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Monetary policy report to Congress.

Report submitted to the Congress on July 20, 1992, pursuant to the Full Employment and Balanced Growth Act of 1978(1)


Economic activity has increased on balance since the beginning of the year, but rather hesitantly in recent months, and inflationary pressures have continued to abate. Against this backdrop, and with money and credit exhibiting renewed weakness in the second quarter, the Federal Reserve has cased money market conditions twice--in April and again in early July. The descent of domestic interest rates, which began in 1989, has now carried nominal yields on many market instruments to the lowest levels in two or three decades.

In mid-February, when the Board presented its last semiannual report on monetary policy to the Congress, the economy seemed to be struggling to regain forward momentum. Growth had come almost to a standstill in the final quarter of 1991, and, while a hint of improvement was evident in some of the indicators that were available in mid-February, convincing signs of a strengthening of activity had not yet appeared. Moreover, in looking ahead at that time, growth seemed likely to continue to be retarded by the still incomplete resolution of major structural adjustments in a variety of sectors, financial and nonfinancial. Chief among those structural impediments were persistent problems in commercial real estate markets, budgetary stress at all levels of government, a downsizing of the defense industry, exceptional caution among financial intermediaries, and ongoing efforts of businesses and households to reduce the level of their indebtedness.

At the same time, however, considerable impetus to activity was thought to be already in train, partly as a result of the substantial easing of money market conditions that the System had implemented in the second half of 1991. Among other effects, the decline in short- and long-term interest rates was reducing debt-servicing obligations and was facilitating needed balance sheet restincturing by borrowers and lenders. In assessing the situation as of last February, the Board members and Reserve Bank presidents recognized that the uncertainties in the outlook were unusually large, but they believed that a moderate pickup in output from the especially sluggish pace of the fourth quarter of 1991, coupled with further improvement in underlying price trends, was the most likely prospect in 1992.

In the event, economic growth did move back into a moderate range in the first quarter of 1992. After keeping a tight grip on their expenditures during the holiday shopping season, consumers stepped up their spending sharply in early 1992; simultaneously, purchases of new houses soared, spurred in part by lower mortgage interest rates. An unusually mild winter also helped to buoy activity in January and February. Although businesses were able to accommodate much of the burst in spending through a drawdown of inventories, the rise in demand sparked a rebound in industrial output. Consumer sentiment, which had deteriorated in late 1991 and early 1992, began to tilt back up in late winter and early spring, and business executives expressed greater optimism. Economic growth, as measured by the annualized rate of change in real gross domestic product, moved up to 2 3/4 percent in the first quarter, the largest quarterly gain in more than three years.

The strength in final demand that seemed to be emerging in the early part of the year does not appear to have carried through the second quarter, however. Households, restrained by a soft labor market and the lack of significant gains in real income, clamped down on their spending after the burst early in the year; real consumption expenditures appear to have grown little, if at all, in the second quarter, and new home sales fell steadily from February through May. 1n addition, exports, which, over the past several years, had been an area of strength in the economy, showed little growth over the first five months of 1992. Although manufacturers boosted production in April and May, they tended to do so more by stretching the hours of their workers, rather than by adding employees to their payrolls. Declines in production became evident in the industrial sector in June, as firms apparently moved quickly to forestall unintended inventory accumulation. In the labor market, the data for May and June showed a disturbing rise in the unemployment rate, to a level of 7.8 percent. On the whole, the growth of total output in the economy likely was positive again in the second quarter--as it had been in each of the four preceding quarters. But, as the Federal Reserve had anticipated at the start of the year, the drag from ongoing structural adjustments has remained heavy.

Inflationary forces have been muted this year. Prices accelerated somewhat in the first quarter, but that flare-up proved to be short-lived, as increases in the consumer price index were small, on average, in the second quarter. The "core" rate of inflation, as measured by the change in the CPI excluding food and energy, averaged 3.8 percent at an annual rate in the first six months of 1992; this rate of rise was a little lower than the average rate of increase during 1991, and it was considerably less than the increase seen during 1990. With inflation expectations down appreciably from recent highs, and with firms striving to reduce their costs on all fronts, a trend toward gradual reduction in the rate of price increase appears to be well established at the present time.

Growth in the broad measures of money was quite weak in the second quarter, leaving both M2 and M3 in June below the lower bounds of their annual ranges. Measured from its average level in the fourth quarter of 1991, M2 increased at an annual rate of 1 1/2 percent through June, while M3 edged down at a rate of 1/4 percent over that same period. As is discussed in more detail below, the sluggishness of money during this period seemed to be more a reflection of changing patterns of finance than of restraint on nominal income growth. Still, private credit growth also was relatively slow, and, in the context of renewed softness in the incoming data on spending and production, the weakness in both money and credit added to concerns about the ongoing strength of the expansion.

In this environment, the System eased money market conditions slightly in April and implemented a reduction of 1/2 percentage point in the discount rate on July 2, along with a commensurate further casing of money market conditions. In total, short-term interest rates have declined about 3/4 of a percentage point since the beginning of the year. Longer-term rates backed up early in the year as the economic expansion appeared stronger than many people had expected, raising market concerns about a revival of inflationary pressures. However, in recent months many bond and mortgage rates have retraced their earlier increases. Broad indexes of stock prices have remained close to record levels. In foreign exchange markets, the weighted average value of the dollar, in terms of the currencies of other Group of Ten (G-I0) countries, appreciated until early March, but recent depreciation, occasioned primarily by a less robust outlook for the U.S. economy, has left the dollar somewhat below its 1991 year-end level.

Declining interest rates in recent years have contributed to sizable reductions in debt-service obligations, as both long- and short-term debt has been rolled over or refinanced at lower rates. In addition, lower long-term rates and high price-earnings ratios on stocks have encouraged businesses to reduce the interest rate risk and the uncertainty associated with short-term funding by relying more heavily on issuance of long-term debt and equity. Households also have taken advantage of lower rates to refinance existing debt, especially mortgages. In addition, over-leveraged households, facing uncertain income and employment prospects and wide spreads between rates charged on consumer credit and yields on monetary assets, have moved to limit debt growth.

The resulting improvements in the financial conditions of households and businesses are evident in several indicators: Delinquencies on consumer loans and home mortgages have declined, ratings for a number of firms have been upgraded, and yield spreads have narrowed on private fixed-income securities relative to Treasury obligations. Of course, not all parties have benefited from lower interest rates; households holding short-term deposits have experienced a sizable decline in interest income. On balance, however, lower interest rates have helped households and businesses strengthen theft balance sheets, thereby building a firmer financial foundation for future economic expansion.

Efforts to return to more sustainable leverage positions have contributed to slow expansion of the debt of nonfederal sectors in the first half of this year. Heavy borrowing by the federal government has kept total debt expanding at the lower end of the Federal Open Market Committee's (FOMC) monitoring range of 4 1/2 to 8 1/2 percent, based on current estimates. Depository credit remains especially weak, reflecting not only muted private loan demands, but also continued caution among depositories. Commercial banks no longer appear to be tightening their nonprice terms of lending, but the degree of credit restraint remains substantial and spreads between loan rates and the cost of funds remain unusually wide. Bank capital positions have improved substantially over the past year; nonetheless, banks are likely to continue working to bolster capital, partly as a consequence of incentives contained in the FDIC Improvement Act.

The contraction of depository credit has been mirrored by the meager advance in the monetary aggregates. This is seen clearly in M3, which includes most of the liabilities banks and thrift institutions use to fund loans and other assets. But M2 has also been affected. Banks and thrift institutions have not actively pursued deposit funding in light of weak loan growth, and retail deposit rates have fallen considerably over the course of the year. Consumers consequently have sought higher-yielding assets outside M2, including those in the capital market where--despite the greater risks involved--returns have appeared more attractive. In addition, given the wide deposit-loan rate spreads, some M2 holders likely have opted to pay down debt rather than to hold monetary assets.

The rechanneling of credit flows away from depositories and the associated sluggish money growth have not been entirely benign; many borrowers face higher costs and stricter terms of credit now than in the past at given levels of market interest rates. Nonetheless, weakness of the monetary aggregates has not been associated with a similar degree of restraint on aggregate demand. Indeed, growth in nominal spending has considerably outpaced that of M2 and M3; put differently, both monetary aggregates appear to have registered sizable increases in their income velocities in the first half of the year. The rise in M2 velocity is particularly notable, given the marked drop in short-term interest rates in the latter part of 1991. Ordinarily, velocity tends to fall for a time after a decline in short-term rates.

Monetary Objectives for 1992 and 1993

In reviewing the annual ranges for the monetary aggregates in 1992, the Committee noted the substantial uncertainties created by the unusual behavior of M2 and M3 velocity thus far this year. If portfolio shifts ebb and more normal relationships of depository credit to spending begin to emerge, growth of the monetary aggregates within the existing ranges would be consistent with the Committee's objectives for making progress toward price stability and fostering economic growth. However, it is unclear whether the forces giving rise to the unusual behavior of the aggregates will wane in coming months or continue unabated. Faced with these uncertainties, the Committee chose to retain the 2 1/2 to 6 1/2 percent range for M2 and the 1 to 5 percent range for M3 announced earlier this year for 1992.

The Committee also reaffirmed the existing 1992 monitoring range for the aggregate debt of domestic nonfinancial sectors. The more cautious attitudes toward borrowing that have damped credit growth this year, and the improving balance sheets of borrowers, should lay the groundwork for sustained economic expansion in years to come.

The ongoing structural changes in the financial system and the tentative nature of the recovery greatly complicated the task of choosing ranges for the coming year. The Committee recognized that the range for M2 probably would need to be reduced at some point to be consistent with the Federal Reserve's long-run objective of reasonable price stability. However, pending further analysis of the recent relationship of money stock movements to income and interest rates, the Committee chose to carry forward the 1992 ranges for the monetary aggregates and debt as provisional ranges for 1993.

Economic Projections for 1992 and 1993

The members of the Board of Governors and the Reserve Bank presidents, all of whom participate in the discussions of the Federal Open Market Committee, generally believe that the most likely scenario for the economy in the second half of 1992 is one in which real GDP increases at a moderate pace and job growth is sufficient to impart a downward tilt to the unemployment rate. In 1993, output growth is expected to pick up slightly further from the 1992 pace, bringing additional small reductions in the unemployment rate. Inflation will likely hold to a gradual downward trend over the next year and a half.

In quantifying their views of the prospects for economic growth, the Board members and Reserve Bank presidents ended up with forecasts that are somewhat stronger than those made in February. A large majority of them see the most likely outcome for this year as being one in which real gross domestic product rises 2 1/4 percent to 2 3/4 percent over the four quarters of 1992; the central tendency of the forecasts for 1993 spans a range of 2 3/4 to 3 percent. With regard to the unemployment rate, the central tendency of the governors' and Bank presidents' forecasts for the fourth quarter of 1992 covers a range of 7 1/4 to 7 1/2 percent, as compared with the second-quarter average of 7 1/2 percent; the corresponding central tendency range for the final quarter of 1993 is 6 1/2 to 7 percent.

The achievement of the projected GDP growth will depend in part on the progress in resolving the various structural adjustments noted earlier. In general, the Board members and Reserve Bank presidents believe that these structural problems will continue to exert negative drag on the economy in coming quarters, but that their force will gradually lessen. On that score, some of the recent trends have been encouraging. In the market for commercial real estate, which has been the most striking area of weakness in the economy in recent quarters, downward pressures on the prices of existing properties seem to have begun to diminish, and the rate of decline in new construction appears to be slowing. In addition, businesses and households also have made considerable progress in strengthening their finances, and even though that improvement evidently has not yet generated more expansive attitudes toward spending and investing, such a shift probably will be forthcoming at some point. An obvious risk in the outlook is that these, and the other, structural adjustments could persist with greater intensity than is anticipated; but, alternatively, a faster resolution of the structural problems--and a stronger pickup of the economy--is not out of the question either.

The governors and Bank presidents expect the rise in the consumer price index over the four quarters of 1992 to end up in the range of 3 to 3 1/2 percent. Although an increase of this magnitude is to the high side of that realized in 1991, inflation rates were held down last year by the unwinding of the oil price shock that had occurred in 1990. Core inflation this year is expected to be lower than it was in 1991, and most Board members and Reserve Bank presidents believe that sustained progress toward the containment of costs and a further easing of inflation expectations will keep the trend rate of price increase on a course of gradual slowing next year as well. With neither food nor energy prices anticipated to depart in any meaningful way from the broad trends of inflation, the total CPI is also expected to slow in 1993, to a range of 2 3/4 to 3 1/4 percent, according to the central tendency of the FOMC participants' forecasts.

Earlier this year, in the Economic Report of the President and the Budget, the Administration issued forecasts that showed nominal GDP growth in 1992 and 1993 that falls within the ranges anticipated by Federal Reserve officials. Consequently, there would appear to be no inconsistency between the System's plans for monetary policy and the short-term goals of the Administration.

Looking more toward the long term, the prospect of a sustained period of declining inflation, together with a resolution of the many structural problems that currently afflict the economy, suggests the opportunity for substantial economic gains and a broadening prosperity. The Federal Reserve, for its part, can best contribute to the achievement of those objectives by keeping its sight firmly on the long-run goal of price stability. But the longer-range progress of American living standards will depend on more than monetary stability. Sound fiscal policies and an open world trading system are essential if we are to enhance capital formation and achieve the greatest possible productivity of our human and physical resources.


After coming almost to a standstill in the final quarter of 1991, economic activity showed more vitality in the early part of 1992. Buoyed by a surge in final sales, real gross domestic product rose at an annual rate of 2 3/4 percent in the first quarter. Growth evidently slowed considerably in the second quarter; in that period, signs of softness began to surface once again in a number of the indicators. Most notably, industrial production and payroll employment turned down in June, after four months of increases, and, with an influx of jobseekers into the labor market, the civilian unemployment rate moved up sharply toward midyear, to a June level of 7.8 percent--about 3/4 of a percentage point above the rate at the end of 1991.

The first-quarter surge in final sales was largely a reflection of a firming of demand in the domestic economy. Consumer spending strengthened markedly in the opening months of the year, housing starts and home sales jumped, and business fixed investment increased for the first time in several quarters. In the second quarter, domestic demand appears to have risen further, but, on the whole, at a slower pace than in the first quarter. By contrast, the external sector of the economy, which had contributed appreciably to growth of the economy in 1990 and 1991, has provided little or no impetus to activity this year; exports have been limited recently by the continued sluggishness of many foreign industrial economies, and imports appear to have moved up after a couple quarters of flatness.

Although price movements were erratic from month to month in the first half of 1992, there was ample evidence that the underlying processes of disinflation still were at work. Wage increases moderated further, and productivity increases also contributed importantly to the containment of costs. The twelve-month change in the consumer price index excluding food and energy, a rough gauge of the underlying rate of inflation in the economy, dropped below the 4 percent mark; as recently as the first quarter of 1991, that measure had been running as high as 5 1/2 percent. The total CPI rose only 3 percent over the twelve months ended in June, held down by small increases in food and energy prices over that twelve-month period.

The Household Sector

Indicators of the economic health of households were mixed in the first half of 1992. Households continued to make gradual progress in reducing their debt burdens in the first half of the year, and the incidence of financial stress seemed to diminish. However, neither income nor wealth displayed the degree of vigor needed to sustain strength in household expenditures.

When the year began, consumer spending was a major question mark in the economic outlook. Consumer outlays for goods had weakened appreciably in the final quarter of 1991, and consumer confidence, which had gone into an alarming plunge during the autumn, continued to soften into early 1992. But--such pessimism notwithstanding-- consumers pushed expenditures up at a very rapid pace in January and raised them further in February; although spending softened in March, the rise in real consumption expenditures for the first quarter as a whole amounted to 5 percent at an annual rate, the strongest quarterly advance in four years. Purchases of durable goods rose briskly, and solid gains were also recorded for a wide range of non-durables. Given the size of those increases--and with housing sales also rising sharply in the early part of the year--it seemed for a time that the forces of expansion might be gathering considerable strength.

However, the first-quarter surge did not carry over into the spring. Indeed, it appears that real consumption expenditures probably were little changed in the second quarter as a whole. Nevertheless, a bright spot in the recent spending data has been the firmness of motor vehicle sales. After bottoming out in January at an annual rate of about 12 million units, the sales of cars and light trucks rebounded to a rate of about 12 1/2 million units in the next three months and then moved up further to a level of 13 3/4 million units in June. Although a portion of the recent strength in auto sales apparently is a reflection of increased business investment in motor vehicles, it also seems likely that households that have put off buying new cars and trucks in the past couple of years are now entering the market in greater numbers.

Real disposable personal income fell after the oil price shock of 1990 and then turned up in the spring of 1991. Growth since then has been positive in each quarter, but a bit erratic and, on average, relatively slow. The level of real income in the first quarter of this year was about 2 percent above the recession low of a year earlier; the average for April and May was up less than 2 percent from the level of a year ago. Growth of wage and salary income has remained sluggish this year, and interest income has continued to decline. By contrast, government transfer payments to individuals have continued to grow rapidly in recent quarters, buoyed, in part, by a rise in unemployment benefits. Starting in March, disposable income also was lifted by a change in tax withholding schedules that altered the timing of tax payments to some extent, delaying a portion of those payments until 1993.

A combination of restrained debt growth and lower interest rates has led to reductions in the debt-servicing burdens of households, although, measured relative to income, the repayment burden still is relatively high by historical standards. The incidence of financial stress among households also appears to have cased somewhat in the most recent quarters for which data are available. Delinquency rates on consumer loans and home mortgages, which rose sharply from mid-1990 to mid-1991, turned down in the second half of last year and declined further in the first quarter of 1992.

Real outlays for residential investment have been rising since the start of 1991. The first-quarter gain--l 13/4 percent at an annual rate--took outlays to a level close to 10 percent above that of a year earlier. Even so, spending gains over the year ended in the first quarter of 1992 recouped less than half of the sharp decline of the preceding four quarters.

For a brief time early this year, residential investment seemed to be picking up considerably more momentum. In the latter part of 1991, mortgage interest rates had dropped to their lowest levels in more than fifteen years, and the sales of new single-family houses, which had already been moving up at the end of last year, surged in January and remained strong in February. Reacting to the rise in demand--and aided by an unusually mild winter-- builders boosted the pace of single-family housing starts to the highest seasonally adjusted level in two years. In March, however, sales of new homes plummeted, and they weakened further in April and May. Starts also retreated; the number of single-family units started in the second quarter was 6 percent below the first-quarter average.

Several factors have affected the recent patterns of the housing indicators. The mild winter weather evidently permitted some starts to be undertaken a bit sooner than they otherwise would have been. In addition, a substantial backup of mortgage interest rates after January undoubtedly cut into demand to some degree; rates on thirty-year fixed-rate conventional mortgages rose from about 8 1/4 percent in mid-January to 9 percent by March and remained above 8 1/2 percent until June. Discussion of a possible tax credit for first-time homebuyers also appears to have raised demand temporarily.

Moreover, the recovery in housing activity probably has continued to be retarded to some degree by negative influences that were evident in 1991. A significant number of potential homebuyers are being deterred by concerns about jobs and incomes. Others now view the purchase of a home as being a riskier, less attractive investment than it once seemed, owing to the sharp declines seen in house prices in some regions in recent years and to the lack of much price appreciation more generally. High vacancy rates and unfavorable demographic trends continue to be formidable obstacles to recovery in the multifamily sector. By contrast, an increasingly favorable factor is the improved affordability of housing: Lower mortgage interest rates--in part a reflection of the less inflationary environment of recent years--have substantially reduced the size of the monthly payment associated with the purchase of a home, measured relative to personal income. In that regard, the latest round of cuts in mortgage interest rates, to the lowest level since 1973, appears to have stimulated some pickup in real estate activity very recently.

The Business Sector

When the year began, the business sector of the economy was still in the process of adjusting to the sluggishness of demand and the mild backup of inventories that had emerged in the second half of 1991. Industrial production, which had declined in the final two months of last year, fell further in January; assemblies of motor vehicles dropped sharply in that month, and cutbacks in output were reported in other industries as well. Those production cuts, coupled with the January surge in household spending, led to a reduction in business inventories, clearing away most of the excess stocks that had accumulated in the final four months of 1991.

Industrial production turned up in February, and, with orders and shipments trending up, additional gains followed in each of the next three months. Assemblies of motor vehicles rose considerably during this period and, by May, were at the highest level since the fall of 1990; although assemblies were reduced by a small amount in June, automakers have announced plans to step up assemblies in the third quarter. Production of consumer goods other than motor vehicles also increased moderately over the four-month period beginning in February; a small portion of those gains was reversed in June, however. Bolstered by strong gains in the production of office and computing equipment, output of business equipment (other than motor vehicles) rose in each month from February through June.

Manufacturing and trade inventories, measured in real terms, fell further in February. Thereafter, inventories appear to have risen somewhat, on net. In manufacturing, the level of inventories at the end of May was relatively low, compared to the level of sales. But, in parts of the trade sector, stocks may have been slightly higher than desired, and with household demand looking sluggish once again, some businesses may have felt it appropriate to pull back a bit on orders for additional merchandise, triggering the production adjustments that were evident in June.

Business profits, which came under considerable pressure during the recession, began rising noticeably in the latter part of 1991 and increased sharply in the first quarter of 1992. The before-tax economic profits of all U.S. corporations jumped 12 1/2 percent in the first quarter and were at the highest level since the first half of 1989. The profits of financial corporations have been boosted by sharp reductions in interest expenses and by a strengthening of their loan portfolios. The economic profits of nonfinancial corporations from their domestic operations also have been rising; in the first quarter of 1992, these profits, on a pre-tax basis, were more than 20 percent above their quarterly low of late 1990. That rise in profits was the result of small increases in volume, a moderate increase in the margin over unit labor costs, and substantial reductions in net interest expenses.

Stress has continued to be evident this year in several industries--notably retailing, airlines, and commercial real estate. Overall, however, corporate balance sheets have been strengthening. Issuance of equity by non financial corporations has been outstripping share retirements in recent quarters, after several years in which the balance ran markedly in the other direction. In addition, the growth of business debt has remained sluggish this year, as internal sources of funds have proved to be large enough to finance a subdued level of business investment. Lower bond yields have enabled firms to replace higher-cost debt and have encouraged a shifting out of short-term liabilities. Among farm businesses, income has dropped back from the relatively high levels of 1989 and 1990, and farmers have cut back on their investment in machinery and equipment. However, farmers' balance sheets appear to be considerably stronger at this point than they were in the mid-1980s, when the sector went through an extended period of severe financial stress.

Business fixed investment turned up in the first quarter of this year, after declining in each quarter from late 1990 to the end of 1991. Real outlays for equipment increased moderately in the first quarter, and business investment in new structures turned up, after five quarters of sharp declines. The second-quarter indicators that are in hand suggest that equipment spending probably increased enough to raise total real business fixed investment further in that period.

The first-quarter rise in equipment spending amounted to about 3 1/2 percent at an annual rate. Increased outlays for computers and related devices more than accounted for the first-quarter gain; spending for that type of equipment has been rising briskly since mid- 1991, boosted by product innovations, extensive price-cutting by computer manufacturers, and the ongoing efforts of businesses to achieve efficiencies through the utilization of new information-processing technologies. By contrast, spending for aircraft, which had been strong in 1990 and for most of 1991, has weakened substantially since last autumn; a first-quarter uptick in those outlays retraced only a small part of the fourth-quarter plunge. Business outlays for motor vehicles were down moderately in the first quarter, but they appear to have firmed in the second quarter. Spending for all other types of equipment, roughly half of which is industrial machinery, was down further in the first quarter in 1992, but at a much slower pace than in 1991. In total, equipment investment appears to be exhibiting the traditional lagged response to changes in aggregate economic activity, the recent pickup being supported by the rise in profits and increased cash flow.

Real outlays for nonresidential structures rose at an annual rate of 2 1/2 percent in the first quarter. Investment in industrial structures was up for the second quarter in a row, and increases also were reported for utilities, private educational facilities, and hospitals and institutions. However, spending for gas and oil drilling fell further in the first quarter, and the outlays for construction of office buildings continued to decline.

In total, the first-quarter level of spending for offices and other commercial structures was about 40 percent below the level of two years earlier, but there are tentative indications that the steepest part of this protracted decline may now be over. Although spending for the construction of office buildings has continued to fall rapidly this year, the outlays for commercial structures other than offices--a category that includes such things as warehouses, shopping malls, and other retail outlets--have changed little, on net, over the past several months. In addition, there are indications that the rate of decline in prices of existing commercial properties has slowed, and transactions in commercial real estate reportedly have picked up in some areas of the country this year.

The Government Sector

Government purchases of goods and services--the part of government spending that is included in gross domestic product--increased at an annual rate of 3 percent in real terms in the. first quarter of 1992, after declining about 1 1/2 percent over the four quarters of 1991. Federal purchases, which fell 3 percent last year, rose at an annual rate of about 1 percent in the first quarter; nondefense purchases moved higher, and the decline in defense purchases was smaller than those seen in previous quarters. State and local purchases, which had declined slightly over the course of 1991, were boosted in the first quarter of 1992 by a surge in the outlays for structures.

Budgetary problems continue to confront many governmental units. At the federal level, the unified budget deficit over the first eight months of fiscal 1992--the period from October to May--totaled $232 billion; this total was about $56 billion larger than the deficit recorded in the first eight months of the previous fiscal year. Federal receipts in the current fiscal year are up only 1 percent from the same period of a year earlier, while outlays have climbed about 7 1/2 percent. On the receipts side of the ledger, the income taxes paid by individuals have been damped by slow income growth, and, despite a pickup recently, the revenue from corporate profits taxes has been weak for the fiscal year to date. Receipts from excise taxes have risen considerably this fiscal year, but these do not account for a very large share of total federal revenue.

The sharp rise in federal spending this year partly reflects a diminished flow of contributions to the United States from our allies in the Gulf War; these contributions are counted as negative outlays in the federal budget, and their shrinkage therefore translates into a rise in recorded outlays. By contrast, spending has been held down this year by a reduction in outlays for deposit insurance programs. This reduction stems, in part, from delays in funding the activities of the Resolution Trust Corporation (RTC), the federal agency that is responsible for cleaning up the problems of insolvent thrift institutions.

Excluding the allied contributions and the spending for deposit insurance programs, federal outlays have risen about 5 1/2 percent this fiscal year. Federal financing of health care has continued to rise at a very rapid pace in fiscal 1992; grants to states for Medicaid, the fastest growing category in the health care budget, are running more than 30 percent above the level of a year ago. In addition, slow growth of the economy and actions taken to extend unemployment benefits have pushed federal spending for income support programs sharply higher, and outlays for social security have been boosted by cost-of-living adjustments and increases in the number of beneficianes. Combined federal spending for other functions has risen only slightly in nominal terms this fiscal year. The mix of this spending is changing, however. Outlays for some nondefense functions--notably law enforcement, education, and health programs other than Medicaid have risen fairly rapidly in fiscal 1992; outlays for defense have been cut back, even in nominal terms, once adjustment is made for the diminished flow of allied contributions.

Many state and local governments still are grappling with severe budgetary imbalances, and further progress toward correcting those imbalances was not evident in the first quarter of 1992. After four quarters in which state and local governments had managed to chip away steadily at the deep deficit in their combined operating and capital accounts, that deficit is estimated to have widened a little in the first quarter, to a total, excluding social insurance funds, of about $26 billion.

Last year's progress in reducing the combined state and local budget deficit was achieved partly through tax increases and partly through spending restraint. With deficits still large this year, legislators and administrators are facing yet another round of painful choices. Tax hikes have been implemented in some places this year, and efforts to curb spending appear to be widespread, even as the demands for many types of government services have continued to rise. Increases in the wages and benefits of state and local workers have slowed considerably in recent quarters, with wage freezes being imposed in some cases. Although state and local employment has risen a little in recent months, partly because of election activity, the cumulative growth in the number of state and local jobs over the past year has been quite sluggish, and some governments have furloughed workers temporarily in order to hold down expenditures. Against the backdrop of these widespread attempts to restrain spending, the substantial first-quarter rise in real state and local purchases may well have been a temporary bulge, rather than the harbinger of a renewed uptrend in state and local spending.

The External Sector

For the year to date, the foreign exchange value of the dollar, in terms of the currencies of the other Group of Ten (G-I0) countries, has declined somewhat, on balance, from its level at the end of 1991. Appreciation early in the year has been offset by subsequent depreciation.

From its low point at the end of 1991, the dollar appreciated through about mid-March, reaching a level nearly 9 percent above where it was at year-end. The dollar was lifted during this period by data pointing to increasing strength in the recovery of U.S. economic activity, which also worked to raise U.S. long-term interest rates relative to those in other countries. From mid-March through April, exchange rates fluctuated in a fairly narrow range. Beginning in May, however, the dollar began to decline as long-term interest rates eased, and as of mid-July, it had more than reversed the rise earlier in the year. The market's reassessment of the prospects for a strong U.S. economic recovery appears to have been a major factor underlying the declines in both the dollar and long-term rates.

Developments abroad reinforced these factors. The dollar rose sharply against both the Japanese yen and the German mark early in the year. Signs of further weakening of economic growth in Japan and the decline of the Japanese stock market worked to depress the yen. Reports of a decline in German output in the fourth quarter of 1991 and increasing expectations that the Bundesbank would not move further toward tightening German monetary policy contributed to the weakness of the mark. Beginning in late April, the dollar started to decline against the yen and the mark. News of a substantial widening of Japan's current account surplus and a belief that the Group of Seven nations supported appreciation of the yen contributed to a turnaround in the dollar's exchange rate against that currency. In Germany, economic activity proved stronger than expected in the first quarter and, along with rapid money growth in that country, led both to a reevaluation of the prospects for an early easing by the Bundesbank and to a rise in the mark.

On balance, the dollar declined more than 3 percent against the mark and was little changed against the yen from the start of the year to mid-July. The dollar appreciated against the Canadian dollar; with Canadian real GNP flat in the fourth quarter of 1991 and posting only a small rise in the first quarter of this year, Canadian authorities eased interest rates and appeared to welcome the associated decline in their currency as a way to help stimulate economic activity. By contrast, the dollar depreciated moderately against the currencies of major developing countries over the first half of 1992, after adjustment for movements in relative price levels.

Prices of U.S. non-oil imports accelerated to a 6 1/4 percent annual rate of increase in the first quarter of 1992, more than double the rate of rise in the fourth quarter of 1991. The jump in import prices most likely reflected the lagged effects of the depreciation of the dollar that occurred during the latter part of 1991. Most of the price increase of the first quarter was reversed in April and May. The price of oil imports declined 15 percent in the first quarter in response to strong OPEC production and warmer-than-normal weather. However, that oil price decline was reversed in the second quarter in response to production restraint by Saudi Arabia and to indications that the Kingdom may be prepared to target prices at a somewhat higher level.

With growth of the U.S. economy still on a relatively slow track, real merchandise imports remained about unchanged in the first quarter, after only a small increase in the fourth quarter of 1991. Increases in imports of capital goods in the first quarter were about offset by declines in imports of consumer goods. Data for April and May show the quantifies of imports of most categories of goods moving up noticeably from their first-quarter averages.

Export volume, which had climbed sharply in the final quarter of 1991, held around its fourth-quarter pace in the first five months of 1992. Despite its recent flatness, export volume in this five-month period was about 7 1/2 percent above the level of a year earlier. The strongest growth in exports over the past year has been in capital goods, particularly to developing countries, reflecting strong investment demand in Latin America (especially Mexico), the Middle East, and in Asia. However, the general slowdown in growth in the major industrial countries last year, and the recessions in some countries, generally continued during the first half of 1992, depressing the growth of U.S. exports to these countries. At the same time, special factors that contributed to the strength in exports last year--notably the surge in investment demand in Latin America and replacement demands from the Persian Gulf countries after the war--have been less pronounced this year.

The merchandise trade deficit narrowed to an annual rate of $70 billion in the first quarter of 1992, slightly below the deficit recorded in the fourth quarter of 1991 and also a little below the 1991 average. The current account showed a deficit of $21 billion at an annual rate in the first quarter, compared with a deficit of $4 billion for calendar-year 1991. However, excluding unilateral transfers associated with Operation Desert Storm in both periods, the current account deficit in the first quarter--$23 billion at an annual rate--was about half the deficit seen in 1991. This improvement in current account transactions reflected a further widening of the substantial surplus on net service transactions (particularly in the areas of medical, educational, and other professional and business services) and an increase in net investment income receipts.

A large net capital inflow was recorded in the first quarter of 1992; foreign official holdings of reserve assets in the United States rose strongly, and private capital transactions showed a small net inflow. Within the private-sector accounts, the first quarter brought substantial capital outflows that were associated with U.S. purchases of foreign securities and increased direct investment abroad--particularly in intercompany debt flows to Canada and the United Kingdom. These outflows were largely offset by a sizable net capital inflow reported by banks, and by private foreign purchases of U.S. securities other than Treasury securities. Inflows associated with foreign direct investment in the United States amounted to less than $1 billion in the first quarter, down sharply from the average pace in recent years; acquisitions of U.S. businesses by foreigners fell sharply, and slow growth in the United States produced reduced earnings to be reinvested in this country. The net capital inflow in the first quarter exceeded the current account deficit by a wide margin, implying a substantial statistical discrepancy in the international accounts--S16 billion at a quarterly rate. The discrepancy in 1991 had amounted to only $1 billion over the year as a whole.

Labor Market Developments

Payroll employment, which had declined somewhat in the final quarter of 1991, fell further in January of this year. Thereafter, employment rose in each month from February through May, before turning down once again in June. In the private sector, the level of payroll employment in June was up only slightly from its level at the end of 1991, and it remained well below the pre-recession peak of 1990.

The sectoral patterns of change in the number of workers on private payrolls continued to vary considerably in the first half of 1992. Employment at establishments that provide services to other businesses rose fairly briskly, especially in the period from February through May. Those gains seemed to be a reflection of a firming of activity in the business sector, but they also may have been symptomatic of businesses' hesitation to push aggressively into expansion; it appears that firms may simply have been turning temporarily to outside help, rather than committing themselves to the expansion of their own payrolls.

Elsewhere, employment in the health services industry continued to rise in the first half of 1992, but in many of the other major sectors employment either changed little or declined. The number of jobs in the construction business in the second quarter was about the same as in the final quarter of last year. Employment in retail trade was also about flat over that same period. In manufacturing, employment fell slightly over the first half of the year, with small declines reported across a wide range of industries.

In total, about 200,000 new jobs were created in the first half of 1992, according to the payroll data obtained from business establishments and governments. An alternative employment series, compiled from the monthly survey of households, showed the number of persons with jobs rising by a larger amount--about 850,000--over that same period. Although a complete accounting of the reasons for the recent disparity between these two surveys is not possible, one possibility is that the payroll survey might not be fully capturing job growth at newly created establishments. If that is the case, then actual employment growth in the first half of this year may have been somewhat stronger than the payroll data indicate, although it still was not comparable to the gains seen at a similar stage of previous economic recoveries.

Despite the rise in employment in the household survey, there were further sharp increases in the number of unemployed, and the civilian unemployment rate rose from 7.1 percent in December to a level of 7.8 percent in June. Unemployment rates moved up, on net, for most occupational and demographic groups during the first half of the year, with especially large increases for adult men and teenagers. Much of the rise in unemployment in the first half consisted of persons who had lost their jobs. In addition, unemployment was boosted by a rise in the number of persons who had entered or re-entered the labor force, but were unable to find jobs; this influence was especially pronounced in May and June, the two months in which most of the first-half rise in the unemployment rate occurred.

The civilian labor force--the sum of those persons who are employed and those who are seeking work but cannot find it--grew very rapidly in the first half of 1992--about 3 percent at an annual rate. However, this surge in the labor force follows a period in which labor force growth had been quite weak, and the percentage increase over the past year is much smaller--about 1 1/2 percent. Moreover, with the labor force participation rate now back to its previous peak and the working-age population estimated to be rising rather slowly in coming quarters, it does not seem likely that labor force growth can be maintained at its recent pace for very long.

The softening of labor markets and easing of inflation expectations since mid-1990 has been reflected in a gradual, but persistent deceleration of labor compensation rates over the past couple of years. The twelve-month rate of change in the employment cost index for private compensation, after peaking at 5.2 percent in the first half of 1990, declined to 4.6 by the end of that year, slowed to 4.4 percent in 1991, and eased still further, to 4.2 percent in the twelve-month period that ended this past March. The annual rate of increase in straight-time wages has been running at less than 3 1/2 percent in recent quarters. However, the cost of benefits that firms provide to their employees has continued to rise rapidly, propelled by the steep climb in the cost of medical insurance and by increases in payments for workers' compensation. Nonetheless, the slower rate of increase in nominal compensation per hour, coupled with a somewhat faster rate of deceleration in consumer prices, has been translating into increases in real hourly compensation.

Productivity has been picking up. In the first quarter of 1992, output per hour worked in the nonfarm business sector was 1.9 percent above the level of a year earlier, a four-quarter improvement last achieved in early 1988 when the economy was still growing rapidly. At the same time that employers have been cautious in expanding output, they have continued to move aggressively to economize on labor input, thus boosting output per hour. The increase in productivity, together with the slowing of hourly compensation, held the rise in unit labor costs to just 1.2 percent over the year ended in the first quarter of 1992, the smallest four-quarter increase in labor costs in eight years.

Price Developments

All the measures of aggregate price change show inflation to have cased substantially from its most recent peak. The 3 percent rate of rise in the consumer price index over the past year is roughly half the rate at which that index increased in 1990; swings in energy prices account for a sizable part of that slowdown, but most non-energy prices have slowed as well. A halving of the rate of price rise also is evident in the fixed-weight price index for gross domestic purchases, a measure that takes account of the prices paid by businesses and governments as well as those paid by consumers. Measures of price change that are related to domestic production (rather than to domestic spending) have slowed by smaller, but still appreciable, amounts. For example, the fixed-weight price index for gross domestic product, the broadest measure of price change for goods and services produced domestically, rose less than 3 percent over the four quarters ended in early 1992; that index had moved up at rates of 4 to 4 1/2 percent in each year from 1988 to 1990.

Consumer energy prices have continued to fluctuate since the end of the Gulf War, but those fluctuations have been relatively subdued. Energy prices at the retail level fell early in 1992, influenced by the mildness of the winter, the further cut in U.S. industrial production early in the year, the persistence of sluggish growth in other industrial countries, and the high level of OPEC production. Later in the winter, however, energy prices began to firm. The upswing in U.S. industrial activity that began in February gave some lift to prices, as did the return to more normal weather patterns in late winter. Further impetus to prices came in the spring, with the apparent mid-May shift by Saudi Arabia toward somewhat greater production restraint than had been expected. In response to these developments, the spot price of West Texas intermediate moved up from a February low of about $18 per barrel to a level of more than $22 per barrel in June. The CPI for energy, basically following the lead provided by the oil markets, rose moderately in March, April, and May, and then jumped 2 percent in June. These increases more than reversed the declines seen early in the year. Even so, the CPI for energy in June was up only moderately from the level of a year earlier, most of the price swings of the past twelve months having essentially cancelled out. In the oil market, the price of West Texas intermediate has softened a little, on net, since June and recently has been in a range not much different from that of a year earlier.

Food prices have slowed considerably over the past year and a half. The CPI for food rose more than 5 percent in each year from 1988 to 1990. But last year they rose only 2 percent, and in the first half of this year, they changed little on net. A temporary runup in fruit and vegetable prices in late winter was reversed in the spring, and increases in the prices of other foods were small on average during the first half of the year. As of June the CPI for food was only O. 1 percent above the level of a year earlier.

The marked slowing of food prices since the end of 1990 is partly the result of declines in the prices received by farmers for their products. In addition, however, the food sector is being affected by forces similar to those that are shaping price trends in other parts of the economy: Demand growth has been relatively sluggish in the food sector, competition is intense in both food retailing and the fast food business, and increases in labor costs have been restrained. Price increases at grocery stores over the past year have been small even for those foods for which farm products account for only a small portion of value added, and the twelve-month rise in prices of food consumed away from home, a category dominated by nonfarm inputs, has been running in the lowest range since the mid-1960s.

The CPI excluding food and energy, which had increased at an annual rate of only 3 percent during the final three months of 1991, climbed at a rate of 4 3/4 percent in the first three months of 1992. The prices of non-energy services rose a little faster in the first quarter than they had in the latter part of 1991, and the prices of commodities other than food and energy, which had changed little in the fourth quarter, surged ahead at an annual rate of 5 1/4 percent. Apparel prices, which had declined in late 1991, moved up rapidly in the first quarter, and fairly large increases were reported for several other commodities. But, the first-quarter flare-up of price increases dissipated in the spring, as the annual rate of increase in the CPI excluding food and energy dropped to less than 3 percent over the three months ending in June. The price indexes for both commodities and services rose much less rapidly during this period than they had in the first quarter.

Looking beyond the many twists and turns that inevitably show up in the price data over any short period, the reports of recent months appear to be depicting a gradual, but broadly based, slowing in the trend of consumer prices. The twelve-month change in the CPI for services excluding energy, a category that has a weight of more than 50 percent in the CPI total, has dropped back about 2 percentage points since early 1991, to a pace of 4 1/4 percent; deceleration is evident for most types of services included in that total. A slower rate of price increase also has emerged across a broad range of CPI commodities, although, somewhat surprisingly, the slowing there has not proceeded as rapidly as in the markets for services.

A sustained casing of inflation pressures also is widely evident in the data on prices received by domestic producers. In June, the producer price index for finished goods other than food and energy was 2 1/2 percent above the level of a year earlier; toward the end of the 1980s, this index had been moving up at more than a 4 percent rate. The prices received by producers of intermediate materials other than food and energy have risen less than 1/2 percent, on balance, over the past year; their cumulative increase over the past three years amounts to just 1 1/4 percent. The prices of industrial commodities, which tend to track roughly the contours of the business cycle, have firmed in the first half of this year, after sharp declines from the autumn of 1990 to the end of 1991; however, in the context of a still hesitant recovery, the recent firming of these prices has been relatively subdued compared with the increases seen during many past periods of stronger expansion in industrial activity.


Monetary policy in 1992 has continued to be directed toward the goal of securing a sustained economic expansion while making progress toward price stability. In furtherance of these objectives, the Federal Reserve this year has cased money market conditions twice--once in association with a cut in the discount rate--and lowered reserve requirements.

On balance, most signs from financial markets this year have been consistent with a moderate pace of expansion in economic activity, but also seemed to indicate questions about lasting gains in reducing inflation. Short-term real and nominal interest rates have declined to unusually low levels, and the yield curve has been extraordinarily steep while share prices have been at near-record levels--a pattern often associated with market expectations of a strengthening economy. In addition, the risk premiums on private credit instruments relative to Treasury obligations have narrowed, indicating growing market confidence in private borrowers and ample credit availability in securities markets. Households and businesses improved their balance sheets by constraining total debt growth, issuing equity, and refinancing costly existing debt with longer-term debt at lower rates. As a result of these actions and the decline in interest rates, borrowers have been successful in reducing the ratio of debt-service payments relative to income.

In contrast with the positive signals from other financial variables, the advance in the money and credit aggregates has been very subdued. M2 and M3 in June stood below the lower end of their annual growth cones, and the debt of domestic non financial sectors was running at the lower end of its range. In part, the sluggish expansion of M2 and M3 seemed to be related to the actions of borrowers and lenders to restructure balance sheets and was not reflected in commensurate weakness in spending. Under pressure to improve their capital positions and earnings and facing weak loan demand from borrowers relying more heavily on longer-term debt from market sources, banks and thrift institutions have not been aggressively seeking to expand loan portfolios. In these circumstances, depositories have cut deposit rates substantially this year, and many customers have shifted their funds to alternative assets or applied their deposit balances toward debt repayment. These actions have resulted in appreciable increases in the velocities of the broad aggregates--a situation the FOMC has taken into account in assessing how much weight to place on slow growth in the aggregates in making policy decisions.

Implementation of Monetary Policy

Early in the year, economic releases and financial market indicators signaled an improvement in economic activity--consumer expenditures and confidence were up, M2 growth surged in late January and February, a wave of refinancing activity indicated households and businesses were successfully reducing debt-servicing costs, and the ebullient tone in the stock market anticipated even stronger economic fundamentals in the future. The Federal Open Market Committee noted these positive developments at its meetings during the late winter and spring, but in view of ongoing impediments to robust expansion--including still-strained balance sheets and limitations on credit availability-- concluded that the recovery was still fragile. Recognizing the tentative nature of the recovery and confident that a disinflationary trend had been firmly established, the Committee remained especially alert in this period to the potential need for further casing of money market conditions if the economy failed to show continued improvement.

During the early months of the year, the bond market seemed to focus on the possibility of a strong recovery, and long-term interest rates backed up about 1/2 percentage point from early January through March. A robust recovery could rekindle upward price pressures and would produce stronger demands for credit. In addition, looming U.S. budget deficits and potential credit needs of countries undergoing the transition from centrally planned to market economies were seen as adding to upward pressure on interest rates in the future.

Despite the rise in long-term rates, corporate bond yields remained well below levels prevailing in recent years. Eager to refinance costly existing debt and to reduce the uncertainty and interest rate risk of short-term funding, many firms issued bonds and used a portion of the proceeds to pay down bank loans. Faced with tepid loan demand and continuing pressures on earnings and capital positions, banks lowered deposit rates promptly as market rates declined and did not raise them when intermediate and long-term market rates backed up in the first quarter. Households responded by shifting funds into nonmonetary assets and by paying down debt at the expense of deposit accumulation. Although these and other portfolio adjustments appeared to play a prominent role in the deceleration of M2, the possibility that income growth might also be slackening, perhaps due to tight lending terms at banks and the reluctance of businesses and households to borrow, could not be ruled out. Incoming data over the spring suggested only a modest further rise in economic activity after February, and given the Committee's concerns about the sustainability of the recovery, the Federal Reserve slightly cased the degree of reserve market pressure in mid-April. The federal funds rate declined to 3 3/4 percent, its lowest sustained trading level since the 1960s; other short-term rates generally followed suit, edging down about 25 basis points. Long-term rates registered little response to the policy action; the rate on the thirty-year Treasury bond was essentially unchanged in the days following the move.

The Federal Reserve's easing of reserve market pressure in April came only days after implementation of a previously announced reduction in reserve requirements. Reserve requirements are effectively a tax on depository intermediation; the cut in reserve requirements on transaction deposits from 12 to 10 percent was intended to reduce this burden on depositories and their customers and thereby to stimulate flows of credit. The effect on credit should come directly as sterile reserves are freed for lending and indirectly as increased earnings improve depository institutions' access to capital and their willingness to lend. This year's reduction in reserve requirements sparked little of the heightened volatility of the federal funds rate that ensued from the reserve requirement cut in 1990. In large measure, the smoother transition this year reflected the higher level of reserve balances available to cover daily clearing needs; balances have been boosted in recent months by a higher level of transaction deposits in concert with a sizable increase in bank clearing balances at the Federal Reserve.

Neither the April easing of reserve market pressure nor the cut in reserve requirements revived the broad monetary aggregates. Other financial indicators, however, suggested that the markets were anticipating continued economic expansion. Spreads on commercial paper and corporate bonds relative to Treasury rates continued to narrow, especially for less-than-prime issues, evidencing easier access to market sources of funds for businesses. Improvement in banks' capital positions placed them in a better position to meet loan demand, and many reported that they were no longer tightening credit standards. In addition, long-term interest rates edged down from their March peak, providing some stimulus to mortgage markets and debt restructuring. On balance, despite continued weakness in the broad monetary aggregates, many financial variables appeared to indicate that conditions conducive to a moderate economic expansion were in place.

Still, overall credit growth remained quite subdued, suggesting that some impediments to borrowing and spending remained, and M2 and M3 turned down further in June. In these circumstances, and with direct readings on the economy indicating some weakening relative to earlier in the year, the Federal Reserve in early July cut the discount rate 1/2 percentage point to 3 percent and allowed this reduction to show through as a similar-sized easing of money market conditions. Banks responded quickly to the policy actions, cutting the prime rate by 1/2 percentage point to 6 percent.

On balance, short-term rates generally have declined about 3/4 of a percentage point this year. Long-term rates, after falling in recent months, have about returned to their lows of early January. The foreign exchange value of the dollar generally has tracked the course of long-term rates, appreciating from January through March and depreciating more recently. On a trade-weighted basis in terms of the currencies of the other G-10 countries, the dollar in mid-July stood at a level somewhat below its 1991 year-end level.

Monetary and Credit Flows

Overall credit flows have been damped this year, reflecting a moderate pickup in spending and efforts by borrowers to pare debt burdens. Although demands for credit by the federal government have been heavy, growth in the debt of other sectors has been lethargic, and, as a result, the total debt aggregate has remained around the lower bound of its annual range throughout much of 1992. Reacting to the difficulties that resulted from carrying heavily leveraged positions in a period of weak economic growth and to wide spreads between the cost of borrowing and the returns on holding financial assets---especially deposits-- households and businesses have sought to reduce debt and restructure balance sheets. Total debt, including that of the federal sector, grew about in line with nominal GDP after many years in which debt growth exceeded income.

Along with limiting debt growth, borrowers have sought to strengthen their balance sheets by refinancing existing debt at lower rates. By issuing equity and refinancing debt, businesses have been successful in reducing debt-service burdens; the ratio of net interest payments to cash flow for businesses has declined appreciably this year. The decline in rates over the past year or so has been especially evident for high-yield bonds, indicating that lower-rated borrowers are regaining some of the access to capital markets lost during the credit distress in late 1990 and 1991. A substantial number of firms this year have been upgraded by rating agencies, reflecting improved economic prospects and the salutary effects of lower interest rates and stronger balance sheets on financial conditions.

Many households also have refinanced debt at more attractive rates. Mortgage refinancing began to increase late in 1991 and was very heavy early this year after mortgage rates fell sharply. Later, as mortgage rates backed up, mortgage refinancing applications subsided, but they remained brisk relative to recent years. Households evidently shared the view of businesses that long-term rates presented an opportunity to lock in attractive financing, and many opted to refinance with longer-term fixed-rate mortgages rather than risk future interest rate increases with adjustable-rate mortgages.

Just as for businesses, refinancings and debt reduction appear to have helped relieve the stress on household balance sheets. The ratio of household debt-service payments to personal disposable income has declined appreciably through May. Delinquencies on consumer loans, auto loans, and home mortgages have fallen this year as well. On the other hand, many households with financial assets substantially exceeding debt have seen their spendable income decrease as a result of lower interest rates. Some of the decline in interest rates compensates for lower inflation--the purchasing power of the principal invested is not falling as rapidly as in previous years--but real returns have declined as well, especially for short-dated assets.

State and local governments have exhibited a similar trend in credit demand; on net, total debt growth has been restrained, but gross issuance of bonds has ballooned as municipalities retinanee existing debt. A substantial portion of the debt being refinanced likely was issued during the high interest rate episodes of the early 1980s.

Not only has total borrowing been muted, but banks and thrift institutions are accounting for a sharply decreasing share of the total. In fact, credit at depositories has declined over the past two and one-half years even as total credit in the economy continued to advance, and this pattern has left its imprint on the monetary aggregates and their velocities. Part of this rerouting of credit flows reflects the closure of insolvent thrift institutions; the RTC usually assumes the assets of closed thrift institutions and effectively finances them with Treasury obligations rather than deposits. Moreover, when the assets are later sold, depositories are not always the acquirers. The shift in credit flows away from depositories also reflects ongoing market and regulatory pressure on banks and thrift institutions to bolster earnings and capital. Responding to increased deposit insurance costs, to past and prospective loan losses, and to regulatory restrictions triggered as capital-asset ratios fall below the highest levels, depositories have maintained wide spreads between loan rates and deposit rates. The prime lending rate, for example, has remained unusually high relative to market rates and the depository cost of funds, and depositories have tightened nonprice terms of credit as well in recent years. On the deposit side, rates have fallen considerably as depositories have moved to limit balance sheet growth and bolster net interest margins.

Bank credit from the fourth quarter of 1991 to June managed only a 2 3/4 percent growth rate, slower than in 1991. Bank lending to businesses has contracted in 1992, leaving total loan growth at banks essentially flat. Overall, the contraction in bank business lending in 1992, which has been at an even faster pace than the decline in 1991, appears to reflect primarily weaker demand, as firms have opted to borrow directly in the market and have relied on strong increases in internal funds. Evidence from survey data indicates very little, if any, additional tightening of credit terms by depositories this year. However, the cumulative degree of tightening over the past two years remains substantial, and many banks apparently are still responding to concerns about the condition of borrowers, cumulative loan losses, and pressures to meet or exceed fully phased-in capital requirements. Foreign banks, which had been aggressively seeking new business in the recent past, have reined in balance sheet growth and have tightened the terms of lending this year by somewhat more than domestic banks.

With loans falling relative to deposits, banks have elected to expand their security investment portfolios, pushing the share of government securities in total bank credit to its highest level in twenty years. It seems likely that some of this increase represents banks taking advantage of the steep yield curve to improve earnings by funding these securities with short-term deposits beating low interest rates. The sharp rise in bank security investments has also been spurred by capital considerations: Mortgage-backed securities issued by government sponsored enterprises (GSEs) are treated more favorably than the underlying loans by risk-based capital standards. As a result, many banks have sold a substantial share of their home mortgage loan portfolios to GSEs and replaced them with the securities issued by these same agencies.

Although continued loan losses and increased deposit insurance premiums have added to bank costs, bank profitability has improved. Earnings have been bolstered by wider net interest margins and some improvement in the quality of loan portfolios. The market has looked favorably on these developments, as gains on bank share prices this year have outstripped advances in broad stock price indexes.

Conditions in the thrift industry appear to have improved this year, at least for solvent institutions. Thrift institutions in fairly secure financial condition have experienced better profit trends analogous to those of banks, and share prices of better capitalized SAIF-insured institutions have fared well over the first half of this year. Still, the improved profit picture for a portion of the thrift industry has not implied any expansion in overall thrift balance sheets; total thrift credit is estimated to have contracted at a 3 1/2 percent rate from the fourth quarter of 1991 to June. A large part of this contraction owes to the significant volume of RTC resolutions conducted through early April of this year. However, additional funds to cover losses have not been appropriated, bringing RTC resolutions to a halt after early April.

The limited growth in total bank and thrift balance sheets has carried important implications for the monetary aggregates. The velocities of the deposit components of the broader aggregates, M2 and M3, have tracked the upward trajectory of the velocity of total depository credit in recent years, and this trend has continued in 1992. M3, especially, has been hindered by the lack of growth of depository credit this year. This aggregate was essentially unchanged in June from its fourth-quarter 1991 level and fell below the 1 to 5 percent annual range set by the FOMC. With retail deposits expanding--if only sluggishly--and depository credit subdued, banks and thrift institutions have shed large time deposits and other managed liabilities. At branches and agencies of foreign banks, large time deposits (Yankee CDs), having decelerated sharply from last year's rapid growth, have been flat this year. Market concerns that lower Japanese stock prices had impaired the capital positions of Japanese banks evidently tarnished the appeal of Yankee CDs for some institutional investors. In response, U.S. branches and agencies of Japanese banks cut back issuance of Yankee CDs, shed liquid assets, and relied more heavily on funding in Eurodollar markets.

Institution-only money market funds were the only source of strength in the non-M2 portion of M3 during the first half of 1992. Investors capitalizing on the sluggish adjustment of money market fund yields to declining market rates accounted for much of the strength in money funds. In addition, some institutional investors, finding their resources augmented rapidly by inflows from former bank depositors, likely have parked some of the cash inflow in money market funds.

The implications of depository retrenchment and household balance sheet adjustments for longstanding empirical relationships between money and spending have been perhaps most pronounced for M2 growth. Despite the pickup in nominal income growth this year and very substantial stimulus from drops in short-term interest rates last year, M2 advanced at only a 1 1/2 percent annual rate from the fourth quarter of 1991 to June, placing its June level below the lower bound of its annual range. The decoupling of the historical relationships among M2, GDP growth, and short-term interest rates is evident in the behavior of M2 velocity. M2 usually rises relative to income (its velocity falls) when market rates drop because rates on M2 deposits do not decline one for one with market rates, inducing portfolio shifts into M2 assets. But in recent months, M2 velocity has risen markedly despite a substantial decline in market rates and a standard measure of opportunity costs the difference between short-term market rates and returns on M2 assets.

In this period of extraordinary retrenchment, depositories apparently have reduced deposit rates in ways not captured in standard measures of average deposit rates, and the pull of market alternatives has been stronger than is captured by comparisons of deposit rates to short-term market rates. For example, banks and thrift institutions appear to have made larger cuts in the relatively high rates offered to individuals with larger balances and in the rates offered on brokered deposits; holders of both types of accounts might be especially sensitive to rates on alternative investments. In addition, depositories have been particularly hesitant to compete for funds at intermediate and longer maturities. As a result, longer-term bank and thrift CDs have not been attractive investments for savers seeking to raise returns by moving out the upward sloping yield curve. In effect, depositories have used retail time deposits as managed liabilities in making balance sheet adjustments. The result has been large outflows of retail time deposits, with a relatively large portion of the outflow finding its way to higher-yielding, nonmonetary assets. Depositors, witnessing substantial declines in the rates on their accounts relative to market alternatives, apparently exited M2 in favor of stock and bond funds or direct equity and bond investments. Of course, in doing so, these depositors sacrificed the benefits of deposit insurance and accepted the risk of asset price fluctuations.

For a time, the depressing effects of depository retrenchment and investor portfolio shifts on M2 were obscured by the confluence of various special factors. Early in the year, demand deposits surged as lower rates required businesses to build up compensating balances and as mortgage servicers held larger balances during the mortgage refinancing boom. Later, the abrupt deceleration in M2 appeared related to the effects of tax flows and RTC resolutions. Federal non-withheld taxes this year were weak relative to previous years, and this may have resulted in a smaller deposit buildup in March and April than could be anticipated by normal seasonal adjustment factors. In late March and early April, the RTC resolved a substantial number of institutions. In the past, a heavy volume of RTC resolutions has appeared to damp M2 growth for a month or two, apparently as acquiring institutions abrogate time deposit contracts and depositors take the opportunity to reallocate their portfolios in light of the current configuration of deposit rates and market rates. Thus the RTC resolutions in March and April likely played a role in slowing M2 growth during April and perhaps even in May.

As the weakness in M2 persisted, however, it became increasingly clear that these special factors were not the whole story. If the deceleration of M2 in March and April reflected evolving seasonal tax patterns, May and June should have witnessed an appreciable rebound in M2 growth. In fact, M2 continued to founder, leaving its level in June well below its February level and also below the lower bound of its annual range. Furthermore, RTC resolutions halted abruptly when additional funding for losses was not forthcoming. By June, M2 should have been largely free of RTC effects, but growth of M2 in June was, in fact, even weaker than in April and May. On balance, these special factors appeared to figure prominently in the month-to-month variations of M2 growth, but the overall advance of M2 this year was impeded by more fundamental forces.

These fundamental forces, involving balance sheet adjustments by depositories and money holders, appear to be boosting the velocity of M2. There is considerable uncertainty, however, about how long this process will persist, and whether it will permanently affect the equilibrium level or cyclical behavior of M2 velocity. One means of evaluating this question will be observations of the future performance of the P-star model in predicting inflation. This model is based on M2 per unit of potential output, normalized by equilibrium velocity, which had proved to be constant. Persistent underpredictions of inflation by this model would suggest that the rise in velocity relative to its historical average may be a more permanent phenomenon.

While highly interest-responsive depositors were tilting their portfolios toward capital market instruments, less rate-sensitive, more risk-averse households simply rolled over a portion of their maturing small time deposit holdings into more liquid M2 deposits, at little or no sacrifice in yield. In fact, while M2 growth overall this year has been moribund, growth in its liquid components has been robust and more in line with historical relationships to income and interest rates. M1, for example, has grown at a 12 percent pace through June, a rate well above its average during 1991 of 8 percent. Especially since the introduction of NOW accounts in the early 1980s, the demand for M1 has become quite interest sensitive, leading to wide fluctuations in the velocity of M1, and the drop in MI velocity this year is consistent with that pattern. Foreign demands for U.S. currency have been more subdued this year, and currency growth has slowed a bit relative to the pace of 1990 and 1991. Even so, moderate growth in currency, together with the brisk advance in transaction deposits, has fueled growth in the monetary base of 7 3/4 percent from the fourth quarter of 1991 to June.

The unusual behavior of the velocity of M3 and, especially, of M2 this year has sparked renewed interest in alternative definitions of the monetary aggregates. Two alternatives that have received some attention are M2 plus stock and bond mutual funds and M2 plus institution-only money funds less small time deposits. Both alternative aggregates have grown substantially more rapidly than M2 in recent quarters. The former adds back into M2 the apparent destination of much of the recent outflows from M2; the latter subtracts the weakest component of M2--retail time deposits--to create a highly liquid aggregate, which behaves over time very much like MI. Both alternatives recently appear to have followed more closely historical relationships with income and opportunity costs than has M2. However, both show periods in the past in which their velocities have been highly variable and difficult to predict. The Federal Reserve is continuing to analyze these experimental monetary measures carefully.

1. The charts for the report are available on request from Publications Services, Board of Governors of the Federal Reserve System, Washington, DC 20551.
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Publication:Federal Reserve Bulletin
Date:Sep 1, 1992
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