Monetary policy report to the Congress.
MONETARY POLICY AND THE ECONOMIC OUTLOOK FOR 1989 Overall, 1988 was another year of progress for the U.S. economy, marked by further substantial increases in output and employment and by a significant improvement in the balance of trade. The dramatic stock-market break of October 1987 did seem to affect real activity for a time, but the underlying strength of the economy soon showed through, and, apart from losses of farm output caused by the drought, growth proceeded at a relatively strong pace throughout 1988. Moreover, the sizable employment gains in January of this year suggest that the economy entered 1989 with considerable forward momentum.
Inflation has remained in check into the seventh year of the expansion. Even so, developments during 1988 were a little worrying, as, for a second year, increases in prices were somewhat larger than they were in earlier years of the expansion. Part of the pressure on prices in 1988 came in the food area and reflected the influence of the drought. However, with labor markets tightening, there also was a quickening in the rise of wages and total hourly compensation, which affected prices more generally.
Federal Reserve policy mirrored the changing economic circumstances of 1988. Early in the year, as in late 1987, the Federal Reserve sought to limit repercussions from the plunge in stock prices and, in particular, to guard against the possibility of a significant contraction in business activity. Pressures on the reserve positions of depository institutions were eased a bit further in early 1988, and interest rates edged down for a time, extending the declines that had begun in October 1987. Growth of M2 and M3 was fairly rapid during this period, nearly reaching the upper bounds of the annual target ranges established by the Federal Open Market Committee (FOMC).
As it became clear in the spring that the economy still was strong, the focus of Federal Reserve policy shifted. For much of the year, there was heightened concern about the potential for increased inflation, largely reflecting rapid growth of spending and a continued tightening of labor and product markets. A sharp upswing in real net exports of goods and services that had begun in 1987 continued into 1988; while this upturn was a welcome and necessary part of the adjustment of the U.S. economy toward a better balance in its external accounts, it also intensified the demands on U.S. producers at a time when the utilization of domestic labor and capital already was quite high. Accommodating the improvement in our external position while limiting the risk of heightened inflation required restraint on the growth of domestic demand.
The shift by the Federal Reserve toward restraint was reflected in a tightening of reserve market conditions that began in late March and continued, in several steps, into 1989. Short-term market interest rates moved up during this period, influenced both by the System's tightening and by the strength of the economy, and the discount rate was raised in August, to its current level of 6 1/2 percent. Growth of M2 moderated after the spring and ended the year just below the middle of the 1988 target range. The growth of M3 also ebbed over the last two quarters, as the needs of banks and thrift institutions to fund credit expansion slackened.
At present, short-term interest rates are about 2 1/2 percentage points higher than they were early last spring. Long-term interest rates, by contrast, have changed little, on net, over that same period; although these rates turned up in the spring of 1988, they leveled off over the summer and edged down in the fall, even as short-term rates were continuing to rise. This behavior of bond yields seems to have reflected of lowering of market expectations of long-run inflation. Monetary Policy for 1989 The commitment by the Federal Reserve to contain inflationary pressures is reflected in the FOMC's decisions to lower the ranges for monetary and credit expansion this year. The Committee has set a range of 3 to 7 percent for M2 growth during 1989 and a range of 3 1/2 to 7 1/2 percent for M3, reaffirming the target ranges established tentatively in June 1988. These ranges were reduced from those for 1988--a full percentage point for M2 and one-half percentage point for M3--signalling the Committee's determination to resist any upward tendencies in inflation in the coming year and to promote progress toward price stability over the long run. The monitoring range for the growth of domestic nonfinancial debt for 1989 was set at 6 1/2 to 10 1/2 percent, which also is lower than that of last year.
In recognition of the degree to which the relationship between the monetary aggregates and economic performance has varied in this decade, the Committee retained the spread of 4 percentage points between the upper and lower ends of the growth ranges that it adopted in 1988. Despite the deregulation of deposit interest rates, M2 velocity has remained very sensitive to changes in market interest rates over periods as long as a year or more. Depository institutions have been slow to adjust some of their offering rates, causing substantial changes over the short and intermediate term in the relative attractiveness to savers of deposits versus market instruments. In these circumstances, it is difficult to specify in advance a narrow range for the appropriate growth of M2 and the other aggregates in the coming year; such growth will depend on the forces affecting the economy and prices and on the response of depository institutions to any changes in market interest rates, both of which are subject to a substantial degree of uncertainty. Moreover, in 1989, the behavior of M2 and M3 also could be influenced by the resolution of problems in the thrift industry, depending, in part, on how pricing practices of these institutions change, on the reactions of retail and wholesale depositors in these institutions, and on the extent of any restraints on the growth of assets of savings and loan associations.
M2 and M3 are now around the lower ends of their 1989 ranges. This slow growth and the accompanying rise in velocity reflect the continuing effects of recent increases in market interest rates. In light of the slow adjustment of deposit rates, velocity could continue to increase, with growth in these monetary aggregates in the lower halves of their ranges. Given the uncertainties about the relation of movements in the aggregates to prices and output, the Committee agreed that in implementing policy, they would need to assess, in addition to the behavior of money, indicators of inflationary pressures and economic growth, as well as developments in financial and foreign exchange markets.
The Committee will continue to monitor the growth of domestic debt in 1989. The expansion of the debt of nonfinancial sectors may slow a little from the 8 3/4 percent pace of 1988, although it is expected once again to exceed the pace of growth in nominal income. The growth of debt could be importantly affected by corporate financial behavior. The expansion of private debt has been boosted in recent years by the substitution of debt for equity in connection with leveraged buyouts and other corporate restructurings, and business borrowing is likely to be especially sizable in the early part of this year, owing to the recent heavy volume of such activity. The federal government, once again, will be placing heavy demands on credit markets, financing its continuing deficit.
(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.
Economic Projections In general, the Committee members, including the nonvoting Reserve Bank presidents, anticipate that real gross national product will grow moderately in 1989, that prices will rise at a pace similar to, or perhaps slightly above, that of 1988, and that the unemployment rate will remain near its recent level--the lowest in a decade and a half. On balance, the FOMC members anticipate a little less real growth and a somewhat higher rate of inflation than does the administration, but the differences are not large.
Members of the Committee believe that the progress of the economy in 1989 will be determined in large measure by developments on the inflation front. Although special factors, such as the drought, contributed to price increases last year, there also have been troubling indications--most notably in recent wage trends--that inflationary pressures have become more widespread and, potentially, more deeply rooted.
Given the tightening actions taken by the Federal Reserve over the past year and the policy of continued restraint on aggregate demand expressed in the monetary targets for 1989, the members of the Committee anticipate that, if there is any further acceleration of prices from the 1988 pace, it will be quite limited. The majority of the Committee members expect that the consumer price index will rise about 4 1/2 to 5 percent this year. This would be a slightly larger increase than in 1988, and thus would represent something of a setback relative to the Committee's disinflationary objective. However, in light of the tautness of markets and the current momentum of wages and prices, these members viewed such a projection as realistic in the context of a prudent effort to restore price stability over time. It should be noted, however, that some members expect a rise in prices that is significantly below the central-tendency range; in their view this far more desirable outcome could flow from the dollar's recent firmness, which will damp the pressures from rising import prices, and from the recognition by business and labor that restraint is needed to preserve gains in international competitiveness.
A particular uncertainty in the inflation outlook for 1989 centers on the prospects for food prices. FOMC members generally assume that a return to more normal weather conditions this year, together with an increase in acres planted, will lead to a sharp rebound in crop production, in which case food prices might help to temper overall inflation. However, because stocks of some key agricultural commodities have been reduced to low levels, there also is risk that another year of drought could generate strong upward pressures on prices. In the energy area, consumer prices could rise sharply early this year, responding to the runup in oil prices around the end of 1988; nonetheless, world oil supplies still look ample, and members of the Committee are assuming that energy prices will increase only moderately over 1989 as a whole.
With respect to real GNP, the central-tendency forecast of the Committee members is for a rise of about 2 1/2 to 3 percent in 1989, about the same as in 1988. However, this forecast incorporates a working assumption that increased farm output will add around two-thirds of a percentage point to the growth of GNP, similar to the amount that the drought pared from growth in 1988. Excluding this swing in farm output, the central-tendency forecast is for considerably slower growth of real output than last year's gain, excluding drought losses, of more than 3 percent.
Although the economy clearly has entered 1989 on a strong note--even discounting the transitory influence of unusually mild weather in many parts of the country--the members feel that growth soon will move to a lower trajectory, owing both to the general influence of monetary restraint and to a number of sector-specific trends. In the business sector, the boom in capital outlays that was evident in the first half of 1988 has since abated, and surveys of plans for 1989 point to moderate gains in overall plant and equipment spending. Government purchases are expected to be held down by budgetary constraints; defense purchases, in particular, have been trending lower under the influence of cutbacks in real spending authority. Recent increases in mortgage rates likely portend some slackening in the pace of homebuilding, and the growth of consumption expenditures also should begin to taper off from the rapid pace of 1988, as a slowing of expansion elsewhere in the economy damps the growth of real disposable income.
With regard to the external sector, real net exports of goods and services declined over the second half of 1988, but most members of the Committee expect some improvement in the months ahead. However, substantial further progress in external adjustment will require a continuing commitment on the part of U.S. firms to capitalize on the enhanced competitiveness resulting from the depreciation of the dollar since 1985. That commitment must take the form not only of continued cost control and price restraint, but also of more intense efforts at marketing abroad and investment in new capacity where constraints are visible. Failure on these counts would almost certainly leave the U.S. economy considerably less well off over the long haul.
Government policy can do much to encourage businesses to make the longer-range commitments needed to bring about better balance in the economy and to foster longer-run growth. A monetary policy directed steadfastly at movement toward price stability is one critical ingredient. But also crucial is action to bring about further progress toward balance in the federal budget. The Committee has assumed that Gramm-Rudman-Hollings targets will be adhered to in the fiscal 1990 budget process; but the creation of an environment favorable for economic growth with stable prices requires that fiscal policies be put in place to produce the prescribed budget results in the out-years as well.
THE PERFORMANCE OF THE ECONOMY IN 1988 The U.S. economy completed a sixth year of expansion in 1988. Real gross national product rose about 2 3/4 percent over the course of the year, the number of jobs increased more than 3 1/2 million, and the unemployment rate remained on a downward course, closing the year at 5.3 percent, its lowest level in 14 years. Progress also was made toward restoring external balance, as the merchandise trade deficit fell sharply.
The year began on a note of uncertainty. The sharp break in the stock market in the fall of 1987 had raised concern that the economy might falter, and some signs of weakness did emerge around the start of 1988. By early spring, however, it became clear that the expansion still had considerable vigor, coming in particular from rising exports and a boom in capital spending. Households, meanwhile, adjusted fairly readily to the loss of stock market wealth, and consumer spending rose at a strong pace throughout the year. Toward the end of the year, net exports and capital spending softened, but there was enough impetus from other sectors to keep real GNP on a firm upward course.
The rate of inflation, which had picked up in 1987, remained somewhat higher in 1988 than in earlier years. The step-up in inflation in 1987 had resulted mainly from a rebound in the price of oil and the pass-through of higher prices for imports. This past year, by contrast, extra price pressures reflected the impact of drought on the price of food and, more generally, a widespread pickup in labor costs in the domestic economy.
The rise in real GNP last year would have exceeded 3 percent but for a severe drought, one of the worst of this century, that caused huge losses of farm output. These losses accounted for most of the slowdown in GNP growth that occurred after the first quarter of 1988. Fortunately, inventories of farm products had been sizable coming into 1988, and a drawdown of stocks helped to buffer households and others from the disruption to output. Within the farm sector, the drought strained the finances of some producers, but the financial condition of many others was not seriously affected, and the sector as a whole remains stronger fundamentally than in the first half of the 1980s, when the boom of the previous decade was unwinding.
In most of the nonfarm economy, the growth of activity was robust in 1988. Production in the manufacturing sector increased 5 percent, nearly matching the previous year's gain, and factory employment rose sharply. Employment also continued to grow rapidly in retail and wholesale trade and among the providers of business and health services. However, oil drilling, which had turned up in 1987, when oil prices were rising, experienced renewed weakness in 1988, intensifying economic stresses in some parts of the country.
The External Sector The U.S. external accounts showed considerable improvement during 1988. On a balance of payments basis, the deficit on merchandise trade fell from an annual rate of $165 billion in the fourth quarter of 1987 to around $120 billion in the second quarter of 1988 and, on average, remained at that lower level in the second half of the year. Over the four quarters of last year, the value of exports rose more than 20 percent; adjusted for inflation, the increase was around 15 percent. Much of the strength in exports, which was concentrated in the first half of the year, appeared to be associated with an improvement in the price competitiveness of U.S. products resulting from an earlier depreciation of the dollar, as well as with efforts at cost control and increases in productivity among domestic producers. Demand for exports also was supported by surprisingly strong economic growth in other industrial countries. The growth in real export volume was spread over most categories of trade; gains were particularly large for capital goods (especially computers and computer parts), automotive products, and consumer goods. The volume of agricultural exports for 1988 was up 9 percent from that for 1987, despite declines in the second half of the year; the value of these exports was boosted further by the drought-induced rise in crop prices.
The value of merchandise imports, other than oil, rose about 7 percent during 1988. The volume of non-oil imports increased about 2 percent. This rise was concentrated mainly in the capital goods area; volume was down for other major categories of imports. The prices of imported industrial supplies (excluding oil) rose significantly in 1988; smaller increases were recorded for consumer goods, automotive products, and various machinery categories. However, price declines for oil and computers held the overall increase in import prices below that of 1987; on a fixed-weight basis, the rise in non-oil import prices during 1988 was 7 1/4 percent. The value of oil imports declined last year, as an increase in physical volume was more than offset by the decline in price.
For the first three quarters of 1988, the current account showed a cumulative deficit of $102 billion, which was balanced by recorded net capital inflows of $88 billion and a statistical discrepancy of $14 billion. Foreign official assets in the United States increased $28 billion on net (this rise included about $30 billion, on net, of official purchases of U.S. government securities). Net inflows through banks were $21 billion. Excluding banking flows, assets held in the United States by private foreigners increased $68 billion on net; purchases of U.S. government securities were sizable (in contrast to net sales in 1987), and direct investment by foreigners in the United States remained near record levels. Excluding bank flows, the assets held abroad by private U.S. residents increased $26 billion. These recorded capital flows during the first three quarters of 1988, plus the likely net inflows in the fourth quarter, brought the recorded U.S. net indebtedness to foreigners to almost $500 billion at the end of 1988.
The foreign exchange value of the U.S. dollar, which had fallen sharply from early 1985 through the end of 1987, has shown wide fluctuations in the subsequent period. Measured against the other G-10 currencies, the dollar currently is up somewhat, on net, from its end-of-1987 low. However, it has declined in real (price-adjusted) terms against the currencies of our major trading partners among the developing countries, especially South Korea, Mexico, and Brazil.
From mid-April to late August of last year, the dollar rose sharply, on average, against the currencies of the other industrial countries, reflecting the influences of Federal Reserve monetary tightening and monthly trade reports that brightened the market's assessment of the outlook for U.S. external adjustment. When measured against a weighted average of the other G-10 currencies, the appreciation during that period was more than 15 percent. After holding steady through September, the dollar then declined sharply in October and November; market perceptions appeared to shift during that period toward a view that monetary restraint in other countries had increased relative to that in the United States, and incoming trade data suggested a stalling of the adjustment process. Since November, the dollar has again risen, partly in response to further tightening actions by the Federal Reserve.
Measured against the G-10 currencies, the dollar currently is about 7 percent above its December 1987 level. If adjustment is made for changes in relative prices, the resulting real appreciation is somewhat greater, as inflation in the United States has exceeded the weighted average of the inflation rates of the other major industrial countries.
The Household Sector At the start of 1988, concern about the possible effect of the stock market break on the real economy centered on the household sector. The drop in share values had pared roughly half a trillion dollars from household wealth, and the degree to which spending would be cut in response to this loss of wealth was not clear.
In the event, the loss of wealth may indeed have left an imprint on consumer demand. The personal saving rate did rise after the crash and, over the next year, averaged about a percentage point higher than in the year preceding the crash. But, with exports and capital investment booming, the growth of jobs and real incomes remained strong in 1988, and the uncertainties spawned by the crash soon gave way to renewed optimism among households. Thus, after the initial, one-time jump in the saving rate, real consumption expenditures grew at about the same pace as the trend in after-tax income; the rise over the year was about 3 1/2 percent.
Consumer spending for big-ticket items was brisk in 1988. The unit sales of domestically produced automobiles moved up a bit from the 1987 pace, and the sales of light trucks and vans, which have more than doubled since the expansion began in 1983, reached another new high. Adjusted for inflation, total consumer spending for motor vehicles increased 6 1/2 percent over the four quarters of the year. Among the household durables, real outlays for furniture and applicances, which had slowed in 1987, moved up 7 1/2 percent during 1988, renewing the strength that had been evident over the 1983-86 period.
Real residential investment fell slightly in the first half of 1988, but it turned up in the second half and, by the fourth quarter, was a little above the level of a year earlier. Starts of multifamily housing units, which had slumped in 1987, fell further in the first quarter of 1988, but then flattened out over the remainder of the year; vacancy rates for multifamily dwellings remain high in many areas and are likely to hold down new construction of these units for some time. In the single-family sector, starts edged down through the first three quarters of 1988, but rebounded toward year-end to the highest levels since the fall of 1987. By historical standards, these swings in single-family starts during 1988 were relatively mild; indeed, from a longer-term perspective, the past six years have been an unusually stable period in the single-family market, in sharp contrast to the boom-and-bust cycles of the 1970s and early 1980s. Total housing starts, of course, have fallen sharply since 1986 because of the steep decline in construction of multifamily units.
The Business Sector Virtually all indicators of business activity exhibited strength in 1988. Business sales, in nominal terms, rose 9 percent over the year. Hiring was brisk in most sectors, and operating rates rose further; in the industrial sector, capacity utilization at the end of 1988 was at its highest level since 1979. Corporate profits remained healthy.
A surge in business equipment spending that had begun in 1987 extended through the first half of 1988, when outlays grew, in real terms, at an annual rate of about 20 percent. The surge was led by sizable investment in high-technology items--computers, communication equipment, and the like--but outlays for other types of equipment also were strong. After midyear, the rise in equipment spending slowed, and some weakness became evident toward the end of the year. However, most reports from the field suggest that the underlying trend in equipment spending still is pointing firmly upward.
Business spending for new construction declined in 1988, reversing the moderate increase of the previous year. Commercial construction, the biggest item in the total, continued to be restrained in 1988 by the big overhang of vacancies that grew out of the building boom of the mid-1980s. Gas and oil drilling, following the lead of oil prices, fell back a little from the pace of late 1987, but remained above the lows of 1986. Construction of buildings for industrial use was little changed over 1988; although capacity utilization is high in manufacturing, many producers also appear to be limiting their needs for additional space by shifting toward technologies that use more compact equipment, by economizing on inventories, or by conserving on space in other ways.
Inventory investment, which had been sizable in late 1987, moderated in 1988, and, with sales on an upward trajectory, stock overhangs were not a problem for most businesses. In manufacturing, stocks grew more rapidly in 1988 than they had in recent years, but much of the accumulation was in industries in which orders and shipments also were generally strong; the ratio of inventories to sales for all of manufacturing moved down during the year from the already low levels of late 1987. In retail trade, concern about a possible overhang of the stocks of non-durables eased a bit during the year, as the ratio of stocks to sales in that sector edged gradually lower from a February high. By contrast, auto dealers' stocks rose sharply in the fourth quarter, and auto manufacturers have enhanced sales incentives and moved to a lower assembly rate in an effort to pare inventories. For all of manufacturing and trade combined, the ratio of inventories to sales varied little over the course of 1988 and was near the lower end of the range in which it has been since the business expansion began.
The Government Sector Budgetary constraints have led to a slowing of government purchases, both at the federal level and among state and local governments. The federal government's purchases of goods and services--the part of federal spending that adds directly to the gross national product--fell 4 percent in real terms from the fourth quarter of 1987 to the fourth quarter of 1988. Roughly half of the decline reflected a drought-induced reduction in the farm inventories owned or financed by the Commodity Credit Corporation (CCC), a reduction that is counted as a negative federal purchase. Excluding this inventory swing, federal purchases were down 2 percent over the year--the first decline since 1976. Over the eight years that preceded 1988, real federal purchases, other than those of the CCC, had risen at an average pace of nearly 5 percent, considerably faster than the growth of real GNP. The downturn in 1988 reflected cuts in the defense area; other non-CCC federal purchases rose somewhat over the year.
On a budget basis, total federal outlays, which are almost three times as great as federal purchases alone, continued to rise in fiscal year 1988, but at a somewhat slower rate than in most previous years. There were further increases in entitlements, greater demands on deposit insurance agencies, and increases in net interest payments. Meanwhile, the growth of federal receipts slowed in 1988 from the rapid pace of the previous year. Receipts from social security taxes rose more than 10 percent, in part because of a rate increase in January of 1988. However, growth in receipts from personal income taxes slowed, as increases in employment and nominal incomes were offset by final reductions in income tax rates legislated under the 1986 tax reforms. The federal budget deficit in fiscal year 1988 was $155 billion, slightly above the level of the previous year.
The real purchases of goods and services by state and local governments rose 3 percent over the four quarters of 1988, a little more than in 1987 but less than the average rate of growth over the preceding three years. Spending for construction, which had risen rapidly in the mid-1980s, was little changed during 1988 as a whole, although some pickup was evident in the fourth quarter. Employment in the state and local sector continued to rise during 1988, reflecting, in part, the increased demands for teachers and other school workers associated with growth in the number of elementary students.
The Labor Markets The rise in the number of jobs during 1988 was somewhat above that of 1987 and brought the total increase in payroll employment since late 1982 to about 18 1/2 million. Virtually all parts of the economy shared in last year's gain. The number of jobs in manufacturing increased 400,000; employment in construction was up 300,000. Close to a million new jobs were created in retail and wholesale trade, and 1.3 million were added in services. Except for a brief slowdown in the summer, the growth of jobs was strong throughout the year.
The continued rise in employment last year led to a tightening of labor markets and called attention to limits on the potential growth of the supply of labor and of output. Growth of the working-age population has slowed in the 1980s, and the increase during 1988 was the smallest annual rise in more than two decades. This slowing of population growth in the 1980s has led, in turn, to a more moderate rate of growth in the labor force, even as the rate of labor force participation, especially for adult women, has continued to rise. A big boost to output during the expansion has come from putting unemployed workers back on the job; now, however, with the unemployment rate at less than 5 1/2 percent, the labor force is more fully utilized than at any time in the last decade and a half.
The tightening of labor markets in 1988 was associated with a pickup in the rise of wages and labor costs. The employment cost index for wages and salaries in the private nonfarm sector increased a bit more than 4 percent over the year--almost a percentage point more than in 1987. The pickup was most pronounced among white collar workers and in the service-producing industries, where unemployment rates currently are the lowest. The cost of benefits provided to employees rose 6 3/4 percent over the year, nearly twice the increase of 1987; the rise reflected both the hike in the payroll tax at the start of 1988 and a surge in the cost of health benefits. Total compensation per hour--wages and salaries plus benefits--rose nearly 5 percent over the four quarters of 1988, after two years in which the annual increases had been in the neighborhood of 3 1/4 percent.
Productivity gains slackened somewhat in 1988. The rise in output per hour in the nonfarm business sector over the four quarters of the year was only 0.7 percent--about half a percentage point below the average over this decade. This slippage in productivity growth in 1988, combined with the faster rate of increase in hourly compensation, resulted in a 4 percent rise in unit labor costs in the nonfarm business sector over the four quarters of 1988--well above the average rate of increase during the previous five years.
Price Developments The broader measures of prices--including the GNP price measures, the producer price index, and the consumer price index--all indicate that inflation was in a range of 4 to 4 1/2 percent in 1988. Except for the CPI, which had moved up into this range in 1987, these measures showed some acceleration last year, and all of them--including the CPI--rose more rapidly than they did in the first four years of the expansion. In contrast to 1987, when the indexes were boosted by a rebound in energy prices and rising prices for imports, the inflationary pressures this past year were augmented by larger increases in labor costs in the U.S. economy and the drought's influence on agricultural prices.
The drought's effects appeared quickly at the retail level in the summer, as price increases picked up for a wide variety of consumer foods. By late autumn, however, the impact of the drought on food prices began to dissipate, and inflation in the food sector returned to a more moderate path. The increase in consumer food prices over the year as a whole was 5 1/4 percent--about 2 percentage points above the average of the preceding five years. Prices in 1989 will be sensitive to weather developments over the spring and summer. In the past, major droughts in the United States have been one-year events, often separated in time by several good growing seasons, and most agricultural observers have been assuming that farm output will rebound in 1989, thereby restraining the prices of farm crops. Currently, however, dry conditions still prevail in some important growing regions, and crop prices could rise abruptly if moisture supplies are deficient in coming months.
Energy prices were little changed at the consumer level during 1988 after a sharp rise in 1987--a pattern that resulted mainly from the continued gyrations in world oil markets. The price of oil, which had risen sharply in 1987, moved lower for much of 1988, as the efforts of OPEC to restrain production unraveled. In late 1988, a new agreement by OPEC to limit production, coupled with higher-than-expected oil consumption and production shortfalls in non-OPEC countries, caused prices to rise sharply once again; however, despite these fluctuations, prices have not made any sustained departure from the range in which they generally have been since the summer of 1986.
Price increases for goods and services other than food and energy were larger in 1988 than in 1987. The pickup, while fairly moderate, was widespread and probably reflected in large part the past year's acceleration in hourly compensation and unit labor costs in the domestic economy. By contrast, the pressures from rising import prices appeared to be a bit less pronounced than in 1987. Even so, higher prices for imports probably were an influence in some areas; the retail prices of apparel, for example, rose nearly 5 percent for the second year in a row. The price increases for industrial commodities slowed in 1988 after steep increases during 1987; by most measures, however, the year-to-year rate of rise in these prices has remained somewhat above that of inflation in general. The producer prices of intermediate inputs, excluding food and energy, rose more than 7 percent during 1988, reflecting the high levels of capacity utilization in a number of industries, as well as the tightening of labor markets.
MONETARY POLICY AND FINANCIAL DEVELOPMENTS DURING 1988 During 1988, Federal Reserve policy continued to be characterized by a flexible approach to monetary targeting, with System actions responding to emerging conditions in the economy and in financial markets, as well as to growth of the monetary aggregates. This approach has been necessitated by the short-run variability in the relation of these aggregates to economic performance, owing primarily to their sizable response to changing interest rates, in addition to spending. In the early months of last year, monetary policy was eased in light of incoming data suggesting a weakening in the economic expansion and the possibility of further financial market disruptions. Subsequent information, however, suggested a growing threat of inflationary pressures, as the economic expansion remained strong and margins of available labor and productive capacity dwindled. To head off a potential acceleration of inflation, the Federal Open Market Committee tightened reserve conditions in a series of steps beginning in the spring and extending into 1989. The monetary aggregates were running close to the upper ends of their growth ranges before the tightening actions, but subsequently slowed, and they closed the year in the middle portions of their ranges.
Implementation of Monetary Policy During the early months of last year, the Committee sought to counter any economic weakness that could result from the stock market break and to ensure the smooth functioning of domestic financial markets. Indicators of aggregate demand suggested that there was a risk of weakness in the economy that warranted some easing of monetary policy. In addition, special emphasis was placed on monitoring domestic financial markets for signs of any new distress and on being alert to the need to alter the provision of reserves quickly in response to any trouble. Against this backdrop, reserve conditions were eased slightly in early February, contributing to reductions in short- and long-term interest rates.
Throughout the spring, incoming economic data suggested that the economy had overcome the effects of lower equity prices on confidence and spending. This information indicated that the economy was expanding at a rate that threatened progress toward long-run price stability. Bond yields increased during this period, as indications of economic strength contradicted the earlier market forecasts of a general slowdown and raised concerns about an uptrend in inflation. Based on evidence of a greater potential for higher wage and price inflation and in the context of rapid growth in M2 and M3, the Federal Reserve firmed reserve conditions further in a series of steps beginning in March and culminating in early August with a hike of one-half percentage point in the discount rate. These moves brought about substantial increases in short-term interest rates, but were accompanied by only small increases in Treasury bond yields, as investors viewed Federal Reserve actions as heading off a long-term acceleration of inflation. The upturn in short-term interest rates, coupled with more optimistic expectations of future inflation, helped boost the foreign exchange value of the dollar during this period.
In view of the policy restraint already in place, which was being reflected in slowing growth in the monetary aggregates, and some signs that economic growth may have been moderating, the Committee postponed any further action over the late summer and early fall, awaiting further information on the course of the economy. During October and November, the foreign exchange value of the dollar declined, partly in response to a rise in foreign interest rates relative to U.S. market interest rates and to investor concern over the lack of progress in reducing the U.S. federal budget deficit and the slowing improvement in the U.S. trade deficit.
In late fall, incoming data suggested that previous monetary restraint had not been sufficient to relieve the potential for higher inflation, and the Committee resumed tightening reserve conditions in a series of moves beginning in November and extending into the new year. As a result of these measures, short-term market interest rates rose. In contrast, bond yields continued to fluctuate narrowly, signalling the market's continued confidence that inflationary pressures would be contained. This confidence, together with the firming of policy, contributed to a strengthening of the foreign exchange value of the dollar.
Behavior of Money and Credit M2 expanded 5.3 percent last year, just below the middle of its target range of 4 to 8 percent. Although demands for M2 were supported by strong growth in income and spending, they were reduced by increases in its opportunity cost--that is, the difference between market interest rates and the yields on M2-type instruments. Early in the year, opportunity costs had declined in response to decreases in market interest rates relative to deposit rates in late 1987 and early 1988, leading to strong growth in M2 and a decline in its velocity--the ratio of nominal GNP to M2--during the first quarter. But as market interest rates moved upward after March and deposit rates lagged behind, the velocity reversed, and it rose 1.7 percent for all of 1988. The response of offering rates was especially sluggish in the last part of 1988. One reason may have been regulatory pressure on thrift institutions and the closing of many insolvent institutions, which often had been overly aggressive in pricing deposits. The extent to which thrift institutions were offering higher rates than banks on small time deposits was greatly reduced, and partly as a consequence, growth of retail deposits was much stronger at banks than at those institutions.
The growth of the components of M2 also responded to changes in deposit rates and market interest rates. Yields on liquid deposits--interest-bearing checking deposits, savings deposits, and money market deposit accounts--changed very little over the year. During the first half of 1988, liquid retail deposits expanded at a strong pace, largely reflecting increases in their relative attractiveness stemming from declines in market interest rates and, to a lesser extent, in rates on small time deposits. Their growth slowed markedly over the last half of 1988, following the reversal in the pattern of interest rate movements. Growth in small-denomination time deposits was particularly robust throughout 1988. Expansion in the early months of the year may have resulted, in part, from shifts in household investment preferences away from stocks toward the safety of these savings instruments. Later, rising yields on small time deposits relative to those on more liquid deposits led households to shift funds from liquid deposits to small-denomination time deposit accounts.
M3 grew 6.2 percent last year, placing it slightly above the midpoint of its target range of 4 to 8 percent. This increase from a 5.8 percent growth in 1987 reflected a modest pickup in the issuance of managed liabilities in M3 to fund credit expansion at banks and thrift institutions. M3 followed a trajectory near the upper end of its target range in the first half of 1988, but moderated thereafter, in association with slowing credit growth at depository institutions. For the year, large time deposits and other managed liabilities included in M3 but not in M2 grew rapidly, as inflows into M2-type deposits were insufficient for banks and thrift institutions to finance their desired pace of asset expansion. This was particularly true in the second half of the year, when M2 growth moderated. To some extent, M3 growth last year was bolstered compared with 1987 by a greater reliance by banks on managed liabilities included in M3 than on nonmoney stock instruments, such as bank borrowings from overseas branches. In contrast, as in recent years, the heavy use of Federal Home Loan Bank advances by thrift institutions--which are not included in M3--has had a moderating effect on M3 growth.
At 4.3 percent, M1 growth last year was down more than 2 percentage points from 1987. Growth of interest-bearing checking accounts moderated, while demand deposits continued running off. As in recent years, the growth of M1 displayed great sensitivity to changes in market rates of interest. Households shifted savings balances between NOW accounts and those M2 components, such as small time deposits, whose yields responded to increases in market rates much more quickly than those on NOW accounts. Because substitutions of this type are internalized within M2, M2 has displayed less sensitivity to interest rates than has M1 in this decade. Demand deposits, the other highly interest-sensitive component of M1, again declined in 1988, partly reflecting increases in their opportunity costs and declines in compensating balances. The amount of such balances that businesses must hold in these non-interest-bearing accounts to compensate banks for services falls when interest rates rise.
The debt of domestic nonfinancial sectors expanded nearly 8 3/4 percent during 1988, down from 9 percent in 1987, placing it near the midpoint of the Committee's monitoring range of 7 to 11 percent. Although debt expansion was well below the pace of the mid-1980s, it still exceeded nominal GNP growth. Federal debt grew marginally faster last year than in 1987. Expansion in nonfederal debt moderated, as state and local governments trimmed debt issuance and as households expanded their mortgage debt at a less robust pace in response to higher mortgage rates. Growth of business debt picked up a bit from the 1987 pace, with short-term debt growing faster than long-term debt. Corporate borrowing was particularly strong, reflecting increased external financing needs for capital investments and for mergers, buyouts, and stock repurchases.
Other Financial Developments Although the economy continued to grow at a strong pace last year and the financial markets recovered from their skittishness following the stock market break of 1987, financial developments in certain markets and sectors warranted the attention of policymakers. Of particular note were the worsening condition of the thrift industry, the need to achieve sounder capitalization of commercial banking organizations, and the rising indebtedness of businesses involved in restructuring activity.
As the year wore on, the dimensions of the problems facing the thrift industry became clearer. Although industry losses eased in the third quarter from their record levels in the first half of 1988, this development appears largely to have reflected FSLIC-assistance transactions during the third quarter, rather than a significant underlying improvement in earnings.
Despite the turmoil in the thrift industry, there has been no noticeable disruption of mortgage activity. In part, the development of a deep secondary mortgage market has separated the origination of loans from the need to fund them. For this reason, the base of mortgage credit has broadened in recent years, making the provision of mortgages far less dependent on the condition of any one type of financial institution or on the regional supply of loanable funds. During the 1980s, the share of home mortgage credit held in securitized form has increased from about 10 percent to more than one-third. The spread between interest rates on fixed-rate mortgages, which have an average life of roughly ten years, and yields on ten-year Treasury notes did not change appreciably over 1988, which also implies that the mortgage markets continued functioning well despite the problems of many savings and loan associations.
In contrast to the thrift industry, preliminary data indicate that U.S. commercial bank profits were reasonably strong in 1988, even after abstracting from the one-time jump in earnings in the fourth quarter associated with the resumption of Brazilian debt payments. Moreover, most large money-center banks with a significant amount of loans to developing countries have continued to build capital, which provides a cushion against default losses. Giving added impetus to efforts to raise equity was the agreement by bank supervisory authorities of major industrial countries to set more stringent, risk-based standards of capital adequacy. These standards, to be fully phased in by 1992, place a greater emphasis on equity capital, take into account the off-balance-sheet activities of banks, and provide a more uniform regulatory treatment of banks based in different countries.
As in 1987, banks lent considerable sums to finance mergers and leveraged buyouts. Although banks have reported that these loans have had a lower rate of loss than all other business loans combined, and although LBO borrowers typically obtain some insurance against higher loan rates, concern remains about bank exposure to losses in the event of an adverse turn in business conditions. For this reason, the Federal Reserve is closely monitoring developments in this area and has just revised its bank examination guidelines to ensure that member bank loans used to finance buyouts and other highly leveraged corporate restructurings meet prudent credit standards.
Leveraged buyouts and other mergers and restructurings led to a record pace of net equity retirements by nonfinancial corporations in 1988. Despite the large volume of this activity in recent years, the overall corporate debt-to-equity ratio is not out of line with observations since the early 1970s, reflecting increased market valuation of equities since the early 1980s. Much of the recent financial restructuring has been a response to fundamental economic factors; it may impose a discipline on corporate management, which in turn can stimulate efforts to improve productivity. Nevertheless, heavy commitments of cash flow to service debt reduce a firm's ability to cope with stresses or industry-specific shocks. To some extent, the substitution of debt for equity is motivated by simple tax-saving considerations, such as the full deduction for interest payments and the double taxation of dividends. For these reasons, reforming the corporate tax system should be a component of public policy in addressing this difficult issue.
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|Title Annotation:||February 21, 1989, pursuant to the Full Employment and Balanced Growth Act of 1978|
|Publication:||Federal Reserve Bulletin|
|Date:||Mar 1, 1989|
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