Monetary policy report to the Congress.
Report submitted to the Congress on February 20, 1990, pursuant to the Full Employment and Balanced Growth Act of 1978.(1)
MONETARY POLICY AND THE ECONOMIC OUTLOOK FOR 1990
The U.S. economy recorded its seventh consecutive year of expansion in 1989. Although growth was slower than in the preceding two years, it was sufficient to support the creation of 2 1/2 million jobs and to hold the unemployment rate steady at 5 1/4 percent, the lowest reading since the early 1970s. On the external front, the trade and current account deficits shrank further in 1989. And while inflation remained undesirably high, the pace was lower than many analysts--and, indeed, most members of the Federal Open Market Committee (FOMC)--had predicted, in part because of the continuing diminution in longer-range inflation expectations.
In 1989, monetary policy was tailored to the changing contours of the economic expansion and to the potential for inflation. Early in the year, as for most of 1988, the Federal Reserve tightened money market conditions to prevent pressures on wages and prices from building. Market rates of interest rose relative to those on deposit accounts, and unexpectedly large tax payments in April and May drained liquid balances, restraining the growth of the monetary aggregates in the first half of the year. By May, M2 and M3 lay below the lower bounds of the annual target ranges established by the FOMC.
Around midyear, risks of an acceleration in inflation were perceived to have diminished as pressures on industrial capacity had moderated, commodity prices had leveled out, and the dollar had strengthened on exchange markets, reinforcing the signals conveyed by the weakness in the monetary aggregates. In June, the FOMC began a series of steps, undertaken with care to avoid excessive inflationary stimulus, that trimmed 1 1/2 percentage points from short-term interest rates by year-end. Longer-term interest rates moved down by a like amount, influenced by both the System's easing and a reduction in inflation expectations.
Growth of M2 rebounded to end the year at about the midpoint of the 1989 target range. Growth of M3, however, remained around the lower end of its range, as a contraction of the thrift industry, encouraged by the Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA), reduced needs to tap M3 sources of funds. The primary effect of the shrinkage of the thrift industry's assets was a rechanneling of funds in mortgage markets, rather than a reduction in overall credit availability; growth of the aggregate for nonfinancial sector debt that is monitored by the FOMC was just a bit slower in the second half than in the first, and this measure ended the year only a little below the midpoint of its range.
Thus far this year, the overnight rate on federal funds has held at 8 1/4 percent, but other market rates have risen. Increases of as much as 1/2 percentage point have been recorded at the longer end of the maturity spectrum. The bond markets responded to indicators suggesting a somewhat greater-than-anticipated buoyancy in economic activity--which may have both raised expected real returns on investment and renewed some apprehensions about the outlook for inflation. The rise in yields occurred in the context of a general runup in international capital market yields, which appears to have been in part a response to emerging opportunities associated with the opening of Eastern Europe; this development had particularly notable effects on the exchange value of the West German mark, which rose considerably relative to the dollar, the yen, and other non-European Monetary System currencies.
Monetary Policy for 1990
The Federal Open Market Committee is committed to the achievement, over time, of price stability. The importance of this objective derives from the fact that the prospects for long-run growth in the economy are brightest when inflation need no longer be a material consideration in the decisions of households and firms. The members recognize that certain short-term factors--notably a sharp increase in food and energy prices--are likely to boost inflation early this year, but they anticipate that these factors will not persist. Under these circumstances, policy can support further economic expansion without abandoning the goal of price stability.
To foster the achievement of those objectives, the Committee has selected a target range of 3 to 7 percent for M2 growth in 1990. Growth in M2 may be more rapid in 1990 than in recent years and yet be consistent with some moderation in the rate of increase in nominal income and restraint on prices; in particular, M2 may grow more rapidly than nominal GNP in the first part of this year in lagged response to last year's interest rate movements. Eventually, however, slower M2 growth will be required to achieve and maintain price stability (table 1).
The Committee reduced the M3 range to 2 1/2 to 6 1/2 percent to take account of the effects of the restructuring of the thrift industry, which is expected to continue in 1990. A smaller proportion of mortgages is likely to be held at depository institutions and financed by elements in M3; thrift institution assets should continue to decline, as some solvent thrift institutions will be under pressure to meet capital standards and insolvent thrift institutions will continue to be shrunk and closed, with a portion of their assets carried, temporarily, by the government. While some of the assets shed by thrift institutions are expected to be acquired by commercial banks, overall growth in the asset portfolios of banks is expected to be moderate, as these institutions exercise caution in extending credit. An increase in lender--and borrower--caution more generally points to some slowing in the pace at which nonfinancial sectors take on debt relative to their income in 1990. In particular, recent developments suggest that leveraged buyouts and other transactions that substitute debt for equity in corporate capital structures will be noticeably less important in 1990 than in recent years. Moreover, a further decline in the federal sector's deficit is expected to reduce credit growth this year. In light of these considerations, the Committee reduced the monitoring range for debt of the nonfinancial sectors to 5 to 9 percent.
The setting of targets for money growth in 1990 is made more difficult by uncertainty about developments affecting thrift institutions. The behavior of M3 and, to a more limited extent, M2 is likely to be affected by such developments, but there is only limited basis in experience to gauge the likely effect. In addition, in interpreting the growth of nonfinancial debt, the Committee will have to take into account the amount of Treasury borrowing (recorded as part of the debt aggregate) used to carry the assets of failed thrift institutions, pending their disposal. With these questions adding to the usual uncertainties about the relationship among movements in the aggregates and output and prices, the Committee agreed that, in implementing policy, they would need to continue to consider, in addition to the behavior of money, indicators of inflationary pressures and economic growth as well as developments in financial and foreign exchange markets.
Economic Projections for 1990
The Committee members, and other Reserve Bank presidents, expect that growth in the real economy will be moderate during 1990. Most project real GNP growth over the four quarters of the year to be between 1 3/4 and 2 percent--essentially the same increase as in 1989, excluding the bounceback in farm output after the 1988 drought. It is expected that this pace of expansion will be reflected in some easing of pressures on domestic resources; the central tendency of forecasts is for an unemployment rate of 5 1/2 to 5 3/4 percent in the fourth quarter (table 2).
Certain factors have caused an uptick in inflation early this year. Most notably, prices for food and energy increased sharply as the year began, reflecting the effect of the unusually cold weather in December. However, these run-ups should be largely reversed in coming months, and inflation in food and energy prices for the year as a whole may not differ much from increases in other prices.
Given the importance of labor inputs in determining the trend of overall costs, a deceleration in the cost of labor inputs is an integral part of any solid progress toward price stability. Nominal wages and total compensation have grown relatively rapidly during the past two years, while increases in labor productivity have diminished. With prices being constrained by domestic and international competition, especially in goods markets, profit margins have been squeezed to low levels. A restoration of more normal margins ultimately will be necessary if businesses are to have the wherewithal and the incentive to maintain and improve the stock of plant and equipment.
Unfortunately, the near-term prospects for a moderation in labor cost pressures are not favorable. Compensation growth is being boosted in the first half of 1990 by an increase in social security taxes and a hike in the minimum wage. The anticipated easing of pressures in the labor market should help produce some moderation in the pace of wage increases in the second half of 1990, but the Committee will continue to monitor closely the growth of labor costs for signs of progress in this area.
Finally, the recent depreciation of the dollar likely will constitute another impetus to near-term price increases, reversing the restraining influence exerted by a strong dollar through most of last year. Prices of imported goods, excluding oil, increased in the fourth quarter after declining through the first three quarters of 1989. The full effect of this upturn likely will not be felt on the domestic price level until some additional time has passed.
Despite these adverse elements in the near-term picture, the Committee believes that progress toward price stability can be achieved over time, given the apparently moderate pace of activity. In terms of the consumer price index, most members expect an increase of between 4 and 4 1/2 percent, compared with the 4.5 percent advance recorded in 1989.
Relative to the Committee, the Administration currently is forecasting more rapid growth in real and nominal GNP. At the same time, the Administration's projection for consumer price inflation is at the low end of the Committee's central-tendency range. In its Annual Report, the Council of Economic Advisers argues that, if nominal GNP were to grow at a 7 percent annual rate this year--as the Council is projecting--then M2 could exceed its target range, particularly if interest rates fall as projected in the Administration forecast. As suggested above, monetary relationships cannot be predicted with absolute precision, but the Council's assessment is reasonable. And, although most Committee members believe that growth in nominal GNP more likely will be between 5 1/2 and 6 1/2 percent, a more rapid expansion in nominal income would be welcome if it promised to be accompanied by a declining path for inflation in 1990 and beyond.
THE PERFORMANCE OF THE ECONOMY IN 1989
Real GNP grew 2 1/2 percent over the four quarters of 1989, 2 percent after adjustment for the recovery in farm output from the drought losses of the prior year. This rate of growth of GNP constituted a significant downshifting in the pace of expansion from the unsustainably rapid rates of 1987 and 1988, which had carried activity to the point that inflationary strains were beginning to become visible in the economy. As the year progressed, clear signs emerged that pressures on resource utilization were easing, particularly in the industrial sector. Nonetheless, the overall unemployment rate remained at 5.3 percent, the lowest reading since 1973, and inflation remained at 4 1/2 percent despite the restraining influence of a dollar that was strong for most of the year.
The deceleration in business activity last year reflected, to some degree, the monetary tightening from early 1988 through early 1989 that was undertaken with a view toward damping the inflation forces. Partly as a consequence of that tightening, the U.S. dollar appreciated in the foreign exchange markets from early 1988 through mid-1989, contributing to a slackening of foreign demand for U.S. products. At the same time, domestic demand also slowed, more for goods than for services. Reflecting these developments, the slowdown in activity was concentrated in the manufacturing sector: Factory employment, which increased a total of 90,000 over the first three months of 1989, declined 195,000 over the remainder of the year, and growth in manufacturing production slowed from 5 1/2 percent in 1988 to only 1 3/4 percent last year. Employment in manufacturing fell further in January of this year, but that decline was largely attributable to temporary layoffs in the automobile industry, and most of the affected workers have since been recalled.
As noted above, the rate of inflation was about the same in 1989 as it had been in the preceding two years. While the appreciation of the U.S. dollar through the first half of the year helped to hold down the prices of imported goods, the high level of resource utilization continued to exert pressure on wages and prices. In that regard, the moderation in the expansion of real activity during 1989 was a necessary development in establishing an economic environment that is more conducive to progress over time toward price stability.
The Household Sector
Household spending softened significantly in 1989, with a marked weakening in the demand for motor vehicles and housing. Real consumer spending on goods and services increased 2 1/4 percent over the four quarters of 1989, 1 1/2 percentage points less than in 1988. Growth in real disposable income slowed last year, but continued to outstrip growth in spending, and, as a result, the personal saving rate increased to 5 3/4 percent in the fourth quarter of 1989.
The slackening in consumer demand was concentrated in spending on goods. Real spending on durable goods was about unchanged from the fourth quarter of 1988 to the fourth quarter of 1989--after jumping 8 percent in the prior year--chiefly reflecting a slump in purchases of motor vehicles. Spending on nondurable goods also decelerated, increasing only 1/2 percent in 1989 after an advance of 2 percent in 1988. The principal support to consumer spending came from continued large gains in outlays for services. Spending on medical care moved up 7 1/2 percent in real terms last year, and now constitutes 11 percent of total consumption expenditures--up from 8 percent in 1970. Outlays for other services rose 3 1/4 percent, with sizable increases in a number of categories.
Sales of cars and light trucks fell 3/4 million units in 1989, to 14 1/2 million. Most of the decline reflected reduced sales of cars produced by U.S.-owned automakers; a decline in sales of imported automobiles was about offset by an increase in sales of foreign nameplates produced in U.S. plants. The slowing in sales of motor vehicles was most pronounced during the fourth quarter of 1989, reflecting a "payback" for sales that had been advanced into the third quarter and a relatively large increase in sticker prices on 1990-model cars. Although part of this increase reflected the inclusion of additional equipment--notably the addition of passive restraint systems to many models--consumers nevertheless reacted adversely to the overall increase in prices. Beyond these influences, longer-run factors appear to have been damping demand for autos and light trucks during 1989; in particular, the robust pace of sales earlier in the expansion seems to have satisfied demand pent up during the recessionary period of the early 1980s. The rebuilding of the motor vehicle stock suggests that future sales are likely to depend more heavily on replacement needs.
Residential investment fell in real terms through the first three quarters of 1989, and with only a slight upturn in the fourth quarter, expenditures decreased 6 percent on net over the year. Construction was weighed down throughout 1989 by the overbuilding that occurred in some locales earlier in the decade. Vacancy rates were especially high for multifamily rental and condominium units. In the single-family sector, affordability problems constrained demand, dramatically so in those areas in which home prices had soared relative to household income.
Mortgage interest rates declined more than a percentage point, on net, between the spring of 1989 and the end of the year, helping to arrest the contraction in housing activity; however, the response to the easing in rates appears to have been muted somewhat by a reduction in the availability of construction credit, likely reflecting, in part, the tightening of regulatory standards in the thrift industry and the closing of several insolvent institutions. Exceptionally cold weather also hampered building late in the year, but a sharp December drop in housing starts was followed by a record jump in activity last month.
The Business Sector
Business fixed investment, adjusted for inflation, increased only 1 percent at an annual rate during the second half of 1989 after surging 7 3/4 percent during the first half. Although competitive pressures forced many firms to continue seeking efficiency gains through capital investment, the deceleration in overall economic growth made the need for capacity expansion less urgent, and shrinking profits reduced the availability of internal finance.
Spending on equipment moved up briskly during the first half of 1989, with particularly notable gains in outlays for information-processing equipment -- computers, photocopiers, telecommunications devices, and the like. However, equipment outlays were flat in the second half of the year; growth in the information processing category slowed sharply, and spending in most other categories was either flat or down. Purchases of motor vehicles dropped sharply in the fourth quarter from the elevated levels of the second and third quarters. There were a few exceptions to the general pattern of weakness during the second half. Spending on aircraft was greater in the second half of 1989 than in the first half, and would have increased still more had it not been for the strike at Boeing. Outlays for tractors and agricultural machinery moved up smartly; spending on farm equipment has been buoyed by the substantial improvements over the past several years in the financial health of the agricultural sector. Over the four quarters of 1989, total spending on equipment increased 6 percent in real terms -- about 1 percentage point below the robust pace of 1988.
Business spending for new construction edged down 1/2 percent in real terms during 1989 -- the second consecutive yearly decline. Commercial construction, which includes office buildings, was especially weak; vacancy rates for office space remain at high levels in many areas, lowering prospective returns on new investment. Outlays for drilling and mining, which had dropped 20 percent over the four quarters of 1988, moved down further in the first quarter of 1989; later in the year, drilling activity revived as crude oil prices firmed. The industrial sector was the most notable exception to the overall pattern of weakness: Real outlays increased 11 percent in 1989, largely because of construction that had been planned in 1987 and 1988 when capacity in many basic industries tightened substantially and profitability was improving sharply.
As noted above, the slowdown in investment spending during the second half of last year likely was exacerbated by the deterioration in corporate cash flow. Before-tax operating profits of nonfinancial corporations dropped 12 percent from the fourth quarter of 1988 to the third quarter of 1989 (latest data available); after-tax profits were off in about the same proportion. Reflecting the increased pressures from labor and materials costs -- and a highly competitive domestic and international environment -- before-tax domestic profits of nonfinancial corporations as a share of gross domestic product declined to an average level of 8 percent during the first three quarters of 1989, the lowest reading since 1982. At the same time, taxes as a share of before-tax operating profits increased to an estimated 44 percent in the first three quarters of 1989; since 1985, this figure has retraced a bit more than half of its decline from 54 percent in 1980.
Nonfarm business inventory investment averaged $21 billion in 1989. Although the average pace of accumulation last year was slower than in 1988, the pattern across sectors was somewhat uneven. Some of the buildup in stocks took place in industries -- such as aircraft -- where orders and shipments have been strong for some time now. But inventories in some other sectors became uncomfortably heavy at times and precipitated adjustments in orders and production. The clearest area of inventory imbalance at the end of the year was at auto dealers, where stocks of domestically produced automobiles were at 1.7 million units in December -- almost three months' supply at the sluggish fourth-quarter sales pace. In response, the domestic automakers implemented a new round of sales incentives and cut sharply the planned assembly rate for the first quarter of 1990. Elsewhere in the retail sector, inventories moved up substantially relative to sales at general merchandise outlets. Overall, however, most sectors of the economy have adjusted fairly promptly to the deceleration in sales and appear to have succeeded in preventing serious overhangs from developing.
The Government Sector
Budgetary pressures continued to restrain the growth of purchases at all levels of government. At the federal level, purchases fell 3 percent in real terms over the four quarters of 1989, with lower defense purchases accounting for the bulk of the decline. Nondefense purchases also declined in real terms from the fourth quarter of 1988 to the fourth quarter of 1989; increases in such areas as the space program and drug interdiction were more than offset by general budgetary restraint that imposed real reductions on most other discretionary programs.
In terms of the unified budget, the federal deficit in fiscal year 1989 was $152 billion, slightly smaller than in 1988. Growth in total federal outlays, which include transfer payments and interest costs as well as purchases of goods and services, picked up a bit in fiscal year 1989. Outlays were boosted at the end of the fiscal year by the initial $9 billion of spending by the Resolution Trust Corporation. On the revenue side of the ledger, growth in federal receipts also increased in fiscal 1989. The acceleration occurred in the individual income tax category, but strong increases also were recorded in corporate and social security tax payments.
Purchases of goods and services at the state and local level increased 2 1/2 percent in real terms over the four quarters of 1989, down more than a percentage point from the average pace of the preceding five years. Nonetheless, there were some areas of growth. Spending for educational buildings increased, and employment in the state and local sector rose 350,000 over the year, largely driven by a pickup in hiring by schools. Despite the overall slowdown in the growth of purchases, the budgetary position of the state and local sector deteriorated further over the year; the annualized deficit of operating and capital accounts, which excludes social insurance funds, increased $6 billion over the first three quarters of 1989 and appears to have worsened further in the fourth quarter.
The External Sector
The U.S. external deficits improved somewhat in 1989, but not by as much as in 1988. On a balance-of-payments basis, the deficit on merchandise trade fell from an annual rate of $128 billion in the fourth quarter of 1988 (and $127 billion for the year as a whole) to $114 billion in the first quarter of 1989. Thereafter, there was no further net improvement. The appreciation in the foreign exchange value of the dollar between early 1988 and mid-1989 appears to have played an important role in inhibiting further progress on the trade front. During the first three quarters of 1989, the current account, excluding the influence of capital gains and losses that are largely caused by currency fluctuations, showed a deficit of $106 billion at an annual rate -- somewhat below the deficit of $124 billion in the comparable period of 1988.
Measured in terms of the other Group of Ten (G-10) currencies, the foreign exchange value of the U.S. dollar in December 1989 was about 3 percent above its level in December 1988, but the dollar has moved lower thus far in 1990. In real terms, the net appreciation of the dollar during 1989 in terms of the other G-10 currencies was about 5 percent as consumer prices rose somewhat faster here than they did abroad, on average. Over the year, the dollar moved lower on balance against the currencies of South Korea, Singapore, and especially Taiwan. From a longer perspective, the modest uptrend on balance in the dollar over the past two years marked a sharp departure from the substantial weakening seen during the 1985-87 period.
The behavior of the dollar differed greatly between the two halves of 1989. In the first half, the dollar appreciated 12 percent in terms of the other G-10 currencies, while depreciating against the currencies of South Korea and Taiwan. The dollar fluctuated during the summer, and later in the year unwound most of the prior appreciation, as U.S. interest rates eased relative to rates abroad and in response to concerted intervention in exchange markets in the weeks immediately after the September meeting of Group of Seven officials and to events in Eastern Europe. In the second half of the year, the dollar rose against the currencies of South Korea and Taiwan while depreciating in terms of the Singapore dollar. Over the course of 1989, the dollar appreciated nearly 16 percent against the Japanese yen and 14 percent against the British pound, but it depreciated slightly against the German mark, the Canadian dollar, and most other major currencies.
On a GNP basis, merchandise exports increased about 11 percent in real terms over the four quarters of 1989--roughly 4 percentage points less than in 1988. This deceleration took place despite continued strong growth in economic activity in most foreign industrial countries (with the exception of Canada and the United Kingdom), and appears to have reflected, in large part, the effect on U.S. competitiveness of the dollar's appreciation and the more rapid U.S. inflation over 1988 and much of 1989. Exports were also depressed in the fourth quarter of 1989 by several special factors, including the Boeing strike. The volume of agricultural exports increased about 11 percent in 1989--a bit faster even than the robust pace of 1988. The value of agricultural exports rose much less, however, as agricultural export prices reversed the drought-induced increases of the previous year.
Merchandise imports excluding oil expanded about 7 percent in real terms during 1989, with much of the rise accounted for by imports of computers. Imports of oil increased 6 percent from the fourth quarter of 1988 to the fourth quarter of 1989, to a rate of 8.3 million barrels per day. At the same time, the average price per barrel increased almost 40 percent, and the nation's bill for foreign oil jumped 45 percent.
The counterpart of the current account deficit of $106 billion at an annual rate over the first three quarters of 1989 was a recorded net capital inflow of about $60 billion at an annual rate and an unusually large statistical discrepancy, especially in the second quarter. More than half of the recorded net inflow of capital reflected transactions in securities, as foreign private holdings of U.S. securities rose nearly $50 billion (half of the increase being in holdings of U.S. Treasury securities), while U.S. holdings of foreign securities increased a bit less than $20 billion. Net direct investment accounted for another substantial portion of the inflow; foreign direct investment holdings in the United States rose more than $40 billion, and U.S. holdings abroad rose only half as much. Over the first three quarters of 1989, foreign official assets in the United States increased almost $15 billion, but this increase was more than offset by the increase in U.S. official holdings of assets abroad, largely associated with U.S. intervention operations to resist the dollar's strength.
Employment growth slowed in the second half of 1989; nonetheless, nonfarm payrolls increased nearly 2 1/2 million during the year. The bulk of this expansion occurred in the service-producing sector. By contrast, the manufacturing sector shed 100,000 jobs. These job losses were more than accounted for by declines in the durable goods industries and appeared to reflect the slump in auto sales, the weakening in capital spending, and the effects of a stronger dollar on exports and imports.
Despite the slowdown in new job creation, the overall balance of supply and demand in the labor market remained steady over the year. The civilian unemployment rate, which had declined about 1/2 percentage point over the twelve months of 1988, finished 1989 at 5.3 percent--unchanged from twelve months earlier. Moreover, there was no increase in the number of "discouraged" workers--those who say they would re-enter the labor force if they thought they could find a job. Nor was there any net increase in workers who accepted part-time employment when they would have preferred fulltime. The proportion of the civilian population with jobs reached a historic high.
Reflecting the tightness of labor markets and the persistence of inflation expectations in the range of 4 to 5 percent, according to surveys, the employment cost index for wages and salaries in nonfarm private industry increased 4 1/4 percent over the twelve months of 1989--about the same as in 1988. Benefit costs continued to rise more rapidly than wages and salaries last year, with health insurance costs remaining a major factor; nonetheless, the rate of growth in overall benefit costs slowed in 1989, in part because of a smaller increase in social security taxes than in 1988. Total compensation--including both wages and salaries and benefits--rose 4 3/4 percent during 1989. Compensation growth in the service-producing sector--at 5 percent--continued to outpace the gain in the goods-producing sector by about 3/4 percentage point.
A slowdown in the growth of productivity often accompanies a softening in the general economy, and productivity gains were lackluster in 1989. Output per hour in the private nonfarm business sector increased only 1/2 percent over the four quarters of the year--1 percentage point below the rate of increase in 1988. In the manufacturing sector, productivity gains during the first half of 1989 kept pace with the 1988 average of 3 percent; in the second half, however, productivity growth slowed to an annual rate of 2 1/4 percent. Reflecting both the persistent growth in hourly compensation and the disappointing developments in productivity, unit labor costs in private nonfarm industry rose 5 percent over the four quarters of 1989--the largest increase since 1982.
Inflation in consumer prices remained in the neighborhood of 4 1/2 percent for the third year in a row, as the level of economic activity was strong and continued to exert pressures on available resources. During the first half of the year, overall inflation was boosted by a sharp run-up in energy prices and a carry-over from 1988 of drought-related increases in food prices. However, inflation in food prices slowed during the second half, and energy prices retraced about a third of the earlier run-up. Prices for imported goods excluding oil were little changed over 1989, on net, and acted as a moderating influence on consumer price inflation.
Food prices increased 5 1/2 percent at the retail level, slightly more than in 1988 when several crops were severely damaged by drought. Continued supply problems in some agricultural markets in 1989--notably a poor wheat crop and a shortfall in dairy production--likely prevented a deceleration from the drought-induced rate of increase in 1988. At the same time, increases in demand, including sharp increases in exports of some commodities, also appear to have played a role. Still another impetus to inflation in the food area last year evidently came from the continuing rise in processing and marketing costs.
Consumer energy prices surged 17 percent at an annual rate during the first six months of 1989, before dropping back 6 percent in the second half. During the first half of the year, retail energy prices were driven up by increases in the cost of crude oil. The increase in gasoline prices at midyear was exaggerated by the introduction of tighter standards governing the composition of gasoline during summer months. Gasoline prices eased considerably in the second half, reflecting a dip in crude oil prices and the expiration of the summertime standards. Taking the twelve months of 1989 as a whole, the increase in retail energy prices came to a bit more than 5 percent. Heating oil prices jumped sharply at the turn of the year, reflecting a surge in demand caused by December's unusually cold weather. The spike in heating fuel prices largely reversed itself in spot markets during January of this year, but crude oil prices remained at high levels.
Consumer price increases for items other than food and energy remained at about 4 1/2 percent in 1989. Developments in this category likely would have been less favorable had the dollar not been appreciating in foreign exchange markets through the first half of 1989. The prices of consumer commodities excluding food and energy decelerated sharply, and this slowdown was particularly marked for some categories in which import penetration is high, including apparel and recreational equipment. Given the dollar's more recent depreciation, however, the moderating effect of import prices on overall inflation may be diminishing. Indeed, prices for imported goods excluding oil turned up in the fourth quarter of 1989, after declining earlier in the year. In contrast to goods prices, the prices of nonenergy services--which make up half of the overall consumer price index--increased 5 1/4 percent in 1989, 1/4 percentage point more than in 1988. The pickup in this category was led by rents, medical services, and entertainment services.
At the producer level, prices of finished goods increased 7 1/2 percent at an annual rate during the first half--almost twice the pace of 1988 -- before slowing to an annual rate of increase of 2 1/2 percent over the second half. In large part, developments in this sector reflected the same sharp swings in energy prices that affected consumer prices. At earlier stages of processing, the index for intermediate materials excluding food and energy decelerated sharply during the first half of the year and then edged down in the second half. For the year as a whole, this index registered a net increase of only 1 percent, compared with more than 7 percent in 1988. The sharp deceleration in this category appears to have reflected a relaxation of earlier pressures on capacity in the primary processing industries, and the influence of the rising dollar through the first half of last year. Also consistent with the weakening in the manufacturing sector and the strength of the dollar, the index for crude nonfood materials excluding energy declined 3 3/4 percent over the year, and spot prices for industrial metals moved sharply lower during the year, in part because of large declines for steel scrap, copper, and aluminum.
MONETARY AND FINANCIAL DEVELOPMENTS DURING 1989
In 1989, the Federal Reserve continued to pursue a policy aimed at containing and ultimately eliminating inflation while providing support for continued economic expansion. In implementing that policy, the Federal Open Market Committee maintained a flexible approach to monetary targeting, with policy responding to emerging conditions in the economy and financial markets as well as to the growth of the monetary aggregates relative to their established target ranges. This flexibility has been necessitated by the substantial variability in the short-run relationship between the monetary aggregates and economic performance; however, when viewed over a longer perspective, those aggregates are still useful in conveying information about price developments.
As the year began, monetary policy was following through on a set of measured steps begun a year earlier to check inflationary pressures. By then, however, evidence of a slackening in aggregate demand, along with sluggish growth of the monetary aggregates, suggested that the year-long rise in short-term interest rates was noticeably restraining the potential for more inflation. But, after an increase of 1/2 percentage point in the discount rate at the end of February, the Federal Reserve took no further policy action until June. Over the balance of 1989, the Federal Reserve moved toward an easing of money market conditions, as indications mounted of slack in demand and lessened inflation pressures. The easing in reserve availability induced declines in short-term interest rates of 1 1/2 percentage points; money growth strengthened appreciably, and M2 was near the middle of its target range by the end of 1989. The level of M3, on the other hand, remained around the lower bound of its range, with its weakness mostly reflecting the shifting pattern of financial intermediation as the thrift industry retrenched. The growth of nonfinancial debt was trimmed to 8 percent in 1989, about in line with the slowing in the growth of nominal GNP, and ended the year at the midpoint of its monitoring range.
Implementation of Monetary Policy
In the opening months of the year, the Federal Open Market Committee, seeking to counter a disquieting intensification of inflationary pressures, extended the move toward restraint that had begun almost a year earlier. Policy actions in January and February, restraining reserve availability and raising the discount rate, prompted a further increase of 3/4 percentage point in short-term market interest rates. Longer-term rates, however, moved up only moderately; the tightening apparently had been widely anticipated and was viewed as helping to avoid an escalation in underlying inflation. Real short-term interest rates--nominal rates adjusted for expected price inflation--likely moved higher, though remaining below peak levels earlier in the expansion; these gains contributed to a strengthening of the foreign exchange value of the dollar over this period, while the growth of the monetary aggregates slowed as the additional policy restraint reinforced the effects of actions in 1988.
As evidence on prospective trends in inflation and spending became more mixed in the second quarter, the Committee refrained from further tightening and in June began to ease pressures on reserve markets. As the information on the real economy, along with the continued rise in the dollar, suggested that the outlook for inflation was improving, most long-term nominal interest rates fell as much as a percentage point from their March peaks; the yield on the bellwether thirty-year Treasury bond moved down to about 8 percent by the end of June. The decline in interest rates outstripped the reduction in most measures of investors' inflation expectations, so that estimated real interest rates fell from their levels earlier in the year. These declines in nominal and real interest rates, however, were not accompanied by declines in the foreign exchange value of the dollar. Rather, because of better-than-expected trade reports and political turmoil abroad, the dollar strengthened further.
In July, when the FOMC met for its semiannual review of the growth ranges for money and credit, M2 and M3 lay at, or a bit below, the lower bounds of their target cones. This weakness, reinforcing the signals from prices and activity, contributed to the Committee's decision to take additional easing action in reserve markets. The Committee reaffirmed the existing annual target ranges for the monetary and debt aggregates and tentatively retained those ranges for the next year, since they were likely to encompass money growth that would foster further economic expansion and moderation of price pressures in 1990.
Late in the summer, longer-term interest rates turned higher, as several releases of economic data suggested reinvigorated inflationary pressures. With growth in the monetary aggregates rebounding, the Committee kept reserve conditions about unchanged until the direction of the economy and prices clarified.
Beginning in October, amid indications of added risks of a weakening in the economic expansion, the FOMC reduced pressures on reserve markets in three separate steps, which nudged the federal funds rate down to around 8 1/4 percent by year-end, about 1 1/2 percentage points below its level when incremental tightening ceased in February. Over those ten months, other short- and long-term nominal interest rates fell about 1 to 1 1/4 percentage points; and most major stock price indexes reached record highs at the turn of the year, more than recovering the losses that occurred on October 13. Reflecting some reduction in inflation anticipations over the same period, estimated short- and long-term real interest rates fell somewhat less than nominal rates, dropping probably about 1/2 to 3/4 percentage point. Still, most measures of short- and long-term real interest rates remained well above their trough levels of 1986 and 1987 -- levels that had preceded rapid growth in the economy and a buildup of inflationary pressures.
Over the last three months of the year and into January 1990, the foreign exchange value of the dollar declined substantially from its high, which was reached around midyear and largely sustained through September. The dollar fell amid concerted intervention undertaken by the G-7 countries in the weeks immediately after a meeting of the finance ministers and central bank governors of these countries in September. The dollar continued to decline in response to the easing of short-term interest rates on dollar assets and increases in rates in Japan and Germany. The German currency rate rose particularly sharply as developments in Eastern Europe were viewed as favorable for the West German economy, attracting global capital flows. Rising interest rates in Germany likely contributed to an increase in bond yields in the United States early in 1990, even as U.S. short-term rates remained essentially unchanged. More important, however, for the rise in nominal, and likely real, long-term rates in the United States were incoming data pointing away from recession in the economy and from any abatement in price pressures, especially as oil prices moved sharply higher.
Behavior of Money and Credit
Growth in M2 was uneven over 1989, with marked weakness in the first part of the year giving way to robust growth thereafter. On balance over the year, M2 expanded 4 1/2 percent, down from 5 1/4 percent growth in 1988, placing it about at the midpoint of its 1989 target range of 3 to 7 percent. The slower rate of increase in M2 reflected some moderation in nominal income growth as well as the pattern of interest rates and associated opportunity costs of holding money, with the effects of increases in 1988 and 1989 outweighing the later, smaller drop in rates (table 3).
M2 has grown relatively slowly over the past three years, as the Federal Reserve has sought to ensure progress over time toward price stability. There appears to be a fairly reliable long-term link between M2 and future changes in inflation. One method of specifying that link is to estimate the equilibrium level of prices implied by the current level of M2, assuming that real GNP is at its potential and velocity is at its long-run average, and compare that to actual prices. The historical record suggests that inflation tends to rise when actual prices are below the equilibrium level and to moderate when equilibrium prices are below actual. At the end of 1986, the equilibrium level of prices was well above the actual level, reinforcing the view that the risks weighed on the side of an increase in inflation; at the end of 1989, that equilibrium price had moved into approximate equality with the actual price level, indicating that basic inflation pressures had steadied.
In 1989, compositional shifts within M2 reflected the pattern of interest rates, the unexpected volume of tax payments in the spring, and the flow of funds out of thrift deposits and into other instruments. Early in the year, rising market interest rates buoyed the growth of small-denomination time deposits at the expense of more liquid deposits, as rates on the latter accounts adjusted only sluggishly to the upward market movements. The unexpectedly large tax payments in April and May contributed to the weakness in liquid instruments as those balances also were drawn down to meet tax obligations. As market interest rates fell, the relative rate advantage reversed in favor of liquid instruments and the growth in liquid deposits rebounded, boosted as well by the replenishment of accounts drained by tax payments.
The M1 component of M2 was especially affected by the swings in interest rates and opportunity costs last year, and in addition was buffeted by the effects of outsized tax payments in April. After its rise of 4 1/4 percent in 1988, M1 grew only 1/2 percent in 1989, with much of the weakness in this transactions aggregate occurring early in the year. By May, M1 had declined at an annual rate of about 2 1/2 percent from its fourth-quarter 1988 level, reflecting a lagged response to earlier increases in short-term interest rates and an extraordinary bulge in net individual tax remittances to the Treasury. From May to December, M1 rebounded at a 4 percent rate as the cumulating effects of falling interest rates and post-tax-payment rebuilding boosted demands for this aggregate. M1 velocity continued the upward trend that resumed in 1987, increasing in the first three quarters before turning down in the fourth quarter of 1989.
The shift of deposits from thrift institutions to commercial banks and money fund shares owed, in part, to regulatory pressures that brought down rates paid by some excessively aggressive thrift institutions. Beginning in August, the newly created Resolution Trust Corporation (RTC) targeted some of its funds to pay down high-cost deposits at intervened thrift institutions and began a program of closing insolvent thrift institutions and selling their deposits to other institutions--for the most part, banks. On balance, the weak growth of retail deposits at thrift institutions appears to have been about offset by the shift into commercial banks and money market mutual funds, leaving M2 little affected overall by the realignment of the thrift industry.
M3 was largely driven, as usual, by the funding needs of banks and thrift institutions; under the special circumstances of the restructuring of the thrift industry, it was a less reliable barometer of monetary policy pressures than is normally the case. After expanding 6 1/4 percent in 1988, M3 hugged the lower bound of its 3 1/2 to 7 1/2 percent target cone in 1989, closing the year about 3 1/4 percent above its fourth quarter of 1988 base. In 1989, bank credit growth about matched the previous year's 7 1/2 percent increase, but credit at thrift institutions is estimated to have contracted a bit on balance over the year, in contrast to its 6 1/4 percent growth in 1988. This weakness in thrift credit directly owed to asset shrinkage at savings and loan institutions insured by the Savings Association Insurance Fund; credit unions and mutual savings banks expanded their balance sheets in 1989. In addition, funds paid out by the RTC to thrift institutions and to banks acquiring thrift deposits directly substituted for other sources of funds. As a result, thrift institutions lessened their reliance on managed liabilities, as evidenced by the decline of 14 3/4 percent over the year in the sum of large time deposits and repurchase agreements at thrift institutions. Institution-only money market mutual funds were bolstered by a relative yield advantage, as fund returns lagged behind declining market interest rates in the second half of the year; these funds provided the major source of growth for the non-M2 component of M3. On balance, the effects of the thrift restructuring dominated the movements in M3, and the rebound in M2 in the second half of the year did not show through to this broader aggregate. As a consequence, the velocity of M3 increased 3 percent in 1989, 1 1/4 percentage points faster than the growth in M2 velocity, and its largest annual increase in twenty years.
Many of the assets shed by thrift institutions were mortgages and mortgage-backed securities, but this appears to have had little sustained effect on home mortgage cost and availability. The spread between the rate on primary fixed-rate mortgages and the rate on ten-year Treasury notes rose somewhat early in the year, but thereafter remained relatively stable. The share of mortgages held in securitized from again climbed in 1989, facilitating the tapping of a base of investors. Diversified lenders, acting in part through other intermediaries, such as federally sponsored agencies, mostly filled the gap left by the thrift institutions. However, some shrinkage of credit available for acquisition, development, and construction appeard to follow from limits imposed by the FIRREA on loans by thrift institutions to single borrowers, though the reduction in funds available for these purposed probably also reflected problems in some residential real estate markets.
Aggregate debt of the domestic nonfinancial sectors grew at a fairly steady pace over 1989, averaging 8 percent, which placed it near the midpoint of its monitoring range of 6 1/2 to 10 1/2 percent. Although the annual growth of debt slowed in 1989, as it had during the preceding two years, it still exceeded the 6 1/2 percent growth of nominal GNP. Federal sector debt grew 7 1/2 percent, about 1/2 percentage point below the 1988 increase--and the lowest rate of expansion in a decade--as the deficit leveled off. Debt growth outside the federal sector eased by more to average 8 1/4 percent, mostly because of a decline in the growth of household debt. Mortgage credit slowed in line with the reduced pace of housing activity, and consumer credit growth, though volatile from month to month, trended down through much of the year. The growth of nonfinancial business debt slipped further below the extremely rapid rates of the mid-1980s. Corporate restructuring continued to be a major factor buoying business borrowing, although such activity showed distinct signs of slowing late in the year as lenders became more cautious and the use of debt to require equity ebbed.
The second half of 1989 was marked by the troubling deterioration in indicators of financial stress among certain classes of borrowers, with implications for the profitability of lenders, including commercial banks. In the third quarter, several measures of loan delinquency rates either rose sharply or continued on an uptrend. Delinquency rates on closed-end consumer loans at commercial banks and auto loans at "captive" auto finance companies were close to historically high levels. At commercial banks as a whole in 1989, both delinquency and charge-off rates for real estate loans were little changed from the previous year. Still, problem real estate loans continued to be a drag on the profitability of banks in Texas, Oklahoma, and Louisiana; in the second half, such loans emerged as a serious problem for banks in New England. On the other hand, smaller, agriculturally oriented banks continued to recover from the distressed conditions of the mid-1980s. Since 1987, agricultural banks have charged off loans at well below the national rate, and their nonperforming assets represented a smaller portion of their loans than that for the country as a whole.
The upswing in the profitability of insured commercial banks that began in 1988 only extended through the first half of 1989. A slowing in the buildup of loan loss provisions, along with improvements in interest rate margins, contributed to these gains, with the money center banks showing the sharpest turnaround. Information for the second half of 1989, although still incomplete, clearly points to an erosion of these profit gains, in part, because of problems in the quality of loans. Several money center banks sharply boosted their loss provisions on loans to developing countries, while evidence of rising delinquency rates on real estate and consumer loans suggested more widespread weakening. Despite these developments, the spread of rates on bank liabilities, certificates of deposit, and Eurodollar deposits, over comparable Treasury bill rates narrowed early in 1990. [Tabular Data 1 to 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:||submitted February 20, 1990, pursuant to the Full Employment and Balanced Growth Act of 1978|
|Publication:||Federal Reserve Bulletin|
|Date:||Mar 1, 1990|
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