Congressional Testimony

CONDUCT OF MONETARY POLICY (Report of the Federal Reserve Board pursuant to the Full Employment and Balanced Growth Act of 1978, P.L. 95-523.) HEARING BEFORE THE SUBCOMMITTEE ON DOMESTIC MONETARY POLICY OF THE COMMITTEE ON BANKING, FINANCE AND IJBBAN AFFAIRS HOUSE OF REPRESENTATIVES ONE HUNDRED FIRST CONGRESS SECOND SESSION FEBRUARY 20, 1990 Printed for the use of the Committee on Banking, Finance and Urban Affairs Serial No. 101-76 U,S. GOVERNMENT PRINTING OFFICE WASHINGTON : 1990 For sale by the Superintendent of Documents, Congressional Sales Office U.S. Government Printing Office, Washington, DC 20402 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis HOUSE COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS HENRY B. GONZALEZ, Texas, Chairman FRANK ANNUNZIO, Illinois CHALMERS P. WYLIE. Ohio WALTER E. FAUNTROY, District of JIM LEACH, Iowa Columbia NORMAN D. SHUMWAY, California STEPHEN L. NEAL, North Carolina STAN PARRIS, Virginia CARROLL HUBBARD, Jr., Kentucky BILL McCOLLUM, Florida JOHN J. LAFALCE, New York MARGE RQUKEMA, New Jersey MARY ROSE OAKAR, Ohio DOUG BEREUTER, Nebraska BRUCE F. VENTO, Minnesota DAVID DREIER, California DOUG BARNARD, JR., Georgia JOHN HILER, Indiana ROBERT GARCIA, New York THOMAS J. RIDGE, Pennsylvania CHARLES E. SCHUMER, New York STEVE BARTLETT, Texas BARNEY PRANK, Massachusetts TOBY ROTH, Wisconsin RICHARD H. LEHMAN, California ALFRED A. (AD McCANDLESS, California BRUCE A. MORRISON, Connecticut JIM SAXTON, New Jersey MARCY KAPTUR, Ohio PATRICIA F. SAIKI, Hawaii BEN ERDREICH, Alabama JIM BUNNING, Kentucky THOMAS R. CARPER, Delaware RICHARD H. BAKER, Louisiana ESTEBAN EDWARD TORRES, California CLIFF STEARNS, Florida GERALD D. KLECZKA Wisconsin PAUL E. GILLMOR, Ohio BILL NELSON, Florida BILL PAXON, New York PAUL E. KANJORSKI Pennsylvania ELIZABETH J. PATTERSON, South Carolina C. THOMAS McMILLEN, Maryland JOSEPH P. KENNEDY fl, Massachusetts FLOYD H. FLAKE, New York KWEISI MFUME, Maryland DAVID E. PRICE, North Carolina NANCY PELOSI, California JIM McDERMOTT, Washington PETER HOAGLAND, Nebraska RICHARD E. NEAL, Massachusetts SUBCOMMITTEE ON DOMESTIC MONETARY POLICY STEPHEN L. NEAL, North Carolina, Chairman DOUG BARNARD, JR., Georgia BILL McCOLLUM, Florida HENRY B. GONZALEZ, Texas JIM LEACH, Iowa FRANK ANNUNZIO.Illinois JIM BUNNING, Kentucky PETER HOAGLAND, Nebraska (ID Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis CONTENTS Page Hearing held on: February 20, 1990 1 Appendix; February 20, 1990 29 WITNESSES TUESDAY, FEBRUARY 20, 1990 Greenspan, Alan, Chairman, Board of Governors of the Federal Reserve System APPENDIX Prepared statement: Greenspan, Alan 30 ADDITIONAL MATERIAL SUBMITTED FOR THE RECORD Board of Governors of the Federal Reserve System, report entitled "Monetary Policy Report to Congress Pursuant to the Full Employment and Balanced Growth Act of 1978," dated February 20, 1990 47 Record of Policy Actions of the Federal Open Market Committee, meeting held on February 6-7, 1990 76 (IHl Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis CONDUCT OF MONETARY POLICY Tuesday, February 20, 1990 HOUSE OF REPRESENTATIVES, SUBCOMMITTEE ON DOMESTIC MONETARY POLICY, COMMITTEE ON BANKING, FINANCE AND URBAN AFFAIRS, Washington, DC. The subcommittee met pursuant to call at 10 a.m. in room 2128, Rayburn House Office Building, Hon. Stephen L. Neal [chairman of the subcommittee] presiding. Present; Chairman Neal, Representatives Barnard, Hoagland, and Leach. Also Present: Representatives Roukema and Saiki. Chairman NEAL, I would like to call this meeting of the Subcom- mittee on Domestic Monetary Policy to order. This morning we are pleased to welcome the Chairman of the Federal Reserve Board, Alan Greenspan, for his presentation of the Federal Reserve Semi-Annual Monetary Policy Report to the Con- gress. Mr. Chairman, welcome. I want to welcome you and I want to commend you for continuing to follow take the course that you and the other Governors are taking concerning the long-term health of our economy. You must take the long view when all the tempta- tions around here are to take the short-term view of things. Noth- ing is more important for the future health of our economy than a monetary policy that aims for price stability, which I know you are pursuing. This long view will be very important for the economic well-being of our country for many years to come. I would like to bring you up to date if I can, on House Joint Res- olution 409, our legislation which would set zero inflation as the primary goal, primary function of monetary policy. You have en- dorsed the legislation in testimony last year before us. Since that time several Nobel prize winning economists have endorsed it, sev- eral regional Federal Reserve Bank presidents have endorsed it, and a number of other prominent economists have endorsed this legislation. Of course, I am delighted by that. I don't know how long it will take, but at some point we have the opportunity of getting the Con- gress behind this long-term view also. As you well know, if we can achieve price stability and low inflation, we can expect enormous benefits to our economy—the lowest possible interest rates, the maximum sustainable growth in our economy, maximum sustain- able employment, maximum sustainable savings and investment and productivity. I think all of these things we want for our econo- my. (l) Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis So I wanted to report to you that we are coming along with our legislation. I wish I could tell you when we will get it passed. I don't know that, but we will certainly keep working on it. I would like to yield at this time to our distinguished ranking Member, if he has any comments to make. Mr. LEACH, Mr. Chairman, I have no further comments, but I would like to certainly share your views of Mr. Greenspan. We ap- preciate your coming this morning. Chairman NEAL. Thank you, sir. Mr. Chairman, we will put your entire statement in the record and would welcome your proceeding as you will. STATEMENT OF ALAN GREENSPAN, CHAIRMAN, BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Mr. GREENSPAN. Well, thank you very much, gentlemen. I cer- tainly appreciate the opportunity to testify today on the Federal Reserve's Semi-Annual Monetary Policy Report to the Congress. My prepared remarks discuss our monetary policy actions and plans in the context not only of the current and projected state of the economy, but also against the background of our longer-term objectives and strategy for achieving them. The final section of the testimony addresses some issues for mon- etary policy raised by the increasingly international character of fi- nancial markets. Last year marked the 7th year of the longest peacetime expan- sion of the U.S. economy on record. Some 2Vfe million jobs were cre- ated, and the civilian unemployment rate held steady at 5*/4 per- cent. Inflation was held to a rate no faster than that in recent years, but unfortunately no progress was made in 1989 toward price stability. Thus, while we can look back with satisfaction at the economic progress made last year, there is still important work to be done. About a year ago, Federal Reserve policy was in the final phase of a period of gradual tightening, designed to inhibit a buildup of inflation pressures. Interest rates moved higher through the winter, but started down when signs of more restrained aggregate demand and of reduced potential for higher inflation began to appear. As midyear approached, a marked strengthening of the dollar on foreign exchange markets further diminished the threat of accelerating inflation. New economic data suggested that the balance of risks had shifted toward the possibility of an undue weakening in economic activity. With M2 and M3 below the lower bounds of their annual ranges in the spring, the Federal Reserve in June embarked on a series of measured easing steps that continued through late last year. Across the maturity spectrum, interest rates declined further, to levels about IVfe percentage points below March peaks. Reductions in inflation expectations and reports of a softer economy evidently contributed to the drop in rates in longer-term markets. The decrease in short-term rates lifted M2 to around the middle of its annual range in the latter part of the year. So far this year, the Federal funds rate has remained around 81A percent, but rates on Treasury securities and longer-term private instruments have Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis reversed some of their earlier declines. Investors have reacted to stronger-than-expected economic data, a runup in energy prices, and increasingly attractive investment opportunities abroad, espe- cially in Europe. Monetary policy was conducted again last year with an eye on long-term policy goals, and economic developments in 1989 were consistent with the Federal Reserve's medium-term strategy for reaching them. The ultimate objective of economic policy as I have stated before is to foster the maximum sustainable rate of econom- ic growth. By ensuring stable prices, monetary policy can play its most important role in promoting economic progress. The strategy of the Federal Open Market Committee (FOMC) for moving toward this goal remains the same—to restrain growth in money and aggregate demand in coming years enough to establish a clear downward tilt to the trend of inflation and inflation expec- tations, while avoiding a recession. If past patterns of monetary behavior persist, maintaining price stability will require an average rate of M2 growth over time ap- proximately equal to the trend growth in output. During the tran- sition, the decline of market interest rates in response to the mod- eration in inflation would boost the public's demand for M2 rela- tive to nominal spending, lowering M2 velocity. M2 growth over several years accordingly may show little deceleration, and it could actually speed up from time to time, as interest rates decline in fits and starts. Hence, the FOMC would not expect to lower its M2 range mechanically each and every year in the transition to price stability. This qualitative description of our medium-term strategy is easy to state, but actually implementing it will be difficult. Unexpected developments no doubt will require flexible policy responses. Any such adjustments will not imply a retreat from the medium-term strategy or from ultimate policy goals. Rather, there will be mid-course corrections that to keep the economy and prices on track. The easing of reserve pressures start- ing last June is a case in point. Successive FOMC decisions to ease operating policy were intended to forestall an economic downturn, the chances of which seemed to be increasing as the balance of risks shifted away from greater inflation. The FOMC was in no way abandoning its long-term goal of price stability, instead, it sought financial conditions that would support the moderate economic expansion judged to be consistent with progress toward stable prices. In the event, output growth was sus- tained last year, although in the 4th quarter a major strike at Boeing combined with the first round of production cuts in the auto industry accentuated the underlying slowdown. On the inflation side, price increases in the second half were ap- preciably lower than those in the first. Against this background, the Federal Reserve Governors and the Presidents of Reserve Banks foresee continued moderate economic expansion over 1990, consistent with conditions that will foster progress toward price stability over time. At its meeting earlier this month, the FOMC selected ranges for growth in money and debt it believes will pro- mote this outcome. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis My testimony last July indicated the very preliminary nature of the tentative ranges chosen for 1990, given the uncertain outlook for the economy, financial conditions, and appropriate growth of money and debt. With the economic situation not materially differ- ent from what was anticipated at that time, the FOMC reaffirmed the tentative 3 to 7 percent growth range for M2 in 1990 that it set last July. This range, which is the same as that used in 1989, is expected by most FOMC members to produce somewhat slower growth in nominal GNP this year. The declines in short-term interest rates through late last year can be expected to continue to boost the pub- lic's demands for liquid balances in M2, at least for a while longer. M2 growth over 1990 thus may be faster than in recent years, and M2 velocity could well decline over the four quarters of the year, absent a pronounced firming in short-term market interest rates. In contrast with M2, the range for M3 has been reduced from its tentative range set last July. The new M3 range of 2Va to 6l/ per- 2 cent is intended to embody the same degree of restraint as the M2 range, but it was lowered to reflect the continued decline in thrift assets and funding needs now anticipated to accompany the ongo- ing restructuring of the thrift industry. The committee's best judgment is that money and debt growth within these annual ranges will be compatible with a moderation in the expansion of nominal GNP. Most FOMC members and other Reserve Bank presidents foresee real GNP growing 1% to 2 percent over the year as a whole. Such a rate would be around last year's moderate pace, excluding the rebound in agricultural output from the 1988 drought. A slight easing of pressures on resources probably is in store. In- flation pressures should remain contained, even though the decline in the dollar's value over the past-half year likely will reverse some of the beneficial effects on domestic inflation stemming from the dollar's earlier appreciation. The CPI this year is projected to increase 4 to 4 ¥2 percent, as compared with last year's 4Vb percent. Experience has shown such macroeconomic forecasts to be sub- ject to a variety of risks. Assessing the balance of risks between production shortfalls and inflation pressures in the current outlook is complicated by several cross-currents in the domestic and inter- national economic and financial situation. One risk is that the weakness in economic activity evident around year-end may tend to cumulate, causing members forecasts about production and employment this year to be overly optimistic. However, available indicators of near-term economic performance suggest that the weakest point may have passed. The inventory correction in the auto industry—a rapid one in- volving a sharp reduction in motor vehicle assemblies in January coupled with better motor vehicle sales—seems to be largely behind us. Industrial activity outside of motor vehicles appears to be holding up. Production of business equipment, where evidence has accumulated of some stability— if not an increase—in orders for capital goods, is likely to support manufacturing output in coming months. From these and similar data, one can infer the beginnings of a modest firming in economic activity. While we cannot be certain Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis that we are as yet out of the recessionary woods, such evidence warrants at least guarded optimism. There are, however, other undercurrents that continue to signal caution. One that could disturb the sustainability of the current economic expansion has been the recent substantial deterioration in profit margins. A continuation of this trend could seriously un- dercut the still expanding capital goods market. However, if cur- rent signs of an upturn in economic activity broaden, profit mar- gins can be expected to stabilize. A more deep-seated concern with respect to the longer-run viabil- ity of the expansion is the increase in debt leverage. Although the trends of income and cash flow may have turned the corner, the structure of the economy's financial balance sheet weighs increas- ingly heavily on the dynamics of economic expansion. In recent years, business debt burdens have been enlarged through corporate restructurings, and as a consequence interest costs as a percent of cash flow has risen markedly. Responding to certain well-publicized debt-servicing problems, creditors have become more selective in committing funds for these purposes. Within the banking industry, credit standards have been tightened for merger and LBO loans, as well as for some other business cus- tomers. Credit for construction projects reportedly has become less available because of FIRREA-imposed limits and heightened con- cerns about overbuilding in a number of real estate markets. Among households, too, debt-servicing burdens have risen to his- toric highs relative to income, and delinquency rates have moved up of late. Suppliers of consumer and mortgage credit appear to have tightened lending terms a little. Real estate values have soft- ened in some locales, although prices have maintained an uptrend in terms of the national averages, especially for single-family resi- dences. These and other financial forces merit careful monitoring. While welcome from a supervisory perspective, more cautious lend- ing does have the potential for damping aggregate demand. It is difficult to assess how serious a threat increased leverage is to the current levels of economic activity. Clearly, should the econ- omy fall into a recession, excess debt service costs would intensify the problems of adjustment. But it is unlikely that in current cir- cumstances strains coining from the economy's financial balance sheet can themselves precipitate a downturn. As I indicated in my prepared text, Mr. Chairman, we expect nonfinancial debt growth to continue to slow from its frenetic pace of the mid-1980's. This should lessen the strain and hopefully the threat to the economy. Among other concerns, recent events have highlighted the com- plex interactions between developments in the U.S. economy and financial markets and those in the other major industrial coun- tries. Specifically, the parallel movements in long-term interest rates here and abroad over the early weeks of 1990 have raised questions: To what extent is the U.S. economy subject to influences from abroad? To what extent, as a consequence, have we lost con- trol over our economic destiny? The simple answer to these ques- tions is that the U.S. economy is influenced from abroad to a sub- stantially greater degree than, say, two or three decades ago, but U.S. monetary policy is, nonetheless, able to carry out its responsi- bilities effectively. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 6 The post-war period has seen markedly closer ties among the world's economies. Markets for goods have become increasingly, and irreversibly, integrated as a result of the downsizing of eco- nomic output and the consequent expansion of international trade. The past decade, in particular, also has witnessed the growing inte- gration of financial markets around the world. Advancing technology has fostered the unbundling and transfer of risk and engendered a proliferation of new financial products. Cross border financial flows have accordingly accelerated at a pace in excess of global trade gains. This globalization of financial mar- kets has meant that events in one market or in one country can affect within minutes developments in markets throughout the world. More integrated and open financial markets have enabled all countries to reap the benefits of enhanced competition and im- proved allocation of capital. Our business can raise funds almost anywhere in the world. Our savers can choose from a lengthening menu of investments as they seek the highest possible return on their funds. Our financial institutions enjoy wider opportunities to compete. In such an environment, a change in the expected rate of return on financial assets abroad naturally can affect the actions of bor- rowers or lenders in the United States. In response, exchange rates, asset prices, and rates of return all may adjust to new values. Strengthened linkages among world financial markets affect all markets and all investors. Just as U.S. markets are influenced by developments in markets abroad, foreign markets are influenced by events here. These channels of influence do not depend on whether a country is experiencing a deficit or a surplus in its current ac- count. In today's financial markets, the net flows associated with cur- rent account surpluses and deficits are only the tip of the iceberg. What are more important are the huge stocks of financial claims— more than $1.5 trillion held in the United States by foreigners and more than $26 trillion of dollar-denominated claims on U.S. bor- rowers held by U.S. residents. This is in addition to the vast quan- tities of assets held in foreign currencies abroad. It is these hold- ings that can respond to changes in actual and expected rates of return. In recent years we have seen several instances in which rates of return have changed essentially simultaneously around the world. For example, stock prices moved together in October 1987 and 1989, and in 1990 bond yields have risen markedly in many indus- trial countries. However, we must be cautious in interpreting such events, and in drawing implications for the United States. Frequently, such movements occur in response to a common worldwide influence. Currently, the world economy is adjusting to the implications of changes in Eastern Europe, where there are tremendous new op- portunities to invest and promote reconstruction and growth. Those opportunities, while contributing to the increase in interest rates in the United States, also open up new markets for our exports. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Moreover, despite globalization, financial markets do not neces- sarily move together—they also respond to more localized influ- ences. Over 1989, for example, bond yields in West Germany and Japan rose about a percentage point, while those in the United States fell by a similar amount. The contrast between 1989 and 1990 illustrates the complexity of relationships among financial markets. Interactions can show through in movements in exchange rates as well as interest rates, and changes in the relative prices of assets depend on a variety of factors, including economic develop- ments and inflation expectations in various countries as well as monetary and fiscal policies both here and abroad. The influence of economic policies abroad and other foreign de- velopments on the U.S. economy is profound, and the Federal Re- serve must carefully take them into account when considering its monetary policy. But these influences do not fundamentally con- strain our ability to meet our most important monetary policy ob- jectives. Developments within U.S. financial markets remain the strong- est influence on the asset prices and interest rates determined by those markets and, through them, on the U.S. economy. Exchange rates absorb much of the impact of developments in foreign asset markets, permitting U.S. interest rates to reflect primarily domes- tic economic conditions. Exchange rates influence the prices of products that do, or can, enter into international trade. Such factors can bring about changes in the composition of production between purely domestic goods and services and those entering international trade, and they can affect aggregate price movements for a time. However, the overall pace of spending and output in the United States depends on the demands upon all sectors of the U.S. econo- my taken together. And our inflation rate, over time, depends on the strength of those demands relative to our ability to supply them out of domestic production. Because the Federal Reserve is able to affect short-term interest rates in U.S. financial markets, it is able to influence the pace of economic activity in the short run and inflationary pressures longer term. To be sure, monetary policy must currently balance more factors than in previous dec- ades. But our goals are still achievable. Monetary policy is only one tool, however, and it cannot be used successfully to meet multiple objectives. The Federal Reserve, for example, can address itself to either domestic prices or exchange rates but cannot be expected to achieve objectives for both simulta- neously. Monetary policy alone is not readily capable of addressing today's large current account deficit, which is symptomatic of un- derlying imbalances among saving, spending, and production within the U.S. economy. Continued progress in reducing the Federal deficit is a more ap- propriate instrument to raise domestic saving and free additional resources for productive investment. The long-term health of our economy requires the balanced use of monetary and fiscal policy in order to reach all of the nation's policy objectives. [The prepared statement of Mr. Greenspan can be found in the appendix.] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Chairman NEAL, Thank you very much for your very interesting testimony. Mr. Chairman, let me start by asking you a couple of questions about our legislation to achieve zero inflation over the next 5 years. As we have held hearings on this proposal, and otherwise asked for comments from economists and others, it has seemed to me that broadly three objections have emerged as having some merit. I would like for you to comment briefly on each of them, if you would. If you see any others I would like to hear them, but so far it seems to me that these three emerge. The first is that if we were to achieve zero inflation over the next 5 years, that would cause a recession. It seems clear to me that the policies needed to achieve zero inflation over that period of time would not cause a recession, but I would certainly like for you to comment on it. A second sort of problem with the idea that we have heard is that inflation and interest rates today poses no prob- lem—somehow the economy and people have adjusted to them and it is all right to have inflation running at 5 percent, to have long- term treasury rates at 8 or 9 percent, to have credit card rates at 17 plus percent and business and consumer rates up over 10 per- cent. I don't think that is all right, but I would like for you to com- ment on that also. A third sort of objection to the idea has been that the Fed must stay entirely independent and that Congress should have no role in setting this overall policy goal, and that would have to include the administration also because, as you know, our legislation is legislation, would require a presidential signature. Let me say those are the three main arguments we have heard the most of. There is, however, a fourth that I would like to you comment on also: that somehow there are other goals that are more important, that is to say that the Fed ought to attempt to control a particular foreign exchange rate for the dollar; or that the Fed ought to shoot for a particular level of short-term interest rates; or that it ought to shoot for a particular level of growth in the economy as opposed to zero inflation. So I guess there are really four questions that I would like for you to comment on, if you would. Mr. GREENSPAN. Well, Mr. Chairman, let me address them seria- tim. We have, of course, given considerable thought to the question of endeavoring to bring inflation down to noninflationary levels, which we define as any particular price level which removes the uncertainties with respect to future inflation from economic deci- sion-making. It is our view that over a period of years we see no difficulty in bringing the inflation rate down from where it exists currently to a noninflationary level in the context of continued economic growth and the avoidance of a recession. Were the change needed to reach price stability required significantly greater, then I think the odds of our being able to do it without recession would be probably lower than any of us would find acceptable. But having brought the inflation rate down from double-digits to under 5 percent, the next stage, while difficult, is still achievable in our judgment with- out bringing on recession. Chairman NEAL. Well, I specifically mentioned 5 years. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 9 Mr. GREENSPAN. I would say 5 years. As I have indicated to you privately and otherwise, I don't like to cite specific numbers with respect to each year or each particular period. I think there is suf- ficient complexity in the economy and the adjustment process that if we are short of the goal at any particular time, I don't think that is as critical as getting it right. Chairman NEAL. Yes, sir, I quite agree with you. Mr. GREENSPAN, The second question which presumes that the current inflation rate, the level of interest rates, and the current state of our financial markets is tolerable, is based on the assump- tion that the markets will stay where they are. I have serious question that they can. In other words, it is plausi- ble and in fact realistic to believe that, if you have a noninflation- ary environment—that is a steady state type of environment which has built into it a structure which can sustain it. One cannot say the same thing about an inflation rate which is approaching 5 per- cent, or somewhat under, but still close enough to that. We are in an area where it is very easy to start inflation acceler- ating. I think the major reason we want to come down from this level is not that it is perceived to be doing great damage—although I think it is doing more damage than people realize—but that the risks of it accelerating from here are larger than I think we should be willing to tolerate. An acceleration in inflation when it takes hold is very difficult to restrain. The ultimate impact of accelerat- ing inflation on employment, on the level of economic growth, and on the stability of the system is just too large, in my judgment, to be tolerable. The third question is should Congress interfere in Federal Re- serve policy. Well, Mr. Chairman, we would like as much flexibility as we can possibly have, but there is the Constitution of the United States which accords authority to the Congress, and that is Con- gress' judgment. Our view basically is that we would like as much flexibility to attain our goals as possible, but this is an authority that comes to us from the Congress and the Constitution, and our judgment in this respect has to be tempered by the view of the Congress, and as a citizen, I think that is right and fully support it in that context. Finally, as to the issue of whether other goals are more impor- tant, there is difficulty in knowing which particular goal affects which structure of the economy. We believe that holding the rate of inflation under control is far more important than any other variable largely because its effect is very significant. As I indicated in my earlier remarks, the maintenance of a noninflationary envi- ronment is a necessary condition and a major contributor toward maximum feasible economic growth and employment. It also probably is the particular goal which would stabilize ex- change rates because, as I have indicated in past testimony before this committee, one of the major goals of the G-7, for example, is to seek domestic price stability, rather, as the easiest, most effec- tive way of achieving long-term exchange rate stability. So in that sense seeking price stability is also a means of seeking long-term exchange rate stability. It is also the way of achieving the lowest nominal and real inter- est rates rather than to seek to achieve those directly. It is far su- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 10 perior to achieve low rates through a noninflationary environment so that while these other goals are clearly important, the interac- tion between those key goals and inflation, in my judgment, runs largely from inflation to those goals. Therefore it is far more effec- tive to endeavor to control the degree of inflation and inflation ex- pectations in an economy to achieve those goals than to endeavor to try to move directly to achieve them. Chairman NEAL. Thank you, sir, very much. Mr. Leach? Mr. LEACH. Thank you, Mr, Chairman. First, let me thank you for an extraordinarily fulsome report. Congress, by statute, gives you that responsibility. The report you have presented to us reflects very much a personal philosophy, as well as an institutional one. We in Congress ought to be apprecia- tive of the fact that the Federal Reserve is one of the few institu- tions that takes its responsibilities seriously in complying with the whole spectrum of reports we legislate. Having said that, let me ask a possibly unfair question: In achieving a balance between lower rates of inflation and higher growth, would it be more effective if Congress were to balance its budget or to pass a law calling for zero rates of inflation? Mr. GREENSPAN. The first is superior to the latter. Mr. LEACH. I am not as sympathetic as some to pejorative legisla- tion. The real task we have to do is to work on the deficit. Central bankers have a tendency, and I think it is part of the confidence inspiring aspect of their jobs, to stress stability in price levels and stability in exchange rates, and point out the relationship between those two stabilities and economic growth. The real ball game is rates of economic growth, not stability in exchange rates or stability in price levels. Here, your report is, I must say, extraordinarily optimistic. You, in effect have hinted that the new figures the Fed is receiving indicates the economy is picking up, particularly in the industrial sector. You have also sug- gested that in the long term you can effectively do your job, which is something that lots of other institutions in American society have a hard time suggesting. The bottom line though is your suggestion that the rate of growth for the economy this year will be 1% to 2 percent. Is that an impressive goal for the Federal Reserve Board? If one turns around the sageness of stability arguments and suggests a rate of growth for the economy of, let's say, % percent greater than that stated. Would you have a little different policy or do you think this is a policy that is most likely to achieve that objective as well? Mr. GREENSPAN. Well, Congressman, let me just say that our goal is not 1% to 2 percent growth. That is the forecast of the members of the FOMC and the non-Member presidents as to what they perceive our overall policies are likely to achieve with respect to the economy as a whole. Our basic policy, if you want to put it in those terms, essentially operates on the money supply, and it is quite conceivable that we can have an expansion of money supply, an improved inflation out- look, and a significantly higher real rate of growth than !3/4 to 2 percent. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 11 In other words, we are not seeking to make the growth rate 1% to 2. What we are seeking is to try to maintain a stable monetary environment, and it may well be that in that environment the fore- cast that the FOMC is making is too pessimistic. I want to emphasize that it is not an integral part of our policy nor is it what we are endeavoring to seek. We don't vote on that forecast. We basically just report it. Mr. LEACH. Well, I did note in your statement at several points, and I have never seen this from you before that the assessment of a majority of the Open Market Committee believes something. Let me ask you what you believe. What do you think the rate of growth of the economy will be this year? Mr. GREENSPAN. It is difficult to answer. Our main crucial goal at this particular point is to put behind us that significant weaken- ing which created a degree of deterioration throughout the latter part of 1989 and to restore some stability. While I think it is pre- mature to argue that that has been achieved, I think that the evi- dence of recent weeks is more encouraging than otherwise. I don't find it very useful to put a specific number down on a forecast because I am not terribly certain what it means. I used to be in the forecasting business, and I was forced to do that and was always concerned about the degree of refinement that that forecast implied when the truth of the matter is, all that economists can do is get a sense of relationships and approximations, and if we can come out even reasonably close in that direction, I think that is as good as we can do. I have no reason to believe that the number will be different from the average of the FOMC. I hope it will be higher. It may very well be higher, but that is not, as I emphasized before, a number we work with. Mr. LEACH. I appreciate that very much, and I must say that I appreciate your optimism in referencing the higher side rather than the lower. I am reminded of Harold Shaprio, who is the Presi- dent of Princeton and formerly headed an econometric modeling team at Michigan. He likes to say that they did a study once at Michigan on their forecasts and over about a 30-year period they had about 2 or 3 years in which they predicted a downturn in the economy. And he said that prediction led the nightly news. Every time they predicted an up tick they got no attention. So it may not be news worthy that you are not predicting a downturn, but I appreci- ate that you are not. Mr. Chairman, if I could ask one modest question on a little dif- ferent subject, and this is more on the micromanagement side of financial regulation. As you know, the Fed has moved in a some- what novel direction in authorizing several Canadian banks to op- erate in ways in this country that American commercial banks cannot, by allowing certain nontraditional activities to be conduct- ed in a subsidiary of the bank, instead of in an affiliate of the bank. Is that a trend that you suspect to continue? Does this decision set a precedent not only for other foreign banks but vis-a-vis U.S. banks? What is the Fed's view on this particular issue and what was Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 12 Mr. GREENSPAN. Mr. Leach, what we endeavor to do is to follow national treatment as closely as we can; that is, that there is a level playing field for all people in the business whether or not they are domestic or foreign. On occasion the structure of foreign banking institutions is dif- ferent from ours and it is often not easy to make the principle ap- plicable. What we try to do in a number of regulations is to find as close an approximation as we can to the spirit of national treat- ment. We have no endeavor to create precedents which create superior positions for foreign institutions relative to domestic. On the con- trary, we work very hard to make certain, as best we can, that there are no differences of that nature. Mr. LEACH. Well, I appreciate that perspective, I would only stress that there are kind of two different ways of looking at cam- parable treatment. The Europeans are saying comparable national treatment is for us to treat their banks the way they treat ours. We say national treatment allows foreign banks in this country to operate the same way as American commercial banks do. The minute we lay down a precedent of giving a foreign entity different treatment than our own national banks, then we lay down a prece- dent which allows other foreign entities to suggest that they should to be treated in the same way. My own sense is that this decision sets a minor precedent that ought to be looked at with a great deal of caution. Thank you, Mr. Chairman. Chairman NEAL. Thank you. Mr. Chairman, in answering Mr. Leach's first question about the budget deficit, you didn't mean to imply, did you, that if we don't balance the budget we somehow ought not to strive to achieve zero inflation? Mr. GREENSPAN. He merely asked me, gave me a choice, one or two. Chairman NEAL. Which legislation would you pass, right, Mr. GREENSPAN. I am sure you would choose one also. Chairman NEAL. I must say I certainly would, although I don't think we have to make that choice. That is what I am trying to get at. You are not implying that there has to be. Mr. GREENSPAN. No. In fact, I have been supportive of both one and two for a long time. Chairman NEAL. Exactly. I would also point out that if we could achieve zero inflation and in fact if we would make it clear we were going to achieve zero inflation that that could have a very positive impact on balancing the budget because it would mean lower interest rates. Now that interest on the national debt is the third biggest item in the budget deficit, if we can lower the interest rate the Government pays on that we will reduce the budget defi- cit. So they work hand in glove. Mr. Barnard? Mr. BARNARD. Thank you, Mr, Chairman. Welcome, Mr. Chairman, to the very, very fine report of what the Federal Reserve did accomplish 1989 and certainly your poli- cies and goals for 1990, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 13 On page 4 of your statement you say that approaching price sta- bility may involve a period of expansion. I need your speech writer for me sometimes. It says here, if you read it, approaching price stability may involve a period of expansion in activity at a rate below the growth in the economy's potential, thereby relieving pressures on resources. You got me coming, and then you got me going on that particu- lar statement. Mr, GREENSPAN. We have many two-handed economists, even speech writers. Mr. BARNARD. That is good to know, especially in this day and age. Does that mean that the inflation that we are experiencing at the very beginning of this year seems to be in keeping not with your policies, but in other words you are sympathetic with that rate of inflation increase that we experienced? Mr. GREENSPAN. Well, the inflation rate so far this year has been horrendous. Last year or this year? Mr. BARNARD. This year. Mr. GREENSPAN. No, this year I would say as best we can judge, looking at the details of the price structure, the big surge in infla- tion which has occurred is essentially constrained to energy and food and has not spilled over into other parts of the economy. So while we are disturbed by this extraordinary surge, in our judg- ment it has not seemingly embedded itself either in higher wage or other costs. Mr. BARNARD. So the Fed at this particular point does not see the need to try to rush to remedy monetary policy? Mr. GREENSPAN. I know of no action we have taken which has responded to those individual price movements. Mr. BARNARD. Mr. Chairman, does the Fed agree with the projec- tions of economic growth and inflation that are currently in the ad- ministration's budget proposal. Do you think that they are optimis- tic? Mr. GREENSPAN. Well, I think that you have to look at those fore- casts in a different context. As I have said previously, administra- tion forecasts presuppose the implementation of all of the Presi- dent's recommendations, including a very significant reduction in the Federal budget deficit. And as I have said to other committees of the Congress, this particular set of forecasts, given the presump- tion that the Congress passes the President's budget in total, is not an unreasonable forecast. Now, one can say that is an unrealistic expectation and may not happen, and surely in detail will not happen. But that is a differ- ent question. So in the sense of an internally consistent forecast, it is not one which I would have great quarrel with. Obviously, we don't agree with that forecast, but the reason we don't agree with it is that we are not required in our view to assume what the administration does assume. Granted that, I think that they have done a job which is a reasonably sensible, bal- anced approach to the economic outlook. Mr. BARNARD. If we rushed, and I use that word selectively, if we rushed to take Social Security off of budget, and which would im- mediately increase the deficit by 67 to $70 billion, how do you see that affecting growth? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 14 Mr. GREENSPAN. You mean growth? Mr. BARNARD. Yes, economic growth. Mr. GREENSPAN. I think the action of doing it as such is probably not something which would have any material effect unless and until the markets presumed that action on the actual deficit would occur as a consequence of that. If the markets perceive that a major reduction in long-term budget expenditures is underway by statute, I think we would find a remarkable response. I think long-term interest rates would fall as inflation expecta- tions would fall, and we would get very significant benefits from that occurring. But we have to distinguish between shuffling the various techniques we employ to measure the budget process and the real actions with respect to those things which affect savings and investment in the economy and Federal borrowing require- ments. Mr. BARNARD, but you expect interest rates in the long run to be reduced, but principally by expectations? Mr. GREENSPAN. No. I would say the mere fact of moving the Social Security Trust Funds off budget and allowing, let's assume, Gramm-Rudman-Hollings to apply to the non-Social Security aspect of the budget would not in itself do anything unless the markets believed that the Congress was serious in meeting those goals, I think that there is a degree of skepticism in the markets which can be addressed, in my judgment, only by action. Mr. BARNARD. Mr. Chairman, as a regulator, are you concerned with the depressed condition of real estate in the Northeast and how it is affecting the banking system in that area? Mr. GREENSPAN. Most certainly we are. In fact, we have moni- tored very closely the whole New England real estate environment, and have been looking at it in some considerable detail. We have been looking at the bank holding companies in New England also in some detail, and are trying to get as much information, judg- ment and sense of the markets as we conceivably can muster. Mr. BARNARD. Mr. Chairman, my time has expired, but I would like to ask one other question, which I think is very significant to something you said. As I understand it, the Fed has out for com- ment the ability of bank holding companies to underwrite corpo- rate equity. Would you like to address, just indicated how the Fed feels about that? Mr. GREENSPAN. Well, let me just tell you specifically what it is we are doing. A year ago when we granted so-called section 20 au- thorizations to underwrite corporate debt, we also indicated that we did not think at that time that the underwriting of corporate equity would be a appropriate and that, in a year, we would review that issue with the implication that if we thought it was the appro- priate thing to do, we would go ahead, but only after Federal Re- serve examiners reviewed the processes of those involved in corpo- rate debt underwriting to make certain that their particular proce- dures and organizations were adequate to field equity as well. Several days ago, the Federal Reserve Board authorized the Fed- eral Reserve Bank of New York to begin to examine the individual banks who have made application to see whether in fact they have Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 15 created a structure which in our judgment would match our re- quirements of safety and soundness in such underwriting activities. I presume that examination activity will begin within several weeks, and when the examinations are complete, it will come back to the Board, and the Board will make a judgment at that particu- lar time as to whether or not individual applications should be moved forward or not. Mr. BARNARD, That examination is examination of underwriting corporate debt? Mr. GREENSPAN. It is to see how they have underwritten corpo- rate debt and whether or not they will have the facilities and tech- nical capabilities, in the judgment of the Board, to move forward into equities. Mr. BARNARD. This year that has elapsed now, has there been any significant—have you noticed anything significant which you feel the Fed would change its policy on underwriting corporate debt? I mean, are you happy with the results of the permission? Mr. GREENSPAN. That is one of the things we plan to be looking at. I know of nothing at this stage which suggests anything nega- tive, and I did not sense anything from my colleagues on the Board to suggest that any of them had altered their basic view that it would be desirable to move forward, provided our criteria were met. Mr. BARNARD, Mr. Chairman, just to satisfy some of the critics— of which I am certainly not one, I applause what the Fed is doing— but during this period of time you have periodically examined bank holding companies to determine the structure in which they are underwriting this corporate debt? Mr. GREENSPAN. When reviews have been taking place, they are general reviews. Mr, BARNARD. All of these underwritings done in separate sub- sidiaries? Mr. GREENSPAN. That is correct. That is required. Mr. BARNARD. Have I got time for one more question, Mr. Chair- man? Chairman NEAL. Yes. Mr. BARNARD. Mr. Chairman, I was interested in the story which indicated that had Drexel Burnham Lambert not gone into bank- ruptcy, that there was a possibility that the Fed would come to their assistance. Did I read that wrong? Mr. GREENSPAN. Well, I can't say that you read it wrong if some- body wrote it. I could merely indicate to you that there is serious question about the accuracy of such a statement. Mr. BARNARD. Well, I was thinking so, too, but I notice it was given wide publicity that the Federal Reserve was contemplating coming to the aid of Drexel Burnham Lambert, I said now certain- ly they are not going to underwrite junk bonds now. That was my last question. Thank you. Mr. GREENSPAN. Let me just say, Mr. Barnard, that the basic concern of the Federal Reserve is not in individual institutions, but in the system, and our concern is always concentrated strictly on making certain that individual firm problems don't spill over into corrosive effects on the financial system, and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 16 Mr, BARNARD. But they would not have had access to the dis- count window? Mr. GREENSPAN. That is correct. They would not have. Chairman NEAL. Mr. Chairman, I would like to ask you to expand your comments on the line of questioning that Mr. Leach pursued, because it seems to me that he has touched on a most im- portant point concerning the conduct of monetary policy, and that is this question of the ideal policy. It is my understanding that achieving and maintaining zero inflation and price stability pro- vides the ideal condition for maximum sustainable economic growth—that there is no other condition that will better assure that we can sustain economic growth at its maximum level and price stability. I would say the same thing about employment. Wouldn't you find that the majority of economists would agree with these ideas that I am expressing now, that that is the way to achieve maximum sustainable economic growth is to maintain price stability. That to maintain maximum sustainable employ- ment, that the essential condition for that is zero inflation and price stability. I believe that you could say that about the maxi- mum level of savings, and therefore, of investment and productivi- ty growth. Don't we know enough now about the way our economy works to say with a high degree of certainty that we can maximize sustainable economic growth, employment, savings, investment, and so on, all the things that we are talking about, including ex- change rate stability by achieving and maintaining zero inflation and price stability? Mr. GREENSPAN. Well, Mr. Chairman, let me distinguish between a necessary condition and a sufficient condition. I would say—and I would certainly include myself in this—that a very substantial ma- jority of economic analysts would argue that a noninflationary en- vironment is a necessary condition for maximum sustainable eco- nomic growth and employment and a variety of other things. I would not—and I would think they would not—say it is sufficient, because it is very easy to envisage an economy with very signifi- cant amounts of Government controls, various different types of in- efficiencies, extremely unstable fiscal policies and budgets, in which we would not achieve those goals. Chairman NEAL. But we are talking about monetary policy. Mr. GREENSPAN. If you are talking about monetary policy, the long-term optimum monetary policy which can contribute most to these various is to maintain a noninflationary environment. Chairman NEAL. Thank you. Mrs. Saiki. Mrs. SAIKI. Thank you, Mr. Chairman. I would like to add my appreciation for the soft landing, Mr. Chairman, of 1989, but looking forward as decisions have to be made up here on the Hill in the context of our concern for the rate of growth, I would like to ask you a question which may be a little unfair, but I would like your personal opinion as to whether a change in the treatment of capital gains promotes growth in our economy. Are we really going to make money as the Treasury sug- gests? I am sorry, would we make money for the Treasury as OMB suggests, or are we going to lose revenues as CBO suggests? I would like to have your opinion on this. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 17 Mr, GREENSPAN. Well, I have always supported a cut in the cap- ital gains tax rate because I don't think it is a productive tax for a market system of the type that we have. I think that a lower cap- ital gains tax would basically over the long run be productive in that it would add to long-term economic growth. I have also said that I, nonetheless, supported the 1986 tax reform compromise, which, as you know, eliminated the preference for capital gains as part of the package which brought the margin- al tax rates down very substantially, and I still support that. In other words, if I am given the choice of a capital gains tax cut fi- nanced by higher marginal tax rates, I wouldn't think that would be a particularly good idea. With respect to the issue of whether or not these are revenue gainers or revenue losers, the estimates are based on a very sensi- tive set of calculations which refer to the expected so-called unlock- ing of existing capital gains and the willingness on the part of indi- viduals who have unrealized capital gains to, in fact, realize them if the tax rate falls. Obviously were they to do that, they would be paying taxes which they would not otherwise be paying, and that in a sense adds to tax revenues rather than losing them. The sensitivity of those assumptions is very high, meaning very small changes in assumptions can create very significant changes in the revenue picture. I have seen estimates on both sides with very small differences in assumptions, and I am personally unable to make a choice as to what is an appropriate estimate, because I have not myself looked at or felt comfortable with the particular details that were presented. So I would just basically say I am gen- erally supportive of the overall principle, hope we can implement it, but would not like to see it done in the context of unwinding what I thought was a very effective Tax Reform Act of 1986. Mrs. SAIKI. Are you saying then, Mr. Chairman, that the gains that we may see with this kind of a plan that the administration has proposed will be a short term gain? Mr. GREENSPAN. Well, not necessarily. I think that clearly most everybody has short, up-front realizable capital gains, and one would assume that one would get the maximum effect of unlocking at the earliest possible point. But I have not looked at the details of the calculation sufficiently to give you a good judgment as to whether those are statistically as good as they can be. I have no reasons to believe that they are otherwise. In other words, they have good people over there making professional judg- ments, and I would have every reason to believe that those esti- mate are as good as you can get. Mrs. SAIKI. Thank you. Chairman NEAL. Mrs. Roukema. Mrs. ROUKEMA. Thank you, Mr. Chairman. Chairman Greenspan, I regret that I was unable to be here for the bulk of your testimony, bit I do note on page 7 that you allude to the fact that you anticipate less feverish activity, less feverish pace, with respect to merger and acquisitions, and I assume here you are alluding also perhaps—I am not sure, but perhaps—to the component of that activity that has been related to junk bonds, and evidently you have taken into account the most recent effects of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 18 the junk bond in the Drexel Burnham Lambert fall, et cetera, into your calculations. Would you be willing to go any further in terms of giving a prog- nosis as to what the future—the effect of this activity, lessened ac- tivity is going to have on the future financial markets? Are we going to see more of abuse in terms of the consequences of the junk bond debacle here? Or don't you like the use of my word "deba- cle"? Mr. GREENSPAN. I wouldn't choose to use it. I don't actually think there is a debacle here. I think what we are looking at is the satiation of the potential for significant restructuring on a profita- ble basis. I think a year or two ago, before this committee or the full committee, as I recall. I discussed the relationship between the rise in real interest rates that occurred in the early 1980s, the im- balances that that created with respect to the optimization of the various different parts of corporations, and argued that the process of trying to reestablish balance was the major reason why the very big surge in mergers, acquisitions, and restructurings occurred. I think that what we have seen since is a very substantial degree of activity in trying to reestablish balance in a number of different firms, and that took as part of it a very large amount of conversion of equity to debt. We have had an extraordinarily large amount of liquidation of equity financed by debt, in many respects financed by junk bonds. In fact, one can say where do junk bonds fit into the balance sheet, and to a very substantial extent, they have displaced equity. In that sense, I think I have argued that that is unfortunate, since the capital asset relationships in corporations have undergone a weak- ening. Having said that, there is no question that there are valuable places for less than investment grade corporate bonds, and I think there have been a number of firms which have effectively used them to finance their balance sheet structure and probably have done better than they would have if junk bonds did not exist. My impression basically is that we will work our way through this turmoil that we have seen in these markets and that it will eventually simmer down. We will find that rather than $200 billion outstanding, we will probably have somewhat less. But junk bonds will be an available part of the overall financing structure of American business, because I do think that they serve a useful pur- pose. I think their issuance may have gotten somewhat out of hand for a while, but I think over the long run they are a logical niche in the system, and I would expect that that is what is going to happen. Mrs. ROUKEMA. So your prognosis is that after some initial tur- moil the patient will stabilize, and not without too much problem with respect either to pensions or other kinds of investment instru- ments? Mr. GREENSPAN. I don't think so. Obviously there are certain in- stitutions that have a bit too much in the way of lower grade secu- rities, but remember that those securities are still a relatively small part of the total investment scene. As a result of that, while there are a handful of institutions which have a disproportionately large amount of such instruments, that is not generally the case, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 19 and I would be most surprised if we had any secondary repercus- sions which could destabilize the total system. Mrs. ROUKEMA. Well, good. I am happy to hear your assessment. Thank you, Mr. Chairman. Chairman NEAL. Mr. Chairman, on the question of junk bonds, isn't it true that there are only 1,300 or 1,400 companies in the whole United States that can issue bonds that are considered by the rating agencies to be investment grade bonds, and by defini- tion, everything else is a junk bond? Do you remember that number? Mr. GREENSPAN. I am not sure that that actually is a real number in the sense that it is a measure of the number of compa- nies which have investment ratings. I am not sure that those who have not issued bonds are in that number, but that is, I believe, a published number, and I will submit that for the record. [Chairman Greenspan subsequently furnished the following in- formation for the record:] At the end of September 1989, approximately 1,350 corporate issuers were rated as investment grade by Moody's Investors Service. This figure represents all issuing entities, including subsidiaries of parent corporations, having a rate of Baa or above. The number of entities actively issuing bonds may be considerably smaller. Chairman NEAL. Anyway, the point I am trying to make, it is a relatively small number compared to the total number of compa- nies in the United States. Mr. GREENSPAN. Oh, yes, it is a relatively small number. Chairman NEAL. It seems to me that those who want to refer to all these other bonds as junk bonds, would not have been pressed to refer to those other companies as junk companies. I don't think they are junk companies. Many of them are the growing companies attracting new investment, producing new products, employment, and it is just a shame to attach this pejorative to their debt issues. They couldn't provide those jobs and so on without being able to attract some capital. It is certain the development of this market in less than investment grade debt is a positive one, it seems to me, not a negative one. Some of this debt has been used in a negative way, but certainly not most of it. Mr. GREENSPAN. Mr. Chairman, I think it has been somewhat over-done, but the mere fact that it has been overdone does not un- dercut the fact that it does serve certain useful purposes. Chairman NEAL. Well, vital purposes, it seems to me. It provides jobs for our people, competitiveness in the world economy. I have been critical and I believe you have also, of efforts to use monetary policy to what a lot of people refer to as stabilization the foreign exchange value of the dollar. In other words, to have that as a primary objective of monetary policy, and as far as I know, that stabilizing exchange rate has not played any kind of distorting role in the recent conduct of monetary policy. And I raise this at this time because it does seem to me that soon we may face some real uncertainty and turbulence in exchange rates. The recent proposal that West Germany and East Germany form a monetary union, it seems to me, will certainly introduce consider- able uncertainty in the exchange rates of this new German mark vis-a-vis the dollar. Do you agree that we should not use monetary Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 20 policy to stabilize this rate, but should rather let financial markets determine the value? Mr. GREENSPAN. Well, Mr. Chairman, in our directives we list the various different factors which we consider in determining policy, and we do look at the exchange rate as an element which will affect the domestic economy and therefore subject to decisions with respect to policy. But in that particular context, how the Fed- eral Open Market Committee will respond to various different sce- narios that can emerge in the months ahead, as a consequence of the growing imminence of the merger of East and West Germany, is as yet too soon to make a judgment. The reason I say that is that it is such a complex set of relation- ships that I wouldn't want to focus precisely on how policy will move in the event of significant changes abroad. AH I can say to you is that the fundamental purpose of policy remains the stabili- zation of the domestic economy and the creation of a noninflation- ary environment. How we would specifically react to significant movements of an unstabilizing nature—should they occur and I must tell you I don't believe that they are in the realm of "what would you do if." There are a long series of contingencies that the Federal Reserve has outlined, and we even have several commit- tees which look into various "what ifs." But they are really so com- plex that unless and until we are actually looking at a specific event, it is really very difficult to know what optimum policy at that point is, because it is likely to depend very concretely on the particular events of that time. Chairman NEAL. Mr. Chairman, as you know, I have been very complimentary of what you and most of the other Board members are trying to do and I support your public statements in terms of achieving zero inflation, price stability, and so on, but now I want to ask you when can we expect a little more progress? If you will look at your own charts in the back of your testimony this morn- ing—the top chart is the GNP price deflator, the bottom one is the consumer price index, and what that shows is that since 1984, except for the year 1986—which was a year in which the bottom really dropped out of oil prices—the average rate of inflation has been about what it is today. That is to say, it has been somewhere in that range of 4 to 5 percent. We both said many times that that is intolerably high level of inflation, and that maintaining a level of inflation at that rate does enormous damage to the economy. It keeps interest rates much higher than they should be, than they could be. It lowers our possible growth rate. It lowers the rate of employment, makes us save less than we otherwise would, and so on. So I would just like to know when can we expect to see some progress in terms of reducing the rate of inflation? Mr. GREENSPAN. Mr. Chairman, I have hesitated to make a spe- cific forecast merely because the particular complexity of the econ- omy at any particular point in time means that it will respond dif- ferently to various different types of monetary policies. Our gener- al thrust is to keep pressure on, endeavor to gradually bring the rate down, but I have purposely avoided with you in earlier conver- sations citing a specific set of price goals independent of everything else. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 21 I think we do intend, and think it is crucially important, to bring the rate of inflation down to a noninflationary level for all the rea- sons we have discussed on numerous occasions, and I think that is the fundamental thrust of our long-term policy. We are biased in that direction, obviously, over the long run. But having said that, we want to be certain that we do not in the process inadvertently destabilize the economy, and as a consequence, I think that if we were to set specific goals of where we think prices should be at any time, we would probably find that we were not optimizing our policy over the long run. So all I can say, Mr. Chairman, is that our view is that the direc- tion of inflation has got to be down, but I don't think it is produc- tive to set specific goals as to where we would like to see it at each point in time. Chairman NEAL. Well, I know the difficulty with that, but I sure would encourage you to do all you reasonably can. Certainly I don't want to see us in any way destabilize the economy, certainly I do not want to see a recession. However, I think we ought to be able to achieve this goal of price stability without creating a recession. A recession would create unnecessary pain, and would sap our will to achieve the goal. But, it seems to me that we can achieve more progress than we have, and that it would benefit all of our people, and I just hope that we can move in that direction more forcefully than we have. Mr, Leach. Mr. LEACH. Thank you, Mr. Chairman. I want to take a little dif- ferent perspective, and let me just suggest, and I am hesitant as a representative of the minority to be partisan, but, Mr. Chairman, the last Democratic President served from 1977 to 1981. The inflation rates were in the double digits. Here they are 4 percent during a time period in which Congress, which is the pri- mary body in American society responsible for fiscal deficits, ran extraordinary deficits. One can agree or disagree with the Federal Reserve Board in all sorts of ways at various points in time. But in terms of maintaining 4 percent inflation, given the level of deficits from the fiscal side, is a mighty impressive performance, and I don't think anyone on this panel ought to be misled into thinking that a lot better job could have been done. It is very impressive what the FED has done to curb inflation. I would like to turn, though, to the subject which I didn't know was going to be raised today and relate it back to the Drexel Burnham and junk bond issue. Frankly, Mr. Chairman, I think the term "junk" is too cheerful a term to apply to these bonds. A junk bond implies something that maybe the buyer may not get a full rate of return. Well, these are more than "junk"; they are dung heap bonds. The reason I say that is that Congress knows better than any other institution that it isn't solely the saver that is losing money, although the savers are losing some. In the S&L collapse, it is Congress and the taxpayer that are is bailing out these bonds. That means they are not just junk; they are dung heaps. Now, beyond that, Mr. Chairman, you have noted that junk bonds from time to time provide smaller businesses equity at a little lower rates than they would otherwise receive, and there are Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 22 some cases that that is good for the economy, good for the smaller businesses. On the other hand, the Chairman of the Federal Reserve Board has pointed out that disproportionately these bonds have been used to replace equity with debt and to the degree that they have been used to replace equity with debt, they are dung heaps for the econ- omy as a whole. Now, coming back to the Drexel issue which was raised, I was a little surprised, Mr. Chairman, that you didn't come down a little more firmly. The fact is the Federal Reserve Board does have ex- traordinary power and can in one way or another intervene and has a legal mandate to intervene to assist far more than the bank- ing sector if it is in the interest of the economy. Well, my view is the social case for saving rogue elephants is non-existent, and the economic case is also in this particular cir- cumstance very weak as well. The failure of large institutions of any variety can be destabilizing, but it strikes me the failure of bad actors, especially ones which feast off over leveraging of the econo- my can be stabilizing rather than destabilizing. I would certainly hope that there is no hint that the Government is prepared to come in in an extraordinary way and prop up a particular financial institution whose social purpose, has ill-served the economy in the last decade and the replication of which will ill-serve it in the next. I just want to raise the flag of concern against dung heap bonds and against the institutions that have propagated them on the American economy, Mr. GREENSPAN. I think it is important to distinguish among the uses to which a significant number of the junk bonds or whatever you want to call them have been applied. Clearly, they have been to a very substantial extent displacing equity. For reasons which I discussed in my prepared remarks, I think the leveraging of corpo- rate America is creating financial strains, a factor with which I personally feel uncomfortable and I have felt uncomfortable with it for quite a long period of time. One can say that an evaluation of the junk bonds issued to date would come out decidedly mixed at best, but I think you have to distinguish between what they have been used for and what they can be used for, and my remarks with respect to them refers essen- tially to the latter because those types of instruments may be the best means by which certain small to medium-sized businesses can finance themselves. Consequently I think it is important not to throw all of that process under one classification. There are actually large variety of differences among various dif- ferent types of junk bonds. It seems like silliness, but there are high-grade junk bonds and low-grade junk bonds, and the markets will eventually make those particular distinctions. With respect to Drexel, there was not at any time any desire on the part of those involved in the U.S. Government, relevant to this issue, who considered bailing out Drexel. I think that the issue of bailing out any institution is a very serious issue. My judgment is we probably do it far more often than we should. I am certain that is the case, and I don't think that there was any inclination at all in this regard. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 23 Mr. LEACH. Well, I appreciate that very much, and I would only make one very minor distinction. There is a difference between high grade and low grade, but there is also a distinction between high purpose and low purpose. You can have a higher grade junk bond, which is used to displace equity or capital with debt, and you can have a lower grade junk bond, which is not designed in that fashion. Mr. GREENSPAN. I would agree with that. Mr. LEACH. Coming back to the responsibility of Congress, one of the great questions given the overleveraging tribulations of the last decade is whether we want to change the mix of our tax policy. I don't know if you are prepared to comment on this, but one of the issues that many of us are concerned with is whether we ought per- haps, to lower the corporate rate in exchange for eliminating some aspects of tax deducibility of interest. Does that strike you as a reasonable kind of tradeoff? Mr. GREENSPAN. Well, I have always argued, Mr. Leach, that one of the problems we have in our system that inhibits savings, which I consider the most crucial short-fall our system now has, is the double taxation of dividends, and in fact the whole structure of cor- porate taxation. Any means that we can find to bring down the level of double taxation of dividends—and I don't want to comment specifically on mechanisms now because they are all very complex and require a good deal of thought—but I think that process, which is unfortunately expensive with respect to revenues, is something that we should nonetheless be looking carefully at. If you are looking at a way of improving the structure of tax- ation in this country and in the broadest sense focusing on improv- ing national savings, looking at that process and hopefully revamp- ing it could be a very productive endeavor, in my judgment. Mr. LEACH. Thank you. Chairman NEAL. Mr. Barnard? Mr. BARNARD. Mr. Chairman, on page 12 of your testimony you enumerated to some degree international financial markets and its effect on monetary policy, and then on page 12 you said that cross- border financial flows have accordingly accelerated at a pace in excess of global trade gains. This globalization of financial markets has meant that events in one market or in one country can affect within minutes develop- ments in markets throughout the world. I would direct a question having to do with the recent announcements that—example, with the German currency union of East Germany and West Germany. We are seeing various reports on the West German mark that it is getting exchange in narrow ranges from the East German mark, I am not asking for your predictions, but do you feel that it will be somewhere between four to eight east marks for every one German mark? Mr. GREENSPAN. Are you talking about the exchange rate be- tween ost-marks and deutsche-marks? Mr. BARNARD. Yes. Mr. GREENSPAN. I can't answer that question because the choice that is involved is a very difficult one. The problem which they have is the extraordinary movement of people from East to West Germany. That is largely caused by the perceived differential in Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 24 the standards of living between the two, and the choice of where you set that exchange rate creates a major problem because clearly from the West Germans' point of view, if the exchange rate is set in favor of the East German mark, that means the addition to the West German money supply then becomes larger. But if the rate is set too low, meaning for the East German mark, it means that the real wage in West German marks is still very low and as a consequence we are very likely to get a continu- ation of the immigration flow, and I think both parties are most anxious to stabilize that. Mr. BARNARD. But in spite of that effort, isn't it somewhat ines- capable that we are going to see higher interest rates in Germany, either from borrowing or otherwise? Mr. GREENSPAN. It is not clear to what the extent to which the current run up in rates has discounted perspective events or not. There is always an inclination to look at an economic development and then project interest rates as though there are not other par- ticipants in the market who have not already made that judgment and taken actions in the markets. It is only when you can perceive an event which the rest of the market has not perceived that you are likely to be able to forecast where rates will or will not go, and it is just as conceivable at this stage that rates could go in the other direction because they may have been over-discounting what in fact the ultimate results may be. So I don't think one can make that statement necessarily. There are tremendous degrees of uncertainty with respect to the process going on in Central Europe at this stage, and I think that we fore- casters require a large element of humility when observing that phenomenon. Mr. BARNARD. In discussing the aspects that are going on in Eastern Europe, you indicated in your remarks that even in the past we have seen tremendous reactions in other countries, and still we have been able to manage monetary policy without any problem, taking into effect those responsible. That was on page 11, A former OMB Director, however, has said that he is concerned that the interest rates in Germany are going to be such that we could "lose the control of our monetary policy." Now, you don't have that fear? Mr. GREENSPAN. No, I do not, Mr. Barnard. Mr. BARNARD. My last question, Mr. Chairman, would be that in response to the vast changes in the globalization situation, are we moving fast enough in this country to address the banking laws that stand in between our institutions becoming—being able to serve the international financial marketplace? Mr. GREENSPAN. I think not. I think that we are lagging somewhat, and I think that if we could accelerate—move toward repeal of Glass-Steagall, for exam- ple—I think we would achieve a much improved financial structure which would enable us to compete increasingly effectively in the international arena. Mr. BARNARD. We probably wouldn't be as subject to national treatment limitations as might develop in the future if we don't do that? Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 25 Mr. GREENSPAN, I can't answer that, but I would say that basical- ly this issue of Glass-Steagall should be fairly high up on the agenda for our considerations. Mr. BARNARD. Thank you, sir. Chairman NEAL. I am going to try to address a point Mr. Leach made without engaging in partisan wrangling. I hope I will be suc- cessful at that. I mean it in this way. One reason I take it up, frankly, is that it seems to me that it is important that on this sub- ject of monetary policy that we have a clear historical understand- ing of how these things work. And Mr. Leach is absolutely correct that under a Democratic administration during the late 1970s the Federal Reserve ran a very high rate of inflation, and it was a mis- take. But the role of the President in that was in appointing the Chair- man of the Federal Reserve System. He appointed the Chairman who guided that policy, and when it was recognized that that policy was incorrect, President Carter appointed Paul Volcker as Chair- man of the Federal Reserve and gave him the specific mandate of lowering the rate of inflation, which he did. Inflation is a monetary phenomenon, and it was caused by the Fed and it was then ground out of the system at least from its double digits to its current levels by the FED. And both of those Fed chairmen were named by President Carter, the one that cre- ated much of it and the one who solved much of the problem. Now, on the question of the role of the Congress in setting and establishing budget deficits, it is important to set the historical record straight. The President, under our system, has enormous power in this regard. President Reagan was the most persuasive President, I guess, clearly since Roosevelt, The Congress did grant him pretty much what he wanted, and these policies he wanted had a lot to do with the deficit. In fact he created much of the deficit that we have today—tripled the nation- al debt in 8 years. Now, it is true that that couldn't have happened unless Congress went along with it. I am trying not to be overly partisan, but to try to say that that was something that the Congress did and that the President had no impact on it just seems to me misses the point entirely. I would like to yield to my friend if he disagrees with anything I have said. Mr. LEACH, Well, I think that several of your comments are thor- oughly valid. I would only suggest, though, that despite the exhor- tations of anyone from the outside, whether they be the President of the United States or a wife, the U.S. Congress has its own re- sponsibilities to administer. A President cannot spend a dime that we do not appropriate and cannot raise revenue that we do not authorize. The Congress of the United States has the primary responsibility for defining whether or not there is a fiscal deficit. Now, the gentleman in the chair is entirely correct in noting that we have had a very persuasive President, He is entirely correct that under that Presidency the deficit rose dramatically, But I will be darned if I do not think that all of us should understand that it is our job to run the fiscal policy of the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 26 United States of America. If we fail we cannot simply blame a pop- ular President, We must blame ourselves. Chairman NEAL. Well, I have to agree with part of that, too. Let me pursue it one more minute, I voted against the Reagan budget. I said at the time I thought it would create a huge deficit. I under- estimated by far the amount of the deficit, but I am a Member of this body. What role do I play in it? What is my responsibility there? It was passed overwhelmingly. I think all Republicans voted for it, and there were enough Democrats to put the policy over the top. A ma- jority of democrats voted against it. Well, where does the responsi- bility lie? Mr. LEACH. Well, if the gentleman would yield, let me just stress that I consider the gentleman from North Carolina to be one of the most distinguished Members of this body, and one for whom I hold in high regard. I do not want to level any personal criticisms, but I think collectively all of us have to recognize that even though we are Vias of a particular body, we are accountable for the body itself. The Congress of the United States committed some egregious errors in the 1980's, and they can't be denied. Chairman NEAL. I thank the gentleman. Mr. Hoagland? Mr. HOAGLAND. Well, thank you, Chairman Neal, for recognizing me. Welcome, Chairman Greenspan, to the committee. It is a pleas- ure to see you this morning. You might recall, Chairman Green- span, it was about a year ago when you gave some testimony before this committee that caused the stock market to go up 25 to 30 points, and I told you the story about how pleased my mother was. Well, I just flew in from Omaha this morning, just got here about a half hour ago. And my mother reminded me last night that you would be testifying this morning and wanted me to give you an opportunity, I know she will be pleased with the optimistic forecast that you have made here, but if you would like to elaborate on that in any respect, I know she would be pleased, and I would be pleased to hear that. Mr. GREENSPAN, Well, all I can say to you, Mr. Hoagland, is I would like to convey to your mother my best wishes and felicita- tions, and I hope that when she conies to visit you I will get to meet her. Mr. HOAGLAND. Well, she does follow you quite closely, Mr. Chairman, and she will appreciate that. And I appreciate it as well, Mr. Chairman, on a different note, I think a number of us were somewhat alarmed at the testimony that we heard from the Gener- al Accounting Office and the Congressional Budget Office about 2Vz weeks ago on the progress of the RTC. We were told then that as of, I think it was—I believe the date was January 15th, that only about 46 institutions had been closed, that those were by and large small institutions with assets in the $200 million to $250 million range, totaling only about $10 billion; that there were hundreds of sick institutions still out there, many of which had billions of dol- lars of assets. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 27 I wonder what you think needs to be done in order to speed up the process, if there is anything that we here in Congress should be doing, what recommendations you might have for your colleagues in the administrative branch. Mr. GREENSPAN. We at the Oversight Board and the ETC Board are programming at this particular stage a significant acceleration of activity. If that fails to materialize to the satisfaction of the Con- gress, then I think that the Congress would want to take a much closer look and find a way in which that could be accelerated. How- ever, at the moment, as I understand it, there is a significant in- crease in scheduled activity in that respect. Mr. HOAGLAND. Have you had an opportunity to discuss with Mr. Kearney his reasons for leaving, Mr. Greenspan, and does that in- crease or decrease your concern about the way things are proceed- ing now? Mr. GREENSPAN. I did speak to Mr. Kearney on it, and I think he repeated to me what he has said in public; namely, that his judg- ment as to what the particular role of the chief executive of the RTC Oversight Board was was different from the view of the Over- sight Board, and I think that it was regrettable. I think it was an honest misunderstanding. I don't think that communication was obviously as adequate as one could have made it. I was sorry to see him resign. I don't consider it a major set-back in the forward thrust of the organization. The work of the Over- sight Board continues a pace and hopefully the transition will appear to be nothing more than a blip. Mr, HOAGLAND. One criticism we are hearing here in Congress is that there are some different agencies involved in approving any given transaction, some overlapping lines of authority, and a gener- al paralysis that is resulting from a fear of excessive criticism from the Banking Committee and other institutions should a large thrift be taken on and the resolution of that be imperfect in some respect or another? Mr. GREENSPAN. I frankly don't know how valid the criticism is. We have a problem but we knew we had it right from the begin- ning—that the structure of the RTC and the Oversight Board is not the type of structure that one would set up for a private corpora- tion. You would not have two boards, in effect, but I think it was the Congress' judgment that even though there is a clear increase in complexity and a decline in managerial efficiency to put this type of complex structure in place, I think it was the judgment of the administration and the Congress that when you are dealing with huge amounts of taxpayer money that there has got to be some po- litical oversight to the system, and that political oversight does create a slowdown. It creates a more complex decision-making process than would exist in the private sector, but I think it is a very understandable tradeoff. I don't think it would be appropriate to put in the hands of an independent agency huge amount of taxpayer funds without the appropriate layering of political control on top of it. We have to recognize that that political control has a cost, and the cost is some inefficiency, so it is a tradeoff that was made when Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 28 FIRREA was first established. I think if you went back to square one you would probably have come out roughly the same. It is up to us to make that system work, and I trust that the speculations in the press and elsewhere that everyone is afraid to move turns out to be inaccurate. Mr. HOAGLAND. So you are satisfied that no structural changes need to be made at least at this point? Mr. GREENSPAN. That's correct, Mr. Hoagland. For the moment I would say let's watch the way this evolves. If it fails to meet the Congress' expectations, then I think it should be reviewed, but I have no reason to believe at this stage that that will in fact be the case. Mr. HOAGLAND. Are you also satisfied, Mr. Chairman, that men and women in the highest jobs in the administration are giving this problem the attention and the concern that it needs and de- serves? Mr. GREENSPAN. I don't know whether I can answer that very specifically. I will say this, that the various people within the Gov- ernment—Secretary of the Treasury, the Deputy Secretary of the Treasury, the Under Secretary of Domestic Affairs, and the Feder- al Reserve Board at various different levels—are heavily commit- ted to this process and, needless to say, the FDIC has taken on a very large operation. Mr. HOAGLAND, Well, thank you, Mr. Chairman. Thank you. Chairman NEAL. Mr. Leach? Mr. LEACH. I want to thank our chairman for spending so much time with us. Thank you. Chairman NEAL. Mr. Chairman, I have no further questions. I want to thank you also for coming this morning and keep up the good work. Just more of it. The subcommittee stands adjourned subject to the call of the Chair. [Whereupon, at 12:10 p.m., the hearing was adjourned, subject to the call of the Chair.] Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 29 A P P E N D IX February-20, 1990 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 30 ror releave on delivery 10:00 A.M. EST February 20, 1990 Tettittony by Alan Greenspan Chairnan Board of Governor* of the Federal Reserve System before the Subcomnittee on Domestic Monetary Policy House Cooaittee on Banking, Finance and Urban Affairs U.S. Bouse of Representatives February 20, 1990 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis Mr. Chairman and Members of the Committee, I appreciate the opportunity to testify today on the Federal Reserve's semiannual Monetary Policy Report to the Congress. My prepared remarks discuss our monetary policy actions and plans in the contest not only of the current and pro- jected state of the economy, but also against the background of our longer-term objectives and strategy for achieving them. The final sec- tion of the testimony addresses some issues for monetary policy raised by the increasingly international character of financial markets. Bcononic and Monetary Policy Dev«lopn»ntB in 1969 Last year marked the seventh year of the longest peacetime expansion of the U.S. economy on record. Some 2-1/2 million jobs were created, and the civilian unemployment rate held steady at 5-1/4 percent, Inflation was held to a rate no faster than that in recent years, but unfortunately no progress was made in 1989 toward price stability. Thus, while we can look back with satisfaction at the economic progress made last year, there is still important work to be done. About a year ago, Federal Reserve policy was in the final phase of a period of gradual tightening, designed to inhibit a buildup of inflation pressures. Interest rates moved higher through the winter, but started down when signs of more restrained aggregate demand and of reduced potential for higher inflation began to appear, A3 midyear approached, a marked strengthening of the dollar on foreign exchange markets further diminished the threat of accelerating inflation. New economic data suggested that the balance of risks had shifted toward the possibility of an undue weakening in economic activity. With M2 and M3 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 32 -2- below the lower bounds of their annual ranges in the spring, the Federal Reserve in June embarked on a series of measured easing steps that con- tinued through late last year. Across the maturity spectrum, interest rates declined further, to levels about 1-1/2 percentage points below March peaks. Reductions in inflation expectations and reports of a softer economy evidently contributed to the drop in rates in longer-term markets. The decrease in short-term rates lifted M2 to around the middle of its annual range in the latter part of the year. Efforts under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRRBA) to close insolvent thrift institutions and strengthen undercapi- talized thrifts led to a cutback of the industry's assets and funding needs. This behavior held down M3 growth in the second half of the year, and that aggregate ended the year around the lower end of its annual range. The restructuring of the thrift industry did not, however, seem to appreciably affect the overall cost and availability of residential mortgage credit, as other suppliers of this credit stepped into the breach. In the aggregate, the debt of nonfinancial sectors slowed somewhat, along with spending, to a rate just below the midpoint of its annual range. So far this year, the federal funds rate has remained around 8-1/4 percent, but rates on Treasury securities and longer-term private instruments have reversed some of their earlier declines. Investors have reacted to stronger-than-expected economic data, s runup in energy Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 33 prices/ and increasingly attractive investment opportunities abroad, especially in Europe. Tha Ultimata Objective* and Medium-Term Strategy of Monetary Policy Monetary policy was conducted again last year with an eye on long-run policy goals, and economic developments in 1989 were consistent with the Federal Reserve's medium-term strategy for reaching them. The ultimate objective of economic policy la to foster the maximum sustain- able rate of economic growth, This outcome depends on market mechanisms that provide incentives for economic progress by encouraging creativity, innovation, saving, and investment. Markets perform these tasks moat effectively when individuals can reasonably believe that by forgoing consumption or leisure in the present they can reap adequate rewards in the future. Inflation insidiously undermines such confidence. It raises doubts in people's minds about the future real value of their nominal savings and earnings, and it distorts decision-making. Faced with inflation, investors are more likely to divert their attention to protecting the near-term purchasing power of their wealth. Modern-day examples of economies stunted by rapid inflation are instructive. In countries with high rates of inflation, people tend to put their savings in foreign currencies and conovodities rather than in the financial investments and claims on productive assets that can best foster domestic growth. By ensuring stable prices, monetary policy can play its most important role in promoting economic progress. The strategy of the Federal Open Market Committee (FOMC) for moving toward this goal remains the same—to restrain growth in money and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 34 -4- aggregate demand in coming years enough to establish a clear downward tilt to the trend of inflation and inflation expectations, while avoiding a recession. Approaching price stability may involve a period of expan- sion in activity at a rate below the growth in the economy's potential, thereby relieving pressures on resources. Once some slack develops, real output growth can pick up to around its potential growth rate, even as inflation continues to trend down. Later, as price stability is approached, real output growth can move still higher, until full resource utilization is restored. While these are the general principles, no one can be certain what path for the economy would, in practice, accompany the gradual approach to price stability. One key element that would minimize the costs associated with the transition would be a conviction of partici- pants in the economy that the anti-inflation policy is credible, that is, likely to be effective and unlikely to be reversed. Stability of the general price level will yield important loag- run benefits. Nominal interest rates will be reduced with the disap- pearance of expectations of inflation, and real interest rates likely will be lower as well, as less uncertainty about tbe future behavior of overall prices induces a greater willingness to save. Higher saving and capital accumulation will enhance productivity, and the trend growth in real GNP will be greater than would be possible if the recent inflation rate continued. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 35 If past patterns of monetary behavior persist, maintaining price stability will require an average rate of M2 growth over tiaie approxi- mately equal to the trend growth in output. During the transition, the decline of market interest rates in response to the moderation in infla- tion would boost the public's demand for M2 relative to nominal spending, lowering H2 velocity. M2 growth over several years accordingly may show little deceleration, and it could actually speed up from time to time, as interest rates decline in fits and starts. Hence, the FOMC would not expect to lower its M2 range mechanically each and every year in the transition to price stability. This qualitative description of our medium-term strategy is easy to state, but actually implementing it will be difficult. Unexpected developments no doubt will require flexible policy responses. Any such adjustments will not imply a retreat from the medium-term strategy or front ultimate policy goals. Rather, they will be mid-course corrections that attempt to keep the economy and prices on track. The easing of reserve pressures starting last June is a case in point. Successive FQMC decisions to ease operating policy were intended to forestall an economic downturn, the chances of which seemed to be increasing as the balance of risks shifted away from greater inflation. The FOMC was in no way aban- doning its long-run goal of price stability. Instead, it sought finan- cial conditions that would support the moderate economic expansion judged to be consistent with progress toward stable prices. In the event, out- put growth was sustained last year, although in the fourth guarter a major strike at Boeing combined with the first round of production cuts Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 36 -6- in the auto industry accentuated the underlying slowdown. On the infla- tion aide, price increases in the second half were appreciably lower than those in the first. Although the CPI for January, to be announced tomor- row, probably trill show a sizable jump in energy and food prices in the wake of December's cold snap, a reversal is apparently underway. Monetary Policy and th« Kconomlc Outlook for 1990 Against this background, the Federal Reserve Governors and the Presidents of Reserve Banks foresee continued moderate economic expansion over 1990, consistent with conditions that will foster progress toward price stability over time. At its meeting earlier this month, the FOMC selected ranges for growth in money and debt it believes will promote this outcome. My testimony last July indicated the very preliminary nature of the tentative ranges chosen for 1990, given the uncertain outlook for the economy, financial conditions, and appropriate growth of money and debt. With the economic situation not materially different from what was anticipated at that time, the FCWC reaffirmed the tentative 3 to 7 per- cent growth range for M2 in 1990 that it set last July. This range, which is the same as that used in 1989, is expected by most FOMC members to produce somewhat slower growth in nominal GSP this year. The declines in short-term interest rates through late last year can be expected to continue to boost the public's demands for liquid balances in M2, at least for a while longer. M2 growth over 1990 thus may be faster than in recent years, and M2 velocity could well decline over the four quarters Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 37 of the year, absent a pronounced firming in short-term market interest rates. In contrast with M2, the range for M3 has been reduced from ita tentative range set last July. The new M3 range of 2-1/2 to 6-1/2 per- cent is intended to embody the same degree of restraint as the M2 range, but it was lowered to reflect the continued decline in thrift assets and funding needs now anticipated to accompany the ongoing restructuring of the thrift industry. This asset runoff began in earnest in the second half of last year, so its magnitude was not incorporated into the tenta- tive M3 range for 1990 set last July. The bulk of the mortgage and real estate assets that thrifts will shed are expected to be acquired by the Resolution Trust Corporation and diversified investors other than deposi- tory institutions. Such assets thus will no longer be financed by monetary instruments included in M3. In addition, commercial banks are likely to be more cautious in their lending activities, reducing their need to issue wholesale managed liabilities included in M3. These influences should retard the growth of M3 relative to M2 again this year. The debt of domestic nonfinancial sectors is expected to decele- rate along with nominal GNP for a fourth straight year, and the Committee chose to lower the monitoring range for this aggregate to 5 to 9 percent for 1990. Merger and acquisition activity has retreated from the fever- ish pace of recent years, reflecting some well-publicized difficulties of restructured firms and more caution on the part of creditors. All other things equal, less restructuring activity and greater use of equity Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 38 finance imply reduced corporate borrowing. An ebbing of growth in house- hold debt also seams probable. Over the last decade, money and debt aggregates have become less reliable guides for the Federal Reserve in conducting policy. The veloc- ities of the aggregates have ranged widely from one quartet or one year to the next, in response to interest rate movements and special factors. In the coming year, the effects of the contraction of the thrift industry on the velocity of M3, and to a lesser extent on that of M2, are espe- cially difficult to predict. While recognizing that the growth rates of the broader monetary aggregates over long periods are still good indica- tors of trends in inflation, the FOMC will continue to take an array of factors into account in guiding operating policy. Information about emerging patterns of inflationary pressure, business activity, and condi- tions in domestic and international financial markets again will need to supplement monetary data in providing the background for decisions about the appropriate operating stance. The Committee's best judgment is that money and dsbt growth within these annual ranges will be compatible with a moderation in the expansion of nominal G1W. Most FOMC members and other Reserve Bank pres- idents foresee real GNP growing 1-3/4 to 2 percent over the year as a whole. Such a rate would be around last year's moderate pace, excluding the rebound in agricultural output from the 1988 drought. A slight eas- ing of pressures on resources probably is in store. Inflation pressures should remain contained, even though the decline in the dollar's value over the past half-year likely will reverse some of the beneficial Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 39 effects on domestic inflation stemming from the dollar's earlier appreci- ation. The CPI this year ie projected to increase 4 to 4-1/2 percent, as compared with last year's 4-1/2 percent. Rifki to ttM tcononic Outlook Experience has shown such raacroeconomic forecasts to be subject to a variety of risks. Assessing the balance of risks between production shortfalls and inflation pressures in the current outlook is complicated by several cross-currents in the domestic and international economic and financial situation. One risk is that the weakness in economic activity evident around year-end may tend to cumulate, causing members' forecasts about production and employment this year to be overly optimistic. However, available indicators of neat-terra economic performance suggest that the weakest point may have passed. The inventory correction in the auto industry—a rapid one involving a sharp reduction in motor vehicle assemblies in January coupled with better motor vehicle sales—seems to be largely behind us. Industrial activity outside of motor vehicles appears to be holding up. Production of business equipment, where evi- dence has accumulated of some stability—if not an increase—in orders for capital goods, is likely to support manufacturing output in coming months. Housing starts were depressed in December by severely cold weather in much of the country. But starts bounced back strongly in January, in line with the large gain in construction employment last month. From these and similar data, one can infer the beginnings of a modest firming in economic activity. While we cannot be certain that we Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 40 -10- are as yet out of the recessionary woods, such evidence warrants at least guarded optimism. There are, however, other undercurrents that continue to signal caution. One that could disturb the attainability of the current eco- nomic expansion has been the recent substantial deterioration in profit margins. A continuation of this trend could seriously undercut the still expanding capital goods market. However, if current signs of an upturn in economic activity broaden, profit margins can be expected to stabi- lize. A more deep-seated concern with respect to the longer-run via- bility of the expansion is the increase in debt leverage. Although the trends of income and cash flow may have turned the corner, the structure of the economy's financial balance sheet weighs increasingly heavily on the dynamics of economic expansion. In recent years, business debt burdens have been enlarged through corporate restructurings, and as a consequence interest costs as a percent of cash flow has risen markedly. Responding to certain well-publicized debt-servicing problerasr creditors have become more selective in coamitting funds for these purposes. Within the banking industry, credit standards have been tightened for merger and LBO loans, as well as for some other business customers. Credit for construction projects reportedly has become less available because of FIRREA-imposed limits and heightened concerns about overbuild- ing in a number of real estate markets. Among households, too, debt-servicing burdens have risen to historic highs relative to income, and delinquency rates have moved up of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 41 -ii- late. Suppliers of consumer and mortgage credit appear to have tightened lending terms a little. Real estate values have softened in some locales, although prices have maintained an uptrend in terms of the national averages, especially for single-family residences. These and other financial forces merit careful monitoring. While welcome from a supervisory perspective, more cautious lending does have the potential for damping aggregate demand. It is difficult to assess how serious a threat increased lever- age is to the current levels of economic activity. Clearly, should the economy fall into a recession, excess debt service costs would intensify the problems of adjustment. But it is unlikely that in current circum- stances strains coming from the economy's financial balance sheet can themselves precipitate a downturn. As I indicated earlier, we expect nonfinancial debt growth to continue to slow from its frenetic pace of the mid-1980s. This should lessen the strain and hopefully the threat to the economy. International financial Mattatc and Monetary Policy Among other concerns, recent events have highlighted the complex interactions between developments in the U.S. economy and financial mar- kets and those in the other major industrial countries. Specifically, the parallel movements in long-term interest rates h«re and abroad over the early weeks of 1990 have raised questions: To what extent is the U.S. economy subject to influences from abroad? To what extent, as a consequence, have we lost control over our economic destiny? The simple answer to these questions is that the U.S. economy is influenced from Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 42 -12- abroad to a substantially greater degree than, say, two or three decades ago, but U.S. monetary policy is, nonetheless, able to carry out its responsibilities effectively. The post-war period has seen markedly closer ties among the world's economies. Markets for goods have become increasingly, and irreversibly, integrated as a result of the downsizing of economic output and the consequent expansion of international trade. The past decade, in particular, also has witnessed the growing integration of financial mar- kets around the world. Advancing technology has fostered the unbundling and transfer of risk and engendered a proliferation of new financial products. Cross border financial flows have accordingly accelerated at a pace in excess of global trade gains. This globalization of financial markets has meant that events in one market or in one country can affect within minutes developments in markets throughout the world. More integrated and open financial markets have enabled all countries to reap the benefits of enhanced competition and improved allocation of capital. Our businesses can raise funds almost anywhere in the world. Our savers can choose from a lengthening menu of investments as they seek the highest possible return on their funds. Our financial institutions enjoy wider opportunities to compete. In such an environment, a change in the expected rate of return on financial assets abroad naturally can affect the actions of borrowers or lenders in the United States. In response, exchange rates, asset prices, and rates of return all may adjust to new values. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 43 -13- Strengthened linkages among world financial markets affect all markets and all investors. Just as U.S. markets are influenced by devel- opments in markets abroad, foreign markets are influenced by events here. These channels of influence do not depend on whether a country is experiencing a deficit or a surplus in its current account. In today's financial markets, the net flows associated with current account sur- pluses and deficits ace only the tip of the iceberg. What are more important are the huge stocks of financial claims—more than $1.5 tril- lion held in the United States by foreigners and more than $26 trillion of dollar-denominated claims on U.S. borrowers held by U.S. residents. This is in addition to the vast quantities of assets held in foreign currencies abroad. It is these holdings that can respond to changes in actual and expected rates of return. In recent years we have seen several instances in which rates of return have changed essentially simultaneously around the world. For example, stock prices moved together in October 1987 and 1989, and in 1990 bond yields have risen markedly in many industrial countries. However, we must be cautious in interpreting such events, and in drawing implications for the United States. Frequently, such movements occur in response to a common worldwide influence. Currently, the world economy is adjusting to the implications of changes in Eastern Europe, where there are tremendous new opportunities to invest and promote reconstruction and growth. Those opportunities, while contributing to the increase in interest rates in the United States, also open up new markets fox our exports. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 44 -14- Moreover, despite globalization, financial markets do not necessarily move together—they also respond to more localized influ- ences. Over 1989, for example, bond yields in West Germany and Japan rose about a percentage point, while those in the United States fell by a similar amount. The contrast between 1989 and 1990 illustrates the com- plexity of relationships among financial markets. Interactions can show through in movements in exchange rates as well as interest rates, and changes in the relative prices of assets depend on a variety of factors, including economic developments and inflation expectations in various countries as well as monetary and fiscal policies here and abroad. The importance of foreign economic policies for domestic eco- nomic conditions has given rise in recent years to a formalized process of policy coordination among the major industrial countries. The purpose of such coordination is to help policymakers achieve better performance in their national economies. It begins with improved communication among authorities about economic developments within each country. It includes systematic analysis of the likely impact of these developments on the economies of the partner countries and on variables such as exchange rates that are inherently jointly determined in international markets. Within such a framework, it is possible to consider alternative choices for economic policies and to account explicitly for the impacts of likely policy measures in one country on the other economies. The influence of economic policies abroad and other foreign developments on the U.S. economy is profound, and the Federal Reserve must carefully take them into account when considering its monetary Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 45 -15- policy. But these influences do not fundamentally constrain oui ability to meet out most important monetary policy objectives. Developments within U.S. financial markets remain the strongest influence on the asset prices and interest rates determined by those markets and, through them, on the U.S. economy. Exchange rates absorb much of the impact of devel- opments in foreign asset markets, permitting U.S. interest rates to reflect prijnarily domestic economic conditions. Exchange rates influence the prices of products that do, or can, enter into international trade. Such factors can bring about changes in the composition of production between purely domestic goods and services and those entering inter- national trade, and they can affect aggregate price movements for a time, However, the overall pace of spending and output in the United States depends on the demands upon all sectors of the U.S. economy taken together. And our inflation rate, over time, depends on the strength of those demands relative to our ability to supply them out of domestic production. Because the Federal Reserve is able to affect short-term interest rates in D.S. financial markets, it is able to influence the pace of economic activity in the short-run and inflationary pressures longec-term- To be sure, monetary policy must currently balance more factors than in previous decades. But our goals are still achievable. Monetary policy is only one tool, however, and it cannot be used successfully to meet multiple objectives. The Federal Reserve, for example, can address itself to either domestic prices or exchange rates but cannot be expected to achieve objectives for both simultaneously- Monetary policy alone ia not readily capable of addressing today's large Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 46 -16- current account deficit, which is symptomatic of underlying imbalances among saving, spending, and production within the O.S, economy. Con- tinned progress in reducing the federal deficit is a more appropriate instrument to raise domestic saving and free additional resources for productive investment. The long-term health of our economy requires the balanced use of monetary and fiscal policy in order to reach all of the nation's policy objectives. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 47 For use at 10:00 a.m., E.S.T. Tuesday February 20,1990 Board of Governors of the Federal Reserve System " Monetary Policy Report to Congress Pursuant to the Full Employment and Balanced Growth Act of 1978 February 20, 1990 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 48 Letter of Transmittal BOARD OF GOVERNORS OF THE FEDERAL RESERVE SYSTEM Washington, D.C., February 20, 1990 THE PRESIDENT OF THE SENATE THE SPEAKER OF THE HOUSE OF REPRESENTATIVES, The Board ol Governors Is pleased to submit Its Monelary Policy Report to the Congress pursuant to the Full Employment and Balanced Growth Act of 1978. Sincerely, Alan Greenspan, Chairman Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 49 Table of Contents Page Section 1: Monetary Policy and the Economic Outlook for 1990 I Section 2: The Performance of Die Economy in 1989 4 Section 3: Monetary and Financial Developments During 1989 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 50 Section 1: Monetary Policy and the Economic Outlook for 1990 The U.S. economy recorded its seventh consecutive the first, and this measure ended the year only a little year of expansion in 1989, Although growth was below the midpoint of its range. slower than in the preceding two years, it was sufficient Thus far this year, the overnight rate on federal to support the creation of 2'/4 million jobs and to hold funds has held at %Vt percent, but other market rates the unemployment rate steady at 5W percent, the have risen. Increases of as much as Vi percentage point lowest reading since the early 1970s. On the external have been recorded at the longer end of the maturity front, the trade and current account deficits shrank specirum. The bond markets responded to indicators further in 1989. And while inflation remained undesir- suggesting a somewhat greater-than-anticipated buoy- ably high, the pace was less than many analysts-and, ancy in economic activity — which may have both indeed, most members of the Federal Open Market raised expected real returns on investment and re- Committee (FOMC}—had predicted, owing in part to newed some apprehensions about the outlook for infla- the continuing diminution in longer-range inflation tion. The rise in yields occurred in the context of a expectations. genera) runup in international capital market yields, which appears to have been in part a response to In 1989, monetary policy was tailored to the chang- emerging opportunities associated with the opening of ing contours of the economic expansion and the poten- Eastern Europe; this development had particularly tial for inflation. Early in the year, as for most of 1988, notable effecls on the exchange value of the West the Federal Reserve tightened money market condi- German mark, which rose considerably relative to the tions in order to prevent pressures on wages and prices dollar, the yen, and other non-EMS currencies. from building. Market rates of interesi rose relative to those on deposit accounts, and unexpectedly large tax payments in April and May drained liquid balances, Monetary Policy tor 1990 restraining the growth of the monetary aggregates in the first half of the year. By May, M2 and M3 lay below The Federal Open Market Committee is committed the lower hounds of the annual target ranges estab- to the achievement, over time, of price siability. The lished by the FOMC. importance of this objective derives from the fact that the prospects for long-run growth in the economy are Around midyear, risks of an acceleration in inflation brightest when inflation need no longer be a material were perceived to have diminished as pressures on consideration in the decisions of households and firms. industrial capacity had moderated, commodity prices The members recognize that certain short-term fac- hat! leveled out, and (he dollar had strengthened on tors—notably a sharp increase in food and energy exchange markets, reinforcing the signals conveyed by prices - are likely to boost inflation early this year, but the weakness in the monetary aggregates. In June, the anticipate that these factors will not persist. Under FOMC began a series of steps, undertaken with care to these circumstances, policy can support further eco- avoid excessive inflationary stimulus, that trimmed nomic expansion without abandoning Ihe goal of price 1 lh percentage points from short-term interest rates by stability. year-end. Longer-term interest rates moved down by a To foster the achievement of those objectives, the like amount, influenced by both the System's easing Committee has selected a target range of 3 to 7 percem and a reduction in inflation expectations. for M2 growth in 1990. Growth in M2 may be more Growth of M2 rebounded to end the year at about the rapid in 1990 than in recent years, and yet be consistent midpoint of the 1989 target range. Growth of M3, with some moderation in the rate of increase in nominal however, remained around the lower end of its range, income and restraint on prices; in particular, M2 may as a contraction of the thrift industry, encouraged by grow more rapidly than nominal GNPin the first part of the Financial Institutions Reform, Recovery, and En- this year in lagged response to last year's interest rate forcement Act of 1989 (FIRREA), reduced needs to movements. Eventually, however, slower M2 growth lap M3 sources of funds. The primary effect of the will be required to achieve and maintain price stability. shrinkage of the thrift industry's assets was a rechan- The Committee reduced the M3 range to 2 W to 6% neling of funds in mortgage markets, rather than a percent to take account of the effects of the restructur- reduction in overall credit availability; growth of the ing of the thrift industry, which is expected to continue nonfinancial sector debt aggregate monitored by the in 1990. A smaller proportion of mortgages is likely to FOMC was jusi a bit slower in the second half than in be held at depository institutions and financed by Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 51 Ranges of Growth for Monetary and Credit Aggregates 1988 1989 1990 Percent change, fourth quarter to fourth quarter M2 4 to 8 3to7 3107 M3 4 to 8 2</z to 614 Debt 7to11 6Vjto10Va 5to9 elements in M3; thrift institution assets should con- well as developments in financial and foreign exchange tinue to decline, as some solvent thrifts will be under markets. pressure to meet capital standards and insolvent thrifts will continue to be shrunk and closed, with a portion of Economic Projections for 1990 their assets carried, temporarily, by the government. The Committee members, and other Reserve Bank While some of the assets shed by thrifts are expected to presidents, expect that growth in the real economy will be acquired by commercial banks, overall growth in be moderate during 1990. Most project real GNP the asset portfolios of banks is expected to be moder- growth over the four quarters of the year to be between ate, as these institutions exercise caution in extending 1X and 2 percent—essentially the same increase as in credit. An increase in lender-and borrower— caution 1989, excluding the bounceback in farm output after more generally points to some slowing in the pace at the 1988 drought. It is expected that this pace of which nonfinancial sectors take on debt relative to their expansion will be reflected in some easing of pressures income in 1990. In particular, recent developments on domestic resources; the central tendency of fore- suggest that leveraged buyouts and other transactions casts is for an unemployment rate of5Vi to534 percent that substitute debt for equity in corporaie capital in the fourth quarter. structures will be noticeably less important in 1990 Certain factors have caused an uptick in inflation than in recent years. Moreover, a further decline in the early this year. Most notably, prices for food and federal sector's deficit is expected to reduce credit energy increased sharply as the year began, reflecting growth this year. In light of these considerations, the the impact of the unusually cold weather in December, Committee reduced the monitoring range for debt of However, these run-ups should be largely reversed in the nonfinancial sectors to 5 to 9 percent. coming months, and inflation in food and energy prices The setting of targets for money growth in 1990 is for the year as a whole may not differ much from made more difficult by uncertainty aboui developments increases in other prices. affecting thrift institutions. The behavior of M3 and, to Given their importance in determining the trend of a more limited extent, M2 is likely to be affected by overall costs, a deceleration in the cost of labor inputs such developments, but there is only limited basis in is an integral part of any solid progress toward price experience to gauge the likely impact. In addition, in stability. Nominal wages and total compensation have interpreting the growth of nonfinancial debi, the Com- grown relatively rapidly during the past two years, mittee will have to take into account the amount of while increases in labor productivity have diminished. Treasury borrowing (recorded as part of the debt With prices being constrained by domestic and interna- aggregate) used to carry the assets of failed thrift tional competition, especially in goods markets, profit institutions, pending their disposal. With these ques- margins have been squeezed to low levels. A restora- tions adding to the usual uncertainties about the rela- tion of more normal margins ultimately will be neces- tionship among movements in the aggregates and sary if businesses are to have the wherewithal and output and prices, the Committee agreed that, in incentive to maintain and improve the stock of plant implementing policy, they would need to continue to and equipment, consider, in addition to the behavior of money, indica- Unfortunately, the near-term prospects for amoder- tors of inflationary pressures and economic growth, as ation in labor cost pressures are not favorable. Com- Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 52 Economic Projections for 1990 FOHC Members and 1989 Actual Other FRB Presidents Administration Central Range Tendency Percent change, fourth quarter to fourth quarter Nominal GNP 6.4 4lo7 5Va to 6Vz 7.0 Real GNP 2.4 1 to 2V4 13/4 lo a 2.6 Consumer price index 4,5 3Va to 5 4 to 4Va 4.11 Average level in the fourth quarter, percent Unemployment rate 5.3 5Vz to 6V2 51/z to 53A 5.4 a 1. CPKW.FOMCforeCBslsareforCPMJ. 2. Percent at total labor (orce. including armed forces resting in the United States. pensation growth is being boosted in the first half of consumer price index, most members expect an in- 1990 by an increase in social security taxes and a hike crease of between 4 and 4V4 percent, compared with in the minimum wage. The anticipated easing of pres- the 4.5 percent advance recorded in 1989. sures in the labor market should help produce some Relative lo the Committee, the Administration cur- moderation in the pace of wage increases in the second rently is forecasting more rapid growth in real and half of 1990, but the Committee will continue to nominal GNP. At the same time, the Administration's monitor closely the growth of labor costs for signs of projection for consumer price inflation is at the low end progress in this area. of the Committee's central tendency range. In its Finally, the recent depreciation of the dollar likely Annual Report, the Council of Economic Advisers will constitute another impetus to near-term price argues thai, if nominal GNP were to grow at a 7 percent increases, reversing the restraining influence exerted annual rale this year-as the Council is projecting- by a strong dollar through most of last year. Prices of then M2 could exceed its target range, particularly if imported goods, excluding oil, increased in the fourth interest rates fall as projected in the Administration quarter after declining through the first three quarters forecast. As suggested above, monetary relationships of 1989. The full effect of this upturn likely will not be cannot be predicted with absolute precision, but the felt on the domestic price level until some additional Council's assessment is reasonable. And, although time has passed. most Committee members believe that growth in Despite these adverse elements in the near-term nominal GNP more likely will be between 5'/4 and picture, the Committee believes lhat progress toward 6 Vi percent, a more rapid expansion in nominal income price stability can be achieved over time, given the would be welcome if i) promised to be accompanied by apparently moderate pace of activity. In terms of the a declining path for inflation in 1990 and beyond. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 53 Section 2: The Performance of the Economy in 1989 Real GNP grew 2 lfi percent over the four quarters of goods and services increased 2 !4 percent over the four 1989, 2 percent after adjustment for the recovery in quaners of 1989, IVi percentage points less than in farm output from the drought losses of the prior year. 1988, Growth in real disposable income slowed last This constituted a significant downshifting in the pace year, but continued to outstrip growth in spending, of expansion from the unsustainably rapid rates of and, as a result, the personal saving rate increased to 1981 and 1988, which had carried activity to the point 5% percent in the fourth quarter of 1989. lhat inflationary strains were beginning to become The slackening in consumer demand was concen- visible in the economy. As the year progressed, clear trated in spending on goods. Real spending on durable signs emerged that pressures on resource utilization goods was about unchanged from the fourth quarter of were easing, particularly in the industrial sector. None- 1988 to the four* quarter of 1989-after jumping theless, the overall unemployment rate remained at 8 percent in the prior year—chiefly reflecting a slump 5.3 percent, the lowest reading since 1973, and infla- in purchases of motor vehicles. Spending on nondura- tion remained at 4 '/4 percent despite the restraining in- ble goods also decelerated, increasing only Vi percent fluence of a dollar Ihat was strong for most of the year. in 1989after a 2 percent advance in 1988. Trie principal The deceleration in business activity last year re- support to consumer spending came from continued flecled, to some degree, the monetary tightening from large gains in outlays for services. Spending on medi- early 1988 through early 1989 that was undertaken cal care moved up 7'A percent in real terms last year, with a view toward damping the inflation forces. Partly and now constitutes 11 percent of total consumption as a consequence of that lightening, the U.S. dollar expenditures—up from 8 percent in 1970. Outlays for appreciated in the foreign exchange markets from early other services rose 3 W percent, with sizable increases 1988 through mid-1989, contributing to a slackening in a number of categories. of foreign demand for U.S. products. At the same time, Sales of cars and light trucks fell % million units in domestic demand also slowed, more for goods than for 1989, to 14V4 million. Most of the decline reflected services. Reflecting these developments, the slow- reduced sales of cars produced by U.S.-owned auto- down in activity was concentrated in the manufacturing makers; a decline in sales of imported automobiles was sector; Factory employment, which increased a total of about offset by an increase in sales of foreign name- 90,000 over the first three months of 1989, declined plates produced in U.S. plants. The slowing in motor 195,000 over the remainder of the year, and growth in vehicle sales was most pronounced during the fourth manufacturing production slowed from 5Vi percent in quarter of 1989, reflecting a "payback" for sales that 1988 to only 134 percent last year. Employment in had been advanced into the third quarter and a rela- manufacturing fell further in January of this year, but tively large increase in sticker prices on !9<9Q-model that decline was largely attributable to temporary cars. Although part of this increase reflected the inclu- layoffs in the automobile industry and most of the sion of additional equipment—notably the addition of affected workers have since been recalled. passive restraint systems to many models -consumers As noted above, the rate of inflation was about the nevertheless reacted adversely to the overall increase same in 1989 as it had been in the preceding two years. in prices. Beyond these influences, longer-run factors While the appreciation of the U.S. dollar through the appear to have been damping demand for autos and first half of the year helped io hold down the prices of light trucks during 1989; in particular, the robust pace imported goods, the high level of resource utilization of sales earlier in ihe expansion seems to have satisfied continued to exert pressure on wages and prices. In thai demand pent up during the recessionary period of the regard, the moderation in the expansion of real aclivity early 1980s. The rebuilding of the motor vehicle slock during 1989 was a necessary development in establish- suggests that future sales are likely to depend more ing an economic environment more conducive to heavily on replacement needs. progress over time toward price stability. Residential investment fell in real terms through the first three quaners of 1989, and with only a slight The Household Sector upturn in the fourth quarter, expenditures decreaseri 6 percent on net over the year. Construction was Household spending softened significantly in 1989, weighed down throughout 1989 by the overbuilding with a marked weakening in the demand for motor that occurred in some locales earlier in the decade. vehicles and housing. Real consumer spending on Vacancy rates were especially high for multifamily Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 54 Real GNP Percent change, Q4 to 04 D rought-Adjusted 1984 1985 1966 1987 1988 1989 Industrial Production Index, 1977- JOO 160 Jan. 140 120 100 1984 1985 1986 1987 1988 1989 Implicit Deflator for GNP Percent change, Q4 to Q4 1964 1935 1986 1987 1988 1989 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 55 Real Income and Consumption Percent change, Q4 to Q4 glpReal Disposable Personal Income f[ Real Personal Consumption Expenditures 1984 1985 1986 1987 1988 1989 Personal Saving Percent of disposable income 1984 1985 1986 1987 1988 1989 Private Housing Starts Annual fate, millions of units, quarterly average 2.4 1.6 0.8 1984 1985 1986 1987 1966 1989 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 56 rental and condominium units. In the single-family which includes office buildings, was especially weak; sector, affordability problems constrained demand, vacancy rates for office space remain at high levels in dramatically so in those areas in which home prices had many areas, lowering prospective returns on new soared relative to household income. investment. Outlays for drilling and mining, which had Mortgage interest rates declined more than a percent- dropped 20 percent over the four quarters of 1988, age point, on net, between ihe spring of 1989 and the moved down further in the first quarter of 1989; later in end of the year, helping 10 arrest the contraction in the year, drilling activity revived as crude oil prices housing activity; however, the response to the easing in firmed. The industrial sector was the most notable rates appears to have been muted somewhat by a exception to the overall pattern of weakness: Real reduction in the availability of construction credit, outlays increased 11 percent in 1989, largely owing to likely reflecting, in part, the lightening of regulatory construction that had been planned in 1987 and 1988 standards in the thrift industry and the closing of a when capacity in many basic industries tightened sub- number of insolvent institutions. Exceptionally cold stantially and profitability was improving sharply. weather also hampered building late in the year, but a As noted above, the slowdown in investment spend- sharp December drop in housing starts was followed by a record jump inactivity last month. ing during the second half of last year likely was exacerbated by the deterioration in corporate cash flow. Before-tax operating profits of nonfmandal cor- The Business Sector porations dropped 12 percent from the fourth quarter of 1988 to the third quarter of 1989 (latest data Business fixed investment, adjusted for inflation, available); after-tax profits were off in about the same increased only 1 percent at an annual rate during the proportion. Reflecting the increased pressures from second half of 1989 after surging 1\ percent during labor and materials costs—arid a highly competitive the first half. Although competitive pressures forced domestic and international environment—pre-tax do- many firms to continue seeking efficiency gains through mestic profits of nonfinancial corporations as a share of capital investment, the deceleration in overall eco- gross domestic product declined to an average level of nomic growth made the need for capacity expansion 8 percent during the first three quarters of 1989, the less urgent, and shrinking profits reduced the availabil- lowest reading since 1982. At the same time, taxes as a ity of internal finance. share of pre-tax operating profits increased to an Spending on equipment moved up briskly during the estimated 44 percent in the first three quarters of 1989; first half of 1989, with particularly notable gains in since 1985. this figure has retraced a bit more than half outlays for information processing equipment—com- of its decline from 54 percent in 1980. puters, photocopiers, telecommunications device;,, and the like. However, equipment outlays were flat in the N'onfarm business inventory investment averaged second half of the year; growth in the information S21 billion in 1989. Although the average pace of processing category slowed sharply, and spending in accumulation last year was slower than in 1988. the most other categories was either flat or down. Pur- pattern across sectors was somewhat uneven. Some chases of motor vehicles dropped sharply in the fourth of the buildup in stocks took place in industries — such quarter from the elevated levels of the second and third as aircraft-whcre orders and shipments have been quarters. There were a few exceptions to the general strong for some time now. But inventories in some pattern of weakness during the second half- Spending other sectors became uncomfortably heavy at times on aircraft was greater in the second half of 1989 than and precipitated adjustments in orders and produc- in the first half, and would have increased still more tion. The clearest area of inventory imbalance at the had it not been for the strike at Boeing. Outlays for end of the year was at auto dealers, where stocks of tractors and agricultural machinery moved up smartly; domestically produced automobiles were at 1.7 mil- spending on farm equipment has been buoyed by the lion units in December—almost three months' supply substantial improvements over the past several years in at the sluggish fourth-quarter sales pace. In response, the financial health of the agricultural sector. Over the the domestic automakers implemented a new round of four quarters of 1989, ratal spending on equipment sales incentives and cut sharply the planned assembly increased 6 percent in real terms - about 1 percentage rate for the first quarter of 1990. Elsewhere in the point below the robust pace of 1988. retail sector, inventories moved up substantially rela- Business spending for new construction edged down tive to sales at general merchandise outlets. Overall, LA percent in real terms during 1989-the second however, most sectors of the economy have adjusted consecutive yearly decline. Commercial construction. fairly promptly to the deceleration in sales, and Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 57 Real Business Rxed Investment Percent change, O4 to Q4 40 ^|j Structures reproducers' Durable Equipment 20 20 1984 1985 1966 1987 1988 1989 Changes in Real Business Inventories Annual rate, billions of 1982 dollars 90 Total Norriarm 45 45 1984 1985 1986 1987 1968 1989 After-tax Profit Share oi Gross Domestic Product' Percent Nonfinancial Corporations 1984 1985 1986 1987 1988 1989 Ratio o( profits tram domestic operations with inventory valuation and capilaf consumption adjustments to gross domestic product o( nonfinancial corporal^ sector. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 58 appear to have succeeded in preventing serious over- early 1988 and mid-1989 appears 10 have played an hangs from developing. important role in inhibiting farther progress on the trade front. During the first three quarters of 1989, the The Government Sector current account, excluding the influence of capital gains and losses thai are largely caused by currency Budgetary pressures continued to restrain the growth fluctuations, showed a deficit of $106 billion at an of purchases at all levels of government. At die federal annual rate-somewhat below the $124 billion deficit level, purchases fell 3 percent in real terms over [he in the comparable period of 1988. four quartersof 1989, lower defense purchases account- Measured in (erms of the other Group of Ten ing for the bulk of the decline. Nondefense purchases currencies, the foreign exchange value of the U.S. also declined in real terms from the fourth quarter of dollar ift December 198(J was about 3 percent above its 1988 to the fourth quarter of 1989; increases in such leve] in December 1988, but the dollar has moved areas as the space program and drug interdiction were lower thus far in 1990, In real terms, the net apprecia- more than offset by general budgetary restraint that lion of the dollar during 1989 in terms of the other G-10 imposed real declines on most other discretionary currencies was about 5 percent, as consumer prices programs. rose somewhat faster here than abroad, on average. In terms of [he unified budget, the federal deficit in Over the year, the dollar moved lower on balance fiscal year 1989 was $152 billion, slightly smaller than against the currencies of South Korea, Singapore, and in 1988. Growth in total federal outlays, which in- especially Taiwan. From a longer perspective, the cludes transfer payments and interest costs as well as modest uptrend on balance in the dollar over the past purchases of goods and services, picked up a bit in two years marked a sharp departure from the substan- fiscal year 1989. Outlays were boosted at the end of the tial weakening seen during ihe 1985-1987 period. fiscal year by the initial $9 billion of spending by (he Resolution Trust Corporation. On the revenue side of The behavior of the dollar differed greatly between the ledger, growth in federal receipts aho increased in the two halves of 1989, In the first half, the dollar fiscal 1989. The acceleration occurred in the individual appreciated 12 percent in terms of (he other G-10 income tax category, but strong increases also were currencies, while depreciating against the currencies, recorded in corporate and social security tax payments. of South Korea and Taiwan. The dollar fluctuated during the summer, and later in the year unwound most Purchases of goods and services al the stateand local of the prior appreciation, as U.S. interest rates eased level increased 2 Vi percent in real terms over the four relative to rates abroad and in response to concerted quarters of 1989, down more lhan a percentage point intervention in exchange markets in the weeks imme- from the average pace of the preceding five years. diately after the September meeting of Group of Seven Nonetheless, (here were some areas of growth. Spend- officials and to events in Eastern Europe. In the second ing for educational buildings increased, and employ- half of ihe year, the dollar rose against the currencies of ment in the state and local sector rose 350.000 over the South Korea and Taiwan while depreciating in terms of year, largely driven by a pickup in hiring by schools. the Singapore dollar. Over the course of J9S9, the Despite the overall slowdown in the growth of pur- dollar appreciated nearly 16 percent again.si the Japa- chases, the budgetary position of the state and local nese yen and 14 percent against ihe Briij.sh pound, but it sector deteriorated further over the year; the annual- depreciated slightly against the German mark, the ized deficit of operating and capital accounts, which Canadian dollar, and most other major currencies. excludes social insurance funds, increased S6 billion over the firs! three quarters of 1989 and appears to have On a GNP basis, merchandise exports increased worsened further in ihc fourth quarter. about 11 percent in real terrm over !he four quarters of 1989 —roughly 4 percentage poims less than in 1988. This deceleration took place despite continued strong The External Sector growth in economic activity in most foreign industrial The U.S. external deficits improved somewhat in countries (wiih the exception of Canada and the United 1989, but not by as much as in 1988, On a bafance-of- Kingdom), and appears to have reflected, in large part, paymenls basis, the deficit on merchandise trade fell ihe effect on U.S. competitiveness of the dollar's from an annual rate of S128 billion in the fourth quarter appreciation and more rapid U.S. inflation over (988 of 1988 (and $127 billion for the year as a whole) to and much of 1989. Exports were also depressed in the $114 billion in the first quarter of 1989. Thereafter, fourth quartet of 1989 by a number of special factors there was no further net improvement. The apprecia- including the Boeing strike. The volumeof agricultural tion in the foreign exchange value of the dollar between exports increased about II percent in 1989-abit faster Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 59 Foreign Exchange Value of the U.S. Dollar * Index, March 1973.100 170 150 130 110 90 70 1984 1985 1986 1987 1988 1989 U.S. Real Merchandise Trade Annual rate, billions of 1982 dollars 600 EDO Imports / 400 300 Exports 200 100 1984 1985 1986 1987 1988 1989 U.S. Current Account Annual rate, billions of dollars 50 50 100 150 200 1984 1985 1986 1987 1988 1989 Index of weighted average foreign exchange value ol U.S. dollar in letms ol cutiendes ol Die oilier G-10 countries. Weights are 1972-76 global trade of each of the 10 countnes ' Average ot first three quarters of 1989, at an annual rale. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 60 even than the robust pace of 1988. The value of of "discouraged" workers-those who say they would agricultural exports rose much less, however, as agri- re-enter the labor force if they thought they could find a cultural export prices reversed the drought-induced job. Nor was there any net increase in workers who increases of the previous year. accepted part-time employment when they would have Merchandise imports excluding oil expanded about preferred full-time. The proportion of the civilian 7 percent in real terms during 1989, with much of the population with jobs reached an historic high. rise accounted for by imports of computers. Imports of Reflecting the tightness of labor markets and the oil increased 6 percent from the fourth quarter of 1988 persistence of inflation expectations in the 4 to 5 per- to the fourth quarter of 1989, to a rate of 8,3 million cent range, according to surveys, the employment cost barrels per day. At the same time, the average price per index for wages and salaries in nonfarm private indus- barrel increased almost 40 percent, and the nation's bill try increased 4M perceniover the 12 months of 1989- for foreign oil jumped 45 percent. about the same as in 1988. Benefit costs continued to The counterpart of the current account deficit of rise more rapidly than wages and salaries last year, $106 billion at an annual rate over the first three with health insurance costs remaining a major factor; quarters of 1989 was a recorded net capital inflow of nonetheless, the rate of growth in overall benefit costs about $60 billion at an annual rate and an unusually slowed in 1989, in part because of a smaller increase in large statistical discrepancy, especially in the second social security taxes than in J988. Total compensa- quarter. More than half of the recorded net inflow of tion-including both wages and salaries and benefits— capital reflected transactions in securities, as for- rose434 percent during 1989. Compensation growth in eign private holdings of U.S. securities rose nearly the service-producing sector—at 5 percent—continued £50 billion (half of the increase being in holdings of to outpace the gain in the goods-producing sector by U.S. Treasury securities), while U.S. holdings of about ^4 percentage point. foreign securities increased a bit less than $20 billion. Net direct investment accounted for another substan- A slowdown in the growth of productivity often tial portion of the inflow; foreign direct investment accompanies a softening in the general economy, and holdings in the U.S. rose more than $40 billion, and productivity gains were lackluster in 1989. Output per U.S. holdings abroad rose only half as much. Over the hour in the private nonfarm business sector increased first three quarters of 1989, foreign official assets in the only 'A percent over the four quarters of the year— United States increased almost $15 billion, but this 1 percentage point below the rate of increase in 1988. increase was more than offset by the increase in U.S. In the manufacturing sector, productivity gains during official holdings of assets abroad, largely associated the first half of 1989 kepi pace with the 1988 average of with U.S. intervention operations to resist the dollar's 3 percent; in the second half, however, productivity strength. growth slowed to an annual rate of 2 'A percent, Reflecting both the persistent growth in hourly com- pensation and the disappointing developments in pro- Labor Markets ductivity, unit labor costs in private nonfarm industry rose 5 percent over the four quarters of 1989-the Employment growth slowed in the second half of largest increase since 1982. 1989; nonetheless, nonfarm payrolls increased nearly 2'/i million during the year. The bulk of this expansion occurred in the service-producing sector. By contrast, Price Developments the manufacturing sector shed 100,000 jobs. These job losses were more than accounted for by declines in the Inflation in consumer prices remained in the neigh- durable goods industries, and appeared to reflect the borhood of 4'^ percent for the third year in a row, as slump in auto sales, the weakening in capital spending, the level of economic activity was strong and continued and the effecis of a stronger dollar on exports and to exert pressures on available resources. During the imports. first half of the year, overall inflation was boosted by a Despite the slowdown in new job creation, the sharp runup in energy prices and a cany-over from overall balance of supply and demand in the labor 1988 of drought-related increases in food prices. How- market remained steady over the year. The civilian ever, inflation in food prices slowed during the second unemployment rate, which had declined about K per- half, and energy prices retraced about a third of the centage point over the twelvemonths of 1988, finished earlier run-up. Prices for imported goods excluding oil 1989 at 5.3 percent—unchanged from twelve months were little changed over 1989, on net, and acted as a earlier. Moreover, there was no increase in the number moderating influence on consumer price inflation. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 61 Nonfarm Payroll Employment Net change, millions ol persona, O4 lo O4 |^j Man irfactu ring 1984 1965 1986 1987 1988 1989 Civilian Unemployment Rate Quarterly average, percent 19S4 1985 1986 1987 1988 1989 Employment Cost Index * 12-month percent change Total Compensation 1984. 1985 1986 1987 1968 1989 ' Employment Cost Index for privaia industry. «xdudtng (arm and household workers. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 62 GNP Fixed-weight Prices Percent change, Q4 to Q4 1984 1985 1986 1987 1988 1989 Producer Prices for Finished Goods Percent change, Q4 to Q4 1984 1985 1986 1987 1988 1989 Consumer Prices* Percent change, Q4 to CM 1984 1985 1986 1987 1988 1989 ' Consumer Price Index for all urban consumers. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 63 Food prices increased 5 V4 percent at the retail level, food and energy decelerated sharply, and this slow- slightly more than in 1988 when a number of crops down was particularly marked for some categories were severely damaged by drought. Continued supply where import penetration is high, including apparel problems in some agricultural markets in 1989—nota- and recreational equipment. Given the dollar's more bly a poor wheat crop and a shortfall in dairy produc- recent depreciation, however, the moderating effect of tion - likely prevented adeceleration from the drought- import prices on overall inflation may be diminishing. induced, rate of increase in 1988. At the same time, Indeed, prices for imported goods excluding oil turned increases in demand, including sharp increases in up in the fourth quarter of 1989, after declining earlier exports of some commodities, also appear to have in the year. In contrast to goods prices, the prices of played a role. Still another impetus to inflation in the nonenergy services—which make up half of the overall food area last year evidently came from [he continuing consumer price index—increased 5 'A percent in 1989. rise in processing and marketing costs. W percentage point more than in 1988. The pickup in this category was led by rents, medical services, and Consumer energy prices surged 17 percent at an entertainment services. annual rate during the first six months of 1989, before dropping back 6 percent in the second half. During the At the producer level, prices of finished goods first half of the year, retail energy prices were driven up increased 7 lfi percent at an annual rate during the first half-almost twice the pace of 1988- before slowing by increases in the cost of crude oil. The increase in gasoline prices at mid-year was exaggerated by the to a 2 'A percent annual rate of increase over the second, introduction of tighter standards governing the compo- half. In large part, developments in this sector reflected sition of gasoline during summer months. Gasoline the same sharp swings in energy prices that affected prices eased considerably in the second half, reflecting consumer prices. At earlier stages of processing, the index for intermediate materials excluding food and a dip in crude oil prices and the expiration of the energy decelerated sharply during the first half of the summer-time standards. Taking the twelve months of year, and then edged down in the second half. For the 1989 as a whole, the increase in retail energy prices year as a whole, this index registered a net increase of came to a bit more than 5 percent. Heating oil prices jumped sharply at the turnof the year, reflecting a surge only 1 percent, compared with more than 7 percent in 1988. The sharp deceleration in this category appears in demand caused by December's unusually cold weather. The spike in hearing fuel prices largely re- to have reflected a relaxation of earlier pressures on versed itself in spot markets during January of this capacity in the primary processing industries, and the year, but crude oil prices remained at high levels. influence of the rising dollar through the first half of last year. Also consistent with the weakening in the Consumer price increases for items other than food manufacturing sector and the strength of the dollar, the and energy remained at about 4Vj percent in 1989, index for crude nonfood materials excluding energy Developments in this category likely would have been declined 3% percent over the year, and spot prices for less favorable had the dollar not been appreciating in industrial metals moved sharply lower during the year, foreign exchange markets through the first half of owing in part to large declines for steel scrap, copper, 1989. The prices of consumer commodities excluding and aluminum. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 64 Consumer Food Prices * Pares rtt change, Q4 to 04 1934 1935 1986 1987 1988 1989 Consumer Energy Prices * Percent change, Q4 to 04 IS 15 I I 1964 1985 1936 1937 1988 1989 Consumer Prices Excluding Food and Energy * Percent change, Q4 to Q4 |j;p) Services Less Energy ^J Commodities Less Food and Energy 1984 1985 1986 1987 1988 1939 1 Consumer Price Indax foi all urban consumer. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 65 Section 3: Monetary and Financial Developments During 1989 In 1989, the Federal Reserve continued to pursue a however, moved up only moderately; the tightening policy aimed at containing and ultimately eliminating apparently had been widely anticipated and was viewed inflation while providing support for continued eco- as helping to avoid an escalation in underlying infla- nomic expansion. In implementing that policy, the tion. Real short-term interest rates—nominal rates Federal Open Market Committee maintained a flexible adjusted for expected price inflation-likely moved approach to monetary targeting, with policy respond- higher, though remaining below peak levels earlier in ing to emerging conditions in Hie economy and finan- the expansion; these gains contributed to a strengthen- cial markets, as well as to the growth of the monetary ing of the foreign exchange value of the dollar over this aggregates relative to their established target ranges. period, while the growth of the monetary aggregates This flexibility has been necessitated by the substantial slowed as the additional pol icy restraint reinforced the variability in the short-run relationship between ihe effects of actions in 1988. monetary aggregates and economic performance; how- As evidence on prospective trends in inflation and ever, when viewed over a longer perspective, those spending became more mixed in the second quarter, aggregates are still useful in conveying information theCommittee refrained from further tightening and in about price developments. June began to ease pressures on reserve markets. As As the year began, monetary policy was following the information on the real economy, along with the through on a set of measured steps begun a year earlier continued rise in the dollar, suggested that the outlook to check inflationary pressures. By then, however, for inflation was improving, mos! long-term nominal evidence of a slackening in aggregate demand, along interest rates fell as much as 3 percentage point from with sluggish growth of the monetary aggregates, their March peaks; the yield on the bellwether thirty- suggested that the year-long rise in short-term interest year Treasury bond moved down to about 8 percent by rates was noticeably restraining the potential for more the end of June. The decline in interest rates out- inflation. But, after a 'A percentage point increase in stripped ihe reduction in most measures of investors' the discount rate at the end of February, the Federal inflation expectations, so that estimaied real interest Reserve took no further policy action until June. Over rates fell from their levels of earlier in the year. These the balance of 1989, the Federal Reserve moved declines in nominal and real interest rates, however, toward an easing of money market conditions, as were not accompanied by declines in the foreign indications mounted of slack in demand and lessened exchange valueof the dollar. Rather, because of betler- inflation pressures. The easing in reserve availabil- than-expected trade reports and political turmoil ity induced declines in short-term interest rates of abroad, the dollar strengthened further. IVi percentage points; money growth strengthened In July, when the FOMC met for its semiannual appreciably, and M2 was near the middle of its target review of the growth ranges for money and credit, M2 range by the end of 1989. The level of M3, on the other andM3 lay at or a bit below the lower bounds of their hand, remained around the lower bound of its range, target cones. This weakness, reinforcing the signals with its weakness mostly reflecting the shifting pattern from prices and activity, contributed lo the Commit- of financial intermediation as the thrift industry re- tee's decision to take additional easing action in reserve trenched. The growth of nonfinancial debt was trimmed markets. The Committee reaffirmed Ihe existing an- to 8 percent in 1989, about in line with the slowing in nual target ranges for the monetary and debt aggregates the growth of nominal GNP, and ended the year at the and tentatively retained those ranges for the next year, midpoint of its monitoring range. since they were likely to encompass money growth that would foster hjrther economic expansion and modera- Implementation of Monetary Policy tion of price pressures in 1990. In the opening months of the year, the Federal Open Late in the summer, longer-term interest rates turned Market Committee excended the move toward restraint higher, as several economic data releases suggested that had begun almost a year earlier, seeking to counter reinvigorated inflationary pressures. With growth in a disquieting intensification of inflationary pressures. the monetary aggregates rebounding, the Committee Policy actions in January and February, restraining kept reserve conditions about unchanged until the reserve availability and raising the discount rate, direction of the economy and prices clarified. prompted a further H percentage point increase in Beginning in October, amid indications of added short-term market interest rates. Longer-term rates, risks of a weakening in the economic expansion, the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 66 Short-Term Interest Rates Percent 18 Monthly 16 14 12 10 Three-month Treasury bill Coupon equivalent 1982 1983 1984 1985 1966 1987 1988 1989 Long-Term Interest Rates Percent Monthly 18 16 14 12 Thirty-year Treasury bond ID 1982 1983 1984 1985 1986 1987 1988 1989 Observations are monlhly averages of daily data; laal observation for January 1990. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 67 FOMC reduced pressures on reserve markets in ihree with the efFectsof increases in 1988 and 1989 outweigh- separate steps, which nudged the federal funds ing the later, smaller, drop in rates. rate down to around 814 percent by year-end, about M2 has grown relatively slowly over the past three 1 'A percenfage points below its level when incremental years, as the Federal Reserve has sought to ensure tightening ceased m February. Over those ten months, progress over time toward price stability. There ap- other short- and long-term nominal interest rates fell pears to be a fairly reliable long-term link between M2 about 1 to 1W percentage points; and most major stock and future changes in inflation. One method of speci- price indexes reached record highs at the turn of the fying lhat link is to estimate the equilibrium level of year, more than recovering the losses that occurred on prices implied by the current level of M2, assuming October 13. Reflecting some reduction in inflation mat real GNP is at its potential and velocity is at its anticipations over the same period, estimated short- long-run average, and compare that to actual prices. and long-term real interest rates fell somewhat less The historical record suggests that inflation tends to than nominal rates, dropping probably about Vi to rise when actual prices are below the equilibrium level M percentage point. Still, most measures of short-and and to moderate when equilibrium prices are below long-term real interest rates remained well above their actual. At the end of 1986, the equilibrium level of trough levels of 1986 and 1987-leveU that had pre- prices was well above the actual level, reinforcing the ceded rapid growth in the economy and a buildup of view that the risks weighed on the side of an increase in inflationary pressures. inflation; at the end of 1989, that equilibrium price had Over the last three months of the year and into moved into approximate equality with the actual price January 1990, the foreign exchange value of the dollar level, indicating that basic inflation pressures had declined substantially from its high, which was reached steadied. around midyear and largely sustained through Septem- In 1989, compositional shifts within M2 reflected ber, The dollar fell amid concerted intervention under- the pattern of interest rates, the unexpected volume of taken by the G-7 countries in the weeks immediately lax payments in the spring, and the flow of funds out of after a meeting of the finance ministers and central thrift deposits and into other instruments. Early in the bank governors of these countries in September. The year, rising market interest rates buoyed the growth of dollar continued to decline in response to the easing of small-denomination time deposits at the expense of short-term interest races on dollar assets and increases more liquid deposits, as rates on the latter accounts in rates in Japan and Germany. The German currency adjusted only sluggishly to the upward market move- rate rose particularly sharply as developments in East- ments. The unexpectedly large tax payments in April era Europe were viewed as favorable for the West and May contributed to the weakness in liquid instru- German economy, attracting global capital flows. Ris- ments, as those balances also were drawn down to meet ing interest rales in Germany likely contributed to an tax obligations. As market interest rates fell, the increase in bond yields in the United States early in relative rate advantage reversed in favor of liquid 1990, even as U.S. short-term rates remained essen- instruments and the growth in liquid deposits re- tially unchanged. More important, however, for the bounded, boosted as well by the replenishment of rise in nominal, and likely real, long-term rates in the accounts drained by tax payments. United States were incoming data pointing away from The MI component of M2 was especially affected by recession in the economy and from any abatement in the swings in interest rates and opportunity costs last price pressures, especially as oil prices moved sharply year, and in addition was buffeted by the effects of higher. outsized tax payments in April. After its 4U percent rise in 1988, Ml grew only "A percent in 1989, with Behavior of Money and Credit much of the weakness in this transactions aggregate occurring early in the year. By May, Ml had declined Growth in M2 was uneven over 1989, with marked at about a 2V4 percent annual rate from its fourth- weakness in the firsl part of the year giving way 10 quarter 1988 level, reflecting a lagged response to robust growth thereafter. On balance over the year, M2 earlier increases in short-term interest rates and an expanded 4& percent, down from 5 W percent growth extraordinary bulgeinnet individual tax remittances lo in 1988, placing it about at the midpoint of its 1989 the Treasury. From May 10 December, Ml rebounded target range of 3 to 7 percent. The slower rate of at a 4 percent rate as the cumulating effects of falling increase in M2 reflected some moderation in nominal interest rates and post-tax-payment rebuilding boosted income growth as well as the pattern of interest rates demands for this aggregate. Ml velocity continued the and associated opportunity costs of holding money, upward trend that resumed in 1987, increasing in the Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 68 M2 and M3: Target Ranges and Actual Growth M2 Billions of doHars 3350 Rate of growth t988:4to1989:4 3250 4.6 percent 3150 3% 3050 2950 I L I I I I 1 2850 O N DJ F M A MJ J A 8 O ND 1988 1989 M3 Billions of dollars 4250 Rate of growth 7.5% 4150 1988:4 to 1989:4 3.3 percent 4050 3.5% 3950 3850 3750 J I 1 I L I 1 I I L 3650 O N DJ F M A MJ J A S O ND 1988 1989 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 69 Inflation Indicator Based on M2 Ratio scale Long-run equilibrium price level / f given current M2 (P*) , - ; — 50 1960 1966 1972 1978 1984 The current price level (P, the solid line) is the Implicit GNP deflator, which Is set to 100 In 1982. The long-run equilibrium price level given current M2 (P*, the dashed line) is calculated as P* - JM2 • V*)/Q*, where V* is an estimate of the long-run value of the GNP velocity of M2—the mean of V2 from 1955:1 to 1988:1—and Q* Is a Federal Reserve Board staff measure of potential real GNP. The vertical lines mark the quarters when the difference between the current price level (P) and the long-run equilibrium price level (P*) switches sign, and thus when inflation, with a lag, tends to begin accelerating or decelerating. For more details, see Jeffrey J. Hallman, Richard D. Porter, and David H. Small, M2 per Unit of Potential GNP as an Anchor for the Price Level, Staff Studies 157 (Board of Gover- nors of the Federal Reserve System. 1989). Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 70 first three quarters before turning down in the fourth and availability. The spread between the rate on pri- quarter of 1989. mary fixed-rate mortgages and the rate on ten-year Treasury notes rose somewhat early in the year, but The shift of deposits from thrift institutions to com- thereafter remained relatively stable. The share of mercial banks and money fund shares owed, in part, to mortgages held in securitized form again climbed in regulatory pressures that brought down rates paid by 1989, facilitating the tapping of a base of investors. some excessively aggressive thrifts. Beginning in Diversified lenders, acting in part through other inter- August, the newly-created Resolution Trust Corpora- mediaries, such as federally-sponsored agencies, tion (RTC) targeted some of its funds to pay down mostly filled the gap left by the thrifts. However, some high-cost deposits at intervened thrifts and began a program of closing insolvent thrifts and selling their shrinkage of credit available for acquisition, develop- deposits lo other institutions - for the most part, banks. ment, and construction appeared to follow from On balance, the weak growth of retail deposits at thrifts FIRREA-imposed limits on loans by thrifts to single appears to have been about offset by the shift jnto borrowers, though the reduction in funds available for commercial banks and money market mutual funds, ihese purposes probably also reflected problems in leaving M2 little affected overall by the realignment of some residential real estate markets. the thrift industry. Aggregate debt of the domestic nonfinancial sectors M3 was largely driven, as usual, by the funding grew at a fairly steady pace over 1989, averaging needs of banks and thrifts; under the special circum- 8 percent, which placed it near the midpoint of its stances of ihe restructuring of the thrift industry, it was monitoring range of 6'^ 10 ID1/; percent. Although the a less reliable barometer of monetary policy pressures annual growth of debt slowed in 1989, as it had dur- than is normally the case. After expanding 6 lk percent ing the preceding two years, it still exceeded the in 19S8, M3 bugged the lower bound of its 3l/i to 6'/2 percent growth of nominal GNP. Federal sector 7J/4 percent larger cone in 1989, closing the year about debt grew 7 ft percent, about!/; percentage point below 3W percent above its fourth quaner-1988 base. In the 1988 increase—and the lowest rate of expansion in 1989, bank credit growth about matched the previous a decade—as the deficit leveled off. Debt growth year's 7 li percent increase, but credit at thrift institu- outside the federal sector eased by more to average tions is estimated to have contracted a bit on balance S'-i percent, mostly because of a decline in the growth over the year, in contrast to its 6W percent growth in of household debt. Mortgage credit slowed in line with 1988. This weakness in thrift credit directly owed to the reduced pace of housing activity, and consumer asset shrinkage at SAIF-insured savings and loan insti- credit growth, though volatile from month to month, tutions; credit unions and mutual savings banks ex- trended down through much of the year. The growth of panded their balance sheets in 1989. In addition, funds nonfinancial business debt slipped further below the paid out by the RTC to thrift institutions and to banks extremely rapid rates of the mid-1980s. Corporate acquiring thrift deposits directly substituted for other restructuring continued to be a major factor buoying sources of funds. As a result, thrifts lessened their business borrowing, although such activity showed reliance on managed liabilities, as evidenced by the distinct signs of slowing late in the year as lenders 14% percent decline over (he year in the sum of large became more cautious and the use of debt to require time deposits and RPs at thrifts. Institution-only money equity ebbed. market mutual funds were bolstered by a relative yield The second half of 1989 was marked by the troubling advantage, as fund returns lagged behind declining deterioration in indicators of financial stress among market interest rates in the second half of the year; certain classes of borrowers, with implications for the these funds provided the major source of growth for the profitability of lenders, including commercial banks. non-M2 component of M3_ On balance, the effects of In the third quarter, several measures of loan delin- the thrift restructuring dominated the movements in quency rates either rose sharply or continued on an M3, and the rebound in M2 in the second half of the uptrend. Delinquency rates on closed-end consumer year did not show through to this broader aggregate. loans at commercial banks and auto loans at "captive" As a consequence, the velocity of M3 increased 3 auto finance companies were close to historically high percent in 1989, 1 'A percentage points faster than the levels. At commercial banks as a whole in 1989, both growth in M2 velocity, and its largest annual increase delinquency and charge-off rates for real estate loans in twenty years. were little changed from the previous year. Still, Many of the assets shed by thrifts were mortgages problem real estate loans continued to be a drag on the and mortgage-backed securities, but this appears to profitability of banks in Texas, Oklahoma, and Louisi- have had little sustained effect on home mortgage cost ana; in the second half, such loans emerged asa serious Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 71 Debt: Monitoring Range and Actual Growth Debt Billions of dollars Rate of growth 10.5% 1988:4 to 1989:4 9950 8.1 percent 9650 6.5% 9350 9050 J I 8750 O N DJ F M A MJ J A S O ND 1988 1969 M1: Actual Growth Mi Billions of dollars 840 Rate of growth 1988;4 to 1989:4 0.6 percent 760 I I I 720 O N DJ F M A MJ J A S O ND 1988 1989 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 72 Share of Residential Mortgage Debt Held as Securities Percent 35 Quarterly through 1989:3 30 25 20 15 10 1980 1981 1982 1983 19B4 1985 1986 1987 1988 1389 Rate Spread Between Primary Home Mortgages and Ten-year Treasury Bonds Percent Monthly 1980 1981 1982 1963 1984 1965 1986 1987 1988 1989 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 73 problem for banks in New England-On the other hand, center banks showing the sharpest turnaround. Infor- smaller, agriculturally oriented banks continued lo mation for the second half of 1989, although still recover from the distressed conditions of the mid- incomplete, clearly points to an erosion of these profit 1980s. Since 1987, agricultural banks have charged off gains, in part, because of problems in the quality of loans at well below the national rate, and their nonper- loans. Several money center banks sharply boosted forming assets represented a smaller portion of (heir their loss provisions on loans to developing countries, loans than that for the country as a whole. while evidence of rising delinquency rates on real The upswing in the profitability of insured commer- estate and consumer loans suggested more widespread cial banks that began in 1988 only extended through the weakening. Despite these developments, the spread of first half of 1989. A slowing ii\ the buildup of loan-loss rates on bank liabilities, certificates of deposit and provisions, along with improvemenls in interest-rate Eurodollar deposits, over comparable Treasury bill margins, contributed to these gains, with the money rates narrowed earlv in 1990. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 74 Growth of Money and Debt (Percent Change) Debt ol domestic nortfinancla) M1 M2 M3 sectors Fourth quarter to fourth quarter 1980 7.4 8.9 9.5 9.5 1981 5,4 (2.5)* 9.3 12.3 10.2 1982 8.8 9.1 9,9 9.1 1983 10.4 12,2 9.8 11.1 1984 5.4 7.9 10.6 14.2 1985 12.0 8.9 7.8 13.1 1986 15.5 9.3 9.1 13.2 1987 6.3 4.3 5.8 9.9 1988 4.3 5.2 6.3 9.2 1989 0,6 4.6 3.3 8.1 Quarterly growth rates (annual rates) 1989 Q1 -0.1 2,3 3.9 8.4 Q2 -4.4 1.6 3.3 7.9 Q3 1.8 6.9 3.9 7.2 Q4 5.1 7.1 2.0 8.0 in parentheses is adjusted for enitts to NOW accounts in 1981. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 75 Velocity of Money and Debt (Quarterly) M1 M2 Ratio scale Ratio scale 7.5 1.4 4.5 1.2 0.8 1961 1968 1975 1982 1989 1961 1968 1975 1982 1989 M3 Debt Ratio scale Ratio scale 2 1 1.8 0,9 1.6 0.8 1.4 0.7 1.2 0.6 0.5 O.S 0.4 1961 1988 1975 1932 1989 1961 1968 1975 1932 1989 Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 76 RECORD, QF_POLj;_CX. ACTIOHS _0g THE OPEH- M&BKET _CCMJITTEE _ oft_Fgbruary 6-7,_ 1990 1. Ppmest ic_pjalicy^ directive The information reviewed at this meeting suggested continued but sluggish expansion in overall economic activity, with conditions uneven across sectors. Industrial activity remained weak, partly because of the depressing effects of an inventory correction on manufacturing output, while the service-producing sector of the economy continued to grow moderately. Aggregate price measures had increased more slowly over most of the second half of 1989, but unusually cold weather in December put temporary upward pressure on food and energy prices. The latest data on labor compensation suggested no significant change in prevailing trends. Total nonfarm payroll employment increased substantially in January aftet growing at a reduced pace on average in previous months. Employment surged in the service-producing sector, and unusually warm weather brought a rebound in hiring in the construction industry. These increases more than offset a large decline in factory jobs associated with sizable short-term layoffs in the motor vehicle and related industries. The civilian unemployment rate remained at the 5.3 percent level that had prevailed over moat of 1969. Partial data for January indicated that industrial production fell sharply. Automobile producers cut back temporarily on assemblies to help reduce bulging inventories of unsold vehicles, and the January thaw in the weather apparently brought a reduction in the generation of Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 77 electricity that more than reversed a December surge- Abstracting from a number of transitory factors affecting production in recent months, industrial activity had changed little since the third quarter, although recent orders data suggested some underlying support for manufacturing output over the near term. Total industrial capacity utilization remained at a relatively high level in the fourth quarter but was down somewhat from its level a year earlier. Adjusted for inflation, consumer spending was little changed in the fourth quarter. Strong gains in spending for services offset declines in purchases of consumer goods, especially new cars and light trucks. Although some of the strength in the services category reflected temporarily high energy-related expenditures, spending for medical and transportation services apparently remained strong throughout the fourth quarter. Near the end of the year, consumers responded positively to incentive programs introduced by automakers to reduce bloated inventories, and higher sales of domestically produced cars carried over to January. Residential construction in the fourth quarter was little changed from its third-quarter level, partly because December's unusually cold weather depressed single-family housing starts in that month. Multifamily starts remained at a low level as vacancy rates for such units moved still higher. Business capital spending, adjusted for inflation, declined in the fourth quarter because of strike activity in the aircraft industry and sharply lower outlays for motor vehicles. Spending for equipment other than motor vehicles and aircraft rose; sizable increases were registered for computers and communications equipment, and moderate Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 78 gains were evident for a wide variety of heavy machinery. A pickup toward the end of 1989 in new orders for equipment other than aircraft, and the return to work of striking aircraft workers, pointed to some improvement in equipment spending in the current quarter. Hon- cesidential construction activity apparently weakened a little in the fourth quarter, partly reflecting the persisting high vacancy rates for office and other commercial space. Manufacturers' inventories fell in December after moderate increases in the two previous months; for the fourth quarter as a whole, increases in factory stocks were well below those for previous quarters in 1989. By contrast, nonauto retail stockbuilding accelerated late in the year, and there were reports that inventory-sales ratios at general merchandisers were higher than desired. The nominal U.S. merchandise trade deficit rose slightly in November from a revised October level. For the two months together, the deficit was up substantially from the averages for both the third quarter and the first nine months of 1989. Total exports for the two- month period were little changed from their third-quarter level as a reduction in exports of aircraft, resulting from strike activity, offset moderate increases in a broad array of other products. Total imports increased rapidly in October-November, with imports of capital goods being especially strong. Indicators of economic activity in major foreign industrial countries were mixed during the fourth quarter of 1989. Growth continued strong in Japan, and most indicators pointed to Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 79 -4- renewed strength for Germany/ Italy, and France. By contrast, growth was sluggish in the United Kingdom and Canada. Producer prices for finished goods jumped in December, largely reflecting higher prices for energy products, most notably for heating oil. Abstracting from food and energy items, producer prices rose faster in December than in November, but the rate of increase in the fourth quarter as a whole remained at the reduced third-quarter pace. At the consumer level, prices rose somewhat more rapidly toward the end o£ 1989, and food and energy prices apparently increased substantially further in January. Among nonfood, non-energy categories, discounting o£ apparel and home furnishings was more than offset by a sharp rise in prices of new cars and by another month of sizable price increases for services. At its meeting on December 18-19, 1989, the Committee adopted a directive that called for a slight easing in the degree of pressure on reserve positions but that provided for giving equal weight to subse- quent developments that might require some easing or tightening during the intermeeting period. Accordingly, the Committee agreed that slightly greater or slightly lesser reserve restraint would be acceptable during the intermeeting period, depending on progress toward price stability, the strength of the business expansion, the behavior of the monetary aggregates, and developments in foreign exchange and domestic financial markets. The contemplated reserve conditions were expected to be consistent with growth of M2 and M3 over the four-month period from November 1989 to March 1990 at annual rates of about 8-1/2 percent and 5-1/2 percent respectively. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 80 Immediately after the Committee meeting, open market operations were directed toward implementing the slight easing in the degree of pressure on reserve positions called for by the Committee. Reserve conditions then remained essentially unchanged over the rest of the intermeeting period. Adjustment plus seasonal borrowing averaged a little more than $300 million for the intermeeting period; the volume was boosted by reserve shortfalls, borrowing by large banks over the long holiday weekends, and, in the latter part of the interval, borrowing by a sizabie bank whose normal access to liquidity had been impaired. The federal funds rate declined from about 8-1/2 percent at the time of tha December meeting to around 8-1/4 percent shortly thereafter; except for some firming in the last week of 1989 owing to reserve shortfalls and year-end pressures, the funds rate remained in the vicinity of that lower level. Other private short-term market rates also declined over the period, including a 1/2 percentage point drop in the prime rate to 10 percent, while Treasury bill rates increased somewhat. Yields on intermediate- and long-term debt instruments rose considerably over the intermeeting period. Some stronger-than- anticipated economic data and rising food and energy prices were interpreted in the financial markets as pointing away from recession and as suggesting little if any moderation in underlying inflation trends. Increases in interest rates abroad probably also had an influence on U.S. interest rates. Stock prices approached new highs at the start of the year but have fallen substantially since then. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 81 In foreign exchange markets, the trade-weighted value of the dollar in terms of the other G-10 currencies declined further over the intermeeting period, as monetary conditions abroad tightened somewhat on average while those in the United States eased slightly. The dollar's movements against individual currencies were mixed; most of its depreciation occurred against the German mark, which continued to be buoyed by developments in Eastern Europe, and against related European currencies. On net, the U.S. dollar remained relatively firm against the yen and the Canadian dollar; the latter declined sharply as Canadian short-term interest rates edged lower amid signs of slow growth in the Canadian economy and a consequent easing of inflation pressures. Growth of M2, measured on a benchmarked and seasonally revised basis, remained relatively strong in the fourth quarter of 1989; for the year, this aggregate expanded at a rate a little below the middle of the Committee's annual range. Partly as a result of further contraction in the assets and associated funding needs of thrift institutions, M3 grew more slowly in the fourth quarter and, for the year, expanded at a rate just below the lower bound of its annual range. In January, both of the broader aggregates increased at slower rates, A sharp drop in trans- actions deposits damped expansion of M2, even though retail-type savings deposits remained strong and money market funds evidently benefited from funds flowing out of weakening stock and bond markets. Growth of M3 in January slowed by less than that of M2. The staff projection prepared for this meeting suggested that the economy was likely to expand relatively slowly over the next several quarters. In the near term, production adjustments to eliminate excess Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 82 inventories, most notably in the motor vehicles industry, were expected to depress manufacturing activity and overall growth; some pickup in the expansion was anticipated after the inventory correction was completed, but final gales were projected to continue growing at a relatively sluggish pace. Homebuilding might rebound somewhat in the near term after being disrupted by December's cold weather, but prevailing interest rates and possible cutbacks in construction lending by thrifts likely would restrain residential construction activity throughout the year. The projection assumed that fiacal policy would be moderately restrictive and that net exports would make little contribution to growth of domestic production in 1990. The expansion of consumer demand would be damped by slow gains in employment and associated limited growth in real disposable incomes. With pressures on labor and other production resources expected to ease only gradually, little improvement was anticipated in the underlying trend of inflation over the next several quarters. In their discussion of the economic situation and outlook, the Committee members generally agreed that continuing growth in economic activity remained a reasonable expectation for the year ahead. Several observed that, on the whole, recent indicators of business conditions provided some assurance that the expansion was no longer weakening and indeed that a modest acceleration might be under way from the con- siderably reduced growth experienced in the fourth quarter. The members acknowledged that there were considerable risks, stemming mainly from the financial side, of a weaker than projected expaneion, and some did not rule out the possibility of a downturn. In the latter connection, Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 83 several commented that they had observed a sense of unease and fragility in the business and financial communities arising from such factors as declining profit margins/ heavy debt burdens, and problems in certain sectors of the financial markets that were contributing to greater caution on the part of lenders and a reduced availability of credit to some borrowers. With regard to the outlook for inflation, members remained generally optimistic that moderating pressures on labor and other resources would lead in time to a lower rate of inflation. However, most members saw little prospect that significant progress, if any, would be made in reducing the underlying rate of inflation in the quarters immediately ahead. Indeed, in part because of temporary pressures in the food and energy sectors, key measures of inflation might well register larger increases in the near term before turning down later. In keeping with the usual practice at meetings when the Committee establishes its longer-run ranges for growth of the monetary and debt aggregates, the members of the Committee and the Federal Reserve Bank presidents not currently serving as members had prepared projections of economic activity, the rate of unemployment, and inflation for the year 1990. In making these forecasts, the members took account of the Committee's policy of continuing restraint on demand to resist any increase in inflation pressures and to foster price stability over time. For the period from the fourth quarter of 1989 to the fourth quarter of 1990, the forecasts for growth of real GRP had a central tendency of 1-3/4 to 2 percent, a pace close to that experienced in 1989 excluding the direct effects of the rebound in farm output after Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 84 -9- the drought in 1988. Estimates of the civilian rate of unemployment in the fourth quarter of 1990 were concentrated in a range of 5-1/2 to 5-3/4 percent. The associated pressures on prices resulted in projected increases in the consumer price index centered on rates of 4 to 4-1/2 percent for the year, compared with a rise of 4-1/2 percent in 1989. Forecasts for growth of nominal GNP had a central tendency of 5-1/2 to 6-1/2 percent. The forecasts assumed that changes in the foreign exchange value of the dollar would not be of sufficient magnitude to have a significant effect on the economy or prices during 1990. In the Committee's discussion of developments bearing on the economic outlook, the members emphasized that despite indications of continuing growth in overall business activity, there were obvious areas of weakness in the economy, notably in manufacturing across much of the nation and in construction in many localities. Business sentiment appeared to have deteriorated in some areas, perhaps more than was justified by actual developments. While local business conditions were clearly uneven, business activity was generally characterized as growing on an overall basis in the various regions, including recent evidence of a modest pickup in some previously depressed parts of the country. With regard to individual sectors of the economy, the outlook for retail sales was clouded to some extent by the uncertain prospects for motor vehicles and the financial problems being experienced by some major retailers; nonetheless, in the context of expected further gains in disposable incomes, many members expected overall consumer spending to be relatively well maintained. Business inventories probably were falling in the current quarter, largely reflecting sharp declines in Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 85 -10- stocks of motor vehicles, but once the correction in that industry was completed, some renewed increases in overall inventory investment were anticipated in line with expanding sales. Current indicators suggested that business fixed investment might be reasonably well maintained, but it also was noted that overbuilding of commercial real estate in many areas would restrain overall nonresidential construction and more generally that depressed profits and cash flows could limit gains in business investment. Concerning the outlook for residential con- struction, conditions in local housing markets varied markedly and the prospects for the nation were difficult to assess, Negative develop- ments included higher mortgage interest rates, a reduced availability of financing for many developers, and the overhang of large inventories of housing units held by the Resolution Trust Corporation (RTC1. Nonetheless, housing demand was holding up in many areas and booming in a few, and on balance most members expected little change this year in overall expenditures for residential construction. A number commented that the prospects for exports were relatively bright; foreign demand was reported to be robust for many types of goods, and overall exports would be given some impetus over time by the depreciation of the dollar over the past several months. Turning to the outlook for inflation, members noted that broad measures of labor compensation did not suggest any lessening of pressures. Unit labor costs appeared to be rising at a faster pace recently than the underlying rate of inflation, squeezing profit margins. Commodity prices displayed mixed changes but generally remained on a high plateau. Business contacts and broader surveys Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 86 indicated a widespread expectation that the current rate of inflation would continue. Moreover, with higher social security taxes and a rising minimum wage adding to labor costs and earlier increases in producer food and energy costs not yet fully transmitted to retail prices, some measures of inflation were expected to show sharper increases over the near term. On the other hand, reports from a number of business contacts indicated that input prices, especially for raw materials, had stabilized or declined in recent months. More generally, a number of members commented that continued limited growth in business activity at a time of uncertainties and concerns associated with various financial problems and declining real estate values in many areas should contribute to some restraint in overall inflationary behavior. Against the background of the members' views on the economic outlook and in keeping with the requirements of the Full Employment and Balanced Growth Ret of 19T8 (the Humphrey-Hawkins Act), the Committee reviewed the ranges that it had established on a tentative basis in July 1989 for growth of the monetary and debt aggregates in 1990. The tentative ranges, which were unchanged from those for 1989, included expansion of 3 to 7 percent for M2 and 3-1/2 to 7-1/2 percent for M3, measured from the fourth quarter of 1989 to the fourth quarter of 1990. The monitoring range for growth of total domestic nonfinancial debt had been set at 6-1/2 to 10-1/2 percent, also unchanged from 1989. With regard to M2, on which much of the discussion was focused, a majority of the members concluded that retention of the tentative range of 3 to 7 percent would best assure the flexibility that the Committee was likely to need to implement its policy objectives during Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 87 -12- the year, ft staff analysis prepared for this meeting indicated that, were interest rates to remain near recent levels, a somewhat higher rate of M2 growth than had occurred in any of the past three years was likely to be consistent with some reduction in the expansion of nominal GNP. According to this analysis, the lagged effects of earlier declines in market interest rates would continue to boost K2 growth in the first part of 1990, and the velocity of M2 was likely to fall for the year as a whole. To the extent that the projected weakness in H2 velocity turned out to be correct, it implied M2 growth toward the upper end of the tentative range on the basis of the central tendency of the members' forecasts of nominal GNP. Given this outlook, an unchanged range for M2 still left considerable leeway for the Committee to embark on a more aggressive policy to restrain inflation, should developments during the year suggest an intensification of inflationary pressures or provide an opportunity to t.ilt the implementation of policy toward greater restraint and faster progress against inflation without impairing the lorwaid momentum of the economy. Thus, although the Committee recognized that o^er time lower ranges and slower M2 growth would be compatible with price stability, retention of the current range did rxot signal a diminished determination to move toward the objective of price •it abiJit-y. PrfifertTj'rea for slightly higher or somewhat lower ranges for M2 -iiM.' wE-rf- expressed. The arguments in favor of a higher range focused f.n • he •is'.;; of a wcaKci economy than was anticipated curront ly and the >•' Utlff) •-!(';•! i al jli( y ot iiioie maiifuvei ing room for an easing of short-run Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 88 -13- policy if such were needed to help avert a cumulative deterioration in economic activity. In those circumstances, faster monetary growth would not be inconsistent with the Committee's long-term commitment to price stability. Other members believed that a somewhat reduced range would allow adequate growth in M2 to sustain moderate expansion in economic activity and would provide a desirable signal of the System' s commitment to an anti-inflationary policy. In thi? connection, the credibility of the System's anti-inflationary policy was seen as an important channel for reducing inflationary expectations directly and thereby lessening the economic costs and time needed to achieve price stability. These members expressed concern that growth around the upper end of a 3 to 7 percent range might well preclude any progress in reducing inflation this year and might make it more difficult to achieve such progress later. For some of these members, however, a 3 to 7 percent range would be acceptable if its upper limit was viewed as a firm constraint on actual growth and if a clear explanation was made of the Committee's commitment to achieve price stability over time- Turning to the ranges for M3 and debt, most of the members indicated that they favored or could accept reductions from the tenta- tive ranges that had been adopted in July 1989 for this year. Some reduction in the range for M3 was thought to be consistent with an unchanged range for M2 for technical reasons associated with the restructuring of the thrift industry and related shrinkage in thrift institution balance sheets. Declines in thrift institution assets and associated funding needs, including liabilities in M3, now seemed likely to be larger in 1990 than had been anticipated last summer, reflecting Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 89 -14- continued efforts of solvent institutions to meet capital standards as well as the closing of insolvent institutions. Beyond that, while a reduction in the M3 range, especially if it was limited, might have little implication for policy, many members believed that the Committee should take advantage of every opportunity to reduce its ranges toward levels that were consistent with price stability. With regard to the monitoring range for total domestic nonfinancial debt, the members expected the expansion of such debt to moderate for a fourth year in 1990, in large measure because of anticipated reductions in debt creation associated with corporate merger arid acquisition activities but also because of some probable ebbing in the growth of household debt. The prospect of slower growth of debt was welcome, given concerns about strains associated with highly leveraged borrowers and high debt servicing obligations. A few members indicated a preference for retaining the somewhat higher ranges for M3 and debt that had been adopted on a tentative basis for this year. In their view, lowering those ranges would tend to send potentially confusing signals, raising questions as to why the M2 range was not reduced also. Also, disparate adjustments in the ranges for the various aggregates could foster an unwarranted impression of the precision with which the Committee felt it could evaluate the ranges. The members generally agreed that setting 1990 target ranges for M2 and particularly for M3 was rendered more difficult by un- certainty about developments affecting thrift institutions, especially given the relatively limited basis in past experience for gauging the likely impact of such developments. The establishment of an appropriate Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 90 -15- range for the growth of nonfinancial debt also was complicated by uncertainty about the extent to which Treasury borrowing would be used to carry the assets of failed thrift institutions as opposed to funding from financial-sector sources through the ETC, With these questions adding to the usual uncertainty about the relationship of movements in the aggregates to broad measures of economic performance, the Committee decided to retain the 4 percentage point width of the ranges. It also agreed that the implementation of policy should continue to take into account, in addition to monetary growth and its velocity, indications of inflationary pressures in the economy, the strength of business activity, and developments in domestic and international financial markets. At the conclusion of the Committee's discussion, a majority of the members indicated that they favored or could accept the M2 range for 1990 that had been established on a tentative basis in July 1989 and reductions of one percentage point and 1-1/2 percentage points respectively in the tentative ranges for M3 and nonfinancial debt. Accordingly, the Committee approved the following paragraph relating to its 1990 ranges for inclusion in the domestic policy directive: The Federal Open Market Committee seeks monetary and financial conditions that will foster price stability, promote growth in output on a sustainable basis, and contribute to an improved pattern of international transactions. In furtherance of these objectives, the Committee at this meeting established ranges for growth of M2 and M3 of 3 to 1 percent and 2-1/2 to 6-1/2 percent respectively, measured from the fourth quarter of 1989 to the fourth quarter of 1990. The monitoring range for growth of tuLal domestic nonfinancial debt was set at 5 to 9 percent for the year. The behavior of the monetary aggregates will continue to be evaluated in the light of progess toward price stability, movements in their velocities, and developments in the economy and financial markets. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 91 -16- Votes for this action: Messrs. Greenspan, Corrigan, fmgell, Boehne, Boykin, Johnson, Kelley, and LaHare. Votes against this action: Mi. Hoskins, Ms. Seger, and Mr, Stern. Messrs. Hosking and Stetn dissented because they wanted a lower range for M2, They were concerned that growth around the upper end of a 3 to 7 percent range would not be compatible with progress in reducing the rate of inflation this year. An upper limit of 6 percent would be preferable and would provide adequate room in their view for policy to foster sustained economic expansion- Mr. Hoskins also stressed the desirability of a predictable and credible monetary policy, which he believed should include persistent reductions in the ranges to levels that would be consistent with stable prices. The favorable effects of such a policy on inflationary expectations would tend to lessen the costs and also accelerate the achievement of price stability. Ms. Seger dissented because she believed that the M2 range should be raised to at least 3-1/2 to 1-1/2 percent. In her view the considerable downside risks to the expansion called for some added room to accommodate the possible need for a more stimulative policy and somewhat faster M2 growth than was contemplated by an unchanged range. In particular, a shortfall in aggregate demands during the first half of the year might well require some easing of policy aimed at countering developing weakness in the economy. In such circumstances, M2 growth somewhat above 7 percent would not be inconsistent with the Committee's anti-inflation objective. She could accept unchanged ranges for growth of M3 and nonfinancial debt, given the outlook foe somewhat slower expansion of both aggregates in relation to M2 than the Committee had anticipated in July 1989. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 92 Turning to policy implementation for the intermeeting period ahead, a majority of the members favored steady reserve conditions. Given indications of some pickup in activity from the latter part of 1989, such a policy offered the best prospects at this point of reconciling the Committee's objective of acceptable and sustained economic growth with that of some reduction over time in inflationary pressures on labor and other resources, A tightening of policy might have some advantages in terms of moderating monetary growth and improving inflationary expectations/ but in this view such a policy would incur too much risk of creating financial conditions that could lead to a weaker economy. Conversely/ significantly lower interest rates could have inflationary consequences in an economy that already was operating at relatively high employment levelsr partly through their effects on the dollar in the foreign exchange markets. Conditions in the economy and in financial markets, both in the United States and abroad, suggested that monetary policy needed to convey a sense of stability. Other members acknowledged that adjustments in monetary policy needed to be made with a special degree of caution in current circum- stances, but on balance they assessed the risks and the related advantages and disadvantages of a change in policy somewhat differently. In one view, the risks of a recession argued for a prompt adjustment toward somewhat less monetary restraint/ especially given the need to bolster relatively interest-sensitive sectors of the economy such as housing and motor vehicles. A differing view focused on the desir- ability of a somewhat tighter policy at this juncture, particularly in Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 93 -18- light o£ the outlook for relatively little progress against inflation as the business expansion tended to strengthen. One member gave special emphasis to the desirability of limiting M2 growth to a path closer to the middle of the Conmittee's range for 1990 to help assure that progress would be made this year in moderating inflationary pressures. In the Committee's consideration of possible adjustments to the degree of reserve pressure during the intermeeting period, a majority of the members supported a directive that did not contain any bias toward tightening or easing. They felt that a symmetric instruction was consistent at this point with their general preference for a stable policy and that an intermeeting adjustment should be made only in the event of particularly conclusive economic or financial evidence, including a substantial deviation in monetary growth from current expectations. One member who preferred a slightly tighter policy indicated that an unchanged policy that was biased toward restraint would be acceptable. Members noted that seasonal borrowing was likely to turn up from its January lows so that some increase in the total of adjustment plus seasonal borrowing would be associated with a given degree of reserve restraint and a given federal funds rate. It was understood that some increase in the borrowing assumption would be made at the start of the intermeeting period and that further adjustments might be made later during the period, subject to the Chairman's review. In keeping with the usual practice, persisting borrowings by troubled depository institutions that had not been classified as extended credit would be treated as nonborrowed reserves in setting target growth paths Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 94 -19- for reserves. More generally, in light of the uncertainties that were involved, the Manager would continue to exercise flexibility in his approach to the borrowing assumption. At the conclusion of the Committee's discussion, a majority of the members indicated that they favored or could accept a directive that called for an unchanged degree of pressure on reserve positions. Some firming or some easing of reserve conditions would be acceptable during the internetting period depending on progress toward price stability, the strength of the business expansion, the behavior of the monetary aggregates, and developments in foreign exchange and domestic financial markets. The reserve conditions contemplated by the Committee were eKpected to be consistent with growth of M2 and M3 at annual rates of around 7 and 3-1/2 percent respectively over the three-month period from December to March. The members agreed that the intermeeting range for the federal funds rate, which provides one mechanism for initiating consultation of the Committee when its boundaries are persistently exceeded, should be left unchanged at 6 to 10 percent. At the conclusion of the Committee's meeting, the following domestic policy directive was issued to the Federal Reserve Bank of Hew York: The information reviewed at this meeting suggests that economic activity is continuing to expand despite weakness in the industrial sector. Total nonfarm payroll employment increased substantially in January after growing at a reduced pace on average in previous months,- a surge in the service-producing sector and a weather-related rebound in construction were only partly offset by a large decline in the manufacturing sector. The civilian unemployment rate wag unchanged at 5.3 percent. Partial data suggest that industrial production in January was appreciably below its average in the fourth quarter. Adjusted for inflation, strong gains in consumer spending on Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 95 -20- services in the fourth quarter offset declines in consumer purchases of goods, especially motor vehicles. Unusually cold weather depressed housing starts appreciably in December, and residential construction in the fourth quarter was little changed from its third-quarter level. Business capital spending, adjusted for inflation, declined in the fourth quarter as a result of lower expenditures on motor vehicles and strike activity in the aircraft industry; spending on other types of capital goods was strong, however, and new orders for equipment picked up toward the end of the year. The nominal U.S. merchandise trade deficit widened in October-November from the third-quarter rate. Consumer prices had risen somewhat more rapidly toward the end of 1989, and prices of food and energy apparently increased substantially further in January. The latest data on labor compensation suggest no significant change in prevailing trends. Interest rates have risen in intermediate- and long-term debt markets since the Committee meeting on December 18-19; in short-term markets, the federal funds rate has dsclined, and other short-term rates show mixed changes over the period. In foreign exchange markets, the trade-weighted value of the dollar in terms of the other G-10 currencies declined further over the intermeeting period; most of the depreciation was against the German mark and related European currencies, and there was little change against the yen. Growth of M2 slowed in January, almost entirely reflecting a drop in transaction deposits. Growth of M3 also slowed in January as assets of thrift institu- tions and their associated funding needs apparently continued to contract. For the year 1989, M2 expanded at a rate a little below the middle of the Committee's annual range, and M3 grew at a rate slightly below the lower bound of its annual range. The Federal Open Market Committee seeks monetary and financial conditions that will foster price Stability, promote growth in output on a sustainable basis, and contribute to an improved pattern of inter- national transactions. In furtherance of these objectives, the Committee at this meeting established ranges for growth of M2 and M3 of 3 to 7 percent and 2-1/2 to 6-1/2 percent respectively, measured from the fourth quarter of 1989 to the fourth quarter of 1990. The monitoring range for growth of total domestic non- financial debt was set at 5 to 9 percent for the year. The behavior of the monetary aggregates will continue Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 96 -21- to be evaluated in the light of progress toward price level stability, movements in their velocities, and developments in the economy and financial markets. In the implementation of policy for the immediate future, the Committee seeks to maintain the existing degree of pressure on reserve positions. Taking account of progress toward price stability, the strength of the business expansion, the behavior of the monetary .aggregates, and developments in foreign exchange and domestic financial markets, slightly greater reserve restraint or slightly lesser reserve restraint would be acceptable in the intermeeting period. The contemplated reserve conditions are expected to be consistent with growth of M2 and M3 over the period from December through March at annual rates of about 1 and 3-1/2 percent respectively. The Chairman may call for Committee consultation if it appears to the Manager for Domestic Operations that reserve conditions during the period before the next meeting are likely to be associated with a federal funds rate persistently outside a range of 6 to 10 percent. Votes for the paragraph on short-term policy implementation: Messrs. Greenspan, Corrigan, Angel1, Boehne, Johnson, Kelley, LaWare, and Stern. Votes against this action: Messrs. Boykin and Hoskins and Ms. Seger. While taking account of the various elements of weakness and fragility in the economy, Mr. Boykin dissented because he preferred a policy directive tilted toward increased reserve pressures should economic and financial conditions warrant. This view was based on his concerns regarding the lagged effects of policy actions and the risks of delaying decisions until there was full confirmation of inflationary pressures. In this context, Mr. Boykin expressed his preference for dealing promptly with inflation if the Committee wished to make progress toward its long-stated goal of lowering the rate of inflation. Mr. Hoskins dissented because he preferred some firming of reserve conditions. He recognized that there was some financial Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 97 -22- fragility in the economy, but he believed that underlying inflation pressures were relatively strong and that the balance of risks pointed to a need for greater monetary restraint to curb such inflation. He emphasized the desirability of tightening monetary policy gradually to reduce monetary growth to a pace closer to the midpoint of the Coranittee's range for the year. Ms. Seger's dissent reflected a preference for some easing of reserve conditions at this point. In her view, even a limited decline in interest rates would provide timely assistance to relatively weak, interest-sensitive sectors of the economy such as housing and motor vehicles and would tend to sustain the expansion itself without adding to inflation risks in the economy. 2. Review of Continuing Authorj^zatj.giis The Committee followed its customary practice of reviewing all of its continuing authorizations and directives at this first regular meeting of the Federal Open Market Committee following the election of new members from the federal Reserve Banks to serve for the year beginning January 1, 1990. The Committee reaffirmed the authorization for foreign currency operations, the foreign currency directive, and the procedural instructions with respect to foreign currency operations in the forms in which they were currently outstanding. Votes for this action: Messrs. Greenspan, Corrigan, Angell, Boehne/ Boykin, Hoskins, Johnson, Kelley, LaHare, Ms. Seger and Mr. Stern. Votes against this action: Hone. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 98 -23- 3 . Authorization jor jjpmestic ppeji_Markgt_ Operations On the recommendation o£ the Manager for Domestic Operations, the Committee amended paragraph 1(a) of the authorization for domestic open market operations to raise from $6 billion to $8 billion the limit on intermeeting changes in System account holdings Of U.S. government and federal agency securities. The increase was the first permanent change in the limit- since March 1985 when it was rai?ed from $4 billion to $6 billion. The Manager indicated that temporary increases had been authorized more frequently in recent years and that the existing limit also was approached more often during intermeeting intervals when no temporary increase was requested. A permanent increase to $8 billion would reduce the number of occasions requiring special Committee action, while still calling needs for particularly large changes to the Committee's attention. The Committee concurred in the Manager's view that a §2 billion increase would be appropriate. Accordingly, effective February 6, 1990, paragraph 1 (a) of the authorization for domestic open market operations was amended to read as follows: 1, The Federal Open Market Committee authorizes and directs the Federal Reserve Bank of New York, to the extent necessary to carry out the most recent domestic policy directive adopted at a meeting of the Committee: (a) To buy or sell U. S. Government securities, including securities of the Federal Financing Bank, and securities that are direct obliga- tions of, or fully guaranteed as to principal and interest by, any agency of the United States in the open market, from or to securities dealers arid foreign and international accounts maintained at the Federal Reserve Bank of New York, on a cash, regular, or deferred delivery basis, for the System Open Market Account at market prices, and, for such Account, to exchange maturing U. S. Government and Federal agency securities with the Treasury or the individual agencies or to allow them to mature without replacement; provided that the aggregate amount of U. S. Government and Federal agency securities held in such Account (including forward commitments) at the close of business on the day of a meeting of the Committee at which action is taken with respect to a Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis 99 -24- domestic policy directive shall not be increased or decreased by more than $8.0 billion during the period commencing with the opening of business on the day following such meeting and ending with the close of business on the day of the next such meeting; Votes £or this action: Messrs. Greenspan, Corrigan, Rngell, Boehne, Boykin, Hoskins, Johnson, Kelley, LaHare, Ms. Seger and Mr. Stern. Votes against this action: None. Digitized for FRASER http://fraser.stlouisfed.org/ Federal Reserve Bank of St. Louis

Alan Greenspan (1990, February 19). Congressional Testimony. Testimony, Federal Reserve. https://whenthefedspeaks.com/doc/testimony_19900220_chair_conduct_of_monetary_policy_report_of

@misc{wtfs_testimony_19900220_chair_conduct_of_monetary_policy_report_of,
  author = {Alan Greenspan},
  title = {Congressional Testimony},
  year = {1990},
  month = {Feb},
  howpublished = {Testimony, Federal Reserve},
  url = {https://whenthefedspeaks.com/doc/testimony_19900220_chair_conduct_of_monetary_policy_report_of},
  note = {Retrieved via When the Fed Speaks corpus}
}