Monetary policy report to the Congress.
Report submitted to the Congress on February 20, 1991, pursuant to the full employment and balanced Growth Act of 1978.1
MONETARY Policy AND THE Economic OUTLOOK FOR 1991
When it reported to the Congress last July, the Federal Reserve was anticipating that the economy would continue to grow in the second half of 1990. Although the first half had been far from robust, with problems clearly evident in some industries and regions, the economy still was expanding and was afflicted with neither the inventory imbalances nor die escalating inflationary pressures that had preceded past cyclical downturns. Indeed, it seemed at midyear that the goal of achieving a reduction of inflation in the context of continued expansion might well be attainable.
But in August die economy was jolted off course by the Iraqi invasion of Kuwait. The surge in oil prices that followed the invasion gave additional impetus to inflation, and it also portended a weakening of activity as the price increases cut sharply into domestic purchasing power. Uncertainties about the course of the economy were heightened enormously, and household and business sentiment plummeted almost overnight, a response that perhaps grew in part out of memories of the difficult adjustments that had followed previous oil shocks in the 1970s. At the time of the invasion, and on into the autumn, sentiment also was being affected by the considerable uncertainty that existed regarding the course of fiscal policy.
Actual production and spending held up for a time after the oil shock, but started to decline in early autumn. The production cuts reduced real incomes still further and added to the cumulating forces of contraction, which included a continued shift toward greater caution by lenders. The economy thus fell into recession in the latter part of 1990, and, given the further declines in employment and production that were seen in January, that recession clearly has continued into the early part of 1991.
The secondary wage-price pressures that many had expected to see after the oil shock have not been much in evidence, probably because those pressures have been countered by the softening of aggregate demand. The underlying rate of increase in prices began to drop back over the last few months of 1990. In addition, the rate of increase in nominal wages and benefits, which already had started to slow in the third quarter, decelerated further in the fourth quarter. These wage and price developments, coupled with the drop in oil prices since mid-autumn, have given the Federal Reserve greater latitude in recent months to focus on steps that will aid in bringing about economic recovery without jeopardizing continued progress toward price stability.
In fact, as it became clear that the inflationary spillover of the oil shock was being effectively contained, and that an appreciable economic contraction posed the greater risk, the Federal Reserve did ease policy markedly. Earlier in the second half, policy already had moved to a slightly more accommodative stance, first in July, to offset the effects on the economy of apparent restraint in private credit supplies, and again in October, when prospective reductions in federal budget deficits enabled interest rates to decline. Over the balance of the year and into 1991, money market rates were reduced substantially further through open market operations and two half-point decreases in the discount rate. In total, most short-term rates have fallen nearly 2 percentage points since mid-1990, with most of the decrease occurring during the last few months, and long-term rates are about 1/2 percentage point lower than they were at midyear. Falling interest rates have contributed to an appreciable decline in the dollar since mid- 1990.
The behavior of the monetary aggregates and credit was an important consideration in the Federal Reserve's decisions to ease policy over recent months. M2 and M3 ended 1990 within the ranges set by the Federal Open Market Committee (FOMC), but they were in the lower parts of those ranges, and their expansion over the fourth quarter and into early 1991 has been quite sluggish. The sluggishness of the aggregates during this period was worrisome because it suggested that the economy was weaker thananticipated and because it indicated the possibility of some undesirable restraint on future spending through constricted credit intermediation by depository institutions. In particular, the thrift industry has been contracting, and banks, concerned about the credit quality of borrowers and facing pressures on capital positions, have become increasingly reluctant to lend, raising interest margins and tightening nonprice terms. To bolster lending incentives, the Federal Reserve in December eliminated the reserve requirements on nonpersonal time deposits and net Eurocurrency liabilities.
To a significant extent, however, overall credit flows have been sustained by sources outside depositories; thus, debt of the domestic nonfinancial sectors grew 7 percent in 1990 and ended in the middle of the FOMC's monitoring range for this aggregate. The effective substitution of non-depository credit for depository credit made it possible to achieve a greater amount of nominal income and expenditure growth for a given expansion of the money stock. One facet of this process was a shifting by the public out of assets that are included in the monetary aggregates and into holdings of Treasury issues and other securities. Velocity, the ratio of nominal GNP to the money stock, exhibited surprising strength: M2 velocity was about unchanged in 1990, even though declines in interest rates ordinarily are associated with falling velocity, and M3 velocity registered an unusually large increase.
Monetary Policy for 1991
In considering its plans for monetary policy for 1991, the Federal Open Market Committee focused on two objectives, consistent with the goals of the Full Employment and Balanced Growth Act: One was to foster an upturn in activity and thus higher levels of employment and real income; the other was to contain and reduce inflation over time to maximize the efficiency of resource allocation and long-range growth and to minimize the capricious and inequitable effects of inflation on the wealth of savers. The translation of these objectives into specific ranges for money and debt was complicated by the effects of the ongoing restructuring of credit flows. Again this year, a number of insolvent thrift institutions are likely to be closed, with many of their assets ending up at the Resolution Trust Corporation (RTC) or disbursed to a wide variety of investors; at other thrift institutions and at banks, restraints on lending may moderate a bit, but growth in depository credit is likely to continue to be constrained by pressures on capital positions. The rechanneling of credit outside depository institutions is expected to continue to distort the relationship of money to income, buoying the velocities of both M2 and M3.
Taking account of these effects, the Committee decided that the ranges for 1991 that were chosen on a provisional basis last July remain appropriate for achieving its objectives. The ranges for M2 and debt are 1/2 percentage point below those for 1990-a further step to ensuring that longer-run trends in money and credit growth are moving toward consistency with the achievement of price stability. At the same time, they allow for money and credit growth sufficient to support a rebound in the economy this year; moreover, the ranges should provide ample room for any policy adjustment that may be required by unanticipated developments in the economy or the financial sector as the year progresses.
The M2 range for 1991 is 2 1/2 to 6 1/2 percent. Growth in this aggregate is expected to strengthen from the sluggish pace of recent months, partly in lagged response to the substantial easing of money market conditions over the past few months. While acknowledging some uncertainty about developing velocity relationships, Committee members stressed that M2 expansion noticeably above the lower end of the range likely would be needed to foster a satisfactory performance of the economy in 1991.
The range of 1 to 5 percent for M3 was not reduced from that for 1990. That range was already at an unusually low level in recognition of the accelerated pace of the restructuring of the thrift industry. Credit growth in 1991 is expected to be moderate and to occur largely outside depositories. Consequently, total funding needs of depositories are expected to be damped, keeping the growth of M3 quite low and raising its velocity further.
The monitoring range for nonfinancial sector debt for 1991 was set at 4 1/2 to 8 1/2 percent. Federal borrowing is expected to be robust, owing in part to the RTC, and also to the effect of the weak economy on the federal budget deficit. By contrast, borrowing by domestic nonfederal sectors is likely to be slow, though still consistent with a rebound in the economy. On the demand side of the credit market, households and businesses appear to be returning to sounder financial practices, seeking a healthier balance between debt and the income available to service it. At the same time, restraints on the supply of credit also may continue to play a role, with some private borrowers facing higher interest rates and tighter nonprice terms on credit, in part because of the stresses faced by many intermediaries. In that regard, the Federal Reserve is working with other federal regulatory agencies to ensure that bank supervisory practices, while prudent and fair, do not unduly impede the flow of funds to creditworthy borrowers.
Economic Projections for 1991
The economic outlook is unusually difficult to assess at this time, owing not only to the obvious uncertainties associated with the war in the Gulf, but also to some unresolved problems in the economy. However, the members of the Board of Governors and the presidents of the Reserve Banks, all of whom participate in the discussions of the FOMC, believe that the most likely outcome is that the economy will swing back into expansion later this year. At the same time, they also anticipate that inflation will be much lower in 1991 than it was in 1990.
With regard to real gross national product, the central tendency of the FOMC participants' forecasts is for a gain over the four quarters of 1991 of 3/4 to 1 1/2 percent. This is in line with the projection of the Administration, which anticipates an output gain of 0.9 percent. With these GNP forecasts so similar, the forecasts of unemployment also are about the same: The Committee's central tendency projections fall in a range of 6 1/2 to 7 percent in the fourth quarter of 1991, a range that brackets the Administration forecast. On the other hand, the Board members and Reserve Bank presidents are more optimistic on average than is the Administration with regard to the prospects for reduced inflation. The central tendency range for the CPI increase this year - 3 1/4 to 4 percent-compares with an Administration projection of 4.3 percent. The Administration's forecast for nominal GNP is at the upper end of the FOMC central tendency range and thus also would be compatible with the FOMC's monetary ranges.
In discussing their projections, the Board members and Reserve Bank presidents stressed that the war introduces a major imponderable into an outlook that, even before, had been subject to considerable uncertainty. The demands of the war on the economy are not fully clear at this point. Nor is it possible to forecast with any precision how household and business confidence will respond to the course of events in the Gulf. Among the significant unresolved economic and financial problems elsewhere in the economy are those in the real estate markets; commercial construction, in particular, still is plagued by a large overhang of vacant space that will severely limit new construction for some time to come. On the financial side, the overexuberance and loose lending practices of the 1980s have given way to large losses and extreme caution among some lenders, who may not be able or willing at present to shift quickly back toward more normal lending behavior. Because of these problems, the Board members and Reserve Bank presidents perceive that, in the near term, the risks to the economy may be skewed to the downside.
On the other hand, some of the potential underpinnings of recovery also are evident. For example, with the further decline in oil prices since the start of 1991, much of the surge that followed the Iraqi invasion of Kuwait now has been retraced; in a reversal of the effects seen earlier, this drop in oil prices is taking pressure off inflation, and it also is augmenting real purchasing power, which will help to bolster spending. Also working in the direction of supporting spending is the decline in interest rates since the spring of 1989. In contrast to past business cycles, when declines in rates usually did not come until the economy was softening, this decline began far in advance of the peak in activity, and its effects on spending should begin to be felt, especially in sectors like housing, where affordability has been considerably enhanced over the last year and a half Meanwhile, the prospects for exports, and for our overall trade and current account balances, continue to look favorable, given the improved competitiveness of U.S. producers. And, any pickup in final demand, whether from domestic buyers or from abroad, should translate fairly quickly into increased production, in view of the success that businesses seem to have had in preventing a buildup of inventories in recent months. As noted above, the Board members and Reserve Bank presidents project a marked slowing of inflation in 1991. A key assumption underlying these forecasts is that oil prices will hold in their recent range, at a much lower level than prevailed through the autumn of 1990. The pass-through of these lower oil prices to consumers is expected to result in a sharp decline in retail energy prices. In addition, increases in wages and benefits seem likely to be more moderate this year, reducing the pressures of labor costs on profit margins and prices. To be sure, there are some near-term negatives in the inflation picture: Labor expenses are being boosted by legislated increases in employers' contributions for social security and by a further rise in the minimum wage, and prices are being affected by a rise in postal rates and increases in various excise taxes. All told, however, the coming year appears likely to be one in which overall price increases will be considerably smaller than in 1990 and in which the downward tilt of the underlying inflation trend should begin to stand out more clearly.
THE PERFORMANCE OF THE ECONOMY IN 1990
When 1990 began, the economy was in its eighth year of expansion, and it remained on a positive course into the summer. During this period, problems were evident in some sectors of the economy, notably construction, where activity was being damped by the persistence of high vacancy rates, and finance, where a significant number of institutions were encountering difficulties that reduced their ability or willingness to provide credit. Overall, however, production and spending still were on a course of expansion at midyear, and while the rate of price increase had not yet started to abate, there were indications that the groundwork for achievement of slower inflation was coming into place without major disruption to the economy.
Then, in early August, the Iraqi invasion of Kuwait set off a chain of events that gave further impetus to inflation and tilted the economy from a path of slow growth to one of contraction. Declines in output and employment were widespread during the remainder of 1990. Real gross national product fell at an annual rate of about 2 percent in the fourth quarter, and the gain over the four quarters of the year amounted to only 0. 3 percent. The civilian unemployment rate, which had held around 51/4 percent through die first half of the year, moved up steadily in the second half, to 6. 1 percent in December. In January of this year, the rate edged up further, to 6.2 percent. The consumer price index rose 6. 1 percent from December of 1989 to December of 1990, the largest annual increase in nearly a decade.
A key link in the chain of events after midyear was a surge in the price of crude oil, from around $20 per barrel in the spot markets in late July to more than $40 per barrel in early October. That surge sent the prices of energy products soaring, sapped household purchasing power, and put further pressures on business profits, compounding the squeeze brought on by rising costs and sluggish sales. Another, less tangible link was the enormous uncertainty about how, and when, tensions in the Mideast might be resolved. Symptomatic of that uncertainty, the various indicators of household and business sentiment remained low toward the end of 1990, even as oil prices dropped back part of the way from their October peaks.
While surging energy prices accounted for much of the acceleration in inflation in 1990, they were by no means the only source of upward price pressure. The year-to-year rate of increase in the CPI excluding food and energy - a rough indicator of basic inflation trends-maintained a gradual upward tilt through the first three quarters of 1990, peaking at a rate of 5.5 percent in August and September; a slight easing of price pressures over the balance of 1990 brought that rate back down to 5.2 percent by year-end. The year-to-year rate of increase in nominal labor compensation, as measured by the employment cost index, also moved up in the first half of 1990; after midyear, however, wage pressures moderated, and the rise in nominal compensation over the year ended up at 4.6 percent, slightly less than the increases recorded in each of the two previous years.
Support for growth of real activity continued to come from the external sector in 1990, as real exports of goods and services rose 5 percent over the four quarters of the year; this gain, however, was considerably smaller than the increases seen in each of the four previous years. Gross domestic purchases, the broadest indicator of domestic demand, fell about 1/4percentage point, on net, over the four quarters of 1990; within this category an increase in government purchases was more than offset by weakness in consumption, homebuilding, and business fixed investment, and a swing in inventories from moderate accumulation late in 1989 to decumulation in the fourth quarter of 1990.
As was true during much of the long expansion of the 1980s, economic trends in 1990 varied appreciably across different regions of the country. The New England economy, which had been very strong through much of the 1980s, slumped in 1990; by year-end, unemployment rates in that region had moved well above the national average. By contrast, the economies of many locales with heavy concentrations of manufacturing - especially capital goods manufacturing - held up fairly well until the oil shock; the continued growth of exports supported activity in those areas. The farm economy was relatively strong again in 1990, although some indications of softening did show up in the second half. Energy producers benefited from the climb in oil prices; exploration and drilling activity was restrained, however, by the great uncertainty regarding the future course of oil prices.
The Household Sector
In midsummer, consumer spending still was on an uptrend, and it edged up a little further after the oil shock, peaking in September. But with real incomes being dragged down by slumping employment and soaring energy prices, the rise in spending eventually ran out of steam. Real outlays fell at an annual rate of 3 percent in the fourth quarter; the quarterly drop likely would have been greater but for tax changes that caused some households to make purchases in advance of the turn of the year.
The declines in real income and spending in the latter part of the year essentially reversed the moderate gains made earlier. Over the year, after-tax income was down about 1/2 percent in real terms; real consumption spending was up over the four quarters of 1990, but only fractionally. The personal saving rate rose over the first half of the year, but then dropped about 1 percentage point in the last two quarters. This drop in the saving rate after midyear was a little surprising from one perspective, in that an unprecedented plunge in consumer attitudes between July and October might have been expected to generate some increase in precautionary saving. Moreover, many households had suffered losses of wealth because of decreases in house prices or in the value of securities they held; these developments would seem to have called for a shift toward reduced consumption out of current income. But, while such forces may well have been at work, they apparently were outweighed by a tendency of households to dip into savings in the short run when faced with a sudden surge in expenses for energy.
Patterns of change in the various categories of consumer spending were mixed in 1990. Real outlays for services continued to trend up over the year, but at a slower pace than during most years of the expansion; on a quarterly basis, growth in these outlays was quite erratic, owing largely to weather-related volatility in gas and electric bills. Real outlays for nondurables fell 2 1/4 percent over the course of the year, an unusually large decline by historical standards. The drop presumably was brought on in large part by the downturn in real income over the four quarters of 1990, the first such decline since 1974.
The real outlays for consumer durables fell 1/4 percent over the four quarters of 1990; they had fallen about 1 1/2 percent in 1989. The drop in 1990 was accounted for by a second year of decline in the purchases of motor vehicles. Outlays for the other durables - furniture, household equipment, and the like - were up about 1/2 percent on net over the four quarters of 1990, after having grown at a moderate pace in 1989. These patterns of change in spending seemed to reflect both macroeconomic forces, notably the slower pace of real income growth after the start of 1989, and the normal workings of household investment cycles. With regard to the latter, household spending for cars, trucks, and other consumer durables over the 1983-88 period were almost 50 percent above the average for the six best years of the 1970s. By 1989 many households may have reached a point where they were in effect `stocked up' and therefore well positioned to delay making new purchases if the timing currently did not seem right.
Spending for residential construction got a transitory boost from good weather in the first quarter of 1990, but then fell sharply in each of the three subsequent quarters. Over the year as a whole, residential investment outlays declined 8 3/4 percent in real terms; they had dropped 7 percent in 1989.
This slump in homebuilding reflected a variety of influences, most of which appeared to enter on the demand side of the equation. The downshifting of real income growth after the start of 1989 may have led households to view their longer-run prospects in a more cautious light and to hold back from housing investments that they might otherwise have undertaken. In addition, the unwinding in some regions of the country of real estate booms seen in the 1980s tarnished the attractiveness of housing as a longer-term investment. These negative developments came at a time when housing demand already was being restrained by a much slower rate of growth of the adult population than was seen in the 1970s and early 1980s.
Builders cut back sharply on new construction in 1990. The annual starts of single-family units fell 11 percent from their 1989 level, and starts of multi-family units declined about 20 percent, from an already low level. However, these reductions in starts still were not large enough to balance the market. The supply of unsold new homes, measured relative to the pace of sales, jumped sharply in the first part of 1990 and then remained high over the rest of the year; the vacancy rate on multifamily rental units dipped temporarily in the spring, but later bounced back up to the high levels seen over most of die period after 1986.
In some instances, new construction activity was deterred in 1990 by the difficulty that prospective builders had in obtaining credit. Failures of thrift institutions severed established credit relationships for some builders, and the thrift institutions that survived moved toward more conservative lending policies, either out of choice or in response to the more stringent capital requirements and lending limits mandated by the Financial Institutions Reform, Recovery, and Enforcement Act. Banks also were cautious about extending credit to builders; with large volumes of problem loans already on their books, banks were very sensitive to the poor conditions in many local housing markets.
In contrast to builders, potential homebuyers did not seem to have serious problems in obtaining financing in 1990; mortgage credit remained readily available, and the spreads between mortgage rates and the rates on other long-term loans actually narrowed. For the most part, consumer credit also appeared to be readily available, as lenders exhibited only a mild tendency to tighten standards on this generally profitable line of business.
The Business Sector
The business sector began 1990 on a rather shaky note. Profits had declined during 1989, and overhangs of business inventories had developed in the second half of that year in some markets, notably autos. In manufacturing, production growth had been restrained late in 1989, and output dropped sharply in January of 1990, led by a steep cutback in auto assemblies. But conditions improved over the next few months. Industrial production rose fairly briskly, in fact, from January into midsummer, and the drop in business profits was halted for a time.
From August on, the business climate was dominated by the oil shock and its attendant uncertainties. After peaking in September, industrial production plummeted over the last three months of 1990, and it closed out the year about I 1/2 percent below the level of a year earlier. The operating rate in industry also fell sharply over the latter part of the year, back to where it had been in early 1987, before capacity pressures started developing in that year. With volume declining and costs on the rise, corporate profits undoubtedly went into renewed decline in the fourth quarter (the official data are not yet available); for 1990 as a whole, the share of profits in total GNP was the lowest of any year since 1982.
Serious overhangs of business inventories were not apparent when the oil shock hit in August, and prompt production adjustments that followed the shock forestalled stockbuilding in the ensuing months. Indeed, real manufacturing and trade inventories fell slightly on net between the end of July and the end of November. Under the circumstances, however, these reductions clearly were not great enough to get actual stocks down to desired levels. In wholesale and retail trade, sales declined sharply from July to November, and the constant-dollar ratios of inventories to sales in these sectors moved up to levels that were around the upper end of the ranges seen over the past two or three years. The inventory-sales ratio in manufacturing also edged up on net between July and November, and manufacturers continued to cut output through the end of 1990 and into early 199 1. Over 1990 as a whole, the level of real business inventories declined about $3 billion, according to preliminary estimates. The rapid reductions of nonfarm inventories that were seen in the fourth quarter of 1990 accounted for all of that quarter's drop in real GNP.
After registering relatively strong gains in each year from 1987 to 1989, business outlays for fixed investment rose only I percent in real terms over the four quarters of 1990. Spending was affected by the squeeze on profits, the easing of pressures on capacity, and the heightened uncertainties regarding the business outlook. These influences showed through most clearly in the outlays for equipment. Real spending for computers and other information processing equipment rose 3 percent on net over the four quarters of 1990; growth had averaged 15 percent per year over the first seven years of the expansion. In addition, outlays for industrial equipment turned down in 1990, as the deterioration of profits and the falloff in operating rates took their toll. Business purchases of motor vehicles bounced around from quarter to quarter, but held in essentially the same range that they have been in for the past several years. By contrast, business outlays for aircraft, which have been very strong in recent years, rose further in 1990.
Nonresidential construction declined 5 percent over the four quarters of 1990. Weakness was concentrated mainly in the outlays for offices and other commercial structures, which together account for about one-third of the total. An excess supply of these structures developed in many cities during the building boom of the mid-1980s, and despite sharp cutbacks in construction after 1985, vacancy rates remained high through 1990. Reflecting this continued imbalance-and the reluctance of creditors to finance new projects in this troubled sector of the economy-the indicators of future activity, such as the data on new contracts and building permits, continued to have a decidedly negative cast through the second half of 1990. Spending for industrial structures rose over the first three quarters of 1990, but fell sharply in the fourth quarter, and the indicators of future construction continued to weaken. As noted previously, investment in oil drilling remained subdued in the second half of 1990, despite the rise in oil prices; in some instances, drillers may have been hampered by shortages of experienced crews, but, more important, the uncertainty about whether prices would remain high enough to justify stepped-up investment prompted a cautious response.
The Government Sector
In the government sector, budgetary pressures intensified in 1990. At the federal level, the rate of growth of receipts slowed to 4.1 percent in fiscal year 1990, less than half the rate of increase in the previous fiscal year and more than I percentage point below the rate of growth in nominal GNP. Meanwhile, spending jumped 9.4 percent in fiscal 1990, and the federal budget deficit increased to $220 billion, up $67 billion from the 1989 fiscal year and well above the target for 1990 that had been laid out in the Gramm-Rudman-Hollings legislation. Finding a way to get back on track toward deficit reduction occupied the Congress and the Administration through much of 1990; an agreement that was reached in October prescribed new targets and new procedures for the five-year period starting in the 1991 fiscal year.
Part of the slowing of receipts in the 1990 fiscal year stemmed from the weakness in corporate profits; collections from that source fell almost $10 billion. In addition, the growth of tax receipts drawn from the incomes of individuals slowed appreciably, from 1 1 percent in 1989 to a bit less than 5 percent in 1990; this slowdown mainly reflected the absence in 1990 of transitory factors that had led to the big jump in these receipts in 1989. On the expenditure side of the ledger, about one-third of the increase of $108 billion in nominal federal outlays in fiscal 1990 was attributable to federal deposit insurance programs; the main portion of these outlays went to honor obligations to holders of deposits in failed thrift institutions. Spending also moved up rapidly in 1990 for entitlements. The outlays for medicare rose 15 percent, pushed up by continued rapid inflation in health costs and an expansion in the number of beneficiaries. Outlays for social security and other income security programs, which together account for close to one-third of total federal spending, rose about 71/2 percent in fiscal 1990, a pickup from the pace of recent years. Net interest outlays, which now account for almost 15 percent of total spending, also continued to climb rapidly. Federal purchases of goods and services, the portion of federal spending that is included directly in GNP, increased 5.5 percent in real terms over the four quarters of 1990. Excluding changes in the inventories owned or financed by the Commodity Credit Corporation, which tend to be very volatile, federal purchases of goods and services increased 4.4 percent, on net, over the year; nondefense purchases were up 3.6 percent and defense purchases, which had registered moderate declines in each of the three previous years, increased 4.7 percent in 1990. The rise in defense purchases came mainly in the fourth quarter of the year and apparently reflected, in part, outlays associated with Operation Desert Shield.
The deficit in the combined operating and capital accounts of state and local governments (excluding social insurance funds) averaged $30 billion at an annual rate over the first three quarters of 1990, and it appears to have widened considerably further in the fourth quarter as the recession cut into tax receipts. State and local budgets first moved into deficit in late 1986, and they have slipped further into the red in each succeeding year. At the same time, concerns have intensified about the repayment abilities of some state and local governing units; as evidence of this, the downgradings of state and local credit ratings outnumbered upgradings by a wide margin in 1990.
In an effort to strengthen their finances, many state and local governments have raised taxes in recent years. Reflecting those increases, total state and local receipts moved up faster than nominal GNP both in 1989 and through the first three quarters of 1990. In addition, spending has been scaled back from planned levels in many cases. Overall, however, the efforts to control spending have collided with the growing demands for services that state and local government traditionally have provided for such things as education, public protection, and health and income support. Thus, while the growth of state and local outlays has slowed from the rate of rise seen earlier in the expansion, it nonetheless has been running above that of total GNP. The nominal rise in state and local purchases of goods and services over the four quarters of 1990 was 7.9 percent; in real terms, purchases grew 2.5 percent over the year.
The External Sector
The merchandise trade deficit narrowed from $115 billion in 1989 to a bit less than $110 billion in 1990, a degree of improvement that was smaller than that seen in either of the two preceding years. A surge in the price of oil imports in the second half of the year led to a jump in the value of imports. In addition, trade flows during the year were influenced to some extent by lagged effects of the finning of dollar exchange rates that had taken place in the first half of 1989. The current account balance averaged $93 billion, at an annual rate, during the first three quarters of 1990, down from a total of $1 10 billion in 1989; the improvement in this account was greater than that in the trade account owing to a strengthening of net receipts from service transactions, those involving such things as travel, education, and finance.
Measured in terms of the other Group of Ten (G-10) currencies, the foreign exchange value of the U.S. dollar depreciated about 12 percent from December 1989 to December 1990. This depreciation extended a decline that began in mid-1989 and more than reversed the earlier appreciation. Adjusted for movements in relative consumer price levels, the dollar's decline in 1990 was slightly less than it was in nominal terms, as inflation in the United States exceeded somewhat the weighted average of inflation rates in the other G-10 countries. In real terms, the weighted-average dollar in December 1990 was at about its low of 1980; the huge appreciation in average exchange rates in the first half of the 1980s thus has been reversed.
The decline in the dollar in 1990 was broadly based against the Japanese yen, the German mark, and other European currencies. The dollar also declined about 10 percent against the Singapore dollar, but it appreciated about 5 percent against the currencies of South Korea and Taiwan, partially reversing declines of the preceding few years. The weakness in the dollar against the G-10 currencies over the past year reflected primarily the influence of different trends in interest rates in the United States and other major industrial countries. Whereas U. S. short-term interest rates trended down through the year and long-term rates were about unchanged over the year as a whole, foreign short-term rates rose by an average of about 1/2 percentage point, and foreign long-term rates rose by an average of about 1 point. Official intervention in foreign exchange markets was small in 1990.
U. S. merchandise exports grew 7 1/2 percent in real terms over die four quarters of 1990, after rising about 12 percent in 1989. Merchandise exports grew rapidly in the first quarter, boosted in part by a strong recovery of exports of aircraft after the Boeing strike of late 1989 ended. Over the next two quarters, real exports changed little on net. Growth of activity in the major U.S. export markets slowed noticeably in the middle of the year; outright recessions developed in Canada and the United Kingdom. In the fourth quarter, export growth picked up again, probably largely in response to the gains in U. S. price competitiveness that took place during the year. Export prices rose moderately during the year.
Merchandise imports excluding oil grew only 2 percent in real terms during 1990, less than half the pace recorded in 1989. The deceleration in imports reflected the net decline in total domestic demand in the United States during the year. The quantity of oil imports fluctuated during the year, but was up only slightly for the year as a whole. At an average rate of about 8.3 million barrels per day, oil imports accounted for roughly half of total domestic consumption of oil in 1990. The price of imported oil surged to an average level of nearly $30 per barrel in the fourth quarter, after having fluctuated in a range of $15 to $20 per barrel for nearly two years.
The current account deficit of $93 billion at an annual rate over the first three quarters of 1990 was matched by a recorded net capital inflow of $26 billion and a large positive statistical discrepancy in the international accounts. Part of the statistical discrepancy may have reflected increased holdings of U.S. currency by foreigners responding to the unsettled political conditions in many parts of the world.
The recorded net inflow of capital was more than accounted for in net transactions reported by banks, which were mainly for the banks' own accounts. Transactions in securities showed a net outflow, as foreigners reduced their rate of net purchases of U. S. corporate and Treasury bonds and actually made net sales of U.S. corporate stocks, while the rate of U. S. net purchases of foreign securities increased. The recorded inflow of direct investment from abroad dropped sharply from the rates recorded in 1988 and 1989; foreign acquisitions in the United States remained strong, but a much greater portion were being financed here rather than abroad. The flow of U.S. direct investment abroad picked up, in part reflecting strong U. S. acquisitions abroad. Foreign official assets in the United States increased $1 1 billion over the first three quarters of 1990, and U. S. official holdings of assets abroad declined slightly.
Payroll employment increased in each month in first half of 1990 and fell in each month of the second half. The declines of July and August, however, reflected layoffs of federal workers who had been hired temporarily to conduct the 1990 Census. In the private nonfarm sector, employment continued to edge up into August and did not turn down decisive until October. More than half a million jobs we lost over the final three months of the year. Over year as a whole (December to December), number of jobs in the private nonfarm sect increased about 250,000 on net, but much of th small gain was wiped out by the further drop employment in January of this year.
Sectoral patterns of employment change varied considerably in 1990. Employment in manufacturing fell about 585,000 from December of 1989 December of 1990; losses of factory jobs proceed at a slow and fairly steady pace through the first half but then accelerated after the onset of the oil shock. The troubled construction sector shed roughly on quarter of a million jobs over the course of the yea after a weather-related jump early in the year, declines went on almost without interruption through December. Employment in retail and wholesale trade was down slightly on net over the course 1990, as small gains through the first seven mon of the year were more than offset by sharp declines the fourth quarter. The number of jobs in the services industries increased in each month of 199 but the rate of gain slowed progressively over year; health services was the only major area which hiring was going on with much vigor year-end.
Growth in the supply of labor was quite subdued in 1990. The civilian labor force increased only 0. 5 percent on a December-to-December basis, smallest annual gain in almost thirty years. Part the explanation for this slow labor force growth that the working-age population has not be growing very rapidly in recent years. In addition, the share of the working-age population that chose participate in the work force declined in 1990, enough to cut labor force growth to about half what it would have been had the participation ra remained unchanged. The sluggishness of the lab markets in 1990 no doubt discouraged some potential entrants from seeking jobs, as typically happens during cyclical slowdowns in the economy. Still, the drop in participation in 1990 left some questions regarding the future trend in the growth of labor supply. A downshifting in the growth of labor supply, to the extent that it is not due solely to cyclical factors, would tend to translate one-for-one into slower growth of potential output over time unless there were at the same time an offsetting pickup in labor productivity, of which there has been little, if any, evidence of late. The flatness of the unemployment rate through the first half of 1990 brought to seven quarters the length of time during which the rate had held tightly around the 5 1/4 percent mark and extended to nearly three years the length of time during which the rate had been below 6 percent. Not since the first half of the 1970s had the unemployment rate been at such low levels for so long. This period of low unemployment, unfortunately, also was a period of sharply increased wage inflation. After rising about 3 1/4 percent in both 1986 and 1987, the employment cost index for compensation, which includes the cost of workers' benefits, as well as wages and salaries, moved up about 4 3/4 percent in both 1988 and 1989; and in the first half of 1990, the year-to-year rate of increase in this measure of compensation rose still further, to 5 1/4 percent.
Labor market tightness was not the only factor putting pressure on wages and compensation between the end of 1987 and the middle of 1990. The security. The efforts of management to contain costs in a time of declining profits probably also were a factor helping to limit wage increases during this period.
The performance of productivity was subpar for a second successive year in 1990. Output per hour in the nonfarm business sector edged down 0. 1 percent over the four quarters of the year, after having dropped 1.6 percent in 1989. More than likely, the behavior of productivity over this two-year period mainly reflected typical cyclical influences, namely the tendency of firms to adjust output faster than hours in response to a slowing of demand. Unit labor costs increased about 4 1/2 percent over the four quarters of 1990, the largest annual rise since 1982.
All of the major price indexes - the consumer price index, the producer price index, and the GNP price indexes - rose faster in 1990 than they did in 1989. In general, the increases seen in 1990 also were the largest since those of the early 1980s. In all of the measures, the pickup in the rate of price increase in 1990 basically reflected the effects of the oil shock in a situation in which underlying inflation pressures already were well entrenched. Acceleration was especially pronounced in those indexes, such as the CPI, that measure price change for goods and services purchased by domestic buyers, as the surge in oil import prices had a particularly strong effect on these measures. By contrast, the GNP price measures, which cover goods and services produced domestically, exhibited a less pronounced degree of acceleration this past year.
The CPI for energy rose 18 percent from December of 1989 to December of 1990. Although the bulk of the 1990 rise came after the start of August, intermittent pressures had surfaced earlier in the year. A severe bout of cold weather at the end of 1989 cut into the inventories of heating oil, disrupted operations at several refineries, and caused the prices of fuel oil and gasoline to soar. After January, fuel oil prices fell back, but gasoline prices remained relatively firm into the summer as still more supply interruptions prevented a rebuilding of stocks.
The August invasion of Kuwait set off another round of steep price increases. World oil production dropped temporarily after the invasion, and the uncertainties associated with the tensions in the Persian Gulf set off a scramble for inventories by refiners and others seeking to guard against a possible further disruption in supplies. The price of oil fluctuated widely in this period, but generally maintained an upward trend into early October. By then, however, the losses of oil from Iraq and Kuwait were being fully offset by increased production from other countries, and demand was weakening. As a result, oil prices turned down and held on a choppy downward pattern through the end of the year, retracing about half of the runup that had occurred between August and early October. A further steep drop came in mid-January of 1991, when initial successes of the coalition forces in the Gulf war seemed to signal a greatly diminished potential for disruption of world supplies.
The CPI for fuel oil also turned down over the last two months of the year, but gasoline prices again held firm, supported this time by a five cent per gallon rise in the federal excise tax that took effect on December 1. Over the year, fuel oil prices increased about 30 percent at the consumer level, and gasoline prices were up almost 37 percent. By contrast, increases over the year in the prices of the service fuels (natural gas and electricity) were quite small -in the range of 1 1/2 to 2 percent; reaction of these prices to the oil shock apparently was damped by ample supplies of natural gas and coal, as well as the customary lags in adjusting rate structures at retail.
The consumer price index for food rose 5.3 percent in 1990; this increase was about the same as those seen in 1988 and 1989. Over the preceding few years, food price increases had tended to run more in the 3 to 4 percent range. To a considerable degree, the continued sharp increases in food prices in 1990 seemed to reflect underlying inflation processes similar to those at work in other sectors of the economy. In addition, prices were affected by the changing supply conditions in agriculture. Production of beef and pork declined in 1990, and their prices at retail increased 9 percent and 17 percent respectively over the course of the year. Dairy production, which had fallen in 1989, turned up in 1990; but with stocks initially at low levels, the rise in production did not have a damping effect on prices at retail until relatively late in the year. The spell of cold weather late in 1989 led to a surge in the prices of orange juice and fresh vegetables early in 1990; toward the end of 1990, another cold snap destroyed citrus crops in California and boosted citrus prices. By contrast, big wheat crops here and abroad in 1990 caused wheat prices to plunge and led to some rebuilding of stocks; at retail, die CPI for cereals and bakery products slowed from an increase of 7 1/2 percent in 1989 to one of 4 1/2 percent in 1990.
The CPI for nonenergy services, which accounts for more than half of the total CPI, rose 6 percent during 1990, after an increase of 5.3 percent in 1989. The prices of medical services, which have been rising rapidly for many years, were up 9.9 percent in 1990; they had increased 8.6 percent in the previous year. The cost of tuition, another category where pressures have been evident in the CPI for some time, rose more than 8 percent in 1990, about the same as in 1989. Elsewhere in the services sector, prices soared for public transportation and lodging. Airlines, which were hit hard by the surge in energy costs, raised their fares almost 23 percent over the year. Price increases for other forms of public transportation were in the 6 to 7 percent range, and the CPI for out-of-town lodging advanced nearly 16 percent over the year. Increases in the costs of many publicly provided services such as water and sewerage maintenance and refuse collection - also were large in 1990; these increases probably reflected the needs of municipalities to raise revenue, as well as environmental imperatives in some instances.
The CPI for commodities excluding food and energy rose 3.4 percent in 1990, after increasing 2.7 percent in 1989. Within this category, tobacco prices again registered a particularly large increase, about 11 percent over the course of the year. This increase partly reflected the pass-through to consumers of a jump in manufacturers' prices; in addition, governments continued to view excise taxes on tobacco products as an attractive way to boost revenues. The CPI for apparel was up 5 percent in 1990; apparel prices had changed little over the course of 1989, and the 1990 rise may therefore have been, in part, an effort to restore margins. New car prices continued to rise, even as sales declined; by contrast, the prices of used cars were down a bit for a second year. The prices of many household appliances fell in 1990, extending the gradual downward trends seen in previous years.
Apart from energy, increases in producer prices were comparatively moderate in 1990. The producer price index for finished goods excluding food and energy rose 3.5 percent over the year, about 3/4 percentage point less than in either of the preceding two years. In manufacturing, the pressures from rising wages and soaring energy costs were partly damped by continued rapid gains in productivity and softening demand. The prices of intermediate materials excluding food and energy rose 1.9 percent during 1990, the second year in a row in which increases for that category have been small; materials prices had increased sharply in 1987 and 1988. The spot prices of raw industrial commodities moved up on net in the first half of 1990, held firm through September, and then fell rapidly in the fourth quarter as the economy weakened; further declines in these prices have been evident in the early part of 199 1.
MONETARY AND FINANCIAL DEVELOPMENTS DURING 1990
Monetary policy has been progressively eased since mid-1990, resuming the trend begun in 1989. The Federal Reserve has acted against the backdrop of a weakening economy, sluggish money growth, improved inflation prospects, greater fiscal restraint, and indications of tightening credit to private borrowers. In response to the System's actions and to developments in economic activity and prices, short-term interest rates, as of mid-February, were nearly 2 percentage points below those prevailing at the time of the Board's July report to the Congress, and long-term rates were down about 1/2 percentage point.
After an initial small cut in money market rates in July, policy was held stable for a brief period, in light of the sharp jump in world oil prices that occurred in the wake of the Iraqi invasion of Kuwait. This shock implied an uncertain combination of increased prices and reduced economic activity. The magnitude of the impact would depend on the extent of die disruption in world oil markets, which could not be forecast with precision. As it became clear in die autumn that the risks of increased inflation were fading relative to the risks of a downturn in economic activity, the Federal Reserve moved aggressively, using a variety of instruments. Open market operations and a reduction of 1 percentage point in the discount rate, taken in two steps, have brought overnight rates down 1 1/4 percentage points since late October; in addition, reserve requirements were reduced in early December to foster easier credit conditions.
In the formulation of policy in 1990, the Federal Reserve continued to examine a variety of information bearing on developments relating to economic activity and prices. Over the year, certain developments in financial markets took on special significance for the economy and monetary policy. The cost and availability of credit was monitored in light of indications that tightening credit supplies were constraining output to a greater degree than was desirable. In addition, considerable attention was paid to money stock movements, especially in the latter part of 1990 and into 1991, when money growth virtually stalled. The Federal Reserve recognized that the relation of the monetary aggregates to broad measures of economic performance remained subject to considerable uncertainty, but the marked sluggishness of money growth was seen as suggesting both weak contemporaneous growth of income and spending and the existence of constraints on the availability of credit through depository institutions that could adversely affect spending in the future.
The Implementation of Monetary Policy
During the first half of 1990, the Federal Reserve took no actions in reserve markets designed to produce changes in money market interest rates. Federal funds - overnight interbank loans of immediately available funds-traded around the 8 1/4 percent level that had been established in December 1989, and other short-term rates were little changed as well. Throughout this period economic activity continued to grow, the unemployment rate held steady, and there were no clear signs of abatement in inflation.
Yields on longer-term debt instruments rose considerably during the early months of the year, restoring the yield curve's usual upward tilt, which had been absent for much of 1989. This rise in long-term rates reflected a stronger economy than some had expected, increased concerns about inflation, and higher foreign interest rates. As the second quarter progressed, however, bond rates began to recede, responding to a shift in sentiment about the strength of the economy and the likely path of monetary policy.
Around that time, growth of the broader monetary aggregates began to slow appreciably. To a large extent, the weakness in the aggregates was associated with a redirection of credit flows away from depository institutions, related mainly to the ongoing restructuring of the thrift industry but also to an apparent decrease in the willingness or ability of banks to lend. For the most part, the decline in depository credit was expected to be taken up by other lenders, with minimal impact on the overall cost and availability of credit. M3 velocity in particular was expected to be boosted substantially in the process, and the FOMC at its July meeting reduced the annual target range for this aggregate by 1 1/2 percentage points. By mid-July, it was increasingly apparent that the pullback by depositories was constricting credit supplies to some classes of borrowers, and the Committee eased reserve conditions to bring down interest rates slightly to offset the effects of this tightening of credit conditions on an already soft economy.
The invasion of Kuwait at the beginning of August fundamentally altered the environment for monetary policy. World oil prices soared, and a considerable measure of uncertainty was added to the outlook for the economy, complicating the formulation of monetary policy. Business and consumer confidence plummeted, and the adverse effects of high oil prices on the public's spending plans, domestic economic activity, and inflation soon became apparent. As volatility in financial markets increased, heightened investor preference for liquidity and safety was evident: Treasury bill rates fell over August and September while private short-term rates changed little; money market mutual funds experienced large inflows, boosting growth of the monetary aggregates late in the summer as investors apparently fled stock and bond markets; and the ongoing decline in the foreign exchange value of the dollar was halted for a while by safe-haven demands.
In these circumstances, the benefits of any easing taken to cushion the possible effects on output the near term needed to be weighed against the for embedding higher energy prices in the rice level and, more important, into inflationary expectations, a reaction that ultimately would undercut sustainable economic growth. Policy decisions were further complicated by the fact that military and political situation underlying the oil rice shock was so fluid; in fact, it clearly was a war-risk premium rather than a current shortage of supply that was maintaining a higher price of crude oil. The possibility existed that any substantial moves in monetary policy might prove ill-advised as circumstances changed, and it appeared that the most constructive role monetary policy might play, until the balance of risks was clarified, would be to foster a sense of stability in the very nervous financial markets.
As it was, financial markets had to contend not only with the Gulf crisis during the late summer and early fall, but also with uncertainties surrounding the timing and extent of a reduction in the federal budget deficit. Yields were buffeted whenever the odds of a meaningful deficit-reduction package appeared to change. For example, Treasury bond rates fell appreciably when an initial budget accord was hammered out and rose when the government was forced to shut down temporarily after the pact failed to win congressional approval. By the end of October, long-term rates had come down again, and a budget agreement involving a major degree of fiscal restraint over a multi-year horizon was successfully concluded. In light of the budget agreement, which promised greater and more durable fiscal restraint, and with the economy weakening, the Federal Reserve took another step to ease pressures on reserve conditions.
Late in the year, indications accumulated that inflationary pressures, apart from those closely connected to the surge in energy prices, were easing. As the economy softened and wage pressures also diminished, it seemed more likely that the effects of higher oil prices would not be built into ongoing inflation trends. Market interest rates declined across the maturity spectrum, although these declines were most pronounced for government obligations owing to heightened concerns about credit quality, which drew investors toward high-grade assets.
Financial strains were experienced by more and more lending institutions, as problems emerged in many real estate portfolios and as a growing number of highly leveraged firms ran into trouble. Efforts by banks and other lenders to protect or improve their capital positions as their loan portfolios deteriorated were reflected in widespread signs of cutbacks in the availability of credit and increases in its cost, especially to less-than-prime borrowers lacking access to securities markets. While much of the tightening of lending standards was welcome from the standpoint of safety and soundness, it exerted a contractionary influence on the economy and was reflected in the slow growth in bank credit and the broad monetary aggregates.
Against this backdrop, the Federal Reserve undertook additional actions designed to support the economy and to counter the tightening in credit terms. In mid-November, the FOMC moved to lower money market rates through open market operations, and in early December, the Board eliminated the 3 percent reserve requirement on nonpersonal time deposits and net Eurocurrency liabilities. This action was taken in response to the increased restraint on lending by commercial banks: Lower reserve requirements reduce funding costs to depository institutions, encouraging them to expand lending. Ultimately, the lower funding costs are passed through as a combination of lower rates for borrowers and higher rates offered to depositors.
Following the reduction in reserve requirements, further actions were taken in reserve markets to bring down short-term interest rates. These actions included additional steps toward a more accommodative supply of nonborrowed reserves through open market operations and two reductions in the discount rate-of a half point in December and of a like amount in January. All of these moves were made in light of further declines in economic activity, sluggish money and credit growth, and evidence of ebbing inflation pressures. In total, the federal funds rate has fallen about 2 percentage points from its mid- 1990 level and about 3 1/2 percentage points from its most recent peak in mid- 1989.
Under the impetus of the easing of monetary policy and the softening of the economy, other short-term rates also fell significantly below mid-levels 1990 by mid-February. The drop in yields on Treasury bills roughly paralleled that in the federal funds rate. Banks reduced their prime rates in two 1/2 percentage point steps in early 1991, but, as a consequence of the tightening in credit supplies, prime rates remained higher than usual relative to rates on federal funds and other sources of funds. Rates on commercial paper and CDs also fell less than those on federal funds or Treasury bills, dropping about 1 1/4 percentage points from mid-levels. 1990 This widening of yield spreads was additional evidence of investor concern about private credits, though these spreads generally remained downturns. However, yields on private money market instruments were under substantial upward pressure in the weeks leading up to year-end when the prospect of publishing financial statements led banks to attempt to hold down credit extension in order to bolster capital ratios and led lenders generally to intensify their focus on asset quality. Spreads soared at times in this period; but the Federal Reserve injected large amounts of reserves, the year-end passed without major dislocation, and yield spreads narrowed substantially in January.
Rates on longer-term securities came down considerably less from their levels in mid- 1990 than those on short-term paper. As of mid-February, the yield on the thirty-year Treasury bond had fallen about 1/2 percentage point since the middle of 1989, and those on private long-term issues were down slightly less. Declines in these yields may have been limited in part by the increased uncertainty and volatility that followed the invasion of Kuwait. Some major stock market indexes had reached record highs in July, but the uncertain outlook both at home and abroad after the invasion of Kuwait and the slump in economic activity pushed stock prices significantly lower in the ensuing months. Since the war broke out in mid-January of this year, however, stock price indexes have moved up sharply, with some indexes reaching new record highs in mid-February. The foreign exchange value of the dollar declined about 10 percent over the second half of 1990; the dollar turned up early this year, but fell again in February.
Behavior of money and Credit
M2 grew unexpectedly slowly in 1990, about 4 percent for the year, well down in the lower half of the FOMC's range. After a robust first quarter, M2 growth weakened markedly over the balance of the year. The expansion of this aggregate was well below what the historical relationships based on income and interest rates would suggest. The substantial declines in interest rates from their earlier levels would ordinarily be expected to offset to some extent the effects of the slowdown in nominal income in the second half of the year. M2 velocity was fairly stable through 1990, but historical relationships suggest that velocity should have fallen given the decline in interest rates.
The shortfall of money growth, relative to historical patterns, probably reflected the shifting of financial flows associated with the contraction of the thrift industry and the increased reluctance or inability of commercial banks to expand their balance sheets. Indeed, the slowdown of M2 growth emerged at about the time that RTC activity picked up. The drop in depository credit, which had its primary effect on the M3 aggregate, also may have damped M2 by lessening the need of commercial banks and thrift institutions to bid for retail deposits. One indication is the apparent cutback in advertising for these deposits during the year. And, as a result of the diminished need for retail deposits, deposit rates were held down relative to returns available on market instruments. In addition, some high-rate contracts were abrogated in the process of closing failed thrift institutions, reducing the attractiveness of these deposits; depositors who were dislodged from existing relationships when thrift institutions were closed may have reallocated their assets in other directions.
Nevertheless, even taking account of these factors affecting the relative attractiveness of yields on M2 assets, M2 growth remains much slower than seems explainable, indicating an underlying reevaluation of, and shift away from, M2 assets. One factor behind such a shift may have been concerns generated by the publicity about savings and loan failures and about credit quality problems at banks. To the extent that households moved assets to money market funds, which grew rapidly in the second half of the year, M2 would not be affected; however, direct purchases of market instruments would reduce M2. For example, noncompetitive tenders at Treasury auctions have been unusually strong, suggesting a shift toward holding these assets directly. In addition, households may have chosen to deplete liquid assets instead of increasing borrowing to maintain spending in the face of higher prices for energy products and the sudden plunge in real income; consumer credit growth was especially slow in the fourth quarter.
The slowdown in M2 last year would have been even more pronounced had it not been for the rapid expansion of currency. At I 1 percent, currency growth was more than twice its 1989 rate and was at the most rapid yearly rate of the postwar period. The bulk of the pickup appears attributable to increased demands for U. S. currency outside our borders, however. Information on shipments overseas suggests that demands for U.S. currency were particularly heavy in areas experiencing economic and political turmoil, especially Eastern Europe, Latin America, and, after the Iraqi invasion of Kuwait, the Middle East. The faster growth of currency, along with the effects of lower market interest rates on incentives to hold transactions balances, boosted MI growth from near zero in 1989 to 4 percent in 1990. The monetary base grew 81/2 percent over the year, also propelled by strong currency growth. By contrast, the total reserves portion of the monetary base was about unchanged, reflecting little net growth in reservable liabilities; transactions deposits increased slightly, but declines were registered m nonpersonal time deposits and net Eurodollar borrowing (abstracting from the effects of the reserve requirement decrease at year-end).
M3 grew 1 3/4 percent in 1990, somewhat less than had been anticipated early in the year. Roughly similar to the quarterly pattern of M2, M3 growth fell off noticeably after the first quarter and ended the year somewhat above the lower bound of its target range. That range itself had been lowered at midyear by 1 1/2 percentage points amid evidence that the drop in thrift assets was proceeding more rapidly than had been expected and that credit flows were being directed away from depository institutions. Banks acquired a substantial amount of deposits from thrift institutions resolved by the RTC, but, unlike in 1989, they did not use newly acquired deposits to expand their balance sheets. Significant loan losses in 1990 limited the ability of banks to generate capital internally and raised the cost of external capital as investors reevaluated risks. At the same time, banks were facing the prospect of new capital standards. Banks used the deposits they acquired from thrift institutions to pay down other liabilities, especially large time deposits, with the result that the shift of M2 deposits from thrift institutions to banks contributed to sharp declines in M3 managed liabilities at banks.
Much of the difficulty in the banking industry can be traced to problems with commercial real estate loans. Before the mid-1980s, developers typically arranged permanent financing for construction and land development projects, usually from institutional investors, before obtaining initial bank financing. But during the period of rapidly rising real estate values in the latter 1980s, many banks no longer required such prearranged "takeouts," and when the real estate market cracked, those banks found themselves holding a substantial volume of undercollateralized loans. At about the same time, there was a significant reevaluation of the prospects for many of the highly leveraged transactions (HLTS) that had been undertaken in recent years; while bank losses attributable to HLTs have not yet been significant, the virtual disappearance of the market for new low-rated bonds has implied that many HLT loans will not be repaid as promptly as hoped. Growing uneasiness about banks' assets has contributed to increases in their cost of capital and, for some banks, of wholesale funding.
Banks by and large are sound and well capitalized, but concerns about the strength of the industry intensified throughout 1990. The General Accounting Office and the Congressional Budget Office issued reports questioning the financial health of some large banks and exploring the implications of possible difficulties with those banks for the Bank Insurance Fund. Banks had to make large provisions for loan losses as delinquency and loss rates rose on most major categories of loans, but especially on real estate loans. By mid-September, rates on the subordinated debt obligations of some major banking institutions had jumped appreciably as investors reevaluated the health of these organizations. Several major bank holding companies chose to redeem portions of their outstanding auction-rate preferred stock rather than pay sharply higher rates. Spreads between bank and Treasury obligations widened significantly, and bank stock prices tumbled. These price movements began to be reversed subsequently. Partly under the influence of lower interest rates, bank stock prices have risen substantially in 1991, reversing much, though not all, of the declines since the summer; spreads on subordinated and other bank obligations have narrowed over the last few months, but remain well above their levels of last summer.
Other financial institutions also have encountered difficulty. Finance companies and, to a lesser extent, insurance companies took a beating in the securities markets beginning in September, as investors reevaluated the holdings of commercial real estate and HLT loans in light of expectations of a weaker economy. Yield spreads widened significantly. Furthermore, signs of mounting financial stress were not limited to the financial sector last year. The number of corporations reducing, omitting, or deferring dividends in the fourth quarter was the highest in more than thirty years. A record dollar amount of corporate bonds defaulted in 1990. Calculated as a percentage of the par amount of noninvestment grade bonds outstanding, the default rate of 8.7 percent was the highest in twenty years and more than double the rate in 1989. While the number of downgradings also reached a record high, most of the downgradings were attributable to deteriorating conditions affecting below-investment-grade nonfinancial corporations and, notably, financial institutions.
Not surprisingly, banks tightened standards and raised lending margins in response to the rising cost of funds, capital shortages, and perceptions of greater risk of default. In the wake of HLT disclosure guidelines, banks instituted management-imposed caps on their exposure to HLTs. Banks with low capital have cut back lending, while adequately capitalized banks-though maintaining substantial credit growth - appeared to be unwilling to step into the breach and increase their lending pace. Survey responses and other information on lending terms suggest especially severe constraints on credit for real estate development and commercial mortgages, but also some cutbacks for business lending more generally. Some of these business borrowers have limited alternative sources, and so the restriction of credit by banks probably has reduced their access to funds.
As a result of the tightening of credit standards and lending terms, but also owing importantly to the ebbing of borrowing demand as the economy turned down, the growth of bank assets slowed in 1990, especially in the fourth quarter. Total loan growth fell to roughly half its 1989 rate, with slowing evident in business, real estate, and consumer lending. There was, however, a strong regional disparity in the slowdown of bank lending, a disparity that was visible in total bank loans as well as in each loan category. In the Southwest, bank loans continued their pre-1990 decline, while, in New England, bank loans experienced a sharp turnaround at the beginning of 1990 from robust growth to outright decline. New England banks were particularly aggressive in selling loans into securities markets, which contributed to the overall drop, as did loan write-offs. For the rest of the country, loans continued to grow.
The slowdown in bank credit growth in 1990 occurred despite a pickup in bank holdings of government securities early in the year and the large transfers of deposits from failed thrift institutions. Thrift credit shrank rapidly during the year as the RTC resolved insolvent thrift institutions, acquiring the bulk of their assets in the process, and as many viable thrift institutions shed assets in an effort to meet the new capital guidelines. The credit contraction at depository institutions probably reduced total credit to some extent, but by far less than one for one. Both the secondary market in mortgages and the securitization of consumer loans substituted to a large extent for bank and thrift intermediation in those sectors. Securitization alone is estimated to have removed more than $40 billion in consumer loans from bank balance sheets during 1990 as banks pared their asset totals to improve capital ratios. Overall, the markets for home mortgages and consumer credit showed little indication that supply conditions were a significant factor restraining growth of these types of credit. Spreads on both asset-backed and mortgage-backed securities did widen a bit in the fourth quarter, but remained well within historical ranges and appeared to have little impact on the cost of funds to consumers. Sluggish expansion of both consumer credit and residential mortgage borrowing in 1990 seemed to reflect ebbing demands associated with slumping markets for housing and consumer durable goods.
Business borrowing slackened further in 1990, reflecting developments on both the demand and supply sides of the market. Although credit needs to finance corporate restructuring diminished-as indicated by the falloff in net equity retirements to roughly half the pace of the previous two years - the mismatch between corporate capital expenditures and internal funds increased in the second half of the year. A tightening of credit availability for all but investment-grade firms became increasingly evident. The pullback in lending to lower-rated borrowers was not limited to domestic banks; it included U. S. offices of foreign banks, which previously had been aggressive suppliers of funds to U.S. borrowers, as well as domestic nonbank lenders such as insurance companies. In addition, bond markets remained unreceptive to offerings of below-investment grade issues.
State and local governments reduced new borrowing and retired sizable amounts of debt that had been advance-refunded earlier, as pressures on municipal credit ratings mounted in 1990. A significant number of local housing issues had their ratings downgraded in response to the slipping credit quality of several banks and insurance companies that provide credit enhancements. Also, late in the year, certain municipalities and some states found themselves paying substantially higher rates in light of their own financial difficulties.
Growth of the debt of all domestic nonfinancial sectors was boosted last year by the federal government, which borrowed in part to fund acquisitions of thrift assets by the RTC. Borrowing for the RTC accounted for about 1/2 percentage point of the 7 percent growth of total debt in 1990. The growth of debt has slowed over recent years, but, even abstracting from the effects of RTC activity, remained well in excess of last year's expansion of nominal income. TABULAR DATA OMITTED
1. The charts for the report are available on request from Publications Services, Board of Governors of the Federal Reserve System, Washington, D. C. 20551.
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|Title Annotation:||Federal Reserve Board|
|Publication:||Federal Reserve Bulletin|
|Date:||Mar 1, 1991|
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