the years ahead. whether that improvement is a few tenths of a percentage point annually, 11 or even more, perhaps moving us Aggregative indicators, such as the closer to the more vibrant pace that unemployment rate and capacity characterized the early post-World utilization, may be suggestive of War II period. It is fair to note, emerging inflation and asset price however, that the fact that labor and instabilities. But, they cannot be factory utilization rates have risen as determinative. Policy makers must much as they have in the past year or monitor developments on an ongoing so does argue that the rate of increase basis to gauge when economic in potential is appreciably below the potential actually is beginning to 4 percent growth rate of 1994. become strained--irrespective of Knowing in advance our true where current unemployment rates or growth potential obviously would be capacity utilization rates may lie. If we useful in setting policy, because are endeavoring to fend off instability history tells us that economies that before it becomes debilitating to strain labor force and capital stock economic growth, direct evidence of limits tend to engender inflation the emerging process is essential. instabilities that undermine growth. Consequently, one must look beyond It is true, however, that, in modern broad indicators to assess the inflation economies, output levels may not be ary tendencies in the economy. so rigidly constrained in the short run In this context, aggregate measures as they used to be when large seg of pressure in labor and product ments of output were governed by markets do seem to be validated by facilities such as the old open-hearth finer statistical and anecdotal indica steel furnaces that had rated capacities tions of tensions. In the manufacturing that could not be exceeded for long sector, for example, purchasing without breakdown. Rather, the managers have been reporting slower appropriate analogy is a flexible supplier deliveries and increasing ceiling that can be stretched when shortages of materials. Indeed, firms pressed; but, as the degree of pressure appear to have been building their increases, the extent of flexibility inventories of materials in recent diminishes. It is possible for the months so as to ensure that they will economy to exceed "potential" for a have adequate supplies on hand to time without adverse consequences by meet their production schedules. extending workhours, by deferring These pressures have been mirrored maintenance, and by forgoing longer in a sharp rise over the past year in term improvements. Moreover, as the prices of raw materials and world trade expands, access to foreign intermediate components. There are sources of supply augments, to a increasing reports that firms are con degree, the flexibility of domestic sidering marking up the prices of final productive facilities for goods and goods to offset those increased costs. some services. 12 In that regard, January's core CPI Whatever the cause, the lingering posted its largest gain since October sense of insecurity doubtless has been 1992, perhaps sounding a cautionary a factor damping wage growth and note. In the labor market, anecdotal overall labor costs. Since the latter, reports of "shortages" of workers have on a consolidated basis, accounts for become more common. To be sure, roughly two-thirds of overall costs increased wages are a good thing if in our economy, slower wage growth they can be achieved without com combined with strong cyclical produc mensurate acceleration in prices, but tivity growth has restrained increases they are not beneficial if they are in unit labor costs and hence in prices merely a part of a general pickup of final goods and services. in inflation. A hopeful sign in this However, as overall output growth regard, however, is that to date the of necessity slows in an environment trends in the expansion of money have of high resource utilization, so will remained subdued, and aggregate cyclical productivity growth. More credit is growing moderately. These over, if labor market tightness developments do not suggest that the assuages job insecurity, pressures financial tinder needed to support the to raise wages might well intensify ongoing inflation process is in place. and unit labor costs could accelerate. That kind of ongoing process also In the later stages of previous business would be expected to involve a cycles, declines in profit margins different expectational climate than absorbed some of the increases in unit seems to prevail today. Despite the labor cost, but some were passed marked improvement in consumer through into final goods prices and confidence overall, the survey readings inflation picked up. Thus far in the on consumers' views of whether jobs current cycle, price increases have are easy to get fall far short of the been muted, not only by subdued unit previous cyclical peak in 1989. labor costs, but also by a prevailing Moreover, there is some evidence that concern among firms that, despite the number of people voluntarily capacity pressures, enough slack leaving their jobs is subnormal remains in the system to foster com currently. This suggests that deep petitive inroads on those who try to seated job insecurity has not fully price above the market. But this form dissipated despite strong job growth of discipline may also become less recently. effective if pressures on resources Some analysts attribute this phe persist. Consequently, it may be that nomenon to workers' concerns about these pressures will lead to some losing health insurance and, for some, deterioration in the price picture in the pension coverage if they change jobs. near term; but any such deterioration should be contained if the Federal Reserve remains vigilant. 13 Policy Action Moreover, in financial markets, the and Financial Markets effects of the policy firmings were muted to an extent by an easing of It was to preserve and to extend the terms and conditions on bank loans gains associated with low and declin and by a drop in the foreign exchange ing inflation-and to avoid the insta value of the dollar. In these circum bilities and imbalances attendant to stances, the Federal Reserve needed to rising inflation-that we began the take further steps to head off potential process of tightening one year ago. instabilities that would threaten the Our view at the time was that the economic expansion. Over the past accommodative policy stance we had year, including our most recent action, adopted in earlier years to contain the we have raised money-market interest effects of financial strains on borrow rates seven times, pulling the federal er~ and lenders was no longer appro funds rate up 3 percentage points, to priate once their balance sheets had 6 percent. Four of these actions were been greatly strengthened. In these associated with increases in the ch~nged circumstances, absent policy discount rate. The discount rate now action, pressures on capital and labor st~ds a~ 5¼ percent, or 2¼ percentage resources could build to the point points higher than it was at the onset where imbalances would emerge and of tightening. costs and prices would begin to A stronger track for economic accelerate, jeopardizing the durability activity, higher credit demands, and of the current expansion. In the event, a _revival of inflation fears pushed up the strength in demand and the yields on securities with intermediate potential for intensification of pres to longer-term maturities from 1½ to sures on prices were even more 3 percentage points over the past year. substantial than envisioned when we Most of that rise was posted in the first st~ted down that road. As we thought three quarters of 1994. As Federal rm?ht_~e possible at this time last year, Reserve action-particularly the ~ s1gruficant upturn in inventory ¾ percentage point move in investment induced a stronger November----came to convince most economy than was generally antici market participants that policy would pated. Additional strains on capacity sufficiently restrain excess aggregate be~ame increasingly evident in higher demand, those inflation fears and pnces at early stages of production uncertainty premiums subsided a bit. processes. 14 This change in attitude, reinforced by Indeed, in some respects, credit has signs of moderating demand, has apparently been easier to get, likely in helped to trim interest rates on reflection of the improved assessment long-term Treasuries and fixed-rate of financial prospects for borrowers mortgages more than one-half of a and the larger capital cushions of percentage point from their peaks in many lenders. In many securities November. markets, quality spreads, when The adjustment in financial markets measured by the difference between to rising interest rates was not, by any rates on private and Treasury instru means, smooth. At the beginning of ments of comparable maturities, have this process of tightening, many been quite thin. Commercial banks members of the Federal Open Market trimmed their own lending margins Committee (FOMC) shared a concern effectively absorbing some of the rise that some market participants, made in market interest rates before they got complacent by the relatively high and to borrowers-and exhibited a: stable returns on long-term assets that renewed aggressiveness in competing had prevailed for a considerable for loans. Bankers themselves reported stretch of time, had taken on substan to us further easing of terms and tial risk in their portfolios as they standards on business loans over the reached for yield-in some instances course of 1994 and into 1995. The leveraging heavily. Taking account of pickup in total borrowing by nonfi this, our first three steps were small nancial businesses was focused with each translating into a ¼ percent primarily on bank loans and other age point rise in the federal funds shorter-term sources of funding. This rate-to allow market participants an shift toward shorter maturities, no extended opportunity to readjust their doubt, importantly resulted from the portfolios in light of rising short-term substantial run-up in longer-term rates. As markets became accustomed interest rates over the year, but there to the new direction of short rates, the probably was some role played by FOMC picked up the pace of firming. banks' efforts to make more loans and Measures of bond-price volatility, both interest income, especially as trading actual and those inferred from options income declined. prices, moved higher when monetary Households also increased the pace policy first began to firm, but rolled of their borrowing. Double-digit back much of that run-up as the year annual growth of consumer credit progressed. helped to fund considerable outlays While securities markets were for durable goods, especially autos. turbulent from time to time, in gen This, too, may have been related, eral, they remained quite resilient in part, to the eagerness of commer and performed their economic func cial banks to make consumer loans. tion of allocating credit quite well. 15 And a wide menu of mortgage These developments have freed up instruments gave home buyers some the flow of international capital, thus flexibility in coping with the rise in potentially improving the efficiency of interest rates. The increasing share of the allocation of the world's resources mortgage originations at flexible and raising world living standards. rates-often involving concessionary They have also permitted markets to initial terms- respond more quickly and with and, perhaps, some easing of loan greater force to a country's macro qualification standards permitted economic policies. This puts a special some buyers who otherwise would burden on the Federal Reserve, not have been able to obtain financing because the U.S. dollar is effectively to go ahead with their home pur the key reserve currency of the world chases. All told, improved access to trading system. In that role, we enjoy credit provided important support to an increased demand for our financial spending. instruments. However, this role also heightens the share of the demand for Some Recent Lessons dollar assets that is related to more volatile portfolio motives. The new Events of the past two months have world of financial trading can punish taught us once again that the global policy misalignments with amazing nature .of trade in goods, services, and alacrity. This is a lesson repeated time financial instruments exerts an exact and again, taught most recently by the ing discipline on the behavior of breakdown of the European Exchange central banks. Technology has Rate Mechanism in 1992 and the defeated distance by slashing the costs plunge in the exchange value of the of gathering information and of peso over the past two months. In the transacting. Advances in computing process of pursuing their domestic and financial engineering during the objectives, central banks cannot be past ten or fifteen years have enabled indifferent to the signals coming from investors and speculators to choose international financial markets. among a wide array of investment Although markets can be harsh instruments, allowing them to manage teachers at times, the constraints that risks better and, when they chose, to they impose discipline our policy exert their notions about future market choices and remind us every day of movements forcefully through the use our longer-run responsibilities. of leverage. The former, improved risk management, has done much to make markets more resilient, while the latter, easier recourse to leverage, may add to the volatility of financial prices at times. 16 While there are many policy The Federal Reserve for its part will considerations that arise as a conse be attempting to foster financial quence of the rapidly expanding conditions that will extend that good global financial system, the most performance through 1995 and important is the necessity of maintain beyond. Our policy actions will ing stability in the prices of goods and depend on an ongoing assessment services and confidence in domestic of a number of forces acting on the financial markets. Failure to do so is economy. One is the effects of the rise apt to exact far greater consequences in interest rates that has occurred over as a result of cross-border capital the past year. The effects of higher movements than might have prevailed interest rates on spending are difficult a generation ago. to pinpoint with any precision, because they occur with a lag and The Economic Outlook have a diffuse influence on the behavior of households and firms Looking ahead to the prospects for the throughout the economy. Data rarely U.S. economy, we must remember that point in one direction, and the avail the nation has entered 1995 with its able information on spending fits this resources stretched. We do not now rule. As yet, the performance of the have the substantial unused capacity economy suggests a slowing in that made possible the especially interest-sensitive spending, but mostly favorable macroeconomic outcomes of concentrated in housing activity. Our 1993 and 1994-rapid real growth and reading of the historical record is that stable or declining inflation. As a the cumulative effect of higher interest result, the likely performance of the rates should lead to a significant economy in 1995 almost surely will deceleration in spending. But, to date, pale in comparison with that of the the jury remains out on whether the previous two years. The growth in slowing that is in train will be suffi output arguably must slow to a more cient to contain inflation pressures. sustainable pace and resource utiliza That judgment also rests impor tion settle in at its long-run potential tantly on a reading of business cycle to avoid inflationary instabilities. Infla developments more generally tion, itself, is unlikely to moderate cycles which often relate to the inter further and may even tick up tempo action of physical stocks and flows. rarily. But overall, the performance of the economy still should be good. We expect growth to continue and inflation to be contained. 17 These dynamics are most clearly seen Similar stock-flow interactions in inventory investment, which has should be at work in spending for always been an important swing factor consumer durables. Large increases in in the post-war era. In 1994, the real outlays for consumer durables increase in inventory investment in over the past three years, partly real terms added almost one percent financed in recent quarters by unsus age point to GDP growth. It appears tainably rapid growth in the volume of most unlikely that business people will credit, may well have exhausted most wish to build their stocks at the pace of the pent-up demand that had they did in 1994. But whether their accumulated when the economy was actions with respect to inventories will sluggish in the early 1990s. turn that plus for growth last year into In another area, actions of this a significant minus in 1995 remains to Congress regarding the federal budget be seen. deficit will have important conse Incoming information does not quences for the economic outlook. A suggest that a substantial inventory credible program of fiscal restraint that correction is imminent. Standard moves the government's finances to a inventory-sales ratios remain on the sounder footing almost surely will find low side of historical experience; those a favorable reception in financial ratios look even lower compared with markets. That market reaction, by historical experience if one subtracts itself, should serve as a source of wholesale and retail markups from the stimulus that would help to offset in published inventory investment whole or in part the drag on spending figures to get a better handle on the that otherwise would be associated underlying physical units of stocks. with reductions in federal outlays and Moreover, even if there were a swing transfers over time. It is also important in inventory investment, it would have to remember that a larger issue is at a more muted effect on domestic stake during these deliberations on the production than the inventory cycles federal budget. Too much of the small of just a few years ago. Rough esti pool of national saving goes toward mates suggest that, currently, perhaps funding the government, to the a quarter of the nominal value of all detriment of capital formation. By wholesale and retail stocks are trimming the deficit, those resources imported, whereas the share was will likely be put to more productive substantially less as recently as the late uses, leading to benefits in the form of 1970s. improved living standards. Federal Reserve policy makers had to weigh these factors and more in determining their individual forecasts. 18 As is detailed in the semiannual The 1-to-5 percent range for M2 Monetary Policy Report, the central provides a reasonable benchmark for tendency of the forecasts of the Board longer-run growth of this aggregate members and the Reserve Bank that could be expected if the behavior presidents was that real GDP would of its velocity was to return to its grow at a rate of 2 to 3 percent over historical pattern under conditions of the four quarters of 1995. This slowing price stability. This would not be true from last year's unsustainable pace for M3, however, which historically was viewed as sufficient to bring has grown faster than M2, but which output growth more in line with that has been depressed in recent years by of its potential, helping to stabilize the a number of factors, including the unemployment rate in the range of the difficult financial adjustment of banks past few months, near 5½ percent. The and thrifts. If the broader aggregate governors and the Reserve Bank M3 returns to its previous alignment, presidents forecast some edging up of its range of Oto 4 percent would have consumer price inflation in 1995, with to be adjusted upward. At 3 to the central tendency of their forecasts 7 percent, the monitoring range for the bracketed by 3 and 3½ percent. If we growth of total domestic nonfinancial are to do our part in helping the debt is centered on the actual growth economy operate at its fullest potential of that aggregate over the past three over time, we need to remain watchful years, but is one percentage point to ensure that this cyclical upswing in lower than the monitoring range in the inflation rate expected for 1995 1994. While the performance of the does not become firmly entrenched. monetary and debt aggregates compared with these ranges will Monetary and Credit Aggregates continue to inform the FOMC' s deliberations, the uncertainties about In discussing these matters at its the behavior of their velocities will meeting earlier this month, the FOMC necessitate careful interpretation of determined that the provisional ranges their behavior and a watchful eye it had chosen for the monetary toward a wide variety of other aggregates and domestic nonfinan- financial and nonfinancial indicators. cial debt in July 1994 remained con sistent with its current outlook for Information Release economic activity and prices. More over, these ranges conform to the One final point: To make our policy projected deceleration in nominal intent as transparent as possible to income that is associated with our market participants without losing our efforts to contain inflation and keep flexibility or undermining our delib the economy on a sustainable path. erative process, at its latest meeting, 19 the FOMC decided to preserve the After careful consideration, the greater openness of its policy making FOMC believed that these steps, which that it established last year. To that essentially formalize the procedures end, all decisions to change reserve that we have been using over the past market conditions will be announced year, strike the appropriate balance in a press release on the same day that between making our decisions and the decision is made. deliberations accessible as soon as The debate surrounding each policy feasible and retaining flexibility in decision will be reported, as is policy making, while preserving an currently the practice, in comprehen unfettered deliberative process. sive minutes of the meeting that are released on the Friday following the Challenges Ahead next regularly scheduled meeting of I and my colleagues appreciate the the FOMC. For students of monetary time and the attention that the policy making, those minutes will be members of this Committee devote to supplemented by lightly edited oversight of monetary policy. Our transcripts of the discussion at each shared goal-the largest possible FOMC meeting. Transcripts for an advance in living standards in the entire year will be released with a United States over tim~an be best five-year lag. Continuing our current achieved if our actions ultimately practice, the raw transcripts will be allow concerns about the variability of circulated to each participant shortly the purchasing power of money to after an FOMC meeting to verify his or recede into the background. Price her comments, and only changes that stability enables households and firms clarify meaning, say to correct gram to have the greatest freedom possible mar or transcription errors, will be to do what they do best-to produce, permitted. A limited amount of invest, and consume efficiently. material will be redacted from these But the best path to that long-run transcripts before they are released, goal is not now, and probably never primarily to protect the confidentiality will be, obvious. Policy making is of foreign and domestic sources of an uncertain enterprise. Monetary intelligence that would dry up if their policy actions work slowly and incre information were made public. A mentally by affecting the decisions of complete, unredacted version of the millions of households and businesses. transcripts of each FOMC meeting And we adjust policy step by step as will be turned over to the National new information becomes available Archives after thirty years have on the effects of previous actions and elapsed, as required by law. on the economic background against which policy will be operating. 20 No individual step is ever likely to be We vary short-term interest rates in decisive in pushing the economy or order to further the goals set for us in prices one way or another-there is no the Federal Reserve Act, namely monetary policy "straw that broke the promoting over time "maximum camel's back." The cumulative effects employment, stable prices, and of many policy actions may be moderate long-term interest rates." substantial, but the historical record Achieving those goals has become suggests that any given change in rates increasingly more complex in the will have about the same effect as a nearly two decades since they were previous change of the same size. put into the Federal Reserve Act, as a Because the effects of monetary consequence of technology-driven policy are felt only slowly and with a changes in financial markets in the lag, policy will have a better chance of United States and around the world. contributing to meeting the nation's Suppressing inflationary macroeconomic objectives if we look instabilities-a necessary condition of forward as we act-however indistinct achieving our shared goals-requires our view of the road ahead. Thus, over not only containing prevalent price the past year we have firmed policy to pressures, but also diffusing unsus head off inflation pressures not yet tainable asset price perturbations evident in the data. Similarly, there before they become systemic. These may come a time when we hold our are formidable challenges, which will policy stance unchanged, or even ease, confront policy-both fiscal and despite adverse price data, should we monetary-in the years ahead. It is, of see signs that underlying forces are course, unrealistic to assume that we acting ultimately to reduce inflation can eliminate the business cycle, pressures. Events will rarely unfold human nature being what it is. But exactly as we foresee them, and we containing inflation and thereby need to be flexible-to be willing to damping economic fluctuations is a adjust our stance as the weight of new reasonable goal. We at the Federal information suggests it is no longer Reserve look forward to working with appropriate. That flexibility, Mr. the Administration and Congress in Chairman, applies to the particular meeting our common challenges. stance of policy-not its objectives. FRB-45000--0295 21

Federal Reserve (1995, February 21). Monetary Policy Report. Monetary Policy Reports, Federal Reserve. https://whenthefedspeaks.com/doc/monetary_policy_report_19950222

@misc{wtfs_monetary_policy_report_19950222,
  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_19950222},
  note = {Retrieved via When the Fed Speaks corpus}
}