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Monetary policy report to the Congress.

MONETARY POLICY AND THE ECONOMIC OUTLOOK

Nineteen ninety-three turned out to be a favorable year for the U.S. economy, with notable gains in real output, declines in joblessness, and a further small drop in the rate of inflation. Financial conditions conducive to growth prevailed throughout the year and gave considerable impetus to activity. With the Federal Reserve keeping reserve market pressures unchanged, short-term interest rates held steady during the year at unusually low levels, especially when measured relative to inflation or inflation expectations. In addition, long-term rates declined further, partly in response to actions taken by the Congress and the Administration to put the federal deficit on a more favorable trend.

Against this backdrop, households and businesses were able to take further steps to reduce the burden of servicing debt, and more expansive attitudes toward spending and the use of credit seemed to take hold. Spending in the interest-sensitive sectors of the economy surged ahead, with particularly large advances in residential investment, business outlays for fixed capital, and consumer durable goods. The growth of real GDP picked up sharply in the second half, and the increases for all of 1993 cumulated to about 2 3/4 percent according to initial estimates. In the labor market, employment moved up at a moderate pace, and the unemployment rate dropped almost a percentage point over the year. Measured by the consumer price index, the rate of inflation edged lower last year, as unfavorable reports in the first few months of 1993 gave way to more subdued readings thereafter. The performance of the U.S. economy stood in sharp contrast to the continued sluggish growth in many of the other industrial countries and helped to buoy the trade-weighted value of the dollar on foreign exchange markets.

In conducting policy through 1993, the Federal Open Market Committee recognized that it was maintaining a very accommodative stance in reserve markets. Reserve conditions had been eased to this degree over the preceding four years to counter the effect of some unusual factors restraining aggregate demand. The Committee recognized that as these forces abated, short-term interest rates would likely have to rise to forestall inflationary pressures that would eventually undermine the expansion.

Toward the end of 1993 and into early 1994, incoming data on the economy and credit flows have increasingly conveyed a picture of considerable underlying strength. The marked speedup of growth in the economy has been reducing spare capacity, as is evident in the recent declines in unemployment and increases in capacity utilization rates in industry. Moreover, while movements in broadly based price indexes have remained relatively favorable, there also have been undercurrents suggesting that the process of disinflation might be stalling out. In particular, after slowing considerably in 1992, nominal increases in hourly compensation--comprising wages and benefits-- fell no further in 1993, and long-term inflation expectations remain stubbornly above recent inflation rates. Also, commodity prices generally have firmed in recent months.

Earlier this month, the Federal Reserve concluded that the weight of the evidence indicated that undiminished monetary stimulus posed the threat that capacity pressures would build in the foreseeable future to the point where imbalances would develop and inflation would begin to pick up. At its February 1994 meeting, the Federal Open Market Committee determined that it was time to move to a slightly less accommodative stance. While the discount rate remained at 3 percent, the federal funds rate edged up to trade around 3 1/4 percent, a little above the prevailing rate of inflation.

Strength in spending last year was supported by increased borrowing by both households and businesses. Continuing declines in a number of interest rates, which sparked considerable refinancing of existing obligations, helped to trim debt service burdens for both sectors, undoubtedly facilitating the pickup in borrowing and spending. Indicators of financial stress, including loan default rates and bankruptcy filings, took a decided turn for the better in 1993. Borrowing by households was robust enough to raise the ratio of debt to disposable income; business debt, held down in part by equity issuance, declined relative to income. The total debt of all nonfinancial sectors is estimated to have grown about 5 percent last year, the same as in 1992, as a diminution of the net funding needs of the federal government was about offset by the pickup in private demand. This growth placed the debt aggregate in the lower half of its 4 percent to 8 percent monitoring range.

The growth of M2 slowed in 1993, albeit considerably less than the deceleration in nominal GDP. For the year, M2 advanced 1 1/2 percent, placing it a little above the lower bound of its 1 percent to 5 percent annual growth cone. M3 expanded 1/2 percent, the same pace as in 1992 and a bit above the lower bound of its 0 percent to 4 percent annual range. The ranges had been adjusted down by the Federal Open Market Committee during 1993. The adjustments were technical in nature and reflected the Committee's judgment as to the extent of the ongoing distortions of financial flows relative to historical patterns and of consequent increases in velocities--that is, the ratios of nominal GDP to money.

The special factors shaping the growth of the monetary aggregates included a marked preference by borrowers for capital market financing rather than bank loans and a configuration of market returns that enticed investors away from the traditional financial products offered by depositories. Bond and stock mutual funds were the primary beneficiaries of this shift, with inflows into such funds in 1993 setting a new record. This continuing redirection of credit flows has rendered the movements of the broad monetary aggregates less representative of the pace of nominal spending than was evident in the longer historical record. In 1993, nominal GDP grew a shade more than 5 percent, or 3 3/4 percentage points above the rate of expansion of M2 and 4 1/2 percentage points above that of M3.

Most of the increase in the broad aggregates was recorded in their M1 component, which grew 10 1/2 percent in 1993, as low money market and deposit interest rates provided little reason to forgo the liquidity of transaction deposits. At times during the year, declines in longer-term market rates produced waves of mortgage refinancing, an activity that is associated with temporary flows through the transaction deposits that are counted in M1. In addition, the currency component expanded at about the same rate as the M1 total, spurred by considerable demands from abroad. The double-digit expansion of M1 deposits pushed reserves up at a 12 1/2 percent rate in 1993, while the monetary base, which includes reserves and currency, increased 10 1/2 percent, the same rate as was posted in the previous year.

Money and Debt Ranges for 1994

At its July 1993 meeting, the Committee provisionally chose the same ranges for 1994 as it had established for 1993--1 percent to 5 percent for M2 and 0 percent to 4 percent for M3 and a monitoring range of 4 percent to 8 percent for the domestic non financial debt aggregate. At that time, the Committee noted that disturbances to the historical relationships between the aggregates and spending required that the actual determination of these ranges for 1994, in February of this year, be made in light of additional experience and analysis.

As noted above, the velocities of M2 and M3 increased further in 1993, but at a slower rate than in the previous year. This deceleration might indicate that the forces that had distorted the aggregates over the past few years, while still potent, were beginning to wane. The yield curve, although quite steep, now offers investors less inducement to move outside M2 in search of better returns than at any time in the past three years. Additionally, firms, having strengthened their financial positions, may feel more comfortable taking on shorter-term obligations and, therefore, may direct more of their business to depositories. Banks, which are better capitalized and whose assets are more liquid, should be in a strong position to meet those needs. Still, capital markets will provide attractive alternatives to the depository sector, suggesting that the forces tending to divert funds from depositories-- and to raise the velocities of the monetary aggregates--will continue to be important. However, the strength of these forces, and whether or how quickly they might be abating, remain difficult to judge.

Against this background, the Federal Open Market Committee at its most recent meeting reaffirmed the annual growth ranges for the money and credit aggregates that it had chosen provisionally last July (table 1). The annual ranges appear to be sufficiently wide to encompass growth of M2 and M3 consistent with Committee members' expectations for nominal income under a variety of alternatives for the behavior of the velocities of the aggregates. If the forces depressing the demand for money relative to income were to persist unabated in 1994, M2 and M3 might be in the lower portion of their cones; should M2 and M3 move closer to their former alignments with spending--buoying the demands for those aggregates and depressing their velocities--then outcomes in the upper portion of the ranges would be expected. The Committee will watch the monetary aggregates closely during the course of the year for evidence on unfolding economic and financial conditions. Given uncertainties about velocity behavior, however, that information will necessarily be assessed in combination with a variety of other financial and economic indicators as the Committee formulates policy. Through 1994, as was true last year, the Committee's primary concern will be to foster financial conditions that help contain price pressures and sustain economic expansion, and it will have to assess the rates of money growth consistent with these objectives as the year goes on.

Debt growth, which has moved in closer alignment with nominal income over the past few years than have the monetary aggregates, will again be monitored in light of a 4 percent to 8 percent annual range. With the federal sector's demands on the pool of saving diminishing, the Committee envisions that an unchanged range would be associated with some pickup in borrowing by the private sector. Healthier balance sheets, lighter debt service burdens, heavier capital spending, and more

Economic Projections for 1994

In general, the governors and Reserve Bank presidents anticipate that 1994 will be another year of progress for the economy, with low inflation and financial market conditions continuing to provide a setting conducive to sustaining moderate economic growth and rising employment opportunities.

The Federal Reserve officials' forecasts of real GDP growth over the four quarters of 1994 span a range of 2 1/2 percent to 3 3/4 percent, with the central tendency of the forecasts being 3 percent to 3 1/4 percent (table 2). The governors and Reserve Bank presidents anticipate that the rise in real GDP will be accompanied by a further increase in labor productivity. Nonetheless, employment gains are expected to be sufficient to bring about some further reduction in the degree of labor market slack over the four quarters of the year. Forecasts of the unemployment rate in the fourth quarter of 1994 span a range of 6 1/2 percent to 6 3/4 percent. Because of changes in survey design, a comparable rate for the fourth quarter of last year is not available; however, the Bureau of Labor Statistics has estimated that the fourth-quarter rate would have exceeded 7 percent on the new basis.

The sectoral composition of growth in 1994 may well resemble that of 1993. The financial adjustments of recent years have left households better positioned and more willing to boost spending. Moreover, with employment rising, real income growth should be supportive of increased consumer expenditures in the coming year, despite the higher taxes confronting some households. Business investment seems likely to be pushed ahead by ongoing efforts to modernize and by further declines in computer prices. By contrast, further cuts in federal outlays for defense likely will continue to be a factor restraining the growth of aggregate demand. With the passage of time, the more accommodative monetary policies now in place in a number of countries, together with the moderate fiscal stimulus in Japan, are likely to lead to a gradual pickup in the rates of growth of foreign industrial countries and U.S. exports. However, U.S. imports from abroad will likely continue to move up at a brisk pace. Net exports of goods and services thus may decline somewhat further, albeit at a slower rate than they have over the past year.

The majority of the governors and Bank presidents expect inflation in 1994 to run a shade higher than in 1993. Most of their forecasts for the rise in the consumer price index are close to 3 percent, although the full range of forecasts extends from a low of 2 1/4 percent to a high of 4 percent. Several developments are likely to work against better inflation performance in 1994. In agriculture, a poor harvest in 1993 has left some crops in very tight supply, and the risk of unfavorable food price developments is greater than it has been in recent years. In addition, although the future course of energy prices is uncertain, a repeat of last year's declines, which helped to hold down the overall CPI, cannot be counted on. More fundamentally, the recent narrowing of the degree of slack in the labor and product markets suggests that competitive pressures damping wage and price increases will be less strong and less pervasive than they have been recently.

The central tendencies of the forecasts of GDP growth, unemployment, and inflation are quite similar to the projections put forth by the Administration in its recent reports. Moreover, insofar as the Administration's numbers were predicated, in part, on the assumption that short-term interest rates would rise modestly in 1994, the recent tightening action by the Federal Reserve does not appear to be inconsistent with the Administration's outlook.

Prospects for sustained growth over the longer run have been bolstered by policy actions on a number of fronts. Considerable work remains to be done, however. Although recent fiscal measures have been helpful in bringing about declines in the federal budget deficit, the Congress and the Administration still must deal with some difficult issues to ensure that the deficit is kept on a downward course through the latter part of the 1990s and into the next century. In the area of trade policy, the nation's long-standing support of an open world trading system was reaffirmed this past year in the form of passage of the North American Free Trade Agreement and the agreement in the Uruguay Round--actions that will yield important benefits over time not only to the United States but also to its trading partners. Nonetheless, serious obstacles to free trade remain. On a wide range of regulatory issues, the Congress and the Administration face decisions that have the potential to promote--or to damage--the flexibility in labor and product markets and the processes of innovation and investment that are so critical to long-run economic progress. In the area of monetary policy, the challenge is to build on the favorable price performance of late in a situation in which the economy will likely be operating closer to full capacity than it has in recent years. With success in keeping the economy on course toward the long-run goal of price stability, the prospects for sustained expansion will be greatly enhanced.

THE PERFORMANCE OF THE ECONOMY IN 1993

The economy recorded significant gains in 1993, lifted, as in 1992, by a surge in activity in the latter part of the year. Job creation picked up, and the unemployment rate fell appreciably. Inflation continued to trend lower.

The rise in real GDP over the year amounted to 2.8 percent, according to the Commerce Department's first estimate. For a second year, the growth of activity was propelled chiefly by rapid gains in the investment outlays of households and businesses. Households boosted their purchases of homes and motor vehicles considerably, and spending for household durables also rose rapidly. Business investment in computers continued to grow at an extraordinary pace in 1993, and outlays for other types of capital equipment strengthened. Investment in nonresidential structures, which had gone through a protracted decline in the latter part of the 1980s and early 1990s, rose moderately last year. Bolstered by the gains in these sectors, the four-quarter rise in the final purchases of households and businesses amounted to about 5 percent in real terms in 1993, matching the large 1992 rise. Not since the 1983-84 period had private final purchases exhibited a comparable degree of strength.

The increase in private spending in 1993 was augmented by a pickup in the spending of state and local governments, especially for construction. By contrast, real federal purchases of goods and services--the part of federal spending that is included in GDP--fell sharply, as outlays for national defense continued to trend lower. The federal budget deficit declined somewhat in fiscal 1993 but remained quite large both in absolute terms and relative to nominal GDP. The combined deficit in the operating and capital accounts of state and local governments increased further.

Growth of the economy continued to be significantly influenced in 1993 by the changing patterns of transactions with foreign economies. The weakness of activity in a number of foreign countries that are major trading partners of the United States tended to slow the rise of U.S. exports of goods and services. At the same time, a significant portion of the rise in domestic spending in this country continued to translate into rapid increases in imports. Net exports of goods and services thus fell for the second year in a row, after a run of several years in which real export growth had outpaced the growth of real imports by a considerable margin.

The CPI rose 2.7 percent over the four quarters of 1993, after increases of about 3 percent in both 1991 and 1992. Price increases were damped last year by falling oil prices, near-stable prices for non-oil imports, and a further rise in labor productivity, which held down production costs in the domestic economy.

The Household Sector

Consumer spending recorded a second year of brisk growth in 1993. Support for the rise in expenditures came from declines in interest rates and moderate increases in real incomes. Household balance sheets continued to strengthen in 1993 and debt servicing burdens diminished, casing the financial strains that had inhibited spending earlier in the 1990s.

In real terms, the 1993 advance in personal consumption expenditures amounted to about 3 percent, measured to the year's fourth quarter from the fourth quarter of the previous year. After surging in late 1992, growth of real outlays slowed in the first quarter of 1993. Whatever tendency there may have been for a "payback" after a period of unusually rapid growth was reinforced by a severe late-winter storm on the East Coast, which temporarily hurt retail sales. Thereafter, spending proceeded at a relatively strong pace over the remaining three quarters of the year.

Consumer expenditures for motor vehicles increased 6 percent in real terms over the four quarters of 1993, after rising 9 percent the previous year. The advance in expenditures continued to come partly from the replacement needs of individuals who had put off buying vehicles earlier in the 1990s, as well as from growth in consumers' desired stock of vehicles. Increasingly, buyers have opted for vans, light trucks, and other vehicles instead of cars, and annual sales of these vehicles in 1993 reached the highest level on record. Car sales also rose, but they remained well below previous highs. Data for January of this year showed strong gains in the unit sales of both cars and trucks.

Expenditures for a number of other types of durable goods also rose rapidly in 1993. Outlays for furniture and appliances scored further hefty gains, in conjunction with sharp increases in sales of new and existing homes. Consumer purchases of home computers and other electronic equipment remained on a steep uptrend. In total, outlays for durable goods other than motor vehicles increased nearly 9 percent over the year, after a rise of 10 percent in 1992. Other types of consumer expenditures, which typically exhibit less cyclical variation than do outlays for durables, rose moderately, on balance, during 1993. Consumer purchases of nondurable goods increased about 1 3/4 percent, after a jump of more than 3 1/2 percent in 1992. Spending for services rose 2 3/4 percent during 1993, the same increase as reported for the previous year.

Real income continued to advance in 1993, although its trend was masked by tax considerations that caused a sizable volume of bonuses that would have been paid to workers in early 1993 to be shifted into the latter part of 1992. Abstracting from these shifts in timing, the beneficial effects of continued economic expansion showed through in most categories of income, much as they had in 1992. Wage and salary accruals, a measure of income as it is earned rather than as it is disbursed, rose about 4 1/2 percent in nominal terms over the four quarters of 1993, considerably outpacing the rate of inflation for the second year in a row. Further gains also were reported over the course of 1993 in dividends and in the income of proprietors, both farm and nonfarm. Transfer payments, which tend to vary inversely with the state of the economy, slowed in 1993 after rising at rates of 10 percent or more in each of the four previous years. Interest income, which had declined on net in 1991 and 1992, edged up slightly over the four quarters of 1993. Because of the shift in timing of bonuses, growth of real disposable income in 1993 was less than in 1992. However, the cumulative gain over the two-year period was about 6 percent, a clear step-up from the performance of the three previous years, when real income growth had averaged less than 1 percent per year.

The personal saving rate--measured as the percentage of nominal after-tax income disbursements that are not used for consumption or other outlays---declined nearly 2 percentage points, on net, over the course of 1993. However, the saving rate in late 1992 had been temporarily elevated by the aforementioned speedup of bonus payments. Looking through that blip of late 1992, a downward drift still is evident in the saving rate from mid-1992 to the end of 1993. Such a pattern is not uncommon when economic recovery is taking hold and consumer purchases of durable goods are rising rapidly. In effect, households have been holding part of their saving in the form of consumer durables, which, at the time of purchase, are counted fully as consumption in the national accounts, but which in reality will yield households a flow of services over time.

Consumer reliance on credit picked up in 1993. The volume of consumer credit outstanding rose 5 3/4 percent during the year, after three years in which credit growth had been quite subdued. Growth of consumer credit was especially rapid in the final quarter of the year--about 9 percent at an annual rate. The mortgage debt of households rose about 7 percent from the end of 1992 to the end of 1993, slightly more than in either of the two previous years.

Continued improvement was evident on the asset side of household balance sheets in 1993. As in 1992, the total nominal value of household assets increased at a pace moderately faster than the rate of inflation. Large increases in stocks and bonds boosted the nominal holdings of financial assets, more than offsetting a reduction in the aggregate holdings of deposits and credit market instruments. The nominal value of tangible assets was lifted by heavy investment in consumer durables and residential structures and by a rise in the average price of existing residential properties. With the jump in growth of consumer credit and the slight pickup in the growth of home mortgage debt, household liabilities rose somewhat faster than in 1992. Nonetheless, net worth appears to have increased, probably in real terms as well as in nominal terms. The incidence of financial stress among households diminished further in 1993, as delinquency rates on various types of household debt continued to decline, in some cases to the lowest levels since the first half of the 1970s. According to survey data, households' own assessments of their financial situations have improved of late, with some survey readings the most upbeat in more than three years.

Residential investment increased about 8 percent in real terms over the four quarters of 1993, building on the 18 percent rise of 1992. As in 1992, most of the advance came from increased construction of new single-family homes. The construction of multifamily housing continued to be adversely affected by a persistent overhang of vacant rental units.

In the single-family market, impetus for activity continued to come mainly from declines in mortgage interest rates, which by autumn had dropped to the lowest levels in more than two decades. Fairly sharp declines in mortgage interest rates took place early in the year, but the effect of those declines on housing activity was apparently short-circuited for a time by a number of influences. A severe blizzard on the East Coast in mid-March temporarily waylaid the start-up of construction in that region, and a huge run-up in lumber prices during late winter also may have discouraged some new construction for a while. Concerns about the possible loss of jobs perhaps continued to deter some potential homebuyers. Other buyers may simply have been holding back, waiting to see how far rates eventually would fall.

In any event, the effects of the drop in mortgage rates began to show through with greater force over the summer and fall, and considerable strength had emerged by year-end in all the major indicators of single-family housing activity. Sales of existing homes rose almost without interruption from April on. By the fourth quarter they had climbed to the highest level on record (the series goes back to 1968). Sales of new homes proceeded in somewhat choppier fashion from month to month, but by the end of the year they had moved well toward the upper end of their historical range. Housing construction also strengthened. The number of single-family starts increased about 18 percent from the second quarter to the fourth quarter, rising to the highest quarterly level since 1979. Although housing starts fell sharply in January, the decline probably was in large measure a reflection of the unusually bad weather across the country that month. According to survey data, consumers' assessments of home-buying conditions continued to be very upbeat in January and early February. Builders' ratings of the market edged down a touch in early 1994 but remained at a very favorable level.

Activity in the multifamily housing market remained depressed in 1993. In the mid-1980s, tax incentives and relatively easy availability of credit encouraged overbuilding in many locales. The proportion of multifamily rental units that were vacant soared and has remained high subsequently, even as construction of multifamily units has dwindled. Starts of these units reached the lowest levels on record early in 1993, and they picked up only modestly thereafter, despite restoration of tax credits for low-income units.

The Business Sector

The year 1993 saw appreciable gains in most important barometers of business activity. Output of the nonfarm business sector increased 3 3/4 percent during the year, the same as the rise during 1992. Profits rose further, and business balance sheets continued to strengthen. Capital spending surged.

In the industrial sector, production rose 4 1/4 percent during 1993, the largest advance in six years. Gains of at least moderate proportions were reported in each quarter of 1993. The gain in the year's final quarter was quite large--on the order of 6 1/2 percent at an annual rate. Output of business equipment held to a strong uptrend throughout the year, as did the production of materials that are used as inputs in the durable goods industries. Output of construction supplies rose moderately in the first half of the year and at a stronger pace in the second half. Motor vehicle assemblies also rose appreciably, with strength early in 1993 and in the year's final quarter more than offsetting a stretch of sluggishness through the middle part of the year. By contrast, output of consumer goods other than motor vehicles rose only modestly, and production of defense and space equipment fell 9 1/2 percent further, extending a downward trend that began in 1987. In January of this year, industrial production rose 0.5 percent. Severe winter weather and the California earthquake cut into the growth of production in the manufacturing sector in January, but the output of utilities was boosted by increased heating requirements. Underlying support for industrial production is coming from large gains in new orders that were reported toward the end of 1993.

The amount of spare capacity in the industrial sector continued to diminish in 1993 and early 1994. The utilization rate in January was 83.1 percent. The rate has increased more than two percentage points during the past year, to the highest level since the second half of 1989. In manufacturing, capacity use in primary processing industries has been running above its long-run average for more than a year, and the rate of utilization in advanced processing industries recently has moved up into line with its long-run average.

Corporate profits, which had surged in 1992, increased an additional 6 1/2 percent over the first three quarters of 1993 and appear to have risen further in the year's final quarter. Financial institutions in general continued to benefit in 1993 from the persistence of a relatively wide margin between their cost of funds and the interest rates on their assets; insurers' profits suffered less drag from natural disasters than in 1992, the year of hurricane Andrew. The profits of nonfinancial corporations moved up slightly further over the first three quarters, boosted by the rise in the volume of output over that period. Operating profits per unit of output held fairly steady, close to the high level reached in the final quarter of 1992. Although nonfinancial corporations raised their prices by only a small amount over those three quarters, they were able to maintain unit profit margins through continued tight control over costs. Gains in productivity restrained the rise in unit labor costs, and net interest expenses per unit of output continued to decline.

Business fixed investment increased about 15 percent in real terms over the four quarters of 1993, after a rise of 7 1/2 percent in 1992. A spectacular increase in outlays for office and computing equipment accounted for about one-half of the 1993 gain. Business expenditures for these items increased more than 25 percent in nominal terms over the year, the steepest annual gain since 1984, and the rise in real terms was greater still. Technological advances embodied in the latest computers made them far more powerful than equipment that was at the forefront only a few years ago, and highly competitive market conditions kept prices on a downward course. More real computing power thus continued to become ever more accessible, and the many businesses eager to boost labor productivity and overall operating efficiency provided a huge market for the new products.

Excluding office and computing equipment, outlays for capital equipment increased about 11 percent in real terms during 1993, the biggest rise in ten years. Business expenditures for motor vehicles advanced about 13 percent, as investment in trucks, which had strengthened considerably in 1992, climbed further. Factories producing heavy trucks were operating at or near full capacity at year-end. Spending for communication equipment also advanced sharply, as did real outlays for many other types of machinery and equipment. Diminished slack in many industries and expectations of continued business expansion were among the chief factors giving rise to the increase in these outlays. Ample cash flow from internal operations provided a ready source of finance.

Commercial aircraft was the most notable exception to the general upward trend in equipment spending. Outlays for aircraft plunged in the second half of 1993, and survey data suggest that spending will remain weak in 1994. The reductions in outlays had been foreshadowed by earlier declines in new orders for commercial aircraft, and producers of aircraft have been scaling back their operations for some time.

Business investment in structures rose nearly 5 percent in 1993, the first annual increase since 1989. Declines in the intervening years had cumulated to about 18 percent. Within the sector, divergent trends were evident once again. Outlays for the construction of office buildings fell for the sixth consecutive year, to a level two-thirds below the peak of the mid- 1980s. Several indicators suggest, however, that the worst of the decline in office construction might be over. The rate at which real outlays fell in 1993 was much smaller than the declines of the three previous years. In addition, the national vacancy rate for office buildings, while still quite high, moved down somewhat; improvement was most noticeable in suburban areas, where vacancy rates previously had been the highest. The value of contracts for construction of office building firmed over the course of 1993. Prices of office buildings continued to trend lower, but survey data suggest that the rate of decline has eased in at least some markets.

Investment increased for most other types of structures in 1993. Outlays for industrial structures, which had declined sharply in 1991 and 1992, rose about 8 percent, on net, over the four quarters of 1993. Outlays for commercial structures other than office buildings increased fairy briskly for a second year; by the fourth quarter, they had retraced about 40 percent of the steep decline that took place during 1990 and 1991. Investment in drilling also rose in 1993, as incentives from rising prices for natural gas apparently offset the disincentives associated with falling oil prices. Spending for other types of structures rose by a small amount in the aggregate.

Swings in business inventory investment played only a small role in the economy in 1993. Inventory accumulation in the nonfarm business sector picked up in the early part of the year, but thereafter, the rate of stockbuilding slowed. Accumulation for the year as a whole was of only modest proportions, especially when compared with the rates of buildup seen during previous business expansions. Conceivably, the usual cyclical patterns in inventory change have been tempered to some degree by the more sophisticated inventory control procedures that have become widespread in the business sector in recent years. Toward year-end, inventories appeared to be comfortably aligned with sales in most industries and were lean in some. Most notable among the latter were the stocks of motor vehicles, which were drawn down by production delays through the summer and strength in sales through the latter part of the year. In view of those developments, producers of motor vehicles have scheduled a further hefty rise in production for the current quarter, with assemblies slated to move up to the highest quarterly rate in more than fifteen years.

In the farm sector, inventories declined in 1993. Stocks were pulled down by weather-related reductions in crop output, especially in parts of the Midwest, where the worst flood of the century caused millions of acres to be left idle and cut deeply into yields on the acres that were planted. Inventories of a number of major field crops are in tight supply, in some cases the tightest since the mid-1970s. Farmers whose crops were hurt by weather suffered income losses in 1993, while the producers whose crops were not hurt benefited from rising prices. Total net farm income thus appears to have held in the range of other recent years, at a level well within the extremes of either boom or bust.

Trends in business finance remained favorable in 1993. Business expenditures for fixed capital and inventories were financed almost entirely with funds generated internally, and, in the aggregate, the relatively little external financing that did take place came partly from positive net issuance of equity. Growth of debt was slow, both in absolute terms and relative to the high rates of debt growth seen in the 1980s. With little growth in debt and interest rates down, the portion of business cash flow required for the repayment of principal and interest declined further in 1993. All this seemed to augur well for sustained expansion of the business sector and the economy.

The Government Sector

Federal purchases of goods and services, the portion of federal outlays that are included in GDP, fell more than 6 percent in real terms over the four quarters of 1993. Real outlays for national defense, which have been trending down since 1987, declined nearly 9 percent over the year. Growth of nondefense outlays fell slightly, on net, after fairy sizable increases in each of the three previous years. The level of real federal purchases in the fourth quarter of 1993 was down about 10 percent from the peak of six years earlier. Real defense purchases dropped about 20 percent over that six-year stretch.

Total federal outlays, measured in nominal terms in the unified budget, rose 2 percent in fiscal 1993, the smallest increase in six years. Outlays for defense fell about 2 1/2 percent in nominal terms, and net interest payments were down slightly--the first decline in that category since 1961. Net expenditures for deposit insurance, which had been slightly positive in 1992, were negative in fiscal 1993, held down in part by delays in funding the activities of the Resolution Trust Corporation. Federal spending for income security slowed from the rapid pace of 1991 and 1992, as economic expansion led to a reduction in outlays for unemployment compensation and a less rapid rate of increase in outlays for food stamps. Growth in federal expenditures for Medicare and other health programs also slowed, but their rate of increase continued to exceed the growth of nominal GDP by a considerable margin.

Growth of federal receipts picked up a bit in fiscal 1993, to a pace roughly matching that of nominal GDP growth. Combined receipts from individual income taxes and social insurance taxes, which account for about 80 percent of total federal receipts, rose about 5 1/2 percent, after a gain of 3 percent in fiscal 1992. Receipts from corporate income taxes, which account for about half of the remaining receipts, increased more than 17 percent in fiscal 1993, after only a small gain in the previous fiscal year.

Taken together, the slowing of federal outlays and the pickup of receipts led to a decline in the size of the federal budget deficit in fiscal 1993, after three years of sharp increases. The 1993 deficit amounted to $255 billion and was equal to 4.0 percent of nominal GDP. The previous year, the deficit had amounted to $290 billion and was equal to 4.9 percent of nominal GDP. In fiscal 1989, toward the end of the last economic expansion, the size of the deficit relative to nominal GDP had reached a cyclical low of 2.9 percent.

In the state and local sector, receipts moved up about in step with the growth of nominal GDP in 1993, but state and local expenditures rose still faster. In nominal terms, the increases in spending cumulated to a rise of about 6 3/4 percent over the four quarters of the year. State and local transfer payments to persons have slowed from the extraordinary rates of increase seen in the early 1990s, a reflection of improvement in the economy and intensified efforts among state and local governments to tighten control over these types of outlays. Nonetheless, the rate of rise in these payments remained in excess of l0 percent in 1993. Nominal purchases of goods and services rose moderately, but at a pace somewhat faster than that of 1992. The deficit in the combined operating and capital accounts of state and local governments widened further during the first three quarters of the year, from an end-of-1992 level that already was quite sizable; in the fourth quarter, the deficit apparently shrank, but not by enough to fully retrace the earlier increases.

In real terms, purchases of goods and services by state and local governments increased 3 percent over the four quarters of 1993, after gains of about 1 1/2 percent per year in both 1991 and 1992. State and local expenditures for structures rose more than 9 percent in real terms over the year, according to preliminary data. Some of the spending went for the repair or replacement of structures that had been damaged in recent natural disasters, such as the summer flooding in the Midwest. In addition, the efforts of state and local governments to cope with the needs of growing populations prompted increased investment in schools, highways, and other state and local facilities. Low interest rates probably convinced state and local officials to undertake more of this new construction in 1993 than they would have otherwise. Growth in other types of state and local purchases continued to be fairly restrained in 1993. Employee compensation, which makes up roughly two-thirds of state and local purchases, rose about 1 1/4 percent in real terms during the year, the same as in 1992. Employment growth in the state and local sector was slow by historical standards again in 1993, and increases in hourly compensation were relatively small. State and local purchases of goods rose only moderately.

The External Sector

The trade-weighted foreign exchange value of the U.S. dollar, measured in terms of the other Group of Ten (G-10) currencies, rose nearly 6 percent on balance from December 1992 to December 1993. The dollar's 1993 rise in real terms (that is, adjusted for movements in relative consumer prices) was slightly greater than its rise in nominal terms, as U.S inflation exceeded weighted-average inflation in the other G-10 countries by about 1/2 percent. The dollar's rise continued into the early weeks of 1994, but by mid-February it had fallen back to a level a bit below its average in December 1993.

The main factor behind the strengthening of the dollar last year appears to have been the general downward revision in perceptions of the strength of economic activity in a number of foreign countries while activity in the United States seemed to be improving on balance, especially in the latter part of the year. The weakening of activity abroad contributed to large declines in interest rates in the foreign G-10 countries, both in absolute terms and relative to levels of interest rates in the United States. On average, foreign short-term rates fell nearly 3 percentage points relative to U.S. rates last year, and foreign long-term rates fell about 1 percentage point relative to U.S. rates. Foreign short-term rates have changed little on average during the first few weeks of 1994, while long-term rates have edged higher.

The dollar rose 8 percent against the mark and by similar amounts against other currencies in the exchange rate mechanism (ERM) of the European Monetary System during 1993. It appreciated a bit further, on balance, in early 1994. Potential existed for much greater divergence of dollar exchange rates against these currencies as the result of a widening of permitted fluctuation margins following the ERM crisis last summer. Strains developed in the ERM in July and August on growing expectations that weakness in the French economy and an anticipated recovery of the German economy would cause French authorities to reduce interest rates ahead of German rates. Growing pressure on the French, Belgian, Danish, and Iberian currencies led to massive foreign exchange intervention, sharp increases in short-term interest rates in those countries, and in early August, a substantial widening of the ERM margins. Later, market pressures eased and interest rates returned to their pre-crisis levels as it became clear that these countries would not make use of the wider margins to ease policy, and as the German economy showed signs of weakening further.

The pound, which had depreciated sharply against the dollar in late 1992 after U.K. authorities pulled it from the ERM and substantially lowered interest rates, fell an additional 4 percent relative to the dollar during 1993. The Italian lira depreciated nearly 20 percent against the dollar last year, reflecting market concerns over political uncertainties and massive budget deficits in Italy. Similar concerns, although on a smaller scale, contributed to the Canadian dollar's depreciation against the U.S. dollar of about 4 percent during 1993.

The Japanese yen was the only currency of a foreign G-10 country to appreciate against the dollar in 1993, rising on balance about 11 percent. The dollar-yen exchange rate appeared to be subject to two conflicting sets of pressures last year. During the first eight months of the year, the dollar depreciated nearly 20 percent against the yen, as market attention appeared to be focused mainly on the rising Japanese external trade surplus and perceived political pressures from abroad, particularly from the United States, to reduce this surplus. The dollar reached a low of almost 100 yen per dollar last August. At that point, statements by U.S. officials expressing concern over the implications of the yen's strength for Japanese growth, accompanied by U.S. intervention support for the dollar, appeared to shift the market's main focus from these external considerations back toward the Japanese domestic economy. Over the latter part of the year, as economic activity in Japan continued to weaken and Japanese interest rates moved lower, the dollar rose against the yen, partially offsetting its earlier decline. That uptrend was halted in February 1994, however, in the face of renewed trade tensions between the United States and Japan, and the dollar fell back close to the low reached in August.

The dollar depreciated slightly in real terms on average against the currencies of major U.S. trading partners among developing countries in Latin America and East Asia in 1993. The Mexican peso rose 6 percent, despite a period of downward pressure amid uncertainty about the outcome of the U.S. congressional vote on the Noah American Free Trade Agreement as that vote drew near. The rise in the peso's inflation-adjusted exchange value has cumulated to nearly 35 percent since 1989, reflecting in part a strong inflow of capital from abroad stimulated by domestic reforms, declining world interest rates, and the anticipated positive influence of NAFTA on Mexico's real growth. The Brazilian cruzeiro rose fairly strongly in real terms against the dollar, as substantial nominal depreciation of the cruzeiro did not keep pace with the even more rapid domestic inflation in that country. Meanwhile, the Hong Kong dollar rose in real terms and the Taiwan dollar fell.

Growth of real GDP in the major industrial countries picked up somewhat, on average, during 1993 from depressed levels in 1992. Growth was lifted as economic recoveries in Canada and the United Kingdom gained some momentum. However, output in Japan and most of continental Europe remained sluggish at best, showing either small increases or small declines for most of the year. The weakness of real activity in the foreign Group of Six industrial countries put further downward pressure on CPI inflation, which receded to roughly 2 percent on average in those countries last year. Further declines in interest rates in most of these countries during the past year should enhance the prospects of recovery in the coming year. The economies of the major developing countries in Asia continued to grow rapidly, fueled in part by exceptionally strong growth in China. Real growth in Mexico fell to near zero, however, reflecting the depressing effects of policy restraint aimed at containing inflationary pressures and, for a time, growing uncertainty about whether NAFTA would be implemented.

The nominal U.S. merchandise trade deficit widened to more than $130 billion in 1993, compared with $96 billion in 1992. Imports grew much faster than exports, partly because the U.S. economic recovery gained momentum while economic growth in U.S. export markets was sluggish on average. The appreciation of the dollar also tended to depress real net exports. The current account worsened about in line with the trade deficit, moving from a deficit of $66 billion in 1992 to nearly $105 billion at an annual rate over the first three quarters of 1993. Net service receipts and net investment income receipts both remained little changed over this period.

U.S. merchandise exports grew 3 3/4 percent in real terms over the four quarters of 1993, based on the initial fourth-quarter estimate from the national income and product accounts. Exports changed little, on net, over the first three quarters of the year but strengthened in the fourth quarter as shipments of machinery and automotive products increased. The growth of computer exports in real terms slowed from the very rapid pace of recent years but still posted an increase of more than 15 percent. Agricultural exports declined as a result of reduced U.S. output in the 1993 crop year. By region of the world, the rise in merchandise exports during 1993 was more than accounted for by increased shipments to Canada, the United Kingdom, and Mexico. Shipments to the sluggish economies in continental Europe and Japan declined somewhat, while the growth of exports to developing countries in Asia slowed from the rapid pace of 1992.

Merchandise imports grew about 14 percent in real terms during 1993. The growth in imports was broadly based across commodity categories. Computers accounted for one-third of the growth in real terms, but imports of consumer goods, machinery, automotive products, and industrial supplies all rose strongly as well. Import prices declined slightly during 1993, reflecting a sharp decline in the price of oil imports. The average price of non-oil imports rose only slightly, reflecting low inflation abroad and the rise of the dollar.

In the first three quarters of 1993, recorded net capital inflows balanced only part of the substantial U.S. current account deficit, as net statistical errors and omissions were positive and large. Sizable net shipments of U.S. currency to foreigners, which are not recorded in the U.S. international accounts, contributed to the positive net errors and omissions.

Net official capital inflows amounted to $48 billion. G-10 countries accounted for part of the inflows. In addition, various developing countries, particularly in Latin America, experienced large private capital flows into their countries and added substantially to their official holdings in the United States.

Net private capital inflows into the United States were negligible in the first three quarters of 1993. However, reflecting the continued internationalization of financial markets, both inflows and outflows grew. U.S. net purchases of foreign securities reached a record $96 billion, about evenly divided between stocks and bonds. Most of these net purchases were accounted for by Western Europe, Canada, and Japan; developing countries in Asia and Latin America accounted for a small but growing share of total U.S. net purchases of foreign stocks and bonds. Foreign private net purchases of U.S. government securities and corporate bonds remained strong; foreign asset holders also resumed making net purchases of U.S. corporate stocks. In addition, capital inflows from foreign direct investors in the United States resumed in the first three quarters of 1993, while capital outflows by U.S. direct investors abroad remained strong.

Labor Market Developments

The labor market strengthened in 1993, as economic expansion began to translate more forcefully into increased job creation. Payroll employment, a measure of jobs that is derived from a monthly survey of establishments, rose almost 2 million over the twelve months of the year. Although this gain was only moderate compared with annual increases in many years of the 1970s and 1980s, it was about twice the increase of 1992. The increase in employment in January of this year apparently was held down by bad weather.

Hiring picked up in most major sectors in 1993. The number of jobs in retail and wholesale trade increased about one-half million, the largest annual rise since 1988. The number of jobs in finance, insurance, and real estate picked up a bit after a five-year period that had encompassed three years of sluggish growth and two years of unprecedented reductions. Construction employment rose 200,000 after three years of sharp declines.

The services industry added about 1.2 million new jobs in 1993. More than one-third of the increase came at firms that supply services to other businesses. Of these firms, the ones exhibiting by far the most rapid growth were personnel supply firms--companies that essentially lease the services of their employees to other businesses, usually on a temporary basis. Many companies requiring additional labor apparently have been attracted by the flexibility of such arrangements, as well as by cost advantages, at least over the short run. Elsewhere in the services industry, health services continued to generate a substantial number of new job opportunities in 1993, even though the gain was not quite as large as those of other recent years. Small to moderate employment gains also were reported during the year at firms supplying a wide variety of other types of services.

Manufacturing employment continued to decline in 1993, but at a slower pace than in any of the three previous years. Although manufacturers boosted output considerably, the gain was achieved mainly through another sizable rise in factory productivity. Labor input in manufacturing reportedly increased only slightly, and the gain took the form of a lengthened workweek rather than increased hiring. By the latter part of the year, the average workweek in manufacturing had reached 41 3/4 hours, the longest since World War II. Hiring did pick up late in the year, however, and a further rise in the number of factory jobs was reported in January of this year. Reliance by manufacturers on workers from personnel supply firms reportedly has increased; because these workers are carded on the payrolls of the personnel firms, actual labor input in manufacturing was greater than the data indicate.

Significant improvement in labor market conditions also was evident in data from the monthly survey of households. The measure of employment that is derived from this survey rose 2 1/2 million over the twelve months of 1993, after an increase of about 1 1/2 million during the previous year. At the same time, the number of unemployed persons fell more than 1 million over the course of 1993, and the civilian unemployment rate declined nearly a full percentage point. Because of changes in the design of the monthly survey of households, the official rate reported for January of this year--6.7 percent--is not comparable with the official rates for 1993 or previous years. However, the Bureau of Labor Statistics has indicated that, abstracting from the changes in survey design, the unemployment rate probably fell in January, with estimates of the size of the decline ranging from 0.1 percentage point to 0.3 percentage point. The aim of the new survey is to achieve more precise classification of individuals whose labor market situations may not have been accurately captured by the questions included in the old survey.

Growth of the civilian labor force--the sum of persons who are employed and those who are looking for work was relatively sluggish again in 1993. The rise over the four quarters of the year was 1.2 percent, only slightly faster than the rate of growth of the working-age population. Over the past four years, labor force growth has averaged less than 1 percent per year, and the labor force participation rate has edged down slightly, on net. Based on data from the old survey, the number of persons who desired work but did not seek it because of a perceived lack of job openings changed little over the course of 1993. In addition, the number of persons outside the labor force and not wanting a job rose about 0.8 percent during the year, pulled up in part by a sharp increase in the number of retirees. Workers whose careers were cut short by business restructurings and defense cutbacks probably augmented the normal flow of workers into retirement. Growth in the number of persons not wanting a job because of attendance in school also increased during 1993, according to data from the old survey. To the extent that these individuals have been honing their job skills, their lack of current participation in the labor force could turn into a positive factor for the economy over the longer run.

The slowing of nominal increases in hourly compensation came to a halt in 1993. The employment cost index for private industry--a labor cost measure that includes wages and benefits and covers the entire nonfarm business sector--increased 3.6 percent from December of 1992 to December of 1993, about the same as the rise of the previous year. Wages rose 3.1 percent over the year, one-half percentage point more than in 1992, and the growth of benefits slowed only a little, to 5.0 percent. Compensation gains picked up for workers in some white-collar occupations, notably sales workers and managers. Slightly bigger gains than in 1992 also were realized by workers in some blue-collar occupations. By contrast, the rate of compensation growth held steady in service occupations and edged down in some blue-collar occupations in which fewer specialized skills are required. The overall rise in hourly compensation during 1993 exceeded the rise in consumer prices by about 1 percentage point. Hourly wage gains more than kept pace with inflation, and the value of benefits provided to workers by their employers continued to rise rapidly in real terms.

Labor productivity continued to increase in 1993, albeit less rapidly than in the earlier stages of the cyclical expansion. According to preliminary data, output per hour in the nonfarm business sector rose 1.5 percent during the year, after large increases in both 1991 and 1992. Although part of the gain in output per hour over this three-year period is no doubt a reflection of normal cyclical processes, the data also seem to suggest that the longer-run trend in productivity is tilting up a bit more sharply than in the 1970s and 1980s, a result of heavy investment by business in new information technologies, of the rising skill of workers in exploiting those technologies, and, perhaps, of the more quiescent inflation environment of recent years. With gains in labor productivity offsetting part of the 1993 increase in compensation per hour, unit labor costs in the nonfarm business sector increased just 1.3 percent, a shade less than in 1992.

Price Developments

Inflation edged down a bit further in 1993. The 2.7 percent rise in the CPI over the four quarters of the year was the smallest increase since 1986, and the four-quarter rise of 3.1 percent in the CPI excluding food and energy was the smallest increase in that measure in more than twenty years. At the same time, however, progress toward lower inflation was sporadic during the year, and the slowing of price increases was less widespread than it had been in 1992. Scattered upward price pressures showed up in the commodity markets from time to time during 1993; late in the year and early in 1994, these increases became more widespread. Producer prices picked up somewhat in January, but prices at the retail level were unchanged, on balance.

The patterns of price change for items other than food and energy were more checkered in 1993 than they had been in 1992, a year when deceleration was widespread among both commodities and services. The CPI for commodities other than food and energy rose only 1.6 percent over the four quarters of 1993 a percentage point less than in 1992. Within this category, the CPI for tobacco fell 5 percent in 1993 after many years of large increases, as the inroads being made by generic brands in that market forced major suppliers to alter their basic pricing strategies. Prices of apparel rose less than 1 percent during 1993, an even smaller increase than in 1992. By contrast, the prices of motor vehicles moved up somewhat faster than in 1992; the price rise for tracks was the largest in recent years. The CPI for non-energy services increased 3.8 percent over the four quarters of 1993, about the same as the rise during the previous year. The index for medical care services slowed for the third year in a row, but airfares rose sharply for a second year. Price increases for other services generally were little different from those in 1992, with small deceleration for some items and small acceleration for others.

Food prices picked up in 1993. The consumer price index for food increased 2.7 percent over the four quarters of the year, an acceleration of about a percentage point from the pace of the two previous years. Because price increases in those two previous years had been held down, in part, by unusually favorable supply developments in agriculture, some pickup of food price inflation might have been in store for 1993 even had weather conditions been no worse than average. In the event, the weather was unusually bad. Severe winter weather disrupted livestock production early in the year; drought in the eastern states hurt crop production in that region during the summer; and flooding of historic severity in the Missouri and Mississippi River basins cut deeply into output of some of the nation's major field crops. At retail, effects of the various supply disruptions showed through in the prices of meats, poultry, and fresh produce. Price increases for other foods, which account for by far the larger share of total food in the CPI, showed almost no acceleration in 1993; most of the value added in production of these other foods comes from nonfarm inputs.

Consumer energy prices declined 0.4 percent over the four quarters of 1993 after rising only moderately in 1992. With world oil production outstripping demand, crude oil prices fell sharply during the last three quarters of 1993, to levels in December that were about 25 percent below those of a year earlier. Gasoline prices, after increasing in the early part of 1993, turned down in March and fell for six additional months thereafter. The string of declines was interrupted in October when federal gasoline taxes were raised, but it resumed in November and continued through year-end. Average pump prices for the fourth quarter were about 4 percent below the level of a year earlier. Fuel oil prices fell about 3 percent over the same period. Prices of the service fuels--electricity and natural gas--increased during 1993. The rise in electricity prices over the year amounted to 1.7 percent, slightly less than the increase posted in 1992. Natural gas prices rose nearly 5 percent for the second year in a row; consumption of natural gas has picked up in recent years, after trending lower through much of the 1970s and a large part of the 1980s. Since the end of last year, oil prices have changed little, on net, as an upswing in prices during the first few weeks of 1994 has been reversed by more recent declines. The CPI for energy continued to fall in January.

The producer price index for finished goods, which includes both consumer goods and capital equipment and covers only the prices received by domestic producers, increased just 0.2 percent over the four quarters of 1993. An identical increase was reported in the PPI for finished goods other than food and energy; the increase in this measure was the smallest in its history, which goes back to 1974. As at retail, price increases for these domestically produced goods were held down, in part, by the sharp drop in prices of tobacco products. More broadly, competition from imports and further increases in labor productivity in manufacturing were important elements in pricing restraint. The prices of intermediate materials excluding food and energy rose 1.6 percent over the four quarters of 1993, a small step-up from the pace of the previous year.

In the markets for raw commodities and other primary inputs, scattered upward price pressures emerged from time to time during the first three quarters of 1993, and fairly widespread increases were reported in the year's final quarter and into early 1994. The producer price index for crude materials excluding food and energy thus moved up sharply over the year, by about 10 percent in all. The weight of these inputs in GDP is quite small, however, and in the absence of more general cost pressures, increases in their prices usually do not impart much upward thrust to the prices of finished goods.

Inflation expectations, as reported in various surveys of consumers and other respondents, flared up for a time during 1993 but retreated in the latter part of the year. According to one such survey, conducted by the University of Michigan Survey Research Center, the rate of price increase expected one year into the future moved up from an average of 3.8 percent in the final quarter of 1992 to an average of 4.7 percent in the third quarter of 1993. The rise was fully reversed in the fourth quarter, however. A similar but much less pronounced swing in expectations was evident in some other surveys as well. The surveys have continued to show one-year expectations of price change running somewhat higher than the actual increases of recent years. Longer-run expectations of price change have remained higher still, with the Survey Research Center's series on average inflation rates that are expected over a five- to ten-year horizon holding in a range of 4 1/2 percent to 5 percent, according to surveys conducted in the second half of 1993 and early 1994.

MONETARY AND FINANCIAL DEVELOPMENTS IN 1993

Financial repair continued in 1993, amid increasing signs that borrowers and lenders were more comfortable with their balance-sheet positions. Households, in particular, and firms, to a lesser extent, stepped up their borrowing as the year progressed. Depository institutions, for their part, were sufficiently encouraged by the stronger economy and the improvement in their own financial conditions to ease the terms and conditions of credit for businesses and households.

Nonetheless, with efforts to strengthen financial positions continuing, financing remained concentrated in capital markets, largely bypassing banks and thrifts. In part spurred by the higher returns available in those markets, investors found bonds and stocks to be more attractive alternative than deposits; flows into bond and stock mutual funds were at record levels last year. As a consequence, the monetary aggregates continued to grow quite slowly relative to the expansion of nominal income. Recognizing the ongoing redirection of financial flows relative to historical norms, the Federal Open Market Committee (FOMC) in February and July 1993 lowered the annual ranges for M2 and M3 for 1993 in two technical adjustments totaling 1 1/2 percentage points for M2 and 1 percentage point for M3. Uncertainty about the extent and duration of the unusual change in velocity meant that growth in the aggregates could not be relied upon to guide changes in reserve conditions, and the FOMC continued to use a wide variety of information about financial and economic conditions for this purpose.

Assessing the incoming information, the Federal Reserve judged that no change was needed in reserve and money market conditions during 1993 to sustain the economic expansion without engendering inflationary pressure. With money market rates remaining in a range not much, if at all, above the core rate of inflation, however, the members of the FOMC viewed that a tightening in reserve conditions at some point would likely be needed to avoid pressures on capacity and a pickup in inflation.

Concerns about a buildup of inflationary momentum increased in the spring, and, over the three months from mid-May until mid-August, instructions from the FOMC to the Federal Reserve Bank of New York indicated that there was a greater likelihood that money market conditions should be tightened rather than eased before the next scheduled meeting of the FOMC. Those concerns again came to the fore as 1994 opened. Considerable underlying strength in aggregate demand and dwindling levels of excess capacity to meet that demand raised the risk that inflation pressures would strengthen down the road, derailing the expansion. Consequently, in February, the FOMC tightened reserve conditions for the first time in five years, nudging short-term rates up 1/4 percentage point.

The Implementation of Monetary Policy

Most short-term interest rates ended 1993 where they had begun the year, at quarter-century lows that had resulted from the substantial easing in reserve conditions engineered by the Federal Reserve from 1989 to 1992. The rate charged for adjustment borrowing at the discount window remained at 3 percent, and federal funds traded around the same rate. Despite the stability of short-term interest rates, longer-term interest rates fell as much as 1 percentage point over the course of 1993, to settle at levels not seen on a sustained basis since the late 1960s. Investors apparently were encouraged by the prospects for low inflation and reduced federal budget deficits. Helped by the decline in long-term rates and by brighter earnings reports, the stock market enjoyed strong gains.

In February 1993, the time of the first FOMC meeting of the year, incoming information suggested that the economy had exhibited considerable strength in the fourth quarter of 1992. Final estimates for that quarter put the increase in real GDP at a 5 3/4 percent annual rate and the growth of nominal GDP in excess of 9 percent. Final demand was seen to be strong, paced by household consumption and business investment. With slack relative to capacity still considerable--the unemployment rate averaged 7 1/4 percent (on the old basis)-- price pressures were not perceived to be likely. The expansion of the monetary aggregates had faltered around the turn of the year, but the sense was that special factors--importantly including a decline of mortgage prepayments that constricted the level of transactions deposits--accounted for some of the weakness. Against this backdrop, it appeared to the members of the FOMC that unchanged reserve conditions would support economic expansion and still be consistent with further declines in inflation and inflation expectations. Moreover, the situation did not seem to call for a presumption of the likely direction of any intermeeting adjustment in reserve conditions; such a symmetric directive had been issued to the Account Manager of the System Open Market Account at the end of the December 1992 meeting as well.

Investor confidence in the longer-term prospects in capital markets apparently strengthened in the weeks that followed, owing in part to a growing perception that significant progress in reducing the path of future budget deficits might be in the offing. By the time of the March Committee meeting, bond yields had fallen appreciably, touching levels last observed in 1973, with the largest declines posted at the longest maturities. Indicators of real activity suggested some slowing from the torrid fourth-quarter pace, but in labor markets, payroll employment had strengthened and the unemployment rate had moved down further. Readings on inflation sparked some concern about the potential for a buildup of inflationary momentum. With fundamental forces still suggesting further disinflation, however, and with those concerns not evident in capital market indicators, or in the exchange value of the dollar, which remained relatively steady, the FOMC retained its symmetric directive.

In May, Committee members were confronted with ambiguous indicators of economic activity, prices, and the financial aggregates, which were all made more confusing by a spell of bad weather that had distorted somewhat the seasonal patterns of spending and production. As for the prices of goods and services, although many analysts thought that the major indexes were distorted by difficulties in seasonal adjustment, data releases showing a variety of price and labor compensation indexes on the high side of investor expectations still roiled financial markets. Slack in the economy remained appreciable, which weighed against any pickup in inflation, but inflation expectations were in danger of ratcheting higher, with possible adverse consequences for inflation itself. Meanwhile, the latest readings on the monetary aggregates showed a burst of growth in early May, but tax-induced distortions and a surge in prepayments of mortgage-backed securities made this information particularly difficult to interpret. In the view of a majority of the members of the FOMC, wage and price developments were sufficiently worrisome to warrant positioning policy for a move toward restraint should signs of mounting inflation pressures continue to multiply. Although they saw no immediate need to alter the degree of reserve pressure, they agreed that current conditions made it easier to envisage a tightening rather than an easing over the intermeeting period, a sense that was embodied in an asymmetric policy directive.

In advance of the July meeting of the FOMC, the unemployment rate had moved back up to 7 percent (on the old basis), while industrial production had changed little over the preceding few months. The surge in the monetary aggregates in May apparently had not marked a trend toward more rapid expansion in broad measures of money. Overall, the evidence pointed toward a sustained economic expansion and some ebbing of the recent upsurge in inflationary pressures. News in that vein, along with progress in the Congress toward adoption of a deficit-reduction package, had fostered a drop in longer-term bond yields in the days leading up to the meeting. The durability of that improvement in market sentiment remained an open question, however. Monetary policy could be viewed as relatively expansive in light of the behavior of a variety of other indicators, including the growth in narrow measures of the monetary aggregates and reserves and the low levels of money market interest rates, in both nominal and, in particular, real terms. In such an environment, Committee members agreed that it was necessary to remain especially alert to the potential for a pickup in inflation. As a result, the FOMC decided to retain the current degree of restraint in the reserve market and an asymmetric tilt toward tightening in the policy directive.

At the time of the August meeting of the Committee, readings on inflation were encouraging: Consumer prices had changed little, and producer prices had fallen over recent months. Data on spending and production had a weakish cast, and the persistence of the sluggishness in the second quarter had become more apparent. These data releases had bolstered investor confidence in the prospects for continued disinflation, while the recently passed legislation on the federal budget offered the promise of meaningful cuts in the deficit over the next several years. Accordingly, longer-term yields fell about 40 basis points. The resulting capital gains apparently added to the allure of stock and bond mutual funds, thereby weakening M2, which only edged up in July. At this meeting, policymakers saw existing reserve conditions as consistent with their goals. Moreover, the dissipation of the inflation threat and the encouraging downward tilt to expectations of inflation suggested to members of the FOMC that the risks were more evenly balanced than of late. As a result, the Committee reverted to a symmetric directive-- instructions that carded no presumption as to the direction of an intermeeting move--which was retained for the remainder of 1993.

Leading up to the September FOMC meeting, the unemployment rate had edged lower, to 6.7 percent (old basis), housing starts had declined, and retail sales were flat in real terms. Substantial drags on economic growth remained: cutbacks in the defense sector; uncertainties regarding the effects of other government policies that had the potential to raise labor and production costs; and slow growth on average in the foreign industrial economies. However, sources of stimulus were also apparent: the cumulative spur to spending of low interest rates, especially at longer maturities; the lessening of balance-sheet constraints on households and firms; and the improving financial condition of the depository sector, which was making credit more available. Given these conflicting influences on spending, the Committee determined that leaving reserve conditions unchanged would be most consistent with maintaining sustainable economic growth.

The incoming data in advance of the final two Committee meetings of 1993 indicated a robust near-term expansion in activity with no immediate inflationary pressure. Although there was a sense that with reserves ample and money market rates at the low end of the range of experience over the past three decades, the next move in policy would be to tighten, the members of the Committee agreed that until trends became clearer, the current stance of policy should be maintained. The prospects of heightened credit demands and forecasts of looming capacity pressures pushed up longer-term interest rates about 3/8 percentage point from their yearly lows set in mid-October. Over that same span, the dollar showed notable strength on foreign exchange markets.

Most market rates held at these higher levels as the FOMC met for the first time in 1994. Readings on activity suggested that 1993 had ended on a very strong note, with real GDP expanding about 6 percent at an annual rate in the fourth quarter and reports suggesting that some of this momentum had carded over into 1994. Slack in labor and product markets had been reduced considerably, and the prices of a number of commodities important in the production of durable goods and in construction had begun to move higher. With that backdrop, the Committee decided that it was time to trim back some of the stimulus provided by the current low level of short-term interest rates before it fed through to higher inflation. The Account Manager was directed to tighten reserve conditions, and the federal funds rate moved up to a range around 3 1/4 percent, while the discount rate remained at 3 percent.

Money and Credit Flows The long expansion of the 1980s was associated with growth of total debt of domestic nonfinancial sectors that was about 1 1/2 times the pace of nominal GDP growth. In the wake of this phenomenal leveraging, the recession and tepid economic recovery from 1990 to 1992 were importantly a balance-sheet phenomenon that was reflected in a slowing in debt growth. In retrospect, it is apparent that this deceleration in debt was one symptom of the general dissatisfaction of both borrowers and lenders with their financial conditions, a concern that also led to some restraint on spending and asset accumulation. Nineteen ninety-three saw some lessening of this restraint, and the growth of the debt of the nonfinancial sectors expanded 5 percent, about in line with nominal GDP. This performance put the debt aggregate in the lower portion of its 4 percent to 8 percent monitoring range, a range that had been set at the first meeting of the year.

The debt of the nonfederal sectors (nonfinancial businesses, households, and state and local governments) expanded 3 3/4 percent last year. For non-financial corporations, a pickup in fixed investment and inventory investment outpaced increases in internally generated funds, pushing the financing gap into positive territory after two years of negative readings; as those firms sought outside funds, they turned, in the main, to long-term debt markets, though net equity issuance remained sizable as well. However, the debt markets in 1993 saw far more activity than the net requirements for external funds implied. Low longer-term rates induced many firms to refinance existing obligations, pushing gross public debt issuance by nonfinancial firms above $190 billion.

Earlier efforts to restructure balance sheets, along with the opportunities afforded by lower long-term rates to refinance existing obligations, apparently put households in a better position to take on new debt in 1993. With debt-service burdens holding at about 16 percent of income, or about 2 1/4 percentage points below the peak set at the end of the previous decade, and with loan rates declining substantially, households assumed new liabilities rapidly enough, on net, to push up the ratio of their total liabilities to disposable income to just under 90 percent in 1993. The largest swing was in the consumer credit category, as households evidently became more confident of the sustainability of the economic expansion and made previously delayed purchases of durable goods, especially autos. The record volume of mortgage originations mostly involved refinancings, but with a pickup in construction activity and some cashing out of equity in the process of refinancing, home mortgages expanded 7 percent, on net, last year. Overall, this pickup in liabilities was dwarfed by a substantial expansion of the asset side of the household balance sheet last year, raising net worth to a level about 4 3/4 times that of disposable income. Within those assets, households continued to shun deposits in favor of the investment products of nonbank intermediaries, notably mutual funds and insurance companies. As a result, deposits shrank to less than 20 percent of total household assets, a post-World War II low. Much of the declining role for deposits probably owed to the pattern of financial returns, with investors, confronted by a steep yield curve, seeking out the higher yields provided by longer-maturity instruments that were mostly available from outside the depository sector.

Depository institutions, pressed by their own balance-sheet problems, were unaggressive in seeking deposits and extending credit in the early 1990s. By 1993, however, commercial banks had made substantial strides in improving their capital standing. About three-quarters of the assets at commercial banks were on the books of well-capitalized institutions as of September 1993, 2 1/2 times the proportion at the end of 1990 (table 3). Partly as a consequence, banks reported on Federal Reserve surveys a substantial casing of terms and standards on business and consumer loans during the year. However, borrowers, endeavoring to lock in longer-term funds, which are not typically supplied by banks, continued to rely heavily on capital markets, keeping the need of depositories to fund asset expansion subdued. Depository credit did expand modestly in 1993, marking a substantial rebound from the declines posted in the previous three years. The increase in depository credit exceeded the growth of deposit funds, as depositories made extensive use of equity, subordinated debt, and other nondeposit funds to finance the expansion of depository balance sheets. Bank credit increased 5 percent last year after two years of growth in the neighborhood of 3 1/2 percent, while thrift credit contracted only modestly. Indeed, thrift credit is estimated to have expanded in the second half of the year, pulled up by extensions of loans by credit unions that outweighed continuing, albeit slackening, runoffs at savings and loans.

Slow expansion of depository credit, together with the increased reliance by banks on nondeposit funds, damped the growth of M3 in 1993. From the fourth quarter of 1992 to the fourth quarter of 1993, M3 grew 1/2 percent, ending the year a little above the lower bound of its annual range of 0 percent to 4 percent (table 4). This range had been adjusted down for technical reasons to acknowledge the appreciable upward trend to M3 velocity over the past few years, which accompanied the shrinking role of depositories in intermediating funds. The part of M3 exclusive to that aggregate declined 3 1/2 percent on a fourth-quarter-to-fourth-quarter basis, held down by a steep drop in institution-only money market mutual funds. Overall, M3 velocity rose at a 4 1/2 percent annual rate in 1993, down almost 2 percentage points from the previous year.

The velocity of M2 rose at a 3 3/4 percent annual rate in 1993 after increasing nearly 5 percent in 1992. The rise in velocity last year was posted even as the return on many competing short-term assets remained relatively constant, and it was this ongoing drift upward in the ratio between nominal GDP and the aggregate that led the FOMC to reduce the annual growth range for M2 from the 2 percent to 6 percent spread that was set in February to the 1 percent to 5 percent range that was ultimately in effect. In the event, M2 grew 1 1/2 percent from the fourth quarter of 1992 to the fourth quarter of 1993, slowing slightly from the 2 percent growth rate in 1992. Even this anemic expansion was accounted for in part by special factors. In particular, foreign demands for currency were strong and transactions deposits were boosted late in the year by a surge in mortgage refinancings that followed when mortgage rates fell to levels not seen in a generation. Refinancings are associated with the temporary parking of funds in transactions and other highly liquid deposit accounts.

Especially after taking account of such special factors, the growth of M2 was quite subdued in 1993, owing in large part to the attractiveness of capital market instruments. Although the bond market rally trimmed as much as 1 percentage point from longer-term yields, the term structure still retained an abnormally steep tilt through all of 1993. Some investors were willing to expose themselves to the greater price risk inherent in capital market mutual funds in the pursuit of higher average returns. Commercial banks took some measures to keep those customers, if not those deposits: Many banks made it possible to buy stock and bond mutual funds in their lobbies. Promotion of these services picked up, and some banks sponsored their own mutual funds or established exclusive marketing arrangements with mutual fund companies, undoubtedly encouraging the diversion of deposits to mutual funds.

At the end of 1993, assets in stock and bond mutual funds totaled about $1 1/2 trillion, up $400 billion from the end of 1992. About one-half of the December 1993 total was held by institutions and in retirement accounts--two categories generally not in M2. M2 plus the remainder of stock and bond funds expanded at around a 5 1/2 percent annual rate in 1993, roughly in line with nominal GDP over that period.

M1 grew at a 10 1/2 percent pace last year, spurred on by double-digit increases in currency and demand deposits. As noted above, the former was importantly boosted by foreign demands, while the latter was closely related to swings in mortgage refinancing. M1 velocity declined at a 4 3/4 percent annual rate, despite the relative stability of money market interest rates. In contrast, the narrow aggregate's velocity had followed the path of short rates down during the easing of monetary policy from 1989 to 1992. Altogether, the drop in M1 velocity in recent years illustrates both its high interest-rate sensitivity and the fairly loose relationship of M1 to interest rates and income. With the rapid expansion of transactions deposits, total reserves grew at a 12 1/4 percent annual rate last year, down from the 20 percent pace posted in 1992. Adding in the increase in currency results in a 10 1/2 percent growth rate for the monetary base in 1993, the same performance as the previous year.

Confronted with this rapid expansion in transaction deposits, and therefore required reserves, and directed by the Federal Open Market Committee to keep reserve market pressures unchanged over all of 1993, the Domestic Desk at the Federal Reserve Bank of New York added about $35 billion of securities, on net, to the System Open Market Account over the course of the year. In keeping with previous FOMC instructions, those purchases were weighted more heavily than in the past toward longer-maturity instruments. As a result, the average maturity of the Treasury securities held by the Federal Reserve moved up slightly over 1993, to 3.2 years.
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Publication:Federal Reserve Bulletin
Date:Mar 1, 1994
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Previous Article:Minutes of the Federal Open Market Committee meeting of December 21, 1993.
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