Statement by Gary H. Stern, President, Federal Reserve Bank of Minneapolis, before the Committee on Banking, Housing, and Urban Affairs, U.S. Senate, March 10, 1993.

I appreciate this opportunity to discuss with you economic conditions in the Ninth Federal Reserve District and my views on monetary policy. Largely by avoiding the swings of the national economy, the Ninth Federal Reserve District's economy has grown steadily but unspectacularly since 1985. In 1985 the nation was expanding, but the District was still affected by problems in its natural resource-based industries. Now, the District's economy is somewhat stronger than the nation's. In recent years, while the nation's economy was sluggish, the Ninth District's economy--less affected by reductions in defense spending and falling commercial real estate prices--grew at a faster rate.

UNSPECTACULAR BUT STEADY

Close to three-fourths of Ninth District business leaders responding to a poll conducted by the Federal Reserve Bank of Minneapolis last fall said their communities' economies were doing better than the nation's. Personal income growth since the trough of the 1990-91 recession supports their observations: Income in the District's four complete states grew faster than in the nation.(1) And in 1992 the District's banks, buoyed by favorable interest rate spreads and strong demand for residential loans, had their best year in a decade. This performance is in marked contrast to March 1985, when the nation was in its ninth quarter of recovery, but the District's states, except Minnesota, were expanding more slowly than the nation. In fact, between the fourth quarter of 1982 and the first quarter of 1985, South Dakota, North Dakota, and Montana ranked forty-fourth, forty-eighth, and forty-ninth respectively in annual growth. During this time the District's banks mirrored the real economy, especially in rural areas, and in 1986 banks had their worst performance in years.

The defense expenditure buildup of the mid-1980s and the commercial real estate expansion largely bypassed the Ninth District; therefore, when these industries suffered in the early 1990s, the region's performance did not deteriorate as much as the nation's.

The Ninth District's relative improvement, however, is more than the avoidance of the economic swings that have occurred nationally (indeed, the District has experienced its own cycles, particularly within its natural resource-based industries). My travels across the Ninth District and visits with its leaders, along with articles in the fedgazette, the Federal Reserve Bank of Minneapolis' regional business and economics newspaper, reveal considerable vitality and adaptability. Increased exports, growing output from industries created by new technologies, expanding tourism, and Canadian cross-border shopping have enabled the region to advance, despite persistent problems in its important natural resource-based industries.

MANY ACRES, MANY RESOURCES, FEW PEOPLE

The Ninth District covers a big area but has a small population. Montana, North Dakota, South Dakota, Minnesota, the Upper Peninsula of Michigan, and northwestern Wisconsin make up nearly 12 percent of the total land area of the United States but contain only 3 percent of its population.

Natural resource-based industries are important in the District but are no longer the driving force they once were. Still, these District industries produce about 16 percent of the nation's agricultural output, 11 percent of mining, and 9 percent of forest products. Such industries are especially important in the District's three western states, accounting for 26 percent of North Dakota's total output, 22 percent of Montana's, and 20 percent of South Dakota's.

These sectors--agriculture, mining and energy, and forestry--have long been important in the Ninth District, but, in general, they are no longer dynamic engines of growth. Instead, these sectors struggle to earn modest profits, maintain employment levels, and replace obsolescent machinery. Agriculture, along with mining and energy, went through a roughly parallel cycle of a 1970s surge followed by a 1980s slowdown and a weak recovery into the 1990s. The forest products sector has followed a different pattern but faces structural problems of its own.

AGRICULTURE'S IMPACT

The rural financial crisis was at its height in 1985. Concerns for the agricultural and rural economies dominated board of directors and advisory council sessions as well as many of my meetings across the District throughout the late 1980s.

Agriculture experienced wrenching adjustments in the 1980s. Good crop prices and low real interest rates led to the quadrupling of land prices between 1970 and 1980. But these factors turned negative in the 1980s and pushed agricultural profitability and land values into a slump. From 1980 to 1987, Ninth District land prices declined 35 percent to 60 percent, and foreclosures increased markedly.

Now the spate of bankruptcies is over. Farm incomes have climbed slowly from mid-1980s lows. Total agricultural debt dropped 30 percent from 1984 to 1990 as lenders wrote off and farmers paid down debt. Land prices stabilized and then rose; by 1992, unadjusted for inflation, they roughly had regained their 1984 levels.

But farm profitability remains tenuous and highly influenced by exchange rates and government support programs. At a recent meeting of our advisory council, one member noted that farmers are broken into two groups: well-capitalized and highly leveraged. Well-capitalized farmers who have not become highly leveraged make reasonable profits, continue to invest in new machinery and facilities, and service debt without problems. But those farmers who were highly leveraged in the early 1980s, even if they escaped liquidation, still face high debt loads, earn only minimal profits at current prices, and are unable to make substantial new investments.

Moreover, small rural towns continue to lose businesses as retailing moves toward larger regional centers. Similarly, the number of farm implement dealers and agricultural input suppliers shrank notably during the 1980s, putting further pressure on the economies of smaller towns.

PRESSURE ON PRICES AND EMPLOYMENT IN MINING AND ENERGY

As in agriculture, the metal mining and energy industries in the Ninth District have experienced financial pressures since the mid-1980s. Ninth District metal mines extract iron ore on the fringes of Lake Superior, copper in the same area and in Montana, and gold in South Dakota and Montana. Coal and oil production are important in both North Dakota and Montana.

Iron ore is by far the District's most important mining sector in terms of employment and value of output. Output grew through the 1970s, declined in the early 1980s, recovered somewhat by 1990, and is again in a slump. Iron mining employment in Minnesota has dropped about 20 percent since 1985. Our remaining ores are low grade and require expensive processing, making it hard for existing iron mines to compete with more recently developed high-grade sources in Latin America. The industry has cut costs, reduced staffing, improved technical efficiencies, and undergone financial restructuring.

Copper and gold are also important mining products in the Ninth District. These mines have important local employment and spending impacts in northern Wisconsin, the Upper Peninsula, western South Dakota, and Montana. Output and employment have been essentially stable over the past eight years in spite of fluctuating prices and limited profitability.

At present, both copper and gold prices are low; copper and gold mine layoffs have occurred recently in Michigan and South Dakota. Few new mines, which are capital-intensive and involve long lead times, are being developed because of current depressed prices. Some officials are concerned that employment and output may thus shrink as ore deposits in existing mines are exhausted.

In the 1970s, coal and oil development apparently faced a bright future in North Dakota and Montana. But these hopes slumped with falling oil prices in the 1980s. While coal production has remained relatively stable, oil output has declined, and both oil exploration and new coal mine development are at a virtual standstill.

EXCESS CAPACITY PLAGUES PAPER INDUSTRY

Since the mid-1980s, the forest products industries have faced problems somewhat different from those of agriculture and mining and energy. The paper industry in Minnesota, Wisconsin, and Michigan is an important source of employment and is value-added. In the late 1980s, we heard reports of substantial new construction or renovation of paper mills. But now the industry is in the middle of a long slump marked by excess capacity nationwide, stagnant prices, and limited profitability. Industry officials do not expect prices to recover for another three years, it was reported at our most recent advisory council meeting. Several mills have laid off workers and are running at less than capacity.

FORESTRY FACES SHRINKING RESOURCES AND TECHNOLOGICAL CHANGE

In Montana and western South Dakota, the forest products industry consists of traditional lumber production, with most timber cut from national forests. As in the Pacific Northwest, available timber supplies are shrinking because of depletion of stocks of mature trees and somewhat tighter environmental regulations. Prices bid for cutting rights are rising dramatically, and profits are squeezed tightly, even at current high lumber prices, according to directors' reports. This situation is apparently a long-term one; output and employment can be expected to continue to shrink. Although this particular sector is not large relative to the entire Ninth District economy, effects on employment and spending may be painful to some communities.

But at the eastern end of the District a whole new sector is emerging. The late 1980s saw substantial construction of plants that use new technology to produce plywood substitutes from what were considered low-value trees. Several such plants, built in Minnesota, Wisconsin, and Michigan over the past decade, are currently running at capacity.

DISTRICT AVOIDS DECLINE IN MANUFACTURING

While many natural resource-based industries were struggling, other District industries escaped the vagaries of national economic swings. This is especially true of defense spending and its effect on the District's manufacturing employment. Although several Ninth District communities were, and still are, vulnerable to base closings, defense spending cutbacks were expected to hit the Pacific, New England, and South Atlantic census regions the hardest. Likewise, Ninth District manufacturing employment was essentially unchanged over the past two years, while nationally it dropped by about 3.5 percent.

While defense orders have been shrinking, manufacturing exports have been increasing for the nation, and District manufacturers have been as successful as their national counterparts when it comes to exporting. Between 1987 and 1991 growth in manufactured exports totaled at least 55 percent in the District and nation.

Avoiding defense cutbacks' full brunt and participating in the export surge have not kept the Ninth District from plant closings and layoffs, but the region has been able to offset many of them. Over the years, Minneapolis-St. Paul has blossomed into a major computer manufacturing center. However, the bloom is now off; these firms have been laying off workers. Nevertheless, the Twin Cities still generates high-tech manufacturing jobs; during the last two years, the increase in instrument manufacturing jobs, primarily medical devices, offset the decrease in computer manufacturing jobs.

Outside Minneapolis-St. Paul, manufacturing is resilient as well. I periodically travel to Ninth District communities as part of my District Dialogue program, and in Aberdeen, South Dakota, and Eau Claire, Wisconsin, business leaders report that they have been able to attract firms to help compensate for major plant closings.

DISTRICT CONSTRUCTION EMPLOYMENT RISES AS NATION'S DECLINES

Ninth District construction, like manufacturing, is also resilient. Although Minneapolis-St. Paul's office vacancy rate rivals the nation's, commercial construction is expanding in Grand Forks, North Dakota, Rochester, Minnesota, and Sioux Falls, South Dakota. Moreover, some communities are experiencing a surge in residential construction. Western Montana, for example, is benefiting from an in-migration of West Coast residents. Thus, over the past two years Ninth District overall construction employment has risen about 1.5 percent, in contrast to its decline at the national level.

In services, as in manufacturing and construction, the Ninth District's performance recently surpassed the nation's. During the past two years, employment in services has increased about 4 percent in the region, well above the increase in the nation as a whole.

TELECOMMUNICATIONS BRINGS JOBS TO THE REGION

Service industries from outside the District are using advances in telecommunications to access the region's labor force. In the past twelve years, bank credit card processors, notably Citibank, have become a major South Dakota industry. They now account for about 5,000 jobs in Sioux Falls, 6 percent of the city's employment. These jobs are not limited only to the region's cities and towns; a Salt Lake City firm has hired farmers and rural residents in northeastern Montana to work out of their homes.

MORE PEOPLE TRAVEL TO DISTRICT

The Ninth District also has benefited from rising tourism. Part of this increase comes from the region's exposure in movies--Dances With Wolves and A River Runs Through It, for example. New attractions, such as the Twin Cities' Mall of America and casino gambling, are also pulling people into the region. Moreover, the dollar's decline has made U.S. travel attractive to foreigners.

CLOSER TIES TO CANADA HELPING BORDER COMMUNITIES

The Ninth District's proximity to Canada has also benefited the region. Although the impact of the U.S.--Canada Free Trade Agreement cannot be easily sorted out from exchange rates and other factors, a 1991 fedgazette poll revealed that Canadian business, particularly in border communities, had increased since the agreement's implementation. Furthermore, in my Dialogue trips to Grand Forks and Minot, North Dakota, and Great Falls, Montana, residents reported how Canadian shoppers are buoying these communities.

Last year, however, the Canadian dollar fell relative to the U.S. dollar, and at recent advisory council meetings, a slowing of cross-border traffic into North Dakota and Montana was reported. Moreover, the Canadian government has recently taken measures, such as tougher duty-free limits, to discourage cross-border shopping.

UNEMPLOYMENT DECLINES

The region avoided the full effect of the economic slowdown of the early 1990s, but the region's businesses have also taken advantage of the opportunities offered by changes in the economy. Consequently, the Ninth District has scored well on one important test for a regional economy--keeping its unemployment low. The United States essentially has the same unemployment rate today as it did in 1985, but unemployment rates have declined in Ninth District states.

While District unemployment rates have been declining, prices and wages have not been increasing as fast as they did nationally. Between 1985 and 1992, the Minneapolis-St. Paul consumer price index rose at a 3.3 percent annual rate, compared with about a 4 percent rate nationally. During the same period, hourly manufacturing wages increased more slowly in the District than they did nationally.

BANKING INDUSTRY IMPROVES WITH ECONOMY

As the District's economy improved, so did the banking industry. For example, the return on average assets (ROAA) of Ninth District banks more than doubled between 1986 and 1992. By 1986, the lagging effects of the 1981-82 recession, the mid-1980s agricultural slump, and problems with loans to developing countries had combined to weaken all types of banks, but agricultural banks were particularly stressed. However, by 1992, District banks reported their highest average ROAA in a decade.

In addition to the increased average ROAA for all District banks between 1986 and 1992, another measure of the solid improvement is a reduction in the number of banks reporting losses. Only seventeen banks reported losses for the first three quarters of 1992, about 2 percent of the District total, compared with 279 for 1986, or 20 percent of all banks.

RESIDENTIAL MORTGAGES DRIVE CURRENT LENDING GROWTH

As discussed earlier, 1986 was a year of retrenching for many banks, so it is not surprising that loan volumes were low. Loan growth then improved through 1988, but in 1990 and 1991 credit quality problems surfaced with commercial loans, in particular commercial real estate and highly leveraged transactions.

By 1992, loan growth had improved again, but the composition of loans changed and was more heavily weighted toward residential mortgages. Favorable long-term interest rates spurred a substantial volume of mortgage refinancings as well as new loans for purchases of new and existing residential real estate. Moderate growth occurred in multifamily residential lending and agricultural lending. Loans to businesses and financial institutions and nonresidential loans to individuals all declined in 1992. It is also interesting to note that banks participating in our seasonal borrowing program were more aggressive in making agricultural and small business loans than were those that did not participate. Also, despite recent concerns about banks investing in securities instead of making loans, District banks' proportion of securities, as a percent of total assets, was unchanged in 1992 from 1986.

ASSET QUALITY, INTEREST INCOME, AND CAPITAL IMPROVE

Concurrently with loan growth, asset quality has improved. The ratio of noncurrent loans to total equity peaked in 1986 and has been declining since then; loan-loss reserve coverage ratios have also improved since 1986; and net charge-offs to average loans have declined significantly since 1986, mirroring the trends of noncurrent loans to total loans and provision expense to average assets.

But also noteworthy was the improvement in 1992 net interest income, which is the difference between interest earnings and interest expense. Short-term interest rates have declined from mid-1991 levels, and banks substantially lowered rates paid on retail deposits, thus reducing banks' funding costs.

Bank capital levels have been rising, in part, because of stronger earnings performance and, in part, because of tougher risk-based capital rules. Also, total equity to assets has shown significant improvement since 1990.

BANKING INDUSTRY FACES RESTRUCTURING

The number of Ninth District banks declined 17 percent between the end of 1986 and the third quarter of 1992 (from 1,363 to 1,143). This reduction was caused by consolidation through acquisitions, by bank failures, and by changes in some states' laws that allowed affiliate mergers.

There have been thirty-four bank failures in the District since 1986, when problem bank numbers peaked, accounting for 14 percent of the reduction in banks.

VIEWS ON MONETARY POLICY

In the broadest sense, and taking a long-run perspective, the object of monetary policy is, it seems to me, to attain the highest possible living standards for our citizens over time. In order to give this goal operational meaning, the Federal Reserve, in my view, should seek to achieve, over time, maximum sustainable growth of real output.

My reading of the accumulated evidence on economic performance both here and abroad is that in the long run the most significant contribution monetary policy can make to achieving maximum sustainable growth in real output is to foster price stability. That is, I am convinced that in the long run, price stability goes hand in hand with sustained economic prosperity. The two goals are not antithetical, and, indeed, price stability is best thought of as a means to the end of sustained prosperity.

In the short run, we in the Federal Reserve may indeed find it appropriate to respond to incoming financial and economic information to keep the economy on, or to return it to, its potential growth path. But, it seems to me, our short-run response should in general be cautious because of uncertainty both about the state of the economy and about the effects of policy on the economy. Moreover, we need to avoid the problem of turning long-run policy into a sequence of short-run decisions. If followed, such an approach runs the risk of adopting a strategy that is persistently inflationary or contractionary, depending on conditions prevailing when it is adopted. (1.) The attachment to this statement is a available from the Federal Reserve Bank of Minneapolis, MN 55401.