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Monetary policy report to the Congress.

Monetary Policy Report to the Congress

Report submitted to the Congress on July 20, 1989, pursuant to the Full Employment and Balanced Growth Act of 1978.(1)


As 1989 began, a reduction in inflationary pressures appeared essential if the ongoing economic expansion was to be sustained. Monetary policy during 1988 had been directed toward reducing the risks of an escalation of inflation and inflation expectations, but at the time of the Board's report to the Congress in February of this year, success in that effort seemed far from assured.

Indeed, among the data reported in the early part of 1989 were very large increases in the producer and consumer price indexes, reflecting not only the effects of run-ups in oil and agricultural commodity prices, but also broader inflationary developments, including unfavorable trends in unit labor costs over the preceding year. Under the circumstances, with pressures on productive resources still intense, monetary policy was tightened further. Reserve availability was curtailed through open market operations, and the discount rate was raised 1/2 percentage point in late February. In response to these policy actions and to expectations that additional tightening moves might be needed, market interest rates climbed throughout the first quarter, and money growth was subdued.

Over the course of the second quarter, several indicators suggested the emergence of conditions that were more conducive to a future easing of inflationary pressures. Growth of the monetary aggregates weakened further, with M2 running noticeably below its target range for the year. Aggregate demand for goods and services moderated, reducing somewhat the strains on productive resources, especially in the industrial sector of the economy. The dollar exhibited considerable strength in the foreign exchange markets, portending a direct reduction in price pressures and slower growth in demands on domestic production capacity. Although the unemployment rate remained essentially unchanged in the neighborhood of 5 1/4 percent--the lowest level since the early 1970s--trends in wages and total compensation showed little, if any, further step-up, reflecting at least in part an awareness among workers and management of the need to contain costs in a highly competitive world economy. Meanwhile, prices of actively traded industrial commodities leveled out, enhancing the prospects for a broader slackening in the pace of inflation.

In this environment, interest rates turned down during the spring, as financial market participants responded not only to the better outlook for inflation but also in anticipation of an easing of monetary restraint by the Federal Reserve. The System began to provide reserves slightly more generously through open market operations at the beginning of June and took an additional small easing step in early July. This helped bring about a further decline in market rates of interest, which by mid-July generally had more than retraced the increases that had occurred earlier in the year. Most short-term interest rates were down about 1/2 percentage point from their December levels, while long-term rates had fallen as much as 1 percentage point on balance.

Monetary Objectives for 1989 and 1990

In February, the Federal Open Market Committee (FOMC) specified a range for M2 growth in 1989 that was a full percentage point below that of 1988 and ranges for M3 and debt that were 1/2 percentage point below those of the previous year (table 1). This was the third consecutive year in which the ranges had been lowered. At the same time, the Committee recognized that, in light of the continuing uncertainty regarding the shorter-term relation between monetary growth and changes in income and spending, a variety of indicators of inflation pressures and economic activity as well as the behavior of the aggregates would have to be considered in determining policy.

In February, the Committee had anticipated relatively slow money growth over the first half of the year because of the effects of the firming of policy through late 1988 and into 1989. In addition to the influence of the higher interest rates on desired holdings of money, however, several special factors--including the difficulties of the thrift industry and a drawdown of liquid assets to meet unusually large individual tax payments--appear to have further reduced money balances in the first half. These factors contributed to a substantial rise in velocity, the ratio of nominal GNP to the stock of money.

By June, money growth had picked up. Nonetheless, M2 ended the quarter just 2 percent at an annual rate above the fourth quarter of last year, compared with its annual growth range of 3 to 7 percent. In June, M3 was at the lower end of its annual range of 3 1/2 to 7 1/2 percent. The rate of expansion of domestic nonfinancial sector debt also slowed in the first half of this year compared with 1988, though by less than the monetary aggregates; debt has grown about 8 percent so far this year, near the middle of its monitoring range of 6 1/2 to 10 1/2 percent.

At its meeting earlier this month, the Committee agreed to retain the current ranges for growth of money and debt in 1989. The Committee anticipates that by the fourth quarter all three aggregates will be well within those ranges. The more rapid growth in M2 and M3 already evident since mid-May is expected to extend through the second half. The recent declines in short-term market interest rates have made M2 holdings more attractive, tending to offset the restraining effects on M2 of previous increases of interest rates. With M2 expansion likely also to be boosted by a further replenishing of liquid balances depleted by tax payments, this aggregate is expected to grow a little faster than nominal gross national product in the second half, bringing it into the lower portion of its annual growth range. The faster growth of M2 should show through at least in part to a quickening in M3 growth over the second half of the year, so that this aggregate would move into the middle part of its range. Domestic nonfinancial debt is likely to remain in the middle portion of its range through year-end.

For 1990, the Committee provisionally decided to use, for all three aggregates, the same growth ranges in force for 1989. The Committee recognized that the economic and financial outlook over the next year and a half is uncertain; in particular, it is unclear at this juncture whether the velocities of M2 and M3 are more likely to trend higher or lower next year. Although the Committee's initial assessment is that growth of money and credit through 1990 within the bounds of the reduced ranges of this year likely would foster the slower inflation and sustained real economic expansion that it is seeking, it will reevaluate the ranges next February in light of the unfolding economic and financial situation. The outlook for spending, prices, and financial markets in 1990 should have clarified somewhat by then, as should the influence on monetary expansion of the ongoing resolution of thrift industry problems. For the long term, the Committee recognized that ultimate attainment of price stability will require that the ranges for money and credit growth be reduced further in future years.

Economic Projections for 1989 and 1990

Voting members of the Committee and other Reserve Bank presidents believe that the monetary ranges specified are consistent with some progress in reducing inflation, which likely will be associated in the near term with the continuation of a slower pace of economic growth. The central tendency of the forecasts is for increases in real GNP of 2 to 2 1/2 percent in 1989 and of 1 1/2 to 2 percent in 1990 (table 2).

The expected easing of pressures on resources should contribute to a damping of inflation in 1990, although the Board members and Bank presidents also are anticipating some near-term relief from the special problems that boosted prices in the first half of this year. Larger crops later this year should result in more favorable behavior of food prices, and the recent peaking of crude oil prices suggests the likelihood of some softening in consumer energy prices. Thus, retail inflation should be considerably slower over the remainder of this year, and the central tendency of consumer price index forecasts for 1989 as a whole is 5 to 5 1/2 percent--compared with the rate of more than 6 percent observed through May. The forecasts for the consumer price index in 1990 center on 4 1/2 to 5 percent.

The Administration's economic forecast, presented in connection with its mid-session update of the budget outlook, does not differ greatly from the projections of the FOMC members. Nominal GNP is near the upper ends of the central-tendency ranges of the FOMC for 1989 and 1990, but with a more favorable mix of real output versus inflation, especially in 1990. There appears to be no basic inconsistency between the policy objectives of the Federal Reserve and the economic forecast of the Administration; indeed, the Administration has indicated that it shares the view that the maintenance of anti-inflationary monetary policy is a precondition for healthy economic expansion.

In an environment of relatively slow overall growth, such as is expected by the FOMC members, some industries and regions are likely to experience setbacks; but major imbalances that could threaten the continuation of the economic expansion are not anticipated. In the household sector, growth of consumer purchases has been sluggish and may remain so for a while. Residential construction activity should pick up some in coming months, in response to the recent decline of mortgage rates, although an overhang of supply in some locales could damp the recovery. Surveys of business plans suggest that capital spending will post further gains over the remainder of 1989, but some moderation from first-half growth rates is to be expected in light of declining levels of capacity use and the recent weakening in corporate profits. Spending on equipment is likely to continue to be buoyed by the desire to modernize industrial facilities so as to enhance efficiency and meet intense competition here and abroad.

The external sector represents an area of considerable uncertainty in the economic outlook for the next year and a half. Real net exports of goods and services increased earlier this year, but improvements may be more difficult to achieve in the period ahead as the effects of past depreciation of the dollar wear off and are offset by those associated with the more recent appreciation. In addition, the path of exports will depend importantly on economic growth abroad, which may slow as a result of policy actions taken by some of our major trading partners to offset mounting inflationary pressures. Ultimately, achievement of the adjustment needed in the external sector will depend not only on governmental policies that foster macroeconomic stability, but also on the determination of U.S. firms to meet foreign competition through application of stringent cost controls and intensified marketing efforts abroad.

A key ingredient in maintaining a healthy pace of economic expansion is further progress in reducing the federal budget deficit. Since 1983, the deficit has fallen relative to GNP from more than 6 percent to around 3 percent, but it remains large by historical standards. Taking the actions required to meet the Gramm-Rudman-Hollings targets on schedule will foster confidence in the U.S. economy, particularly among financial market participants. At the same time, reduced demands by the federal government for credit will free up the available supply to interest-sensitive private sectors, such as housing and business investment. The Committee thus views as highly encouraging the commitments expressed by the Congress and the Administration to begin soon to address the problems of meeting the fiscal 1991 budget target.


After two years of rapid expansion, economic activity decelerated substantially in the first half of 1989. Even at this more moderate pace of growth, however, job creation was considerable--nearly 1 1/2 million between December and June--and the civilian unemployment rate, fluctuating around 5 1/4 percent, remained in the lowest range since the early 1970s.

Inflation rose in the first half of 1989, but most of the increase appears to have resulted from transitory events. In particular, energy prices increased sharply, as the rise in crude oil prices between November 1988 and May 1989 was passed through, and food prices surged as the agriculture sector continued to experience adverse supply developments. Outside food and energy, the rate of inflation has, on average, remained at about its 1988 pace, even in the face of relatively high levels of resource utilization.

This apparent stability of underlying price trends is attributable in part to the appreciation of the dollar on exchange markets. So far in 1989, prices of imported goods other than oil have been virtually flat on average, restraining increases in the prices of domestically produced items. In addition, despite the tightest labor markets in some time, wage trends have been fairly stable, helping to limit the acceleration in unit labor costs during a period in which productivity has weakened.

The External Sector

Developments in foreign exchange markets have played an important role in shaping events in the domestic economy in recent years. After depreciating over most of the period from 1985 to late 1987, the foreign exchange value of the dollar in terms of other Group of Ten (G-10) currencies changed little, on net, in 1988, as a decline in the final few months reversed much of the increase that had occurred earlier in the year. In December the dollar began to rebound, and it rose substantially through mid-June before dropping back somewhat. The appreciation of the dollar through the first half of 1989 was frequently met by concerted intervention sales of dollars by U.S. and foreign monetary authorities.

During December, and in the first quarter of this year, the dollar rose in response to perceptions of a relative tightening of U.S. monetary policy. Reports of somewhat higher rates of inflation and news about the strength of the economy contributed to expectations that Federal Reserve policy would be tightened still further. There was a brief pause in the dollar's rise after the Group of Seven finance ministers and central bank governors stated in April that a further rise in the dollar that undermined the adjustment process would be counterproductive.

In May and early June, the dollar appreciated significantly on balance, even though interest rates on nondollar assets rose relative to those on dollar-denominated instruments. Sentiment in favor of the dollar was, perhaps, partly a response to concerns about political events abroad, but the data on the U.S. trade balance, which were better than expected, also may have played a role. For a while, the dollar's rise appeared to be associated with expectations of capital gains on U.S. stocks and bonds. Since mid-June, the dollar has retraced much of its second-quarter rise, under the influence of increasing interest rates abroad, declines in dollar rates, and some easing of demands for dollar assets after the initial response to political uncertainties in certain other countries.

Measured in terms of a trade-weighted average of the other G-10 currencies, the dollar is about 8 percent higher than it was in December 1988 and about 12 percent higher than it was in December 1987. After adjustment for changes in relative price levels, the appreciation of the dollar has been larger because U.S. inflation has remained above the average for the other G-10 countries. Meanwhile, the currencies of South Korea and Taiwan have risen moderately against the dollar so far in 1989.

In most of the other industrial countries, economic growth has been strong. The resulting very high rates of capacity utilization and the diminishing slack in labor markets, together with higher world oil prices and special factors, have spurred an appreciable pickup in inflation abroad in recent quarters. Policymakers in many foreign industrial countries have responded by raising official interest rates. Growth of the newly industrializing economies in Asia has slowed recently, though the rates remain relatively high. In contrast, developing countries that are burdened with large external debts have continued to struggle to achieve sustained economic growth.

The U.S. merchandise trade deficit in the first quarter was $110 billion at a seasonally adjusted annual rate, significantly better than the figure for the fourth quarter and that for 1988 as a whole. In the first two months of the second quarter, the trade deficit was essentially unchanged from the first-quarter pace.

Exports have continued to expand this year, although not so rapidly as in 1988. Export gains have been broadly based, with notable increases for agricultural goods, industrial supplies, capital goods, and consumer goods. Meanwhile, imports have increased moderately; in fact, in April and May imports of products other than petroleum averaged less than 1 percent above their fourth-quarter rate. Notable decreases were recorded in imports of consumer goods and automotive products. So far in 1989, the value of oil imports has risen sharply, as higher prices for petroleum and petroleum products were accompanied by a small increase in physical volume. The further improvement in the U.S. trade balance in the first five months of this year reflects several factors, most importantly the strength of economic activity abroad, the slower growth of U.S. activity, the continuing, if diminished, benefit for U.S. price competitiveness from the depreciation of the dollar through the end of 1987, and the restraint that the recent rise in the dollar placed on prices of non-oil imports.

The current account deficit widened in the first quarter to $123 billion. The increase from the fourth-quarter rate was more than accounted for by capital losses on assets denominated in foreign currencies resulting from the dollar's appreciation. Setting aside those losses, the current account balance in the first quarter showed a deficit of $108 billion, an improvement of about $22 billion from the previous quarter. Nearly all of this improvement resulted from the narrowing of the trade deficit. Preliminary information on capital transactions in the early months of 1989 suggests an increase in net private foreign purchases of U.S. Treasury securities and corporate bonds and substantial foreign direct investment in the United States.

The improvement in real net exports accounted for nearly half of the overall rise in the GNP during the first quarter, more than reversing its negative contribution in the fourth quarter. The contribution to GNP growth in the second quarter probably was negligible, however, as real net exports may have begun to be depressed by the loss in U.S. price competitiveness associated with the cumulative rise in the dollar since the end of 1987.

The Household Sector

Much of the slowing in overall economic growth in the first half of 1989 reflected a deceleration in consumer spending. The slump in demand was fairly broad, encompassing a variety of durable and nondurable goods. Despite the widespread availability of special financing deals and other incentives, sales of motor vehicles in the first half were about 6 percent below the pace of 1988 as a whole. A weakening in purchases of furniture and appliances likely was related in part to the drop in home sales.

Consumption slowed against a backdrop of strong income growth in the early part of the year, although weaker income growth was evident in the spring. Personal income gains in the first quarter were accentuated by the assumption of the national income accountants that the income of farm proprietors would return to normal levels over the year, after the drought-induced reductions in 1988. With hiring down in the spring, increases in wages and salaries softened noticeably, showing virtually no growth in real terms. Also, growth of the nonwage components of personal income was weaker on balance in the second quarter.

The personal saving rate has been on a distinct upswing since reaching a forty-year low in mid-1987. Several explanations have been propounded for the recent rise, among them the lower level of household net worth relative to income since the stock market break of 1987, higher costs of consumer credit (especially in after-tax terms, because of the phase-down of interest deductibility), and concerns about a potential softening of the economy. Whatever the cause, households appear to have adopted a more cautious spending stance, though it also should be noted that the personal saving rate has remained below the norms of the 1960s and 1970s.

Residential construction declined over the first half in response to the rise in interest rates and to earlier overbuilding in some markets. The more recent drop in rates, which began in May, likely will be reflected in some improvement in construction over the summer and fall. Total housing starts, at an average annual rate of 1.44 million units through May, were down 3 1/4 percent from their 1988 pace.

Starts in the single-family sector averaged about 1 million units at an annual rate between March and May, a period relatively free from the weather-related distortions that affected construction in January and February. Interest rates on fixed-rate mortgages rose above 11 percent for the first time since 1985, with part of the rise attributable to investor concerns about sizable future liquidations of mortgage assets by troubled thrift institutions. Also, rates on adjustable-rate mortgages (ARMs) rose nearly a full percentage point during the early months of 1989, as discounting of initial interest rates on ARMs was reduced. In recent years, relatively low initial terms on ARMs led an increasing number of households to favor this instrument for home purchases. Since their highs in the spring, interest rates on ARMs have fallen more than 1/2 of a percentage point, while fixed-rate mortgage rates have dropped about 1 1/4 percentage points.

Meanwhile, multifamily starts fell further in the first half of the year from the already low level recorded in 1988. Multifamily housing production has been limited by an overhang of vacant rental units. Moreover, building in this sector continues to reflect the effects of the Tax Reform Act of 1986, which, by curtailing many of the financial advantages associated with investment in rental housing, sharply reduced its after-tax profitability.

The Business Sector

In contrast to the household sector, business capital spending strengthened in early 1989, responding in part to high levels of capacity utilization in the United States and to international pressures to lower costs. In the first quarter of 1989, real business fixed investment rose at an annual rate of 7 1/2 percent, and such spending appears to have increased substantially further in the second quarter.

The gain in investment has occurred in the equipment category. Particularly noteworthy in the first quarter was a sharp rise in outlays for industrial machinery. Increases in that area, which includes spending for fabricated metal products, engines, turbines, and a variety of other types of industrial apparatus, have been exceptionally strong since mid-1987. Spending for high-technology equipment also has been robust. Computer outlays decelerated during the second half of 1988, possibly reflecting some hesitation on the part of potential purchasers in response to the rapid pace of new product announcements; but spending was up considerably in the first quarter, and another gain appears in train for the second quarter.

High levels of factory utilization apparently have spurred a rise in industrial building in recent quarters. Outlays for construction of office and other commercial buildings also rose earlier this year, although the level of total spending on commercial structures remained below that of the 1985-86 period, depressed by excess space in many areas. And, while the rise in energy prices led to some increase in oil and gas drilling in the spring, the level of activity remained very low compared with that of the early 1980s.

Inventory investment slowed over the first five months of 1989, as businesses adjusted with apparent promptness to the more moderate expansion of final demand. Inventory buildups by manufacturers have been concentrated in the aircraft and other capital goods industries, where production has risen and order backlogs are large. In contrast, in the retail sector, automobile inventories rose sharply in the first quarter and have remained high. In an effort to reduce the overhang before introducing new models in the fall, carmakers have lowered factory assembly rates and have enhanced sales incentives. Qualitative reports have suggested that stocks at some other retailers also may have risen above desired levels, although most firms appear to have been following cautious inventory policies, and problems of excess stocks seem to be limited.

In the first quarter of 1989, before-tax economic profits of nonfinancial corporations declined, in part because unit labor costs increased as sales growth slowed and productivity deteriorated. The drop in profits was spread over most types of businesses; the largest decline was in the manufacturing sector, which had especially strong gains in both 1987 and 1988. Meanwhile, corporate tax liabilities edged up in the first quarter, owing in part to higher profits generated from the rise in prices of inventories. The combination of lower operating profits and higher tax liabilities reduced the internal cash flow of nonfinancial corporations.

The Government Sector

In the first quarter, real federal purchases of goods and services, the part of federal outlays that is counted directly in GNP, were virtually unchanged. Such purchases are dominated by defense; nominal spending authority in this area has been virtually flat since 1985, and procurement of some major new weapon systems is winding down. As a result, real military purchases have fallen and in the first quarter were nearly 5 percent below the mid-1987 peak. The decline in defense spending has been partially offset by increases in other federal purchases. Inventories held by the Commodity Credit Corporation edged down further in the first quarter, but the rate of decline has been slowing (on a seasonally adjusted basis) since the middle of last year as the effects of last summer's drought have dissipated. Spending for the space program and for tax and immigration enforcement also has risen.

On a unified budget basis, total nominal outlays for the fiscal year through May were more than 6 percent above the comparable year-earlier total. Spending related to the thrift institution problem spiked at year-end 1988 and then dropped sharply in the first half of this year. On the other hand, growth has continued in entitlement spending (principally Medicare and Social Security) and in net interest outlays.

Federal receipts have grown even more rapidly than outlays, buoyed by increases in employment and income. In addition, there was an extraordinary spurt in nonwithheld tax collections in April and May, the sources of which are at this point uncertain. Some possible explanations relate to the Tax Reform Act of 1986 and include greater-than-anticipated effects from its base-broadening provisions and a shifting of income from earlier years into 1988, when the reduction in personal tax rates was fully phased in. In addition, realizations of taxable capital gains may have been hefty last year because of the large number of corporate mergers and leveraged buyouts. All told, receipts thus far in 1989 are 10 percent above year-earlier levels, and the Administration now projects that the total budget deficit for FY 1989 will be $148 billion, compared with the $155 billion recorded in FY 1988.

Real purchases of goods and services by state and local governments have been on a moderate uptrend this year. Outlays for personnel and construction in the education and law enforcement areas have been subject to considerable upward pressure. Some other expenditures have risen because of federal mandates, especially those in recent health legislation. As in the federal sector, growth of state and local outlays has been tempered by budgetary pressures; excluding retirement trust funds, which are running a large surplus, the sector had a deficit of about $17 billion at an annual rate in the first quarter. Revenue experience was favorable this spring, however, as a significant number of states reported personal income tax receipts that were larger than expected.

Labor Markets

Job growth was substantial over the first half of 1989, though it slowed in the spring. In the first quarter, additions to nonfarm payrolls averaged 264,000 a month, about the same pace seen over the previous two years. By spring, hiring had begun to slow, and payroll employment growth dropped back to 200,000 per month in the second quarter as a whole. Even at this reduced rate, however, job gains were larger than are likely to be sustained, given the underlying trend in labor force growth. Manufacturing employment declined in the second quarter, while the number of construction jobs was about unchanged. Growth of employment moderated in the service-producing sectors, where advances have been the largest over the course of this business expansion.

The moderation in the growth of the demand for labor in the second quarter did not lead to any appreciable reduction in labor market tightness. The unemployment rate has fluctuated between 5.0 and 5.4 percent thus far this year; in June it stood at 5.3 percent. Although many Americans remain involuntarily unemployed, the difficulty of matching workers with jobs--given considerations of skill and location--is much greater than it was earlier in the expansion.

By at least one aggregate measure, the rate of increase in wages seems to have leveled off in recent quarters. Average hourly earnings of production and nonsupervisory workers accelerated from late 1986 through mid-1988; since then the rate of increase has flattened out, and in June earnings were up 3 3/4 percent from a year earlier. The employment cost index for wages and salaries in the private nonfarm sector, a broader measure of wages that is available only through March, indicated some easing of wage trends in the goods-producing sector; however, in the service-producing industries, the trend remained sharply upward. The cost of benefits provided to employees in the goods and services sectors rose slightly faster than wages over the year ended in March, and total compensation per hour--wages and salaries plus benefits--was up 4 1/2 percent over that period, in the same range as the 12-month increases recorded in the preceding three quarters.

Productivity performance has deteriorated somewhat in recent quarters. In some instances, higher levels of production have forced firms to use less efficient capital and to employ less skilled labor. Output per hour in the nonfarm business sector was down in the first quarter, and virtually unchanged on a four-quarter basis. With the sizable increases in compensation over the same period, unit labor costs accelerated to an annual rate of 5 1/4 percent, the largest year-over-year increase since late 1982. In manufacturing, the rise in unit labor costs in the year ended in the first quarter was about 1 percent; unit costs had declined earlier in the business expansion. This step-up in unit labor costs reflects a slackening in the improvement of factory productivity; compensation increases have remained moderate.

Price Developments

Inflation increased sharply in early 1989, reflecting higher costs for food and energy. The consumer price index for all items, a broad-based measure for finished goods and services, rose at an annual rate of more than 6 percent through May, compared with the pace of 4 1/2 percent in 1987 and 1988. The producer price index for finished goods recorded an even more pronounced acceleration, owing to the greater importance of food and energy in that index. However, the underlying inflation trend has not deteriorated: Excluding food and energy, inflation at the retail level has been running at a rate of around 4 3/4 percent, about the same as in 1988.

Energy prices began rising sharply last November, after the OPEC nations agreed to limit crude oil production. Subsequently, temporary supply disruptions in Alaska and in the North Sea added to price pressures. The posted price of West Texas Intermediate, the U.S. benchmark for crude oil, jumped from about $13 per barrel in November to more than $19 in early May. As a result, energy prices at the producer level soared, and consumer energy prices rose nearly 25 percent at an annual rate between December and May. More recently, posted prices of crude oil have remained between $19 and $20 per barrel.

Increases in retail food prices were large in the first half of 1989, in part reflecting the lingering effects of last summer's drought and additional damage to some crops this year. From the beginning of the year through May, the rise in the consumer price index for food was close to 8 percent at an annual rate. Although drought curtailed the winter wheat crop for 1989, total crop acreage has expanded, and overall production should rebound this year if weather conditions are satisfactory. In addition, meat supplies seem likely to hold fairly steady over the second half of this year. Thus, pressures from the supply side should not be a big factor in the food price outlook.

Excluding food and energy, prices for commodities at the consumer level have risen at a rate slightly lower than that recorded for 1988. A marked diminution of increases in non-oil import prices associated with the appreciation of the dollar apparently has restrained the prices of many goods, notably apparel and a variety of household items. In contrast, inflation in the service sector has increased, especially in labor-intensive services, such as medical care, entertainment, and public transportation.

At early stages of processing, prices of goods have risen little or declined in recent months. Prices for many crude industrial commodities, which had climbed sharply in 1987 and 1988 with the expansion of factory output, have softened this year. This in turn has helped hold down the increase in prices at the intermediate level of production; the producer price index for intermediate materials, excluding foods and energy, was unchanged on net in the second quarter.


In conducting monetary policy over the first half of the year, the Federal Open Market Committee continued its effort to foster long-run price stability, so as to build a base for sustainable expansion of the economy. In again reducing the ranges for money and debt growth at its February meeting, the Committee recognized that restraint on the expansion of money and credit would be needed to promote this goal.

At the same time, the Committee realized that considerable uncertainty remained about the behavior of the monetary aggregates. Relatively wide monetary ranges--4 percentage points in breadth--were retained, in part to take account of the substantial interest rate sensitivity of money demand over horizons of as long as a year and of the unpredictable effects on money demand of the resolution of the crisis in the thrift industry. Moreover, in these circumstances, the Committee recognized that, in addition to the behavior of the monetary aggregates, a variety of indicators of inflationary pressures and the course of economic activity would have to be taken into account in shaping policy over 1989.

The Implementation of Monetary Policy

As noted previously, developments early in 1989 suggested that a worrisome risk remained that inflation was picking up and could become more deeply embedded in the economy. Wage and benefit costs had accelerated in 1988, and the readings for the consumer and producer price indexes were troubling. Extending the move toward restraint that began almost a year earlier, the Federal Reserve increased reserve market pressures at the start of this year and again in mid-February. On February 24 the discount rate was raised 1/2 percentage point to 7 percent.

These policy actions were accompanied by market increases, of about a percentage point, in most short-term interest rates. Yields on long-term securities also moved up, but by considerably less than short-term rates. The foreign exchange value of the dollar strengthened as interest rates in the United States rose relative to those abroad. Money growth slowed: M1 was roughly flat in the first quarter, and M2 and M3 decelerated from already reduced rates in the second half of 1988.

By spring, the outlook for spending and prices had become more mixed. Employment growth still looked strong; indicators of capital spending suggested a rebound from the fourth quarter of 1988; and prices continued to advance rapidly. But consumer demand appeared to have moderated; industrial production was weakening; and the behavior of commodity prices and some other indicators of potential price trends suggested that inflationary momentum might begin to wane. In view of the uncertainties surrounding the outlook and taking into account the subdued pace of money growth, the Committee left reserve market conditions unchanged through the middle of the second quarter.

Many interest rates began to move off their March highs early in the second quarter as indications mounted of moderation in the pace of economic activity and in underlying price pressures. With the passing weeks, a considerable weakening in housing activity became evident, and incoming data showed employment to be expanding at a noticeably slower rate. Market expectations of some additional tightening of monetary policy shifted to anticipations of an easing. The ensuing decline in interest rates did not, however, prompt a drop in the foreign exchange value of the dollar. Instead, the dollar appreciated further over this period, in part because of political uncertainties abroad and in part because of data on the U.S. trade balance that were better than expected. The dollar also may have gained support for a while from expectations that the rallies in U.S. securities markets would continue. The monetary aggregates weakened further in April and early May, reflecting the drawdown of liquid balances to make personal tax payments that were larger than expected. In May, M2 fell to the lower edge of the parallel band associated with its annual target range, and M3 slipped just below the bottom of its growth cone.

The FOMC eased policy slightly at the beginning of June and again in early July. The federal funds rate moved down about 1/2 percentage point in two steps to around 9 1/4 percent. Evidence that the more moderate pace of economic activity was persisting, indicators of the behavior of wages and sensitive prices, and the weakness of the monetary aggregates all were consistent with a prospective ebbing of inflationary pressures. Moreover, the dollar was appreciably above year-end levels, which could be expected to have favorable effects in restraining inflation. While inflation remained a concern, an intensification of price pressures did not appear to be a present danger, and the risks of cumulating weakness in the economy had increased.

Although the easing steps were largely expected, most short-term interest rates continued downward in anticipation of further monetary policy actions, more than offsetting their first-quarter rise. The bond market rallied further, leaving long-term rates by mid-July down 1/2 to 1 percentage point on balance from late-1988 levels. Stock prices continued their brisk upward movement, reaching post-October 1987 highs. The value of the dollar also moved down somewhat in late June and dropped further in early July; it retraced most of its rise during the second quarter, although remaining well above its level at year-end 1988.

The Behavior of the Monetary Aggregates

Growth of the monetary aggregates was quite sluggish over the first half of 1989, reflecting the effects of increases through March in market interest rates relative to returns on monetary assets, some depositor concern over the problems of the thrift industry, and large tax payments by individuals (table 3). From the fourth quarter of 1988 through June, M2 edged up at an annual rate of only 2 percent, markedly below last year's pace of 5 1/4 percent. M2 velocity rose sharply through the second quarter.

The deceleration of M2 in the first quarter stemmed largely from a combination of continued increases in market interest rates and unusually slow upward adjustment of rates paid on retail deposits. Yields on NOW accounts moved up only about 10 basis points over the year ended in March, while those on other liquid deposits--savings and money market deposit accounts (MMDAs)--rose about 1/4 and 1 percentage point respectively; many short-term market rates increased more than 3 percentage points over the same period. Rates on small time accounts increased much more than those on the more liquid retail deposits, but they too failed to keep up with the rise in market yields.

Some of the sluggishness in the adjustment of returns on retail deposits over this period may have reflected continued regulatory pressures on thrift institutions to moderate their pricing of deposits, as well as the closing last year of some insolvent institutions with aggressive pricing policies. More broadly, the slow upward adjustment of deposit rates, especially on accounts without fixed terms--NOW accounts, MMDAs, and savings deposits--also reflected the continued evolution of pricing strategies by depository institutions in the deregulated environment. By concentrating upward rate adjustments in small time deposits and offering more sophisticated account structures, in which larger balances receive higher rates, institutions found that they could retain the bulk of their funds while minimizing the effects of higher market rates on their overall interest expense.

Nonetheless, as yields on market instruments became increasingly attractive relative to those on deposits over the first quarter, some funds were redirected to instruments not included in the monetary aggregates. Noncompetitive tenders for Treasury bills and notes, a rough indicator of the extent to which individual investors are increasing their holdings of Treasury securities, surged early in the year and remained strong through March. The increase in demand for Treasury securities was greater than would have been expected from interest rate movements alone, suggesting that depositors' nervousness about the problems of the thrift industry were playing a role too. Although the President submitted to the Congress a comprehensive plan for resolving the industry's difficulties early in the year and gave assurances that the U.S. government would back insured deposits fully, thrift institutions insured by the Federal Savings and Loan Insurance Corporation (FSLIC) experienced large outflows of deposits throughout the first quarter. These outflows apparently depressed overall M2 growth somewhat during that period, but the bulk of the funds likely remained within the aggregate. Commercial banks experienced relatively strong growth in core deposits, and M2-type money market mutual funds, whose rates adjust relatively quickly to changes in market interest rates, saw sizable inflows of funds.

The increased opportunity costs of the first part of the year continued to damp money growth into the second quarter, but, in addition, liquid balances were drawn down to meet large April tax payments. Nonwithheld personal tax payments were $16 billion greater this April than last. The tax-related effect was manifested in a sharp drop in the liquid components of M2 in late April and into May as the payments continued to clear. Transaction accounts posted large declines, outflows of savings and MMDA balances accelerated, and inflows to money market mutual funds paused. Balances began to bounce back in late May, however, as depositors started to rebuild their holdings of monetary assets; and in June, M2 grew at an annual rate of 6 3/4 percent.

Also contributing to the rebound in holdings of money balances after mid-May were declines in opportunity costs as market interest rates headed down. Yields on small time deposits lagged this move, and returns on these deposits at times exceeded those on market instruments. Demand for Treasury securities through noncompetitive tenders fell back, and growth in small time deposits, already robust, jumped to an annual rate of more than 20 percent for the quarter. Yields on small time deposits at thrift institutions responded somewhat more slowly than those at banks to the downturn in market interest rates, and growth of these deposits at thrift institutions surged. Largely because of this strength in small time accounts and because the most anxious depositors probably had already moved their funds elsewhere, overall deposit balances at FSLIC-insured thrift institutions stabilized in the second quarter.

M3 grew at an annual rate of 3 1/2 percent from the fourth quarter of last year to June, placing it at the lower bound of its target range. In the first quarter, expansion of M3 was subject to offsetting forces. It was bolstered somewhat by bank funding needs generated by strong demand for business loans. Added demand for commercial and industrial loans stemmed both from merger-related financings and from shifts to short-term borrowing by businesses facing rising long-term interest rates and investor concerns about "event risk"--the possibility that a firm's debt obligations would be significantly downgraded in a corporate buyout or restructuring. Acting to damp M3 growth over the first quarter, however, was heavy reliance by thrift institutions on Federal Home Loan Bank advances and other borrowings, which are not included in the money stock. M3 growth edged down a bit in the second quarter with some easing of bank credit demands and strong growth in government deposits--also not included in the money stock--resulting from the large volume of tax payments. By June, however, M3 had rebounded as tax effects unwound.

Reflecting interest rate and tax-related effects, M1 declined at an annual rate of 3 1/2 percent from the fourth quarter of 1988 to June. Balances in other checkable deposits, which had moved down a little over the first quarter in response to higher opportunity costs, dropped substantially in late April and early May as the tax payments cleared. Demand deposits also declined on balance over the first half of the year, because opportunity costs increased and because the balances businesses are required to hold to compensate their banks for services fell. After changes in market rates of interest, banks often adjust with a lag the "earnings credit" rates used to determine the level of required compensating balances; thus, downward adjustments to compensating balances can continue for some time after market rates have stopped rising. The large personal tax payments also affected household demand-deposit balances. Late in the quarter, however, both demand and other checkable deposits began to increase, perhaps as some of the earlier influences started to be reversed with the drop in market interest rates over the second quarter.

Credit Flows

The aggregate debt of domestic nonfinancial sectors expanded at an annual rate of close to 8 percent over the first half of this year, near the midpoint of its monitoring range and down somewhat from its 1988 pace. The growth of federal sector debt slowed as tax receipts surged. Expansion of the debt of nonfederal sectors also moderated, partly in response to higher levels of market interest rates over much of the first half of the year. Household borrowing in mortgage markets slowed as increases in lending rates damped housing demand, while the pace of consumer borrowing slackened along with the deceleration in consumption spending.

Mortgage lending by thrift institutions did not appear to be unusually weak in the first few months of 1989, given the prevailing interest rates. These institutions coped with weak deposit flows by running off cash and investments and, through the first quarter, stepping up borrowing from the Federal Home Loan Banks. Despite signs of a reduction in mortgage lending activity by these institutions in the second quarter, the overall availability of housing credit did not appear to be significantly impaired.

Spreads between rates on both fixed-rate mortgages and mortgage-backed securities and rates on Treasury instruments of comparable maturity did widen over the first six months of the year, with some market participants reportedly fearing that large-scale liquidations of mortgage-backed securities by troubled thrift institutions could adversely affect the market for those instruments. However, the widening also may have reflected other developments: a general increase in uncertainty about movements in long-term interest rates (and therefore about prospective prepayments), and the flattening of the yield curve, which discouraged issuance of derivative mortgage instruments and thus reduced demand for the underlying mortgage-backed securities.

Total borrowing by nonfinancial businesses in the first half of the year was close to its 1988 pace. Credit demands continued to be buoyed by sizable merger-related financing in the first quarter, and an apparent pickup in capital expenditures increased business borrowing in the second quarter even as credit demands related to mergers and restructurings, while still strong, eased a bit. Because of investor fear of event risk triggered by the RJR--Nabisco acquisition in late 1988 as well as higher long-term rates through much of the period, corporate borrowing was concentrated in short-maturity vehicles. Commercial paper issuance surged during the first half of the year; businesses also relied on bank loans, albeit to a lesser extent. In response to investor concerns about event risk, many firms issued bonds with relatively short maturities of one to five years, or they brought issues to market with straight puts or with so-called poison puts--covenants designed to protect against negative effects on bondholders from future restructurings. Toward the end of the second quarter, with the introduction of these protections and the decline in rates, long-term financing in the corporate bond market was on the upswing.

Net issuance of tax-exempt securities by state and local governments fell sharply over most of the first half of 1989. Investor demand for tax-exempt securities remained strong and, with diminished supply, the ratio of tax-exempt to taxable yields fell to its lowest level since 1984. This ratio rose somewhat late in the second quarter, when the decline in long-term interest rates began to bring forth an increase in refunding activity and a pickup of issuance of bonds to raise new capital. [Tabular Data 1-3 Omitted]

(1)The charts for the report are available on request from Publications Services, Board of Governors of the Federal Reserve System, Washington, D.C. 20551.
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Title Annotation:report submitted on July 20, 1989
Publication:Federal Reserve Bulletin
Date:Aug 1, 1989
Previous Article:Record of policy actions of the Federal Open Market Committee.
Next Article:Priced services, 1988 and 1989.

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